In his debut for the ISLO Robert Nielsen goes through the bizarre and tragic nature of the recent “deal” on the Promissory Notes. Robert blogs over here normally.
Whenever discussing the banks people often preface their comments by saying that they don’t know much about economics. It is assumed that the bank bailout only seems absurd due to a lack of economic knowledge, that in actual fact the government is following well-established economic principles. As an economics student, let me tell you that nothing is further from the truth. There is no economic logic or theory behind the government’s actions. If it looks like they are making it up as they go along, that’s because they are.
Sometimes we take out history books and look at strange beliefs and actions of past generations. It seems inexplicable that in the past divorce and homosexuality were illegal or that people could elect Charles Haughey. It baffles the mind. No doubt this is how future generations will view the bank bailout. They will scratch their heads and try and figure out why politicians bankrupted the state for no purpose. They will ask us why it happened and why they have to repay it. I doubt we will be able to answer. So if the bank bailouts don’t make any sense to you, it’s not your fault or ignorance due to lack of economics training. It’s because it doesn’t make any sense.
All of this should put the news about the promissory notes into perspective. The promissory notes are essentially an IOU (promissory comes from the word promise, as in promise to repay). They were formed when it was decided that Anglo Irish Bank needed €30 billion (it is an excellent question why Anglo needs and gets €30 billion, but it’s one that has not been answered), but state didn’t have the money so they used IOUs instead. However, these IOUs are very uncertain notes and it’s not clear what standing they have. So the ECB was pushing for them to be converted into bonds, which are loans that the government has to pay back (the state is the sovereign, hence they are called sovereign bonds). So what happened on Thursday night was that the promissory notes (which we could potentially not pay) were converted into sovereign bonds (which we have to pay). Instead of repaying them over the next 10 years, we won’t have to repay them until 2038 to 2053.
This deal has been described as a good and bad deal and it is either one depending on how you look at it. It is certainly better to pay the debt in the future than right now. We are currently in dire economic straits and are strapped for cash, whereas things will have hopefully improved by then. As each generation is usually richer than the last, we will hopefully be much richer in 30 years and paying back the debt won’t be so difficult. Also inflation will diminish the amount we have to pay (just as £100 isn’t worth as much as it was 30 years ago, it won’t be worth as much in 40 years time). In fact the more inflation we have the easier it will be to repay the debt so inflation is a good thing in this case. However, the ECB is fanatical in its opposition to inflation going to absurd lengths to keep it extremely low. Hence 1-2% inflation (the ECB’s target rate) won’t make that large a dent in the debt.
That is why some economists have welcomed the news. If we have to repay the debt this is the best way to go. Some have said that this is the best deal we could have gotten. The real importance of the deal is not its economic but its political effect. Fine Gael and Labour can now claim they got a deal on the bank debt and didn’t break their promises, so we can now forget the whole thing. The messy task of repaying the debt falls to another government when few if any of the current cabinet will even be alive. Enda Kenny is already trying to spin it is a great stroke that will save €20 billion (it won’t it only delays the payments. In fact it could cost more once interest is added on.)
This leads to the obvious question of do we have to repay the debt? In my three years as an economics student and in all the books I’ve read, I’ve yet to come across a reason why we should. I know of no theorist of any school of thought who has argued that the state should pay the liabilities of a private bank. I know of no precedent of the bank bailout. Even government supporters can’t find a reason, instead they say there is no option, it has to be done, and Europe is forcing them.
Let me tell you how things are supposed to work. In a capitalist economy a bank is set up by private individuals with the hope of making some money. They take a gamble in their action, knowing that they could lose their investment but also knowing that they could gain profits. That is how capitalism works; people take risks in the hope of making gains. They may borrow money from bondholders (the bondholders are simply people who lent money to the banks. We have no idea who they are) There is a risk that bondholders may not be repaid the money they lend so they charge interest to compensate for this and earn a profit. Normally, if they make a bad loan to someone who can’t repay them, they lose the money. Tough, but that’s capitalism.
