One month to go for Ireland

The government of Ireland has collapsed. Green Party members withdrew from the coalition on the weekend, leaving the Fianna Fail to effectively govern alone as a caretaker government. March 11 elections have been moved up to February 25. Greens woke up to the prospect of losing core voters angry at their party supporting the bailout of bankers whilst cutbacks are imposed on the general population.

Ireland must pass a budget to receive funding from the IMF, and IMF funding is part of the financial package that Europe put together to save countries like Ireland: the European Financial Stability Fund. Fianna Fail may succeed in garnering support form the opposition, particularly its main rival, Fianna Gail.

Fianna Fail, a big-L Liberal party (which in Europe means pro-market), and Fianna Gail, a centre-right Christian party are not that far apart and could succeed in pulling together for a gesture of national unity. Fianna Fail was in power when the financial crisis started and bears the stigma of letting the Irish economy collapse, (albeit under a different Tioseach (head of government)). The infighting within the party has already started. A grand coalition or a minority government would stabilise the country, but at the cost of failing to address needed reforms and a rethinking of how extensively Ireland subsidises its banks.

At stake is Ireland's understanding of what it holds to be right, especially what the state's role in the modern Irish economy is, and why the bankers are so (un)deserving of state aid. What is to be done? Who should benefit and who should pay? Will Ireland regain some of its independence from the banks, as it once regained from England, or will it chose to uphold subsidies for the country's richest institutions?

It will likely come down to a visceral, gut decision on the part of the Irish electorate--on how they see the relationship between banks, the state, and the people.

Who pays when a country defaults?

Yesterday's deal to bail out Ireland rejected a long-standing German demand that investors holding Irish government bonds take a haircut in return for EU aid to the banks.

Accepting a haircut is financial market-speak for accepting a reduction in the value of the bonds you hold. The German government, which has been one of the most openly critical of the behaviour of investors during the crisis, has insisted that there is no reason to provide public insurance for private risk-taking. Investment is a rewarding business, but also a risky one, and when investments go bad, investors have to accept losses.
 
When a government like Ireland can't pay its debts, bondholders run the risk of receiving nothing in return for their scraps of paper. The alternative is that they collectively agree to avert total disaster by agreeing to take only a portion of what is owed them, and extending new loans to give the country extra time. This is what is known as restructuring a country's debt. Outside governments can increase the likelihood that they will agree by sweetening the deal with extra loans to the country that can't pay. This gives the group of private bondholders a bigger pie to distribute, it softens the blow for the country that can't pay, and it prevents the country from collapsing. This is why the most likely source of this outside funding is the country's most important trade and investment partners. This was the case for Mexico in the mid-1990s, when the United States helped bail it out. And it is the case for Ireland and Greece today. It's enlightened self-interest.

Except that the European Union, unlike the United States, asks nothing of bondholders in return. They are, unless anything changes, getting 100% of their investment guaranteed by the euro zone in the final instance. And they are using that money to wage a further war against other countries they have in their sights. This week, the first salvos were shot at Portugal and Spain.

This European attitude is something to watch. So far, Germany has been unable to convince its fellow member states to make bondholder haircuts a condition of EU aid. Instead, the message that the Irish and others, including the European Commission are sending out, is that they are terrified that bondholders will turn their backs on the country entirely.

Why watch this point if European countries are not united in their assessment of whether bondholders must share in the cost of the crisis? Because the war has only started. We have yet to see financial markets attack a large country. If and more likely, when that happens, the EU will have to make some very tough decisions about how much it is prepared to give now (and that is limited), how much, if any, it is prepared to borrow collectively to bail out its weakest states (which implies a radical re-thinking of European economic principles and law) and how much the bondholders must pay.

If European governments listen to Berlin and make bondholders share the burden, they will be doing nothing different than has happened many times before. International investment will not dry up as long as the crisis is used wisely to restructure the economy, improve corporate governance and improve the regulation of financial markets as Ireland rebuilds.