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Home > Blogs > Anthony Harrington > Ireland bond deal with its central bank "sets precedent" says Weidmann

Ireland bond deal with its central bank "sets precedent" says Weidmann

Ireland bond deal with its central bank Anthony Harrington

At a recent press conference, Mario Draghi batted away a seemingly endless stream of questions about the European Central Bank's take on Ireland's recent get-out-of-jail-free swap deal, saying only, and repeatedly, that the ECB "took note" of the deal - an opaque statement if ever there was one. However, the Bundesbank President Jens Weidmann was less coy. In an interview with Bloomberg he called the deal "a departure from normal fiscal policy" and said that there was a danger that it would set a precedent for others to follow.

So what did the Irish Government "make" its "independent" Central Bank do, that had the press in such a twitter? One of the best commentaries on the deal comes from Karl Whelan. There are two basic facts you need to have to keep in mind when contemplating this issue. First, the Treaty of Rome outlaws monetary financing. This means that a state central bank cannot create a chunk of money, lend it to one of the nation's commercial banks, then write off that debt. That would be the equivalent of monetizing the debt, ie using the state's ability to create fiat money to make debt vanish. It is banned because obviously monetizing debt debases the currency. If all European central banks did this then the euro  would be creating another instance to set alongside the hyperinflation experienced by the Weimar Republic and Zimbabwe. Some way down this road wheelbarrows for carrying cash become an essential shopping accessory.

The second fact is that post the deal, the immediate debt burden on the Irish government has become considerably lighter - for the next decade at least. How does an ordinary debtor lessen their debt repayment? Clearly, the easiest way is to seek to spread the repayments over a longer term. This the debt deal does - pushing the repayment term out 40 years. Does it do it in a way that is within the ECB's "rulebook"? Not exactly, but since Ireland was not in a position to meet some EUR 6.2 billion of repayment that was due from it this year (EUR 3.2 billion for 2013 plus a delayed EUR 3.2 billion from 2012), said repayment originating as a result of the Irish Government’s bailout of the two Irish "minnow" banks, Anglo Irish and the Irish Nationwide Building Society, the ECB has been placed squarely on the horns of a dilemma. It could watch the Irish government fudge the rules, without slapping its wrist and crying foul, or it could face the consequences of an Irish default. Since the standard euro politician's Modus Vivendi is always to favor a fudge over a vote-losing catastrophe, the ECB "took note" of the Irish deal. (Hence the rich comedy of Draghi's answer.)

A rapid summary of the deal would be something like this. The Irish government initially wrote EUR 30 billion of promissory notes guaranteeing the debts of these two minnows, which the administrators of the two banks used to pay back bondholders and European banks who had lent to the two. That this was daft, just about everyone now admits. Those who gambled on the Irish property boom by lending to Anglo Irish and Nationwide, should have been allowed to lose their money. They gambled and lost.

The promissory notes written by the Irish government were a step short of sovereign debt, so some room was left that would have allowed the notes to be renegotiated. Under the latest deal done by the Irish Government, the promissory notes have been effectively transformed into bonds, ie, sovereign debt. Sovereign debt cannot be waived away under European rules since, as with the above example of bank debt, it would be monetary financing.

Whelan's explication of the deal is illuminating. Under the new deal the Irish Government will pay 3% on its debt, rather than 8% and the term of the debt has been pushed out, with repayment of principal starting in 2038 and ending in 2053. The general idea is that inflation and GDP growth will both combine to make the debt much easier to repay at this distant future date. However, and it is a big “however”, the terms of the deal mean that the Irish government has to offer these bonds in tranches for sale to outside buyers in a few decades. At present the bonds are held by the Irish Central Bank. The idea that they will be offered for sale and not held to maturity by the central bank is supposed to get around the EU provision that prevents central banks in the EU from simply financing their government’s debt. But this introduces an important new dimension. The Irish government is selling the deal as a huge saving on what the bailout had been costing it, and there is no doubt that it is a saving in the early years. But no one on the planet can say at this point in time what interest rate the Irish government might have to put on the bond to get a sale away to third party investors at some distant future date. So it is by no means clear how much of a saving the whole manoeuvre will generate. What is certain is that the deal has stretched EU rules against monetization of debt about as far as they can be stretched, while ensuring that a generation of Irish children yet unborn will, at some date, have to step up and shoulder the interest payments on a gigantic loan that never should have been.

Further reading on the Sovereign Debt Crisis:

Tags: central bank , Irish Government , Treaty of Rome , Weimar Republic , Zimbabwe
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