Posted by: Dirk | November 19, 2010

Landesbanken, Ireland and what to do about it

While Ireland’s finances, mostly those of its financial institutions, are slowly getting worse and worse, the question arises: who lent that much money to those institutions? It takes two to tango, and putting blame on one dancer after the performance stalled would certainly be unfair. Sadly, the German Landesbanken are among the biggest creditors of Irish financial institutions. The reason for this is reported by the Irish Times. I would call this the last Hurrah of the Landesbanken:

The last big potential trigger for change in the sector was ignored – and contributed to the banks’ current plight. The Landesbanken used to rely on funding themselves cheaply with the help of guarantees from their state owners. When the EU ordered an end to such practices by 2005, many Landesbanken used a last flurry of cheap debt to invest heavily in foreign commercial property, subprime debt and other structured securities – with disastrous consequences.

On a side note: remember those stress tests which the Landesbanken passed? This policy instrument should have lost all credibility. As with monetary policy, expectations matter a lot, but if you are unable to use your instrument in a way that at least seems compatible with reality, you will lose your reputation. If increasing confidence was the idea behind these stress tests, than a rise in confidence then was traded against a fall in confidence now. Or better, a rise in uncertainty, since while this is happening rules will be made up along the way. There is no euro zone resolution mechanism for this kind of scenario (a so-called SDRM – sovereign debt restructuring mechanism). It wasn’t supposed to happen. That doesn’t mean though that nothing could be done, as Nouriel Roubini rightly points out:

The current debate on a European SDRM is therefore a red herring. The reason the EU has so far decided to provide emergency financing to Greece and Ireland is not because it lacks a legal mechanism for orderly restructuring; it is rather because of concerns about systemic contagion. But an orderly restructuring via exchange offers is the best way to reduce this risk. The sooner the EU admits this, the sooner Europe can put its financial house back in order.
However, this is only half of the story. On the real side, it is not clear that Nouriel Roubini’s proposal will also bring the current accounts in line with the position needed to unwind foreign debts accumulated in the run up to the crisis. A fall in prices  (and wages) in countries like Ireland will probably increase their exports – or maybe it won’t, but we can look at the debate by Keynes and Ohlin on the transfer problem – but worsen the financial situation – lower wages will make it more difficult to repay debt. This woudl be the debt-deflation as described by Fisher (1933), which had grave consequences during the Great Depression.
The euro zone, I would argue, needs a more comprehensive solution. On the financial side, an orderly restructuring would help. Then, something must be done to make sure that the kind of imbalances that caused the crisis in the first place cannot happen again. There are many solutions to this problem, and it will take time to figure out what is best. As it stands, Germany is putting deflationary pressure on the whole euro zone by reigning in government spending and continuing its policy of putting additional costs on workers and not on firms. Countries like Greece and Ireland will find it very hard to let their firms regain international competitiveness without reverting to lower nominal wages, which makes repayment of foreign debt more difficult.

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