ANALYSIS:The best policymakers can hope for is to mitigate the effects of the banking system's failure. We are beginning the painful process of downsizing and restructuring a global industry, writes DAN O'BRIEN
THE GRAVITY of the crisis in Irish and global finance cannot be overstated. It can, however, be mis-described, as frequent allusions to storms attest. For analogies, it is to geology, not meteorology, that we must look to in order to understand what is happening.
Tectonic movements are now taking place in international finance. These shifts are causing the global economic landscape to change. Most obviously, the financial services industry itself is in a state of collapse. The contraction of a major economic sector is having, and will continue to have, a direct impact on employment and output. A second, and even more important change for the wider economy is that this collapse precludes a return to “normal” bank lending.
It is understandable that businesses and consumers, many of whom are in difficult and even desperate situations, clamour for the normality that they have come to know. But any hope of this is forlorn. Banks’ loan books will now shrink. This very painful process must take place if the threat finance poses to prosperity is to be contained.
In Ireland the transition to the new normality will be more wrenching than elsewhere because Irish banks became more dependent on the now-failed international system to fund their domestic lending than those of most other countries. This will lead to tighter lending for a longer period. The most that can be hoped for is that it will happen gradually rather than suddenly.
The restructuring and downsizing of global finance will hit Ireland in another way, too. The country’s International Financial Services Centre will shrink in line with the industry worldwide, a process that had already begun in the first half of 2008, according to the latest data on financial services exports. It has much further to go.
What can any government do at this time of acute crisis? At the risk of over-extending the metaphor, it is helpful again to think of violent geological change. Formulating and implementing a policy response to the financial crisis is akin to trying to traverse a landscape undergoing an earthquake: the ground underfoot is unstable, reference points are moving and chasms are opening up.
The extreme difficulty of attempting to respond is evident from the lack of successes in any country in restoring some semblance of stability. Despite the many policy measures put in place across the world, not a single country can claim to have succeeded in placing its financial system on a firm footing. Developments over the past week in three of the world’s largest economies illustrate this.
The US’s Troubled Asset Relief Programme, which has been changed almost on a weekly basis since it was set up in the autumn, is proving ineffective, as the continuing, slow-motion implosion of two financial services behemoths – Bank of America and Citibank – demonstrates all too clearly.
When Britain rolled out its recapitalisation scheme in October it was hailed as a model for others. Within weeks that view was held by no one. One Monday morning, a second round of capital injections was announced and more taxpayers’ money will almost certainly be poured into the system in the weeks and months ahead.
Germany, with its large state-owned banking sector and absence of any domestic credit boom, has fared little better than the countries whose banks were at the root of the problems. Last week its second largest bank, Commerzbank, required a second messy infusion of public money to avoid collapse and a string of other banks are negotiating the terms of life-saving capital injections.
These examples, and many others, demonstrate that there is no road map to be followed that would allow a way out of the earthquake zone, never mind a definite set of policy measures that would halt the tectonic movements themselves.
Under the circumstances, policy makers are limited to trying to mitigate the effects. They must make up responses as they go along. Flexibility and creativity are indispensable.
For those of us who comment from high perches in the media or academia it is necessary to acknowledge the enormity of the challenges facing those who have to make the hard calls.
The Government deserves excoriation for its economic mismanagement and complacency over many years. There are also questions about what precisely were all the reasons behind the Government’s decision to nationalise Anglo Irish Bank.
But all that said, and on balance, the decision was the lesser of two great evils. To see why, we must look beyond Ireland’s shores.
In September some of the finest minds in the world of economics judged that the investment bank, Lehman Brothers, was not systemically important and could be allowed to fail. To say that that judgment has been proved wrong does not begin to describe a decision which may come to be seen as triggering a second Great Depression.
Given the impossibility of untangling banks’ connections with each other, the effects of the collapse of a bank on the rest of the financial system are unknowable to anyone. Aware of this, policy makers everywhere have since avoided taking chances and propped up all financial institutions. Not a single bank anywhere has been allowed to fail.
A second reason that may have influenced the Government in its decision to nationalise Anglo Irish Bank was the possible international effects of allowing the bank to collapse.
In these pages on Tuesday, UCD’s Morgan Kelly proffered the view that Anglo Irish Bank’s bondholders, who are mostly foreign, and the insurers of those bonds (likely to be overwhelmingly foreign), should be made take the hit for the bank’s recklessness and the regulatory failures of the Irish authorities. While it is very tempting to agree, other countries’ governments might well have differed – recall how Britain reacted when it believed its citizens were victims of Iceland’s blunders.
In addition, given that the value of the insurance contracts taken out on those bonds, in the form of credit default swaps, is likely to be in multiples of their value (because the market for those products is wildly out of control), it is perfectly possible that default of those bonds could have caused new fissures to open in the extremely fragile international financial system.
Could Ireland afford to be seen as a country adding to the crisis rather than taking its responsibilities seriously? Hardly. And all the more so because soon the country may need others’ solidarity. The Irish economy is moving rapidly towards the abyss. It may even be too late for any domestic action to prevent it going over the edge.
If this proves to be the case, Ireland will require all the help it can get from others.
- Dan O'Brien is senior Europe economist and editor at the Economist Intelligence Unit. His book, Crisis, Conflict and Progress, will be published by Gill Macmillan in September