Irish Diversion
Monday, January 23, 2012 | Charles Marohn This week I had planned to finish up the traditional neighborhood versus suburban development discussion we've been hashing over here all month. I spent an inordinate amount of time last week tending to my primary obligation -- my family -- and had to spend the weekend getting caught up on everything I'd missed. I don't want to short change this topic so I'm putting it off slightly. Check back later in the week.
In the meantime, I wanted to share a video exchange between a reporter and an ECB official regarding Ireland and it's obligations to pay back bondholders. This needs a little bit of setup, and for that I'm going to turn to Michael Lewis, knowledge I picked up from his book Boomerang: Travels in the New Third World, and a piece he wrote on Ireland in Vanity Fair.
The first paragraph of the Vanity Fair piece sets the table perfectly:
When I flew to Dublin in early November, the Irish government was busy helping the Irish people come to terms with their loss. It had been two years since a handful of Irish politicians and bankers decided to guarantee all the debts of the country’s biggest banks, but the people were only now getting their minds around what that meant for them. The numbers were breathtaking. A single bank, Anglo Irish, which, two years before, the Irish government had claimed was merely suffering from a “liquidity problem,” faced losses of up to 34 billion euros. To get some sense of how “34 billion euros” sounds to Irish ears, an American thinking in dollars needs to multiply it by roughly one hundred: $3.4 trillion. And that was for a single bank. As the sum total of loans made by Anglo Irish, most of it to Irish property developers, was only 72 billion euros, the bank had lost nearly half of every dollar it invested.
He describes in Boomerang exactly what happened. As the cheap credit was flowing, banks in Ireland took on enormous amounts of borrowed money to loan out, largely to Irish citizens who themselves were getting rich in housing and real estate development. When the artificial housing bubble burst and property values started to decline, these banks went from being illiquid (lacking cash to fund operations) to being insolvent (having more debt than assets) very quickly.
To understand what happened next, it is important to understand who these Irish banks owed money to. Much like our banks here in the United States, the money they were playing with was private money. Shareholders (of which the country of Ireland was a significant one), investors, pension funds, etc... In other words; private investors. Some were senior bondholders that would be paid first and some were subordinate, meaning they were the first to take losses.
And losses they should have taken. But they didn't. Unlike their neighbors in Iceland, which let their banks fail and re-established a reality-based banking system, the Irish government bailed out their banks. All of them. Nobody took losses, even those with subdominant (very risky) debt. All of these massive liabilities -- something like 35% of GDP -- became the government's.
And where did the government get the money? They are in the Euro and so, unlike the United States, they can't simply print the money to essentially tax everyone by diminishing the currency's purchasing power. The Irish government had to borrow the money from the banks. Not Irish banks -- that would have been absolutely ridiculous -- but from German banks, French banks, etc...
This shell game was done to "save" the financial system. Interesting thing happened though. After turnng the private debt into public debt by borrowing from the private sector, the financial system promptly turned on Ireland. Since the country now had such high debt levels, they were a higher risk for default. A higher risk for default means a higher interest rate and higher borrowing costs. Higher borrowing costs makes them a higher risk for default. And on and on and on.
To be protected from default, Ireland needed a bailout. They needed the International Monetary Fund (IMF) and the European Central Bank (ECB) to come in and buy their debt from the private sector, thus removing the private sector and making a high percentage of the resulting debt public. This stabilized interest rates.
Now that things are stable, the Irish people can go about the decades long process of austerity and stagnation necessary to service this enormous debt. What started with crazy lending by a handful of Irish banks has become the indentured servitude of the Irish people to German banks and the European Union, the latter an institution that was supposed to help create prosperity in Ireland.
I guess it is the kind of prosperity you get from a credit card binge at Walmart. The cheap junk all breaks before the bill is even paid off and the only ones truly richer are the Walmart execs and the Chinese.
