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WHY IRELAND MAY DEFAULT ON DEBTS, AND WHAT TO DO NEXT

The Irish government's response to the banking meltdown has increased the likelihood of Ireland defaulting on

its debts, Richard Douthwaite argues, to the point of inevitability - a crisis that may only ease with the introduction

of a new currency.

Can Ireland avoid a default? Coming up with an

answer is complicated by the fact that debt

counsellors always have trouble getting their

clients to admit the full extent and seriousness

of their situation and countries are no differ-

ent.

For example, it was revealed in mid-February

that the Greek government had paid two Wall

Street firms, Goldman Sachs and Morgan Stan-

ley, to help it keep a lot of its borrowing off its

books soit

could circumvent EU rules. Our gov-ernment is no better. It has set up a "special

purpose vehicle" so that the billions that Nama

will borrow won't be treated as part of the na.

tional debt although, of course, it actually is.

More seriously, the Irish government has re-

fused to regard as part of its own debt the

debts it took on when it guaranteed the banks.

BNP Paribas figures show that the bank guar-

antees amount to (480 billion, equivalent to

244% of our national income. If you add in the

amount the state owes directly, over (77bn

and rising every second (the national debt

clock at http://www.financedublin.com/debt-

c1ock.php is truly frightening), the total debt

for which the government is responsible comes

to just under three times the nation's income.

The huge chunk of national income required to

service this 557bn debt has either to be

earned by the banks or collected in taxes. If the

banks make losses - as they will continue to do

for several years until the mess left by the

property bubble is cleared up - the govern-ment will not only have to cover any interest

shortfall but borrow more itself to replace their

missing capitaL This extra borrowing obviously

adds to the country's interest bill the following

year, making the situation worse.

As a result, it is impossible for the country to

support its current level of debt. A quick-and-

dirty calculation shows why. If the average in-

terest rate at which the government and the

guaranteed banks are borrowing is around 4%

and three times national income has been bor-

rowed, roughly 12% of the country's income

gets swallowed up in interest payments. This

percentage would go up if the interest rate

rose, of course. Such a rise is likely because,

whatever happens to international rates,we

can expect lenders to become increasinglyreo

luctant to put money into an over-extended

country.

A game Ireland can't win

It's a game the state can't win. last year,the

National Treasury Management Agencypaid

2.5bn, equivalent to 7.7% of the state'stolal

tax revenue, in interest on the (then) (75bn

national debt. If that same low interest rate

(3.3%) applied to the whole SS7bn,(Therate

at which the country was borrowing at the end

of February was about 4.6%) about 57%of all

taxes would be required - provided the tax.

take stayed the same, But of course it would.

n't. If the government introduced spending

cuts sufficient to enable it to pay over halfits

income to its creditors, the total tax revenue

would collapse.

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(below) Such is its inter the area that Goldman Sachs chief operating officer, Gary Cohn - pic-

tured here at the 'Mana 9 Global Risks' session at the World Economic Forum meeting in Davas.

in January 2009 has visited A 'ce since November to pitch debt products. and has met the

Greek pnme minister, George Pa eoUj (above) a map ofEurope published in the Financial Times

in Fttbruary ows ho highly inv "Kl Ireland is in the government's bank rescue packages

An inflation could happen this way. When the .

There are two problems with this. One is that,

if the money was only given to states with se-

vere debt problems, the "moral hazard" argument

would be raised by the financially-cautious

ones excluded from the distribution. "The re-

cipients are being rewarded for their profli-gacy" they would say. A solution might be to

allocate the money on the basis of population

- so much per head. However, to be effective,

this would require such large sums of money

to be created and distributed that it would

raise fears of inflation.

So I expect several miserable months of in-

creasing difficulty to pass until, all of a sudden,

something happens which means that the Na-

tional Treasury Management Agency is unable

to sell new bonds to raise the money it needs

to repay ones that are about to mature and Ire-

land will default.

With a much reduced tax take, the government

will be unable to reduce its borrowing despite

its recruitment embargoes and harsh spending

cuts. Its higher social welfare bills and the cost

of recapitalising the banks and meeting Nama's

needs will see to that. Potential lenders will see

what's going on and demand an increased rate

of interest on their money. This will make the

state's position worse and require it to borrow

more.

