Cowen, Lenihan etc have been a disaster but they are an elected disaster. There is no substitute for the truth.

The Irish Times – Saturday, January 15, 2011
‘Ireland’s meltdown is the outcome of the policies of its elected politicians’

Lorenzo Bini-Smaghi: If banks collapse, the impact on the economy and on the people will be even stronger. This is an Argentine-type scenario. I would not advise any country to go through that. In order to avoid that, you have to keep in place what you have and ensure a smooth transition.

Photograph: Brenda Fitzsimons

A senior European Central Bank official speaks to ARTHUR BEESLEY in Frankfurt about the factors that brought about the collapse in the Irish economy and whether any other course of action might have resulted in a better outcome

IN A LARGE corner office on the 34th floor of Frankfurt’s Eurotower, his foot resting on a coffee table, Lorenzo Bini Smaghi is quietly defending the European Central Bank’s role in Ireland’s bailout by the EU and the IMF.

He rejects outright the contention that the ECB pushed the Government into the rescue zone, defends the interest rate on the bailout loans and warns that default is not an option for Irish banks or the Irish State.

“We and the governments of the other countries have helped Ireland because we think that Ireland is solvent. If the Irish people think that Ireland cannot remain solvent, they should know the major disruptive effects that this could produce on the Irish economy, as they would be the first to suffer,” he says.

A lean Italian in his mid-50s, Bini Smaghi is a ranking member of the ECB executive board and was a key figure behind the scenes in the drama that saw Ireland seek an EU-IMF bailout two months ago.

He is the first senior European official to publicly describe in detail, from the perspective of an EU institution, the sequence of events that led Ireland over the edge. He argues that it’s not necessarily a negative thing to have taken external aid, but reveals that the bank repeatedly pressed the Taoiseach, Brian Cowen, and his finance minister, Brian Lenihan, to do more to avoid that fate.

Although the rescue deal will inflict years of austerity on the beleaguered Irish people, Bini Smaghi argues that the measures themselves will not destroy the economy. Ireland’s meltdown is the outcome of policies made by politicians the people elected, he says. As the bubble inflated, the Government, taxpayers and regulators believed it was in their interest to keep the party going. While recognising that cutbacks and tax hikes are severe, he says the only way out is for taxpayers to foot the bill.

“WHEN THERE are people who say that the Irish taxpayers are suffering from the problems created by the banking system, I would remind that for many years the Irish taxpayers benefited from that system,” he says.

“Democracies have to be accountable and consistent with their own choices. I don’t think anybody outside Ireland should tell Ireland what to do, but you should not complain if now you have to increase taxes as a result of the choice of economic model the Irish people made.”

This was in essence an Irish decision, he insists.

“I think it was a choice of the Irish. It was the choice of the successive governments, and their voters, to try to adopt a growth model very similar to the British one, with an overly competitive financial system, underestimating the risks associated with this kind of model. Many others were not aware of the risks.”

For many months last year, there was nothing but praise from Frankfurt for the austerity policies championed by Cowen and Lenihan. But conditions worsened appreciably in the wake of the Greek bailout as the rising cost of rescuing Ireland’s ailing banks came into view. By the time the Government sought aid, a succession of top ECB central bankers had declared publicly that they wanted clarity over Ireland’s position.

Alarming reports that the bank wanted Dublin to accept a rescue package were not denied. Frankfurt simply declined to comment. But Bini Smaghi says it’s “totally wrong” to say the ECB forced the Government’s hand. The driving force was the collapse of investor confidence and the decision was entirely the Government’s own.

“If anybody forced the Government it was the markets. As the markets were getting away from Ireland, the ECB could not replace one to one all the euros which were going out. We clearly mentioned it to the Irish authorities.”

Feeding off each other at that time were unsustainable public finances – with a debt to GDP ratio in excess of 10 per cent – and a worsening situation in the banks relying on the credibility of Government guarantees. Bini Smaghi pinpoints a credit rating downgrade last August by Standard Poor’s as a crucial moment, another being bank stress tests the previous month in which the nationalised Anglo Irish Bank did not feature.

Whereas Cowen and his ministers had responded swiftly during 2009 as fiscal conditions worsened, Bini Smaghi says there was no comparable action to reassure markets when the heat came on last year. Ireland was listing from the summer, its position worsening all the time as investors took fright.

“Markets waited and waited and since they saw no policy reactions they started to lose confidence in the course of the summer. Remember there was a downgrade – in August – but there was no policy reaction, no announcement that a tough budget was in preparation and no announcement of the measures. The loss of confidence also affected the banking system and this created a spiral which led to the crisis and in the end the request for financial assistance.”

IS BINI Smaghi saying that a decision to pre-announce very severe measures for the 2011 Budget might have prevented the descent into bailout?

