Ireland's Problem

| Wed Dec. 1, 2010 1:33 PM PST

Via Paul Krugman, Barry Eichengreen writes today about the recent bailout of the Irish banking system. "I’m probably the most pro-euro economist on my side of the Atlantic," he says. "I’m also a believer in the larger European project. But given this abject failure of European and German leadership, I am going to have to rethink my position."

The problem is simple: Ireland's banks are insolvent, so the EU has provided the Irish government a truckful of money that it's going to use to guarantee its banks' debts. Basically, this means that bank bondholders are being bailed out via loans that Irish citizens will eventually have to repay. "Ireland will be transferring nearly 10 per cent of its national income as reparations to the bondholders, year after painful year. This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know."

So why not just let the banks fail and pay off their debts at pennies on the dollar? Answer: because a lot of their bondholders are French and German and British, and if they get stiffed there might be a domino effect throughout Europe. In other words:

Policy makers in Germany — and in France and Britain — are scared to death over what Ireland restructuring its bank debt would do to their own banking systems. If so, the appropriate response is not to lend to Ireland — to pile yet more debt on the country’s existing debt — but to properly capitalize their own banking systems so that the latter can withstand the inevitable Irish restructuring.

But European officials are scared to death not just by their banks but by their publics, who don’t want to hear that public money is required for bank recapitalization. It’s safer, in their view, to kick the can down the road in the hope that something good will turn up — to rely on “the luck of the Irish.”

As a resident of California, I have some advice for the EU: something good is really unlikely to turn up. Kicking the can down the road just makes the can mad. Like it or not, you're better off dealing with this stuff sooner rather than later.

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