Morgan Kelly and the Bailout

There are two planks to Morgan Kelly’s “solution” to Ireland’s plight. The first is to eliminate the Budget deficit as quickly as possible. The second, having achieved the first, is to “walk away” from the bailout deal.

I can agree entirely with the first objective. It makes no sense to run deficits, thus raising our debt level by perhaps €40bn or more over the next three or four years, simply to remunerate our public servants and social welfare recipients well in excess of the norm in countries such as the UK, from which we borrow  money and with which we try to compete. There is no way to cut public expenditure substantially without pay and social welfare reductions because these account for about 70% of current expenditure. I remain to be convinced that the Croke Park deal can deliver savings on the enormous scale now required.

The argument that large pay cuts would deal a devastating blow to the economy is overstated since the average level of public sector pay is about €50,000 per annum. This is well above the €30,000 overall average in the economy. Thus reducing incomes of public servants would impact most on discretionary items, such as holidays and cars compared to cuts in lower paid households. Moreover, the expectations of consumers in general have been so adversely affected in the past three years that significant savings have been accumulated. Government action to reduce the deficit quickly would help improve confidence that no further large tax increases were likely and consumers could believe that it was safe to run down savings by consuming more. This would be a vital boost to demand and jobs.

As to the second plank in the Kelly argument that we should “walk away” from the bailout, I have some serious reservations. In practice what would this mean?

He seems to suggest, in relation to the debts of the Bank’s to the ECB, that we should leave the ECB tgo worry about how to retrieve that. The Irish domestic banks are funded by the ECB to the tune of €80bn with a further €50bn lent by the Irish Central Bank. Were Ireland to suggest that this debt would not be repaid, the ECB could take legally take the collateral pledged against these loans. Since the loan extend are only 95% of the collateral the banks would take a €4bn hit on such an exit.  It is thus not possible to “walk away” from the ECB debt. However, were Ireland to take such a step it would be a default, in which case we may as well default on the €190bn of Government debt because access to international loans would be shut.

Morgan Kelly’s solution,  in its most extreme form, would involve leaving the Euro and re-establishing a separate currency. This is no panacea. Domestic control of our currency, interest rates and fiscal policy in the 1980s resulted in devaluation, recession, inflation, and emigration.

If the new Pound at were re-established at, say a one-for-one exchange rate with the Euro, the immediate market response would be a sharp fall in the currency of maybe50% (Iceland). The next stage would be for Inflation to increase dramatically, eroding the purchasing power of wages.   Interest rates would be likely to increase sharply (Iceland 18%) because the outstanding national debt would need to be re-borrowed as the term of the loans expired, (bonds matured.) Interest rates would also be increasing because of rising inflation and a lack of confidence in Ireland’s management of the economy.

The plight of the banks would worsen as deposits would flee the system. The Government’s guarantee to depositors could not be honoured, as it would be impossible for Ireland to borrow abroad in such circumstances to obtain the cash to protect depositors. Exchange controls would have to be re-imposed. The Irish Central Bank would have to print money to keep the banks afloat. The Government’s debt would be redefined as Irish pounds and then eroded by inflation. We would be an old style hyper inflation South American economy

This option would have a profound impact on Ireland’s reputation and place in the world for at least a generation. As a one of the economies in the world most dependent on international business this would be catastrophic. If this extreme case is not to be contemplated, as I believe it should not, is a middle way possible?

The answer must surely be that there is. We cannot walk away from fifty years of the Whitaker philosophy that we compete and co-operate on an international platform. EEC entry and the encouragement on foreign investment helped Ireland step away from protectionism and dependence on our major trading partner, the UK.

We can argue to Europe that by accepting the bailout in advance months in advance of it being absolutely essential, Ireland helped curb contagion in financial markets in the Euro area in December 2010. Therefore Europe owes us something.

We can’t “walk away” but we can negotiate. That is the basis of a good partnership. There is no alternative suitor out there. 

Eunan King

11 May 2011