‘Cementgate’, 29 September 2010—the enduring image of our current crisis. (Irish Times)
Crises can be seen in three separate but overlapping contexts: economic fluctuations (see sidebar opposite), banking and the international context. Before 2008, the role of banks was a major issue in the US from 1929 and more briefly in 1931 in central Europe. If we seek to trace the history of bank failure in Ireland, its modest scale disappoints. The only banking failures that seriously influenced economic activity were in 1733 and 1754–5. We have to go forward to the failure of Munster houses in 1820 for a comparable scenario. After 1820, in the era of joint stock banking, failures occurred in 1836, in 1856 and in 1885.
The most devastating credit failure in history was the collapse in 1720 of the John Law experiment in France. The Scottish adventurer among other things took over the management of the national debt. Coin was to be replaced with paper money. The notes were slow to appear and were far too large for small wholesale and for all retail transactions. Eventually, for a distrustful public, coin was allowed to circulate again beside notes (but as people believed that it would soon be revalued to entice more of it into circulation they hoarded it). There were now two prices—soaring prices in notes and much lower prices for the relatively few who could pay in hard cash. High prices, falling lower incomes and erratic access to means of payment for workers and for bargemen on rivers and carters on roads (two vital categories for the movement of goods) created sheer misery among the ordinary people. A consequence of this chaotic situation, the worst peacetime credit crisis of ancien régime France, was that in public discourse paper money remained a dirty word until the Revolution.
Moral hazard with a vengeance
Bank of Ireland HQ, Baggot Street, Dublin. Following amalgamation in the 1960s, the new confidence of Irish banks was soon reflected in glittering new headquarters buildings, art collections and lavish in-house catering for senior executives and their guests.
Amalgamation of southern Irish banks into two groups in the 1960s, Allied Irish Banks and the Bank of Ireland Group, was prompted by a fear of foreign takeovers if Irish banks remained small. The new confidence was soon reflected in glittering new headquarters buildings, art collections and lavish in-house catering for senior executives and their guests. More damagingly, it also led into diversification, which was beginning to become fashionable in financial circles. The well-intentioned but ill-fated industrial investment by Bank of Ireland in 1977 in Fieldcrest in Kilkenny was the first such instance. More disturbing was what began to take place at AIB with the purchase of the Insurance Corporation of Ireland (ICI) in 1983. ICI was bought in a hurry; it was well known in London for reinsuring doubtful risks (famously telegraph poles in Australia, a risk other houses avoided because of the havoc caused by bush fires). When ICI’s difficulties came to light in late 1984, AIB, fearing the worst, made the case to the Irish authorities that the solvency not only of AIB but of the whole system was at risk. Funds provided by the State (£400 million) were recouped by a levy on insurance policies. The proper course should have been for the State to remain deaf to AIB’s tale of woe and to insist that the costs should be recouped by suspension of AIB dividends for as long as was necessary. At the subsequent general meeting of the bank, the shareholders, instead of firing the directors (who privately had fears of a revolt), applauded them. It was the introduction with a vengeance of moral hazard into the Irish banking world: the loss of $700 million by a rogue currency trader at AIB’s American bank Allfirst, a settlement of €65 million with the Revenue Commissioners in respect of deposit interest retention tax (DIRT) evasion and numerous cases of overcharging (the worst being on foreign exchange transactions over ten years) all followed.
The estimated cost for mending the broken Irish banking system is of the order of €50 billion, though the cost to NAMA (the vehicle for taking toxic assets from banks and disposing of them) will prove less if there is a recovery in property markets. Was there an alternative, or could insurance of bonds have been excluded and the costs reduced? When the crisis was revealed in September 2008 by Anglo-Irish’s cry for help, the proper response should have been to let the run on the bank force it to close its doors—in other words, to fail—and for the State without delay to temporarily nationalise the two biggest banks (AIB and Bank of Ireland) and others to halt a run on the system at large. This would have had the result that the State’s commitment to cover the costs in rescuing banks would be c. €15 billion, with the costs for Anglo-Irish borne mainly by its mostly large-scale and external depositors (small depositors would have been covered by an existing guarantee). Irish politicians have an obsession with the country’s financial good name. But the reality is that investors, always in need of borrowers, have short memories, otherwise financial history would have come to an end very many centuries ago.
Lack of knowledge and lack of political courage
Anglo-Irish was not allowed to fail for two reasons. First, the Department of Finance, the Central Bank and the Regulator, taken by surprise, saw the crisis as one of liquidity (a temporary shortage of cash to meet withdrawals) rather than of insolvency (an ugly gap between a bank’s funds and its obligations to depositors and bondholders). The fortnightly Phoenix, while expressing doubts about the solvency of Anglo-Irish in articles both in 2007 and in January 2008, qualified them on the evidence of the superficial strength of the balance sheet, now known to have been doctored. Second, even had there been better knowledge, this course would have required political courage. The State would have been held responsible for the resulting chaos at Anglo-Irish and the plight of its reckless borrowers, though in reality, dependent as it was on large-scale deposits, their flight had already made it an insolvent bank lending in the main to what were already insolvent developers.