My view is that this country's economic life will

carry on breaking down month by month. Do-

mestic demand will continue to shrivel as a re-

sult of wage reductions, higher taxes and the

public's reluctance to spend because of the

high level of uncertainty and the cancellation

of state and private projects. With their mar-

kets slipping away, more companies will col-

lapse under the weight of their debts. Figures

released by ICC Information in February show

that 21% of trading companies already have a

'negative net worth'. In other words, their bal-

ance sheet liabilities exceed the value of their

assets. Their collapse will throw thousands out

of work and many more mortgage holders into

arrears. The banks will suffer huge losses as

their bad debts mount and will need billions

more in state support.

Those still in work will save all they can to build

themselves a safety cushion. This will starve

the economy of its monetary life-blood as the

banks which take in their savings will be unable

or unwilling to lend the money on.

Two possible ways out

Short of a massive increase in exports and for-eign inward investment, only two unlikely

events can prevent this. One is that the Euro-

pean Central Bank abandons its orthodoxy and

uses quantitative easing to create money out

of nothing and gives it to eurozone govern-

ments to enable them to payoff a significant

proportion of their debts.

too - the USdebt is 390% of its GOP,for exam-

ple - their recoveries will also be squashed by

their higher energy bills. The world economy

will never again have a period of rapid growth

which is long enough for us to get our foreign

debts down to a manageable level.

(373.6)_

I can't buy this scenario. If the world economy

begins to grow again, the demand for energy

will rise. As a result of inadequate investment

in developing new supplies, this will push up

the price Ireland has to pay to import its fuel,

and the payments would compete for the

euros we require to meet our interest bill.

Moreover, as Ireland's best export customers

and sources of investment are highly indebted

would see that the tide had turned and con-

tinue to support the country. The risk of de-

fault would recede.

country. Some of this money would find its way

into the government's tax coffers. Its bill for un-

employment payments would be cut, and,

with more money about, the banks would do

better and present the state with lower bills for

their bad debts. In short, the government

would not have to borrow so much. lenders

. . . . . . . . " " " ' "

8.0%

(4.0)

s

1.00/0(5.6)

5.9%(27.3)

14.7%(33.5)

Government rescue packages for banks

IrJCludt5, capital qectl( ll l$. as5l' t buying

and guarantH'S OIl debt ISSlJaI"ICe.Exdudes deposit guarantH'S

The government hopes that, if the global econ-

omy recovers, a surge in demand for Irish ex-

ports and an increase in foreign investment will

save the situation by bringing money into the

the country or, to put it another way, ten times

our gross domestic product. This compares

with 1,671bn at the end of 2008 and a mere

{S04bn at the end of 2002. According to IMF

data, even at the end of 2007 Ireland was the

most heavily indebted country in the devel-

oped world in terms of the ratio of private sec-

tor, household and corporate debt to GOP.

If this argument isn't enough to convince you

that a default is unavoidable, consider this: the

joint World Bank/IMF/BIS database figure for

this country's total external debt shows that at

the end of last September, Ireland owed

$2,397bn to the rest of the world. That's about

$600,000 for each man, woman and child in

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While David McVVillianlfl(abova) baa proposed that w leave th uro, others such as Prof Chari

Goodhart (below), of th. London School of Economics, point out that this would cause an immed.i.

ate banking cruds; (p77) If Ireland defaults, anything valuabl. with a government connection could

be seized such as Aer lingus plan.s landing In other countries

institutions which had lent money to eurozone

governments got it back, they would want to

lend it out again. Most probably, they would

have to do so outside the eurozone because,

thanks to the ECB,the governments within it

would no longer be looking for loans. The in-

stitutions would sell their euros for foreign ex-

change. This would push the value of the euro

down, restoring the competitiveness the zone

has lost since a euro was worth less than a dol-

lar. The zone's exports would boom and im-

ports would fall as they would become more

expensive. The increased exports and lower

imports would boost the zone's manufactur-

ers' order books. Employment would rise.