Now here's the video I started with. What you are going to see is an Irish report named Vincent Browne ask ECB official Klaus Masuch (country of origin unknown to me, but the undertone of nationalism creeps in the conversation ever so slightly). His question: Explain to the average Irish citizen why this debt should be paid, why Ireland shouldn't just default.
Incidentally, this isn't a question just for taxi drivers and curmudgeon reporters but one that is being asked at the highest levels of finance.
And it isn't a question that is ultimately going to be asked only in Ireland either.
One other thing to point out here. The cheap money high started when Ireland began using the Euro in 2002. Check out the following graph of Irish GDP. Project out the pre-2002 growth trend and compare it to what actually happened. I'm not suggesting that is a rigorous economic analysis, but one has to ask how much of the underlying bubble has yet to burst. Who knows -- I certainly don't -- but it is clear that the system has been divorced from sound economics for some time.
The brilliance of Jared Diamond's incredible book Collapse: How societies Choose to Fail or Succeed, is how he studies complex systems by examining natural experiments in history to identify commonalities and trends. Michael Lewis has done for national finance what Jared Diamond did for anthropology. His verdict for larger systems that continue the present course is no less damning.
If you find this material interesting and would like to know more about how to apply this thinking to your community, join us at the Strong Towns Network, a social enterprise for those working to implement a Strong Towns approach.
Reader Comments (8)
I guess it is the kind of prosperity you get from a credit card binge at Walmart. The cheap junk all breaks before the bill is even paid off and the only ones truly richer are the Walmart execs and the Chinese.
This is the most useful metaphor I've heard to help people understand what's happening/happened. I will use it frequently. Thanks!
Ok... I try to follow and understand the economic issues that Europe and the world are dealing with, but so much of it seems over my head. So let me try to clarify for myself here, if you don't mind me asking...
Is the issue debate here about whether Ireland defaults on the loans? And if that happens, the ECM (which is essentially Germany and France?) don't get their money, and might go bankrupt too? Which means then at Germany and France's economies are exposed? And if Germany and France collapse, the whole European Union could crumble?
Do I have that right, or am I looking at it too simply?
If I have this straight, the reason the US, Ireland, Greece, Italy, and everyone else props. up failing banks is that they are worried about liquidity. If the banks fail and stop lending money, the gears of the economy will seize up?
I have read about Iceland's situation, but don't know where it was that they allowed the banks to fail. I believe it might have been before the IMF, Iceland, and other countries attempted to inject capital into the failing banks. The people of Iceland seemed to imply that they wouldn't undergo austerity measures to pay for something that is a private sectors problem. This resulted in losses for those who had investments vehicles in those banks that failed. Many citizens of other countries had money (large sums of money that vanished mind you) in Iceland's banks, hence some of the international communities disdain for the path Iceland has taken. I applaud their decision. There is no way in hell an Icelander should be paying someone (foreign or otherwise) for a bad investment decision.
What I keep thinking about is in the United States experience in 2007/8, had they allowed the most egregious offenders of the banking crisis (Goldman Sachs, BOA, Citigroup) to fail, but capitalized a new bank(s) that would be sold off after the crisis was stabilized, what would be the financial repercussions? Anyone with investments in GS, BOA, Citi. would be up a creek. That includes municipal/state/corporate pension plans, etc., so a lot of people would be hurting and that obviously would be bad for many people. I suppose it is a lesson in sustainability that can be tied into towns...and that you shouldn't put all your eggs in the same financial basket, just as a town has to have a diverse economy to weather a changing economic landscape. You can't just be a manufacturing town, retail mecca or a college town, you should diversify.
Regarding the newly capitalized banks, those would be spun off to the market and sold as an IPO, so the Treasury would recoup the money 'printed' to start them. We bailed out the banks with printed money too mind you......just as long as that money was removed from the economy after it was recouped.
The way things worked out, it seems we rewarded failure, greed and 'too big to fail'. Iceland is the one place that really learned a lesson here, with Ireland, Greece, the US, and others destined to meet this failure again as they continue to prop. up a system that has no business succeeding on borrowed (read magically created) money.
