Ireland’s Blanket Guarantee Supporters: Still Wrong After All These Years

Five years ago, Ireland’s government guaranteed almost all of the debts of six privately-owned banks.  The subsequent bailout of these banks has cost the Irish public over €60 billion with about half of this due to the now-notorious Anglo Irish Bank.

The Cause Of all Our Problems - Anglo Irish Bank

(Photo credit: infomatique)

One might have hoped that those who took the guarantee decision would now express regret. However, politicians from Fianna Fail and the Green Party, the parties then in government, still defend the decision. In continuing this defense, these politicians will undoubtedly now cite the recent article in the Irish Times by former IMF economist Donal Donovan, which claims that the guarantee was the “least worst” (in other words “best”) option available to the government.

Economics can be a tricky business and sometimes the true merits of policies run counter to peoples’ gut feelings. However, if you had thought that a decision to guarantee almost every euro owed by the Irish banks was a reckless one that maximised the subsequent cost to the public, it turns out you’re absolutely right and in this case the contrarian economist is wrong. Donovan’s arguments in favour of the particular guarantee offered by the Irish government ignore widely-understood best practice in crisis management and are based on a flawed understanding of legal issues.

Ireland’s banks were in crisis in September 2008 and there were strong arguments for some form of government intervention to preserve financial stability. Indeed, in the months after the collapse of Lehman Brothers, most European governments offered guarantees of various forms to their banks.

However, with the exception of Denmark, these governments offered guarantees that were far more limited in form than the Irish one.  Specifically, schemes were put in place in the UK, Germany, France, Italy and elsewhere that guaranteed only new bond issues. (See this ECB report for a detailed description). This approach dealt with the problem at hand (banks having difficulties in getting funding) without making the public responsible for the full stock of debt that had been accumulated by their banks.

Most likely, other European governments were aware of the dangers of blanket guarantees. Research from the World Bank and the IMF had repeatedly demonstrated that guarantees of this type resulted in a substantial increase in the costs of banking crises.

While the “new debt only” approach to guarantees was adopted throughout the rest of Europe, it is dismissed out of hand by Donal Donovan who argues that the need to provide guarantees for new funding when existing debt subsequently fell due would have led to the government guaranteeing the same amount of money.   This ignores the reality that the Irish banks had plenty of “locked-in” long-term funding that could not have be pulled at short notice.  For example, as of September 2008, Anglo had €38 billion in liabilities with a maturity over three months (see its annual report).

Even after passing the guarantee, the Irish government knew within three months that Anglo was a rogue institution. So a “new funding only” guarantee would have allowed the government to apply well-understood resolution tools for closing Anglo. Retail deposits (which accounted for less than twenty percent of Anglo’s liabilities) could have been moved on to a new institution and the remaining “bad bank” could have been put into liquidation with unguaranteed creditors taking losses on their investments.

Those who argue that such a resolution would not have been possible should remember that both events have now occurred. Anglo’s deposits were moved to AIB in 2011 and the rest of the bank was put into liquidation this year.  Unfortunately, these actions were taken long after public money had been used to fill almost all the hole in Anglo’s balance sheet. I don’t wish to argue that an earlier application of these resolution tools would have been costless for the Irish public but they would have substantially reduced the burden on the public while maintaining financial stability.

Donovan’s article repeats an argument often rolled out by the last government to defend the form of the guarantee, which is that Irish law would not have allowed for a selective guarantee that covered some liabilities but not senior bonds.

This argument is based on a flawed understanding of debt contracts and the legal basis for guarantees. Contractual clauses for senior bonds that state that they rank equally with other liabilities are only operable in a liquidation. Independent of the outcome of any liquidation, governments are free to provide additional insurance to whichever creditors they choose. If Donovan’s argument was correct, then deposit insurance would be illegal because governments could not single out this class of creditors for special protection. In reality, no such prohibition exists.

