Learning from Ireland
I love the way that the WSJ today covers the collapse of Ireland’s banking system, and with it the country’s fiscal leadership. There’s little if any actual news here, but that’s a feature, not a bug: it frees up the WSJ‘s writers and editors to present the big-picture narrative in as clear and compelling a manner as possible, without having to overemphasize some small factoid which they happen to be breaking.
The story reads like one of those epic lyric tragedies of old, where no one ever learns from their mistakes, and errors simply compound endlessly. First, the Irish government, convinced that the country’s banks were suffering from a liquidity crisis rather than a banking crisis, decided to solve that problem in the way that only a government can — with a blanket guarantee of substantially all of the banks’ liabilities.
But of course the banks were fundamentally insolvent, and so began a series of cash drains on the government, each one meant to be the last and final. First there was €1.5 billion for Anglo, and €2 billion each for Bank of Ireland and Allied Irish. Then there was another €7 billion for Allied Irish and Bank of Ireland. Then Anglo’s losses reached €20 billion, with another €48 billion “at risk” of default. And where are we now?
The total capital injected into banks by the government so far: €34 billion, with at least another €12 billion on the way. The bailouts mean Ireland will run a government deficit equal to 32% of its gross domestic product, the highest figure ever in any euro-zone country. Skeptics say a still-sinking property market will next sour residential mortgages, inflating the government tab even more.
Yes, this inconceivably enormous bailout tab—32% of GDP would correspond to an annual deficit of $4.7 trillion here in the U.S., or something over $40,000 per household—has been run up on commercial real-estate losses alone. If and when Ireland’s residential mortgages start defaulting, the country is surely toast.
Bankers, auditors, regulators, politicians—all of them made the same mistake, in Ireland, which was to believe the numbers they were being shown. Numbers are like that: once they’re printed and ratified, they become perceived as hard facts, in the way that merely verbal statements never are. If a politician says “our banks are solvent,” that’s a contentious statement; if PricewaterhouseCoopers comes out with a massively overoptimistic take on the strength of Anglo’s loan book, backing up an official-looking report with lots of numbers and institutional authority, people simply believe them implicitly.
One of the authors of the article, Charles Forelle, has a great accompanying blog entry in which he explains that Ireland’s crisis came out of the blue: it wasn’t a slow-moving train wreck like Portugal. And even with hindsight, it would have been incredibly hard for either the Irish government or the European Union to prevent the build-up of bad loans.
That blanket guarantee of banks’ liabilities, of course, was entirely preventable, and in hindsight a very bad idea. While the banks’ smaller depositors deserve to remain whole, their other lenders should have taken much larger haircuts by now. Instead, they’ve been bailed out by Irish taxpayers, which doesn’t seem fair at all. The Irish government is sovereign, of course: it could always unwind that guarantee if it wanted to. But at this point, it’s too late to do that, since unwinding the guarantee would immediately precipitate a massive run for the exits and a monster sovereign collapse.
One of the key lessons we’ve learned in this crisis is that any time a small country takes pride in its large and profitable international banks, everything is liable to end in tears. Big banks are too big to fail, which means their national governments have to bail them out—but when the banks are as big or bigger than the government in question, such a bailout becomes politically and economically disastrous. My feeling is that no government should ever allow its banks to become too big to bail out, because no government can credibly promise not to bail out such banks should they run into difficulties.
If you look down the Financial Stability Board’s list of the top 30 systemically-important financial institutions, there are definitely a few on there which look like they’re too big for a national bailout. The two big Swiss banks certainly are, and possibly the two big Spanish banks, too; then there’s six insurers as well. I have no idea what can be done about this: no one’s going to blunder in and force UBS and Credit Suisse to break themselves up just because they happen to be based in a small Alpine nation. But the lessons of Iceland and Ireland should wear heavily on any government with an oversized financial sector.