George -- Yeah, you've got it, but let me elaborate slightly.
Here is how these bailouts work. The ECB bailout fund is given a sum, say $200 billion, by the governments of the EU. With the $200B, they then go and borrow $800B to make a total fund of $1 trillion. They then used that money to buy $1T worth of government debt from countries like Ireland, Greece, Portugal, Spain and Italy.
If this leveraged, house-of-cards, fund loses 20% of its value, it's done. That is all of the equity. There will be massive losses everywhere and there will be a world of hurt, as you describe.
Once you get that, you can see how ridiculous this situation is. If a bank like Lehman, which was levered 40 to 1, has just 2.5% of their investments go bad, their entire equity is wiped out and they are done. Today you not only have banks in this leveraged position but the bailout funds and individual countries. The idea of a default -- or worse, widespread public sentiment in support of a default -- scares the heck out of everyone. There's no buffer.
Which is why they keep giving Greece money despite the craziness of their situation. It is all about keeping the balloon in the air.
-chuck
@Scott,
I think what you propose would have worked better than what we did. That having been said, if it ultimately resulted in a few players with immense power and control, the situation would simply have repeated itself. It is not the corruption and greed of this particular batch of bankers, it is the system that creates this. I think the ultimate answer lies in a simpler system that focuses on resiliency, not growth.
-chuck
Chuck...understood your position regarding a system-wide failure that is based on a market that is ever increasing at unsustainable rates of return based on a "ponzi" scheme, however since we (begrudgingly, the "free" market based world) seems so opposed to the notion of regulating our financial sector, that instead of rewarding it with bailouts, that it would become self regulating because failure would have consequences for those who participated in the ponzi scheme at all levels. Pension programs would make different decisions about how to wisely invest pensioners monies in a world where no one comes to the rescue. If no one is there to save you, would you think twice about derivative based securities as a financial investment vehicle? Probably not!
What we (in the US and much of Europe) have now is the worst of both world. We haven't made any headway in the throttling back of unsustained growth through intelligent regulation, and have only encouraged that unsustainable system by rewarding it with a bailout. Although I am not sure how much regulation Iceland has introduced following their banking sector failures, they at least didn't reward the failure of a system that was rife with corruption and greed with the likes of a "keep going, everything is fine" card.
Scott
errr....end of 1st paragraph.....you would think twice about these types of investments......got my euphemism all screwed up.
@Scott, I see your point, but I believe that it doesn't deal with the problem of asymmetry. Consider the following:
Year Company Profit Executive Bonus Shareholder Value
1 $1,000,000,000 $50,000,000 $0.10
2 $1,050,000,000 $52,500,000 $0.11
3 $1,102,500,000 $55,125,000 $0.11
4 $1,157,625,000 $57,881,250 $0.12
5 $1,215,506,250 $60,775,313 $0.12
6 $1,276,281,563 $63,814,078 $0.13
7 $1,340,095,641 $67,004,782 $0.13
8 $1,407,100,423 $70,355,021 $0.14
9 $1,477,455,444 $73,872,772 $0.15
10 $(15,000,000,000) $0 $(1.50)
TOTALS $(3,973,435,680) $551,328,216 $(0.40)
So for each of the first nine years, everyone makes money and the executive gets a nice bonus. A "stable", 5% rate of growth is realized year to year. Then the whole system blows up. The shareholders lose their money and all their gains while the company folds. But your executives walk away with half a billion in compensation.
I agree with you that, absent real financial reform, we have a mess. Your approach would be better than what we have. But unless we solve this asymmetry of results and stop allowing executives at too-big-to-fail institutions to essentially hold us all financially hostage for their own gain, we are just going to be dancing around the problem.
And by the way -- I am a capitalist, free market, low regulation guy. What is going on today on Wall Street is not free market capitalism.
-chuck