WHY IRELAND MAY DEFAULT ON DEBTS, AND WHAT TO DO NEXT
The Irish government's response to the banking meltdown has increased the likelihood of Ireland defaulting on
its debts, Richard Douthwaite argues, to the point of inevitability - a crisis that may only ease with the introduction
of a new currency.
Can Ireland avoid a default? Coming up with an
answer is complicated by the fact that debt
counsellors always have trouble getting their
clients to admit the full extent and seriousness
of their situation and countries are no differ-
ent.
For example, it was revealed in mid-February
that the Greek government had paid two Wall
Street firms, Goldman Sachs and Morgan Stan-
ley, to help it keep a lot of its borrowing off its
books so it could circumvent EU rules. Our gov-
ernment is no better. It has set up a "special
purpose vehicle" so that the billions that Nama
will borrow won't be treated as part of the na.
tional debt although, of course, it actually is.
More seriously, the Irish government has re-
fused to regard as part of its own debt the
debts it took on when it guaranteed the banks.
BNP Paribas figures show that the bank guar-
antees amount to (480 billion, equivalent to
244% of our national income. If you add in the
amount the state owes directly, over (77bn
and rising every second (the national debt
clock at http://www.financedublin.com/debt-
c1ock.php is truly frightening), the total debt
for which the government is responsible comes
to just under three times the nation's income.
The huge chunk of national income required to
service this €557bn debt has either to be
earned by the banks or collected in taxes. If the
banks make losses - as they will continue to do
for several years until the mess left by the
property bubble is cleared up - the govern-
ment will not only have to cover any interest
shortfall but borrow more itself to replace their
missing capitaL This extra borrowing obviously
adds to the country's interest bill the following
year, making the situation worse.
As a result, it is impossible for the country to
support its current level of debt. A quick-and-
dirty calculation shows why. If the average in-
terest rate at which the government and the
guaranteed banks are borrowing is around 4%
and three times national income has been bor-
rowed, roughly 12% of the country's income
gets swallowed up in interest payments. This
percentage would go up if the interest rate
rose, of course. Such a rise is likely because,
whatever happens to international rates, we
can expect lenders to become increasinglyreo
luctant to put money into an over-extended
country.
A game Ireland can't win
It's a game the state can't win. last year,the
National Treasury Management Agency paid
€2.5bn, equivalent to 7.7% of the state's tolal
tax revenue, in interest on the (then) (75bn
national debt. If that same low interest rate
(3.3%) applied to the whole €SS7bn, (Therate
at which the country was borrowing at the end
of February was about 4.6%) about 57%of all
taxes would be required - provided the tax.
take stayed the same, But of course it would.
n't. If the government introduced spending
cuts sufficient to enable it to pay over halfits
income to its creditors, the total tax revenue
would collapse.
 If this argument isn't enough to convince you
that a default is unavoidable, consider this: the
joint World Bank/IMF/BIS database figure for
this country's total external debt shows that at
the end of last September, Ireland owed
$2,397bn to the rest of the world. That's about
$600,000 for each man, woman and child in
Government rescue packages for banks
IrJCludt5, capital qectl(lll$. as5l't buying
and guarantH'S OIl debt ISSlJaI"ICe.
country. Some of this money would find its way
into the government's tax coffers. Its bill for un-
employment payments would be cut, and,
with more money about, the banks would do
better and present the state with lower bills for
their bad debts. In short, the government
would not have to borrow so much. lenders
too - the US debt is 390% of its GOP,for exam-
ple - their recoveries will also be squashed by
their higher energy bills. The world economy
will never again have a period of rapid growth
which is long enough for us to get our foreign
debts down to a manageable level.
My view is that this country's economic life will
carry on breaking down month by month. Do-
mestic demand will continue to shrivel as a re-
sult of wage reductions, higher taxes and the
public's reluctance to spend because of the

•
Exdudes deposit guarantH'S
high level of uncertainty and the cancellation
of state and private projects. With their mar-
kets slipping away, more companies will col-
lapse under the weight of their debts. Figures
released by ICC Information in February show
that 21% of trading companies already have a
'negative net worth'. In other words, their bal-
ance sheet liabilities exceed the value of their
assets. Their collapse will throw thousands out
of work and many more mortgage holders into

•
arrears. The banks will suffer huge losses as
........ """'" (373.6)_ ••••
their bad debts mount and will need billions
5.9% more in state support.
(27.3)
8.0%
Those still in work will save all they can to build
(4.0)
s••••••••••• themselves a safety cushion. This will starve

•
1.00/0
(5.6)
the economy of its monetary life-blood as the
banks which take in their savings will be unable
or unwilling to lend the money on .