“It’s difficult to recreate history, but certainly in 2009 when the Government announced bold measures, this had a very strong impact on the markets. This kind of boldness was not repeated in 2010.

“On the contrary, the impression was that actions were delayed while uncertainties about what increased.”

He won’t say if that was a matter of political mismanagement or incompetence. However, he says the ECB told Cowen and Lenihan at successive European summits and finance ministers’ meetings and at meetings with Irish central bank governor Patrick Honohan that they should bring forward the Budget.

“We took all the opportunities to tell the Irish Government that they had to take bold actions very quickly,” he says.

Yet they didn’t?

“The response was that the budget would be presented in time, in line with the Irish parliamentary procedure, early December. But the markets did not wait so long.”

Is he saying, therefore, that the failure to take action meant that there was no scope to wait until December?

“Well, when you lose the confidence of the markets, you can’t just wait to follow the normal procedures. In 2009, for instance, the Irish Government announced tough measures much before the Budget, and this was very convincing for the markets.”

By Budget day, of course, the EU-IMF deal was done and the “adjustment” target had risen to €6 billion from the €4 billion foreseen earlier in the year. “The more you wait, the more expensive it is, that’s the lesson of this crisis. If governments are not ahead of the curve they will have to adopt even tougher measures, which then are difficult for the citizens to accept.”

Many observers say all hope had been lost once Brian Lenihan declared on September 30th that the bank rescue would cost €50 billion, a multiple of prior estimates and a figure so large it seemed fanciful in the extreme to suggest it was manageable. Nevertheless, Bini Smaghi argues that this was not strictly so.

“Under the hypothesis that confidence would come back, the numbers were probably right. But in order to restore confidence the Irish authorities should have taken a series of measures not only in budgetary terms but also in terms of restructuring and recapitalisation of the banking system.”

Important here was an EU-mandated bank stress test in July, whose assessment was confined to Allied Irish Banks and Bank of Ireland. Bini Smaghi says it would have been credible to leave Anglo out of the this process only if the restructuring solution for the bank had been identified at that time.

“When the stress tests show capital shortcomings, the remedies have to be put rapidly in place. So unless you budget the money for the needed recapitalisations, markets tend to think that something else may happen and they run away.”

What is more, Bini Smaghi says weakness in the Irish exercise damaged the standing of parallel stress tests on large banks throughout Europe, which at the time were cast as an important element of the battle to contain the wider debt crisis.

“Ultimately the assumptions that were made to stress the banks, in particular in terms of house prices, were just not conservative enough,” he says.

“The reality turned out to be worse than the assumptions of the stress tests. And unfortunately the fact that the Irish stress test turned out not to be credible affected the credibility of all the other stress tests. This is why we need a new round of stress tests with more peer review and control on what national authorities are doing.”

This he attributes to weakness on the Irish side.

“Judging from our side, the Irish supervisor underestimated the risks on the Irish banks’ balance sheets and the stress tests turned out not to be rigorous enough.”

Pressure on the banks intensified in September when they were unable to meet “huge” refinancing needs on private markets.

“We were seeing that the banks – particularly in September when they were not able to refinance themselves – were increasingly resorting to the liquidity provided by the ECB and the Central Bank of Ireland. The amount of the exposure with the ECB was in the order of tens of billions and going up,” he says

“The share was a multiple – more than 10 times – of the share of Ireland’s GDP in the euro area … However, the perspective that the ECB would replace entirely the market was not acceptable.”

Bini Smaghi says Ireland’s banks remain reliant on emergency ECB funding to a similar extent. This is hardly sustainable. The difference now, however, is that the EU authorities now know where they are going as a result of the bailout deal. The banking system in future will be smaller.

“Not all banks have a business model for the future so the regulator has to be given the powers to rapidly restructure the banking system. I don’t know how many banks there will be in the future in Ireland, probably fewer.”

AS FOR the terms of the bailout, an expression Bini Smaghi will not himself use, he has no sympathy for the argument that the interest bill is too high.

“This is IMF rules basically,” he says, dismissing the suggestion that the IMF charges less to other countries. Any difference with other IMF programmes is in the order of decimals, he argues.

“This first is in an internationally agreed mechanism. Second, the Irish Government is borrowing at a cost now much lower than the market price. So the funds received from the rest of Europe are much cheaper than the ones Ireland would pay if it borrowed directly from the markets.

“Of course some would say the lower the interest rate the better, but there must also be an incentive to avoid asking for this facility too easily. And there must be an incentive to repay it quickly. So that’s the principle for the IMF surcharge mechanism.

But will the interest rate – roughly 5.7 per cent on average – curtail the recovery of the Irish economy?

“There is no reason why this should happen, if I look at the growth potential of the Irish economy. I think what is important is that the Irish adjustment programme is implemented rigorously and swiftly and allows to regain credibility in the market.

