Tuesday, November 16, 2010

The Real Question - Who Pays?

A seriously bum rap

Here's what's supposed to happen: you borrow some money, and then you repay it. And the emphasis is on the word "you".

Now, what's so hard about that? The practice has been around for centuries, and nobody can honestly claim ignorance of the rules.

Yet somehow, when borrowers decide they can't make their repayments, it's rarely seen as their fault. Instead, the blame is landed on the lender, either for making it too easy to borrow in the first place, or for demanding repayment in times of difficulty. Tyler has never thought it fair that poor old Shylock loses his ducats because some smart-ass amateur lawyer gets the borrower off on a technicality, especially when Shylock would still have had to honour his own debts to his depositors. But you're meant to cheer.

And so to the current Irish crisis.

The Irish have borrowed A Lot of money. Their citizens borrowed a lot to buy property, their government borrowed a lot to... ummm... spend, and their banks borrowed a lot to punt around, largely on property loans. Their external debt is now a staggering 1300% of GDP, most of it now effectively nationalised through the government formally guaranteeing its banks' debts.

Here's how it ramped up during the go-go years to reach its current €1.74 trillion (chart is in millions of Euros, taken from the highly informative Ireland After NAMA):

So who's to blame?

Well, yes, the Irish of course. For borrowing so much. Obvious.

But Tyler is just listening to J Humphrys summarising the situation for BBC R4 Today: "...the vultures are circling Ireland... the country may be forced to hold out the begging bowl... the vultures may then turn their rapacious attention elsewhere..."

Those greedy flesh-ripping lenders - why does anyone put up with them?

But what's the real question beyond the tabloid emotion? The real question - as we all surely understand by now - is who's going to pay? Not just for Ireland's debts, but for Greece, Portugal, Spain, Italy, etc etc.

As regular BOM readers may recall from this blog, traditionally there have only ever been four options for governments with too much debt. Let's review them to see who actually ends up paying:
  1. Repayment - ie the government runs budget surpluses. Taxpayers pay.
  2. Default - most likely in the form of a partial default via debt restructuring (aka haircuts, debt for equity conversions, or coupon conversions). Lenders pay. 
  3. Inflation tax - where debt is denominated in fixed money terms (as most is), governments can work off their debts by engineering inflation - effectively a gigantic stealth tax on debt holders. Lenders pay, including anyone who has been foolish enough to save their nest egg in a building society account.
  4. Growth - GDP growth is the holy grail of indebted governments. Growth makes a given amount of debt less significant relative to GDP and tax revenues with each passing year. It's a get-out-jail free card for both the borrower and the lender.
But this is where Ireland and the others have a problem. Because they're members of the Euro, and that pretty well nukes options 3 and 4. As everyone in the real world always understood, the Euro makes it impossible for individual members to crank their own printing presses. Ireland and the others can't impose an inflation tax, and can't depreciate their currencies to stimulate growth - they're locked in.

Which means the only options are either to repay - whatever the tax and spending implications - or to default.

Now, the average Irish/Greek/Portuguese/Spanish citizen is going to opt for default - no question. But sadly, the lenders aren't nearly so keen. And since the lenders largely comprise banks based in other member states of the EU (including Britain), those members are not keen either.

Which is why Ireland and the others' membership of the Euro has brought a fifth option into play - transfer the debt to taxpayers in other countries.

And that's precisely what is being done with the EU's €750bn bail-out package, agreed during the Greek crisis in May. Taxpayers elsewhere are being forced to guarantee up to €750bn of loans to basket cases like Ireland.

Fortunately, the UK's share of these guarantees is limited, because - thank God - we aren't members of the Euro (keeping us out was one of only two useful things G Brown ever achieved). But even so, it could still be well over £10bn (including both our €8bn share of the European Financial Stabilisation Mechanism and our €4bn share of increased IMF lending).

But spare a thought for the German taxpayer. They've always run a tight Lutheran ship in terms of their own borrowing, but now they're being called upon to guarantee tens of billions of Euros in loans to the wild free spending PIIGS. And they will note that the EU's announced €750bn bail-out fund only covers a fraction of the total external debt of the PIIGS, which comes in at over €5 trillion.

Of course, at the level of the entire Eurozone, there IS an alternative. As several commentators have argued over the last few days, the European Central Bank could fire up the presses. It could flood the world with Euros just as the Fed is flooding the world with dollars. It could do so until Euro inflation - currently around 2% - takes off.

But if you're a normal everyday punter in Germany, why would you feel any better about that? You almost certainly never wanted the Euro in the first place, and went along with it only because you were assured it would be the rock solid Deutschemark by another name. How are you going to react when your Euro savings are obliterated simply to shore up the PIIGS?

At the end of the day, a bout of Euro inflation looks increasingly likely - all the other options are simply too hard for Europe's rulers to swallow. German taxpayers are going to be left feeling just like these American furry animals feel about the Fed's antics on the dollar printing press (HTP JWK):

PS If by any slight chance anyone is reading this thinking the inflation storm won't affect us, today's re-acceleration of UK inflation to 3.2% - above market expectations - is an excellent reminder of reality.

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