14.7%
(33.5)
•• With a much reduced tax take, the government
will be unable to reduce its borrowing despite
its recruitment embargoes and harsh spending
cuts. Its higher social welfare bills and the cost
of recapitalising the banks and meeting Nama's
needs will see to that. Potential lenders will see
what's going on and demand an increased rate
the country or, to put it another way, ten times would see that the tide had turned and con- of interest on their money. This will make the
our gross domestic product. This compares tinue to support the country. The risk of de- state's position worse and require it to borrow
with €1,671bn at the end of 2008 and a mere fault would recede. more.
{S04bn at the end of 2002. According to IMF
data, even at the end of 2007 Ireland was the I can't buy this scenario. If the world economy So I expect several miserable months of in-
most heavily indebted country in the devel- begins to grow again, the demand for energy creasing difficulty to pass until, all of a sudden,
oped world in terms of the ratio of private sec- will rise. As a result of inadequate investment something happens which means that the Na-
tor, household and corporate debt to GOP. in developing new supplies, this will push up tional Treasury Management Agency is unable
the price Ireland has to pay to import its fuel, to sell new bonds to raise the money it needs
The government hopes that, if the global econ- and the payments would compete for the to repay ones that are about to mature and Ire-
omy recovers, a surge in demand for Irish ex- euros we require to meet our interest bill. land will default.
ports and an increase in foreign investment will Moreover, as Ireland's best export customers
save the situation by bringing money into the and sources of investment are highly indebted Two possible ways out
Short of a massive increase in exports and for-
(below) Such is its inter the area that Goldman Sachs chief operating officer, Gary Cohn - pic-
eign inward investment, only two unlikely
tured here at the 'Mana 9 Global Risks' session at the World Economic Forum meeting in Davas.
in January 2009 has visited A 'ce since November to pitch debt products. and has met the events can prevent this. One is that the Euro-
Greek pnme minister, George Pa eoUj (above) a map of Europe published in the Financial Times pean Central Bank abandons its orthodoxy and
in Fttbruary ows ho highly inv "Kl Ireland is in the government's bank rescue packages uses quantitative easing to create money out
of nothing and gives it to eurozone govern-
ments to enable them to payoff a significant
proportion of their debts.

There are two problems with this. One is that,

if the money was only given to states with se-
vere debt problems, the "moral hazard" argument
would be raised by the financially-cautious
ones excluded from the distribution. "The re-
cipients are being rewarded for their profli-
gacy" they would say. A solution might be to
allocate the money on the basis of population
- so much per head. However, to be effective,
this would require such large sums of money
to be created and distributed that it would
raise fears of inflation.

An inflation could happen this way. When the ••.

CI73
institutions which had lent money to eurozone
governments got it back, they would want to
lend it out again. Most probably, they would
have to do so outside the eurozone because,
thanks to the ECB, the governments within it
would no longer be looking for loans. The in-
stitutions would sell their euros for foreign ex-
change. This would push the value of the euro
down, restoring the competitiveness the zone
has lost since a euro was worth less than a dol-
lar. The zone's exports would boom and im-
ports would fall as they would become more
expensive. The increased exports and lower
imports would boost the zone's manufactur-
ers' order books. Employment would rise.