“This will enable Ireland to go back to the market quickly. But the interest rate on the support programme has been defined on the basis of standard practices, which are applied to all countries around the world which apply to the IMF. I don’t know if anybody can get a better deal.”

Given the scale of Ireland’s economic challenge, Bini Smaghi says the question of reducing the rate is not really a “major” issue.

“It’s not one percentage point more or less which will change the nature of the problem, which is that Ireland has to go through a major fiscal adjustment, has to do it swiftly and regain credibility in the markets. And the faster it goes, the lower will be the interest rates that the market will charge when Ireland will borrow again from the markets.”

STILL, is it feasible to reduce the rate? “I think we cannot have tailor-made solutions for individual countries. If we apply a rule, it has to be the same for all countries. So I don’t exclude that one day the rule may be changed, we have to learn from experience, but I don’t think that this should be done for just one country. It should be done to improve the system for all.” He dismisses the notion that austerity will ruin Ireland’s economy. “To some extent the growth of the Irish economy over the past decade has been built on a model by which taxes were kept very low. This has led to very strong growth, but may also be unsustainable over time.

“We are now back to reality to find out that a more sustainable growth requires higher taxes. I don’t think it means, as you say, that fiscal adjustment will lead to a destruction of the Irish economy, but maybe a change in model and an adjustment to a more sustainable economic model.” But is the burden of adjustment on taxpayers simply too high?

“It probably looks high looking backwards but it’s back to reality. The pre-crisis growth model which benefited from substantial tax revenues from an overinflated banking system was not sustainable and it now requires an adjustment,” he says.

“SUCH AN adjustment is not smooth. The Irish taxpayer is the automatic stabiliser of the Irish economic model. It benefits in good times, and suffers in bad times. That’s part of the model chosen by the Irish people.

“That’s why the Irish debt to GDP ratio went from 140 to 20 per cent and now it’s back up to 100.

“You have to think whether you want to continue to have this kind of model which relies extensively on volatile corporate taxation income. When volatility occurs, it hurts negatively the individual Irish taxpayer. This kind of a model can apply very sharp shocks to taxation for the Irish taxpayer.” In a similar way, he expresses scant regard for the argument that there is an inherent injustice in the failure to force bailout cost on senior bank bondholders.

“Again, the banks have been the basis of the growth and prosperity of Ireland. Unless you want to change model, and make all the banks broke, you have to ensure a smooth transition which requires a recapitalisation and support of the banking system through public funds.

“If banks collapse, the impact on the economy and on the people will be even stronger. People who have deposits cannot get their money back, your own savings are affected.

“This is an Argentine-type scenario. I would not advise any country to go through that. In order to avoid that, you have to keep in place what you have and ensure a smooth transition.” He therefore excludes any possibility of a “haircut” for senior bank bondholders and says that would fatally compromise the effort to regain investor confidence.

“If you want to put that into question, you put into question everything and the markets will also question the trust in the Irish state. If the Irish state says, ‘support us, trust us, we will repay you’, and after a while you say ‘sorry, we won’t repay you’, then there’s no way to regain the confidence not only of the markets but also of the rest of the people of Europe who have supported Ireland.

“As I have said, Ireland is now borrowing from the rest of the euro area at a rate which is the one that the markets would charge.”

Similarly, he rules out any question of Ireland making use of new European provisions which will compel private sovereign debt investors to take losses on debt issued after 2013 in the event of future bailouts.

“The agreement of the European Council for the future European Mechanism is that private sector involvement in the form of restructuring will take place only in very extreme cases, when the country is not solvent,” he says.

“Look at those countries which defaulted, like Argentina, Pakistan, Ukraine, Zimbabwe, Cote d’Ivoire. Look carefully what happened in all these countries.

“The poorest people in these countries are those who suffered most.

“Do the Irish people want to go through the same experience?”


Here are some of the main observations on Ireland made by Mr Bini Smaghi:

“We took all the opportunities to tell the Irish Government that they had to take bold actions very quickly . . . In private conversations, Mr Trichet mentioned this several times on the margins of the European council or the euro group.”

“We continued to finance and increase our exposure to the Irish government and banks, while at the same time we encouraged the Irish authorities to take swift corrective actions.”

“It’s difficult to recreate history, but certainly in 2009 when the Government announced bold measures, this had a very strong impact on the markets. This kind of boldness was not repeated in 2010. On the contrary, the impression was that actions were delayed while uncertainties . . . increased.”

“It would be dramatic for Ireland if just by changing government you renege on the promises that Ireland as a sovereign has made.”

“This kind of a model can apply very sharp shocks to taxation for the Irish taxpayer. But that’s to some extent the choice that the Irish people have made”

“Look at those countries which defaulted, like Argentina, Pakistan, Ukraine, Zimbabwe, Cote d’Ivoire. Do the Irish people want to go through the same experience?”