This is why the bank bailout makes no sense. Instead of the bondholders losing their money when Anglo collapsed, the government guaranteed that they would get all of their money back. So despite making a gamble and losing, they would get all their money back. It was a case of heads I win, tails you lose. No matter what would happen, the bondholders would win. This naturally is bizarre and you may be wondering why anyone would ever do this. Part of this is cronyism, that the politicians have close connections with the banks and are willing to bail their friends out. Part of it is ignorance, that the government had no idea what it was doing when it signed the bank guarantee. Part of it is that it simply doesn’t make sense. However, a crucial role is that of the ECB. Most of the bondholders are probably other banks. If they lose their investment they may go bankrupt causing great economic damage and causing other banks to go bankrupt. This could launch a domino effect that threatens the entire European financial situation.
So that is why the ECB is so insistent that we repay the bondholders and pay the promissory note in full. Surely if the rest of Europe gains from our protection of the bondholders, they should contribute towards the bailout? This is the argument that David McWilliams (who’s definitely no Socialist) makes. He argues that we are in a stronger position than we realise, that the ECB needs us. We should use our bargaining position to get financial help from Europe instead of shouldering the burden alone. Our negotiators should take an if-we-go-down-we’ll-take-you-down-with-us approach. I’m not saying we should blackmail the ECB or hold them ransom, but . . . . it would be better than our current approach. This is what Greece did and they ended up getting a large write down on their debt. This is why the promissory notes deal is so important, that was our last chance to strike a hard bargain.
What would have happened had we not paid the promissory notes? Would the sky have fallen? Would we have been unable to borrow again? Not quite. It would have pissed a lot of people off and made it more difficult, but we would still be able to borrow, for the simple reason Europe needs us. If we can’t borrow then we hit crisis point and worst case scenario, go bankrupt. This means we don’t repay our loans and who lent us the money? The ECB and other European banks. So they would have had to keep lending to us if they wanted their money back and wanted to avoid financial collapse. Some brinkmanship could have completely turned the tables to our advantage.
There is great deal of confusion over the markets and the rate of interest on our borrowing. In a nutshell, the interest rate is the risk that we will not repay the loan. So if the markets think we will default, they will charge a high rate, if they think we’re safe, a low rate. It is argued that if we fail to repay Anglo’s debt, the markets will punish us with an extremely high interest rate that will bankrupt us. However, this misses the crucial point that the interest rate is based on the future not the past. It is the future chance of default that they are concerned with. So if we default on some of our debt, we have less overall to pay and therefore more likely to repay that portion. In fact, I would say the markets are waiting for us to do a partial default of the bank lending. They know Ireland cannot possibly repay the crushing loan and therefore will have to default eventually. This is why we could no longer borrow, because the markets knew we will buckle under the weight of our debt. An examination of the interest rate of sovereign bonds (yes, I know I’m cool) shows a spike after every bailout and recapitalisation. The markets know that the debt is far too large and we cannot pay it. If we drop the bank debt and move to more realistic debt levels we can borrow again. It won’t be easy or painless but it is a hell of a lot better than the current plan.
I’ll finish up here and hope you were able to keep up and weren’t too confused. The one simple fact you should take away is that the debt is too bid. It is a burden we cannot carry, a mountain too tall to climb. If you forced a debt of €1 million onto a student, they couldn’t pay it back. No matter how you fiddled with the interest rate or the repayment schedule, they couldn’t pay you back. It’s too much. The Anglo debt is too large; we cannot pay it no matter how hard we try. Despite the efforts of the ECB and the government we will have to at least partially default. The promissory notes were the last chance to get an easing of the burden that is crushing us. Instead future generations have been forced to promise to pay €30 billion for reasons they will never understand. It is a promise we cannot keep.
Robert Nielsen