Very probably, the effect on wages and prices

would be limited as there's a lot of unemploy-
ment and spare industrial capacity. However,
if the extra demand did cause a significant in-
flation, it would be a very good thing as, by
raising their wages, it would make it easier for
people to service their debts. Businesses
would also be helped because their debt bur-
den would be lowered in real terms. As a re-
sult, Irish banks would find that they had fewer
bad debts and needed less support from the
state, which itself would have additional tax
revenue, reduced social welfare costs and a
lower interest bill because of its lower debt.
All in all, a very positive scenario but one which
won't happen because of the widespread feel-
ing that it is somehow improper to create
money and give it away. Instead, the ECB is
likely to offer loans to hard-pressed govern-
ments to enable them to stagger on but, as
these countries already owe massive amounts
of money, the new loans won't solve the prob-
lem at all.
The other unlikely event which might rescue
Ireland would be Germany leaving the euro-
zone itself in order to avoid having to use bil-
lions of its taxpayers' money to bail out the
PIIGS - Portugal, Ireland, Italy, Greece and
Spain - or Club O'Med as they are beginning to
be called. The main proponent of this idea
seems to be Ambrose Evans-Pritchard of The
Daily Telegraph, the doomiest economic writer
I know. He writes that the departure of Germany,
Holland and a few others would bequeath "the
legal carcass of EMU to the Club Med bloc.
"This is the only break-up scenario that makes
much sense," he continues. "A German exit
would allow Club Med to uphold contracts in
euros and devalue with least havoc to internal
debt markets. The German bloc would enjoy a
windfall gain. The D-Mark II would be stronger.
Borrowing costs would fall. The North-South
gap in competitiveness could be bridged with
less disruption for both sides."
While David McVVillianlfl(abova) baa proposed that w leave th •• uro, others such as Prof Chari ••
Goodhart (below), of th. London School of Economics, point out that this would cause an immed.i.
ate banking cruds; (p77) If Ireland defaults, anything valuabl. with a government connection could
be seized such as Aer lingus plan.s landing In other countries
from the two banks. ness and allow space for an inflation to bring
incomes more in line with domestic debt levels
The non-guaranteed banks would anticipate and excessive asset values. It also negotiates
this and refuse to credit their customers with with its creditors to write down the value of its
payments made by anyone with an account in foreign debts. Ireland can neither devalue nor
a guaranteed bank. As this embargo would in- renegotiate its debts as it is trapped in the euro
clude the state, social welfare payments and system, which lacks both an escape route and
public sector wage cheques would be kept in a rescue mechanism.
limbo until new guarantees or some other sort
of confidence-building measure had been put So the nightmare would go on. In the absence
into place. The defaulting banks are likely to be of the collective debt write-down and inflation
given away with the promise of a tax-funded that a devaluation provides, the only way that
dowry to international banks with solid repu- the private debt burden can be lifted is by in-
tations, and an international organisation, dividuals and companies going bankrupt and
probably the IMF, will probably move in and having most of their debts written off. Their as-
guarantee government payments. sets would be sold at very low prices since no-
one would be willing to pay much in the throes
Unfortunately, while the takeover of the two of an economic collapse. After a decade or
big banks and the hand-over of the economic more of misery, the individually-negotiated
management of the country to the IMF would write-downs would return the total debt-to-
allow economic life to struggle on, it would not national-income ratio to a supportable level at
solve the underlying problem, because the which asset values might be a tenth of their
country's debts, public, corporate and per- level today.
sonal, would be unaffected. If a country with
its own currency defaults, it normally devalues The country would be wrecked by this process.
its currency both to improve its competitive- Education and health care would suffer savage ~

What happens when Ireland defaults?

One cannot predict exactly what will happen
when Ireland defaults because the money sys-
tem depends on confidence and it's not clear
how much of that would be lost. My view is
that Bank of Ireland and AlB will quickly find
themselves defaulting too because the state
guarantee would become valueless and they
would become unable to borrow. A lot of im-
ports would then be stopped because overseas
banks would refuse to honour letters of credit