The fact that the ECB used their influence in 2010 to convince the Irish government to continue repaying unguaranteed debt is cited by Donovan as a further argument that the blanket guarantee was unavoidable. However, these discussions took place after the Irish government had taken on all of Anglo’s debts which over time became debts to the ECB.  This gave the ECB enormous power over the Irish government in 2010. A limited guarantee in 2008 followed by a quick resolution and liquidation of Anglo would have kept the Irish government out of this precarious situation in the first place.

The final excuse offered for the blanket guarantee – that the government believed the banks had a liquidity problem but not a solvency problem – also lacks merit.

A liquidity problem did not require the guaranteeing of locked-in debts and, in any case, the evidence that the banks were heading towards a serious solvency problem was all around us by September 2008.  Brian Lenihan had already admitted the construction sector had come to a shuddering halt and warnings from economists and journalists such as Morgan Kelly, Alan Ahearne and Richard Curran should have given pause for thought before placing the debts of the banks on the public’s shoulders.

People are perhaps understandably tired at this point of again debating the merits of what happened five years ago. However, the additional debt piled on the public by the guarantee will make a big difference to ordinary Irish people’s lives in the coming years, forcing more fiscal adjustment than would be necessary if there was a lower level of debt.   And Ireland’s issues with problem banks are not necessarily a thing of the past.  A country that won’t learn from its mistakes will be condemned to make them again.

Fianna Fail may well be back in government in Ireland in a couple of years and their continued defence of the blanket guarantee policy increases the chances that such a guarantee could be put in place again.  Donal Donovan’s arguments, however well-meant they may be, do not provide reasonable justification for an approach to banking problems that is unsound, unfair and unnecessarily expensive for the public.

The Anglo Tapes, The Guarantee And Ireland’s Economic Crisis

Probably the biggest economic story in Europe this week has been the release of recorded phone calls from 2008 between executives of the now-notorious Anglo Irish Bank.  Anglo was a recklessly aggressively property development bank with, as the euphemism goes, serious corporate governance issues.  When the bank got into trouble, its liabilities were guaranteed by the Irish government.

The Cause Of all Our Problems - Anglo Irish Bank

(Photo credit: infomatique)

Paying off Anglo’s creditors ended up costing the Irish government over €30 billion, the equivalent of about 20 percent of GDP or about €6500 (or $8500) per person in the country.  The newly-released recordings (from the weeks prior the guarantee decision) show Anglo executives were aware that the bank was undergoing a severe crisis and needed more state financing than they were willing to admit to the public officials.  They also show a fairly contemptuous attitude to these same officials.

The Anglo tapes raise many questions and I’ll return to these questions later. However, for now I want to make a few points about the guarantee decision and the role that it played in Ireland’s economic crisis.

The reaction to the tapes in Ireland has, justifiably, been one of outrage. However, there is also a growing public perception that the fiscal austerity of recent years has largely been the responsibility of a few rogue bankers. I think this perception is incorrect and it would be a mistake for the public to ignore the crucial roles played by a far wider set of economic policy mistakes made by governments they elected.

Here is a new paper I have written titled “Ireland’s Economic Crisis: The Good, the Bad and the Ugly”. One of the points the paper makes is that Ireland would be undergoing a severe fiscal crisis even the state hadn’t spent a cent on its banks.  The public debt-GDP ratio went from 25 percent in 2007 to about 120 percent today while a sovereign wealth fund worth about 20 percent of GDP has largely been wiped out.

Bank-related costs have been about 40 percent of GDP, with about half of that due to Anglo. This means that large fiscal deficits, rather than bank-related costs, have accounted for the majority of the build-up in net debt over the past few years. Even without spending a cent on Anglo, Ireland would have a debt ratio of 100 percent of GDP and a large fiscal deficit.

The additional debt due to bailing out bank creditors certainly played a crucial role in Ireland having to enter an EU-IMF program in 2010. However, while it is easy to blame external bodies for the pain associated with austerity, Ireland’s policy makers have had little choice over the past few years in relation to tax increases and spending cuts.

