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This week, the eurozone's "new normal" played out as a textbook example of how short-term market concerns can have a constructive impact on Europe's long-term economic future. Under increasing political and economic pressure from rising bond market spreads, the Irish and Portuguese governments finally "did the right thing" and took productive policy actions. The eurozone's "new normal" (discussed here) is working as intended.
The Irish government—after squandering its credibility with overly optimistic cost estimates—attempted to draw a final line under the costs of its monumental bank bailout by raising the estimate of that cost by about 50 percent to €50 billion ($68 billion). In the process, the Irish government abandoned the view that the banking crisis had been caused by "a few rotten apples." In addition to bailing out (again) Anglo Irish Bank, the government agreed to take over Ireland's erstwhile biggest bank, Allied Irish Bank, and double the size of the bailout of the Irish Nationwide Building Society. Instead of a few rotten apples, it turns out that there are only a few good ones in the entire apple orchard and that the problem does not derive from one specific irresponsible bank (Anglo Irish Bank). The implosion has occurred throughout the entire Irish banking and real estate development sectors.
The belated acceptance of the true scale of the disaster by the Irish government, forced on it by financial markets, is welcome news for Ireland's longer-term prospects. As Japan illustrated in the 1990s and early 2000s, unwillingness to own up to the true scale of a banking crisis is the worst possible longer-term response to a crisis. That bond markets have helped speed up this process in Ireland can only be welcomed.
Of course, honesty about banking crises comes at a cost, as reflected by the record-breaking new projected 2010 Irish budget deficit of no less than 32 percent of GDP, of which at least 20 percent is a one-off expense related to the banking sector recapitalization with public money. The crucial next question, of course, is how to pay for it all.
Finance Minister Brian Lenihan, in his statement on September 30, provided only part of the answer to that question. It is welcome that the Irish government intends, as he said then, to "share the burden with subordinate bondholders in Anglo Irish Bank." Given the scale of the restructuring of this bank, "bailing in" subordinate bond holders is appropriate, as is avoiding potential systemic implications by continuing to protect senior bondholders. However, with only about €2.5 billion in outstanding affected lower Tier 2 bonds and lower Tier 1 and 2 notes, scalping subordinate bondholders in a debt buy-back with serious haircuts will save the Irish taxpayer only a limited sum of money.
Instead, the Irish government will—in a new 4-year budget consolidation program to be announced in November—outline how it intends to restore sustainability to Irish public finances and adhere to European Union public deficit rules by 2014. In other words, severe additional austerity measures will be how Ireland will pay for its banking crisis. The domestic political battle to distribute this additional pain will be bloody, but plans for necessary action are welcome.
In Portugal, on September 29, the government responded to similar bond market pressure by finally announcing a more credible plan to reduce its 9.4 percent budget deficit, including cuts of 3.5 to 10 percent for public sector wage earners making more than €1,500 a month. Also unveiled was a freeze on state pensions in 2011, reductions of up to 25 percent in some social payments, and a 2 percentage point increase in the value-added tax to 23 percent. Clearly bond market pressure was instrumental in overcoming a domestic political crisis and forcing through an agreement between the two major parties in Portugal, the ruling center-left socialists (PS) and the opposition center-right social democrats (PSD). This too is good for the long-term future of Portugal and the broader European economies.
This week's events will help answer a question sometimes asked: Who will buy eurozone peripheral sovereign debt after the Greek debacle? The answer seems clear—real money managers, pension funds, and other market participants will not shy away from buying these relatively high-yielding securities (much less so in today's record low-yield environment), when they see that bond market messages about deficient policies are being taken seriously by national governments.
The question is therefore not who will buy peripheral eurozone debt in the future—the usual suspects will do so at the attractive yields on offer—but why these sophisticated market participants were willing for so long—until the global financial crisis—to buy this debt without examining the true risk?