CI75
 cuts. If it survived, the social welfare system
would be a shadow of its current self and the
brightest and best of the population would
leave for pastures new. Many buildings would
be abandoned and others would fall into dis-
repair since no one would be able to afford to
maintain them. Some rail lines would close and
many local roads would be barely usable.
Before that stage was reached, however, there
would be massive demonstrations demanding
new solutions. What might these solutions be?
One, which has already been proposed by
David McWilliams and others is that we leave
the euro. That's not easily done. It's not just a
matter of printing new Irish pound notes and
minting coins. As Professor Charles Goodhart
of the london School of Economics and Dim-
itrios Tsomocos of Oxford University pointed
out in the Financial Times recently, no country
can sensibly plan to leave the eurozone, be.
cause "any sniff of thinking about that would
cause an immediate banking crisis:'
Moreover, Ireland's existing debts are denom-
inated in euros and any attempt to renege on
those would probably result in the seizure of
the country's assets abroad. Remember that
Britain used anti-terrorist legislation to seize
Icelandic assets when that country defaulted.
Anything valuable with an Irish government
connection could conceivably be seized to use
as a bargaining chip. Aer lingus planes could
be impounded when they touched down al-
most anywhere abroad.
The least bad domestic option
The Goodhart/ Tsomocos prescription for Ire-
land would be that the government should
issue a new currency, (let's call it the punt), and
use it for public sector wages and social wei.
fare payments. It would pass a law making its
new money acceptable for all internal pay.
ments between Irish residents, but not for any
external payments between Irish residents and
those living abroad. Taxes would be the only
payments within the country for which punts
could not be used.
On the day that the new money was in-
troduced (and it would have to be
done with great secrecy) our
bank balances in Irish banks
on the one hand and our
outstanding loans to
them on the other
would be switched
to punts on a one
euro equals one punt
basis. Rents, private
sector wages interest and
loan repaymentsto Irishresidents
would then be made in punts.
However, loans from and deposits
in foreign banks would stay in euros
and anyone who had borrowed from one
of them would still have their euro debt.
Because taxes would still be paid in euros, the
government would get a lot of them in. It
would transfer these to the Central Bank and
ask it to manage the punt/euro exchange rate
so that it eventually stabilised at a level that
represented, say, a 25% internal devaluation.
This target figure would limit the number of
punts that the government could spend into use.
As Goodhart and Tsomocos point out, all ex-
ternal monetary relationships, including inter.
est payments, would remain unchanged so
no-one overseas would be upset by what had
happened. All internal price/wage relativities
and tax rates would remain unchanged but the
enhanced activity would raise government rev-
enue, and there would be a reduction, as
measured in euros, in the state's interest,
wages and social welfare bill for payments to
Irish residents.
"It would be messy, and an unattractive dual
currency mechanism," Goodhart and Tsomo-
cos write, without mentioning Ireland specifi-
cally. "But it could work; it has done so before
now in other countries and circumstances. It
might be the least bad option."
My view is that there would be a constitutional
challenge to the re-designation of the money
in people's bank accounts as punts rather than
euros on the basis that the punts were an in.
ferior currency that was going to decline in
value. But this challenge would come after the
event. By the time the Supreme Court's judge-
ment came through, the economy should be
beginning to improve, requiring more punts to
go into circulation to lubricate the higher level
of activity. If so, the government could use some
of them to compensate bank account
holders.
The big advantage of the
new punt would be that,
as it would not be
borrowed into cir-
culation, it would
not disappear
w hen
debts
have to borrow punts to get them back into
use. The new units would just go round and
round from account to account indefinitely,
making our currency system much better
suited to a no-growth or contracting economy
than it is today. It would not even be necessary
to issue punt notes and coins, at least at first,
as euros would still be in use.
The only problems I can see are that:
1. The government could spend too many
punts into circulation, particularly if
an election was due, and this could
cause an excessive rate of inflation,
just as government-created money
did in Argentina in the 1980s, when
prices rose by over 5,000% in a single
year. However, this danger could be
removed by having an independent
Central Bank tell the state how many
punts it could issue.
2. Our massive external debts would
be unaffected and we would have to
devote a major part of our export
earnings for many years to paying
them off. This would reduce living
standards, of course, but at least we
could have something close to full
employment.
Unfortunately, I can't see any government hav-
ing the guts to adopt this solution. So, if noth-
ing is going to be done at either the European
or the national level, communities will have to
come up with solutions themselves. There's a
lot of interest in community currencies at pres.
ent especially amongst Transition Town Initia-
tives. One transition group, Future Proof
Kilkenny, is working with the city's cham-
ber of commerce and the Mayor's of-
fice on a plan for a debt-free
electronic currency. If this goes
ahead, it will be completely
different from anything
else in the world. I'll
write about it in
the next issue.
CI77