Very probably, the effect on wages and prices

would be limited as there's a lot of unemploy-

ment and spare industrial capacity. However,

if the extra demand did cause a significant in-

flation, it would be a very good thing as, by

raising their wages, it would make it easier for

people to service their debts. Businesses

would also be helped because their debt bur-

den would be lowered in real terms. As a re-

sult, Irish banks would find that they had fewer

bad debts and needed less support from the

state, which itself would have additional tax

revenue, reduced social welfare costs and a

lower interest bill because of its lower debt.

All in all, a very positive scenario but one which

won't happen because of the widespread feel-

ing that it is somehow improper to create

money and give it away. Instead, the ECB is

likely to offer loans to hard-pressed govern-

ments to enable them to stagger on but, as

these countries already owe massive amounts

of money, the new loans won't solve the prob-

lem at all.

The other unlikely event which might rescue

Ireland would be Germany leaving the euro-

zone itself in order to avoid having to use bil-

lions of its taxpayers' money to bail out the

PIIGS - Portugal, Ireland, Italy, Greece and

Spain - or Club O'Med as they are beginning to

be called. The main proponent of this idea

seems to be Ambrose Evans-Pritchard of The

Daily Telegraph, the doomiest economic writer

I know. He writes that the departure of Germany,

Holland and a few others would bequeath "thelegal carcass of EMU to the Club Med bloc.

"This is the only break-up scenario that makes

much sense," he continues. "A German exit

would allow Club Med to uphold contracts in

euros and devalue with least havoc to internal

debt markets. The German bloc would enjoy a

windfall gain. The D-Mark II would be stronger.

Borrowing costs would fall. The North-South

gap in competitiveness could be bridged with

less disruption for both sides."

What happens when Ireland defaults?

One cannot predict exactly what will happenwhen Ireland defaults because the money sys-

tem depends on confidence and it's not clear

how much of that would be lost. My view is

that Bank of Ireland and AlB will quickly find

themselves defaulting too because the state

guarantee would become valueless and they

would become unable to borrow. A lot of im-

ports would then be stopped because overseas

banks would refuse to honour letters of credit

from the two banks.

The non-guaranteed banks would anticipate

this and refuse to credit their customers with

payments made by anyone with an account in

a guaranteed bank. As this embargo would in-

clude the state, social welfare payments and

public sector wage cheques would be kept in

limbo until new guarantees or some other sort

of confidence-building measure had been put

into place. The defaulting banks are likely to be

given away with the promise of a tax-funded

dowry to international banks with solid repu-

tations, and an international organisation,

probably the IMF, will probably move in and

guarantee government payments.

Unfortunately, while the takeover of the two

big banks and the hand-over of the economic

management of the country to the IMF would

allow economic life to struggle on, it would not

solve the underlying problem, because the

country's debts, public, corporate and per-

sonal, would be unaffected. If a country with

its own currency defaults, it normally devalues

its currency both to improve its competitive-

ness and allow space for an inflation to bring

incomes more in line with domestic debt levels

and excessive asset values. It also negotiates

with its creditors to write down the value of its

foreign debts. Ireland can neither devalue nor

renegotiate its debts as it is trapped in the euro

system, which lacks both an escape route and

a rescue mechanism.

So the nightmare would go on. In the absence

of the collective debt write-down and inflation

that a devaluation provides, the only way that

the private debt burden can be lifted is by in-

dividuals and companies going bankrupt and

having most of their debts written off. Their as-

sets would be sold at very low prices since no-

one would be willing to pay much in the throes

of an economic collapse. After a decade or

more of misery, the individually-negotiated

write-downs would return the total debt-to-

national-income ratio to a supportable level at

which asset values might be a tenth of their

level today.

The country would be wrecked by this process.

Education and health care would suffer savage ~

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cuts. If it survived, the social welfare system

would be a shadow of its current self and the

brightest and best of the population would

leave for pastures new. Many buildings would

be abandoned and others would fall into dis-

repair since no one would be able to afford to

maintain them. Some rail lines would close and

many local roads would be barely usable.

Before that stage was reached, however, there

would be massive demonstrations demanding

new solutions. What might these solutions be?

