Banks must be left fail and bondholders take hit

Passing the referendum on the fiscal treaty has put the Government in a position that is at once both easy and difficult.

The position is easy in that the parameters of fiscal policy are set out for the next number of years. The position is hard in that the implementation of these policies is going to result in wrenching adjustments to all aspects of Irish life. There are two different kinds of adjustments to be made.

Firstly, we are still running a primary deficit — ie government income is less than the sum of spending minus interest payments.

Bringing this into broad balance is going to be a sine qua non for accessing regular market bond financing.

Secondly, we also need to consider the issues facing us from the fiscal treaty.

While any nominal growth emerges and while government net spending does not run out of control, the parameters of the treaty can be met.

In recent months, there has been a slight glimmer of good news for the Government in terms of taxation. Income tax has shown strong growth, up 12% over the year. What is more problematic is that expenditure is still rising, but this is largely driven by health and social welfare.

Small, or even medium increases in expenditure are inherently unlikely to result in a proportional increase in output. The same cannot necessarily be said on the downside — a quality system requires constant high levels of quality inputs, and it is easy for the system to begin to fail with slight reductions in the quality or quantity of inputs.

And the difficulty for the Government will be to shrink expenditure. Despite the tax take rising, unemployment remains high, and the domestic economy has flatlined, as is evident from retail sales and the labour force both shrinking.

Any measured growth in the economy for the next few years will only come from the high-tech, low-job export sector. The future of Ireland, therefore, is crucially dependent on the future of the Europe.

This future is now clearly resting on the shoulders of the ECB, shoulders that are being shrugged as if the crisis was nothing to do with it. Right now, the epicentre of the crisis has moved to Spain. Although Spain has a reasonable debt-GDP level of about 80%, there are concerns about its banks’ losses

It is this, combined with the near certainty that the Spanish taxpayer will end up footing the bill, that has spooked the markets.

Spanish banks may be broke, but the ECB will not allow them to fail. Nor will they allow bondholders to be burned. An Anglo-style promissory note would allow Spanish banks to ease their liquidity problems, as might any euro area lending solution. It would not solve their solvency. So long as the ECB, via its Bundesbank roots, keeps obsessing about inflation, it will not allow itself to take a holistic perspective on price stability.

To solve the euro and Irish crisis will require co-ordinated movements. Banks must be allowed to fail, and senior bondholders must be forced to take losses. The disruption to financial markets that that will cause is less than will be caused if the euro breaks and in any case, the ECB’s insistence on a sovereign-bank linkage has caused untold damage. That will assist in cleaning the Spanish quagmire. Existing bank recapitalisations in Ireland and the bulk of Greek debt should be converted to a long-term low-interest rate loan, on condition that we adhere to good governance standards.

But, above all else, European leaders must make it clear to Germany that mutual adjustment in the eurozone requires both sides to move. This is no longer economics, it is high international politics, a game in which we Irish have little experience or evident competence.

Brian Lucey is associate professor of finance in TCD