Bankers, in crisis, unscrupulously play up the vulnerability of the system at large (as a means of getting the State to shoulder the costs), and civil servants prove deferential or timid: the story of 1985 repeated in 2008. People desperately want their banking system to work (which explains why over the centuries banking systems have survived at all). Eighteenth-century banks, each with a few hundred customers (who could easily clear out the resources of a bank in a single morning) and hence much more at risk than modern institutions, are instructive in this matter. Assurances from the public authorities and businessmen (i.e. that they were not withdrawing their own moneys) usually halted a panic. No general closure of the banks ever occurred.
Left: The bicycle, along with the alarm clock and box camera, became common in the homes of rural Ireland following the boom of the 1890s/1900s.
Jack Lynch’s spending spree in 1977–9 in a country coming out of recession laid the foundations for the problems of the 1980s, painful ones of indebtedness, fiscal gap and high taxation. Little more than a decade later, the roots of the current crisis were created by property and development incentives, which were kept in place or added to even though the property market overheated. How does it compare with the banking failures in other countries and in our own recent past? There were no bank failures in Ireland in the 1950s or the 1980s (setting aside the AIB dèbâcle in 1985). But in other respects the current crisis does bear comparison with the 1980s. National debt rose to 118% of GDP; it will be 98% and rising at the end of this year. GDP, however, fell little in the 1980s; in 2007–10 it has fallen by 10%, a figure not far short of the 14% fall in Finland in the early 1990s, the worst contraction of GDP in modern times in a developed country. In Sweden in 1992 the State, after a write-down of the value of toxic assets, guaranteeing bank deposits and creditors, effectively took banks over temporarily, and at what proved relatively modest costs. In Ireland the €50 billion bank bailout (at this stage mostly in promissory notes) amounts to slightly more than 30% of GDP—a huge sum, but if spread over, say, ten years it works out at 3% of GDP. In other words, the annual cost for a single year is close to the grand total of 5% of GDP (falling to 2% in the final outcome) in Sweden, 9% and 5% respectively in Finland, or a total cost of 5% of GDP in the United States (though that is unfinished business). The Irish case seems closer to the infamous German war reparations of the 1920s. Total reparations in 1921 (without taking into account later reductions) by modern reckoning would have amounted to an annual 4–7% of GDP.
Fiscal deficit
The German situation was not unmanageable, but the politics of a defeated nation created a corrosive resentment. In Ireland the elephant in the room is the fiscal deficit. Without the current fiscal crisis an annual charge of 3% of GDP could be borne with relative ease (though it would represent every year the sacrifice of more desirable investments). The general government deficit for 2009 is 14.3% of GDP, but even without the injection of €4 billion into Anglo-Irish Bank it would have been a huge 11.7%. Of course, current Irish fiscal debt arose from the almost overnight conversion of reassuring surplus into nightmare large deficit as the property boom and related taxes collapsed. Where indebtedness is financed from domestic resources, countries can tolerate it. Japan’s debt, 200% of GDP, has proved manageable, and incomes have held up well (though the famously egalitarian character of Japanese society has been harmed).
The international context
On the world canvas in recent decades the central feature has been the huge American deficit and the large Chinese surplus largely invested in US government stocks. Imbalances of themselves have a long history, though until the US–Japan nexus of the 1980s and 1990s they were smaller and less global. The first global one, or at least the first imbalance not centred on London, occurred in the 1920s, when the US was a major lender and Germany a major borrower: this interdependence also explains why contagion, economic and financial alike, spread so rapidly across the world after 1929. It requires an effort now to realise how in economic textbooks into the early 1960s the ‘dollar gap’ (persistent excess of exports over imports) was seen as a fact of economic life, and an unchangeable one. It was not, of course. The Vietnam War soon saw to that, and one of the first people to spot the danger of the euro-dollar (dollar accounts for purchases in Europe) was General de Gaulle. In recent times US foreign indebtedness, magnified by a policy of low domestic taxation, left American consumers free to spend on consumer imports, thus contributing to the easy money world-wide of recent years. But a more insidious result was that easy money made bankers’ returns on orthodox investments low and encouraged the creation of more risky investment vehicles. The most disastrous manifestation of that was in the US: high-interest sub-prime mortgages were made marketable by their securitisation for sale to wholesale investors.
Broadly speaking, by historical standards interest rates have been too low and for too long. If American borrowing and Chinese surplus were both smaller (the latter by devoting more resources to raising low incomes at home) the world would have been a safer place in banking terms. If higher rates return—as they will—they will make the world safer for banking but will increase the costs of servicing Irish foreign loans. Though the Irish outlook is gloomy, the lessons of history are that faltering economies can be turned around with a surprising degree of speed. This was the case for Sweden and Finland in the early 1990s, and for Ireland in the transition from the lost 1980s to the Celtic Tiger years (and in the late 1950s too). In the early 1990s, in a world whose prospects were looking up, recovery was relatively rapid. Now, however, the economic outlook is at best uncertain; industrial countries could face the sort of stagnation that Japan experienced in the 1990s and 2000s. Even more disturbingly, a fear of competitive devaluations (to cheapen the price of exports to foreign purchasers) is on the horizon. HI
Louis Cullen is Professor Emeritus of Modern Irish History at Trinity College, Dublin.
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