One, which has already been proposed by

David McWilliams and others is that we leave

the euro. That's not easily done. It's not just a

matter of printing new Irish pound notes and

minting coins. As Professor Charles Goodhart

of the london School of Economics and Dim-

itrios Tsomocos of Oxford University pointed

out in the Financial Times recently, no country

can sensibly plan to leave the eurozone, be.

cause "any sniff of thinking about that would

cause an immediate banking crisis:'

Moreover, Ireland's existing debts are denom-

inated in euros and any attempt to renege on

those would probably result in the seizure of

the country's assets abroad. Remember that

Britain used anti-terrorist legislation to seize

Icelandic assets when that country defaulted.

Anything valuable with an Irish government

connection could conceivably be seized to use

as a bargaining chip. Aer lingus planes could

be impounded when they touched down al-

most anywhere abroad.

The least bad domestic option

The Goodhart/ Tsomocos prescription for Ire-land would be that the government should

issue a new currency, (let's call it the punt), and

use it for public sector wages and social wei.

fare payments. It would pass a law making its

new money acceptable for all internal pay.

ments between Irish residents, but not for any

external payments between Irish residents and

those living abroad. Taxes would be the only

payments within the country for which punts

could not be used.

On the day that the new money was in-

troduced (and it would have to be

done with great secrecy) our

bank balances in Irish banks

on the one hand and our

outstanding loans to

them on the other

would be switched

to punts on a one

euro equals one punt

basis. Rents, private

sector wages interest and

loanrepaymentsto Irishresidents

would then be made in punts.

However, loans from and deposits

in foreign banks would stay in euros

and anyone who had borrowed from one

of them would still have their euro debt.

Because taxes would still be paid in euros, the

government would get a lot of them in. I t

would transfer these to the Central Bank and

ask it to manage the punt/euro exchange rate

so that it eventually stabilised at a level that

represented, say, a 25% internal devaluation.

This target figure would limit the number of

punts that the government could spend into use.

As Goodhart and Tsomocos point out, all ex-

ternal monetary relationships, including inter.

est payments, would remain unchanged so

no-one overseas would be upset by what had

happened. All internal price/wage relativities

and tax rates would remain unchanged but the

enhanced activity would raise government rev-enue, and there would be a reduction, as

measured in euros, in the state's interest,

wages and social welfare bill for payments to

Irish residents.

"It would be messy, and an unattractive dual

currency mechanism," Goodhart and Tsomo-

cos write, without mentioning Ireland specifi-

cally. "But it could work; it has done so before

now in other countries and circumstances. It

might be the least bad option."

My view is that there would be a constitutional

challenge to the re-designation of the moneyin people's bank accounts as punts rather than

euros on the basis that the punts were an in.

ferior currency that was going to decline in

value. But this challenge would come after the

event. Bythe time the Supreme Court's judge-

ment came through, the economy should be

beginning to improve, requiring more punts to

go into circulation to lubricate the higher level

of activity. If so, the government could use some

of them to compensate bank account

holders.

The big advantage of the

new punt would be that,

as i t would not be

borrowed into cir-

culation, it would

not disappear

w hen

debts

have to borrow punts to get them back into

use. The new units would just go round and

round from account to account indefinitely,

making our currency system much better

suited to a no-growth or contracting economy

than it is today. It would not even be necessary

to issue punt notes and coins, at least at first,

as euros would still be in use.

The only problems I can see are that:1. Thegovernment could spend too many

punts into circulation, particularly if

an election was due, and this could

cause an excessive rate of inflation,

just as government-created money

did in Argentina in the 1980s, when

prices rose by over 5,000% in a single

year. However, this danger could be

removed by having an independent

Central Bank tell the state how many

punts it could issue.

2. Our massive external debts would

be unaffected and we would have to

devote a major part of our exportearnings for many years to paying

them off. This would reduce living

standards, of course, but at least we

could have something close to full

employment.

Unfortunately, I can't see any government hav-

ing the guts to adopt this solution. So, if noth-

ing is going to be done at either the European

or the national level, communities will have to

come up with solutions themselves. There's a

lot of interest in community currencies at pres.

ent especially amongst Transition Town Initia-

tives. One transition group, Future Proof

Kilkenny, is working with the city's cham-

ber of commerce and the Mayor's of-

fice on a plan for a debt-free

electronic currency. If this goes

ahead, it will be completely

different from anything

else in the world. I'll

write about it in

the next issue.

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