As I discuss in the paper, Ireland’s fiscal crisis is largely the consequence of the extreme over-concentration of the economy in the years prior to the crisis on the construction sector.  Lax banking regulation allowed an excess supply of credit to fuel a huge housing bubble, construction activity was off the charts and the government relied heavily on revenues from this sector to finance tax cuts and spending increases. Once the bubble popped and the construction sector collapsed, the government was left with a massive loss of revenues and a substantial increase in welfare spending.

Without budget cuts, Ireland was heading for deficits of over 20 percent of GDP in 2009 and even this year, after years of spending cuts and tax increases, the deficit is still over 7 percent of GDP.  Deficits on this scale were not sustainable for a euro area member state, so Ireland would be undergoing austerity today even if the EU and the IMF had never arrived to provide funding.

This point is important because it makes it all the more difficult get the public to accept tax increases or spending cuts when they view these cuts as simply the fault of a group of rogue bankers. This viewpoint also distracts from the rogue economic policy making of elected politicians and senior civil servants.

Worth noting is that this is the second Irish economic crisis of my lifetime. Sometimes, the current era feels like a repeat of my teenage years with fiscal crises and high unemployment blighting the country.  To avoid another future crisis, debate in Ireland needs to move beyond blaming Anglo’s bad eggs towards asking wider questions about how to run their economy on a sustainable basis.

Having made these points, I want to emphasize that I do not at all agree that the bank guarantee was a correct or unavoidable decision, even given what Irish policy makers knew at the time. This is the position put forward by Irish economists, Donal Donovan and Antoin Murphy in an extensive chapter on the guarantee in their new book. (In fact, Donovan and Murphy argue that the guarantee would have been the correct policy even if the authorities knew the true state of the banks so that it would cost 40 percent of GDP!)

This book makes a number of points I disagree with but, since it’s not available for people on the internet to read, there is perhaps little point in going into too much detail here. I will quickly make two observations.

First, the strength of the arguments made by Donovan and Murphy is well summarized by their argument for why it may have been reasonable to include subordinated bank debt in the guarantee.  They argue that

It has been suggested that, given the high degree of uncertainty, if not panic, prevailing, attempts to fine-tune the coverage of the guarantee might not have been well understood by markets the following morning and could have derailed the overriding objective of restoring confidence in the Irish banks.

This is a bizarre argument. For starters, the guarantee was fine-tuned because undated subordinated debt was excluded. However, the idea that financial market participants would have been “confused” that the government failed to guarantee debt that is explicitly contractually required to take losses in the event of a liquidation simply defies belief. I spoke with many financial market professionals in the years after the guarantee and their only reaction to the guaranteeing of subordinated debt was confusion as to why it was included.

More importantly, Donovan and Murphy’s extensive chapter does not consider the most obvious alternative to the type of guarantee offered by the Irish government. This alternative was to guarantee deposits for some period of time as well as specified new bond issues but to leave previous bond issues uncovered.

This ECB paper from 2009 details the emergency measures taken by all EU countries and shows that guaranteeing new bond issues only was the approach taken by almost all countries.  Such a guarantee would have had the exact same impact in providing a (temporary) improvement in the funding situation for Irish banks without unnecessarily guaranteeing the bonds owned by investors who had unwisely given money to a recklessly-run bank.

Anyone who thinks there was no way to tell in “real time” that the guarantee was a bad decision is advised to watch this video of my colleague Morgan Kelly’s instant reaction to the decision. The arguments of the other participants in the debate also give you an idea how weak the case was for making this decision.

So the guarantee decision was a bad one and exacerbated the losses associated with Ireland’s banking crisis. But the austerity being suffered in Ireland has wider causes than the behavior of a few bad apples at Anglo Irish Bank and debate on future policies needs to focus on a wider set of issues than how to deal with rogue bankers.