Tuesday, November 30, 2010

Ireland and beyond

Ireland is still in a fix it has not been fixed. In an effort to cut-off the belief in knock on effects a huge package has been given to Ireland that is so massive that Ireland probably will not be able to afford it. Irish banks are in trouble as is Ireland and as are all those banks that lent to them. And while all the Ireland bailout stories are about Ireland, Ireland is not the point. The Ireland and Irish credit default swaps are at issue as well as the not guaranteed loans. In other words the real worry here is not about Ireland but about the various kinds of knock-on effects. These range from the crises spreading to Spain and Portugal to an intensified concern about the banks that lent to these countries.

Europe ran some stress tests but those tests did not really imply much more than mild haircuts on sovereign debt. Everyone knows it was not a real test just as you know the difference between how people act in a fire drill is different compared when there is a real fire. With Ireland we shovel money in, tie Ireland’s hands and feet and pretend everything will be fine. How did this happen?

The e-zone was badly conceived as fiscal rules were too loose. Some of the nations in the Zone have run inflation rates that have further widened price level differences (exacerbating competitiveness issues) within the currency area, instead of narrowing them. This is a difficult and painful situation to remedy. Countries within the Zone cannot depreciate against one another; they are in a locked currency grid. Since December of 1998 German core HICP price level has fallen nearly 8% below the e-Zone average while Greece is 20% above that average, Spain is 12% above that average, Portugal and Ireland are nearly 9% above that average and Italy is 6% above that average. Those are huge shifts of competiveness to give away within a fixed exchange rate system. That list of higher-than-average inflation countries pretty much identifies the countries that are under pressure in the Zone, too. Putting that toothpaste back in the tube will be a huge job. It will take more than just financing or a little soaping down with some Irish Spring.

The current bail out of Ireland has shifted eyes to Portugal and to Spain, Spain being a much larger potential problem than the all the previous countries with difficulties combined. Spain is a large e-Zone nation. The Irish bail out has ratcheted Ireland’s already large deficit-to-GDP ratio from 12% to 32% and some seem to think it can deal with that. Such a burden from the bailout must be viewed with extreme suspicion. Ireland will now operate with a huge weight around its neck. However, any plan that would have given it debt relief would have impacted the international banking system which may still not be off the hook. As Ireland wavers in its task, the banks will remain nervous. On top of that, concerns continue to mount about who is next. Italy’s bonds’ spread to Germany bunds ratcheted to a historic high on Monday. That’s not exactly a vote of confidence in the steps that have been taken to calm frayed nerves.

The economic news shows progress; the burden for the future on some Zone economies is nonetheless huge. The challenge is for the ECB to make one monetary policy that can survive these sorts of strains; it is an extreme challenge, the ultimate reality show. With such a Bundesbank-influenced staff we know how the ECB will tilt its policy and that just brings us back to being skeptical about how this sort of a bailout can work, one that just mounds up the debt on a troubled economy. Have Europe’s banks been saved or are they standing on still-thin ice that continues to make strange cracking sounds? I guess it’s probably not a good time to do another round of stress tests on Europe’s banks, is it?

While the Zone has toted up some nice numbers for November in the EU Commission survey we know that there are termites actively munching on that wooden framework. Solid as it may seem it is under duress. Ireland’s debt load likely cannot be borne by Ireland. It cannot be reduced since that world harm banks or trigger credit default swap payments. We are back in familiar, though not very tasty, soup.

Getting competiveness back in line is a main challenge for the Zone. But how Ireland gets there from here with that load of debt is beyond me. There will have to be some sort of restructuring before long. Is Europe just hoping to forestall the issue until banks are healthier? Can we wait that long? More questions are raised than answered by this alleged bailout which is why we should not call it that. It is a bail-along like a sing-along and it will go on for some time with everybody joining in most of them off-key.

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