The European Diktat

Barry Eichengreen has an excellent article about the Irish bailout, comparing it to German reparations after WWI. I would like to expand on this point with further analogy to the post-WWI world.

The main issue for Ireland is that it has too much debt (remember, debt is a practical issue, not a moral one) and even with reasonable growth it will not be able to handle this debt burden. Now, when a borrower borrows more he can handle, he should suffer for that, so that he and other borrowers know that you can't borrow too much. When a lender lends imprudently, he should suffer for that, so that he and other lenders learn you can't lend imprudently.  The Irish bailout, however, seeks to impose costs only on the Irish people (the borrowers) while leaving the lenders (bondholders) untouched. Europe is telling Ireland that it must pay a heavy debt.  This is unreasonable. This is the European diktat.

A much more sensible solution, as mentioned in the linked article,  is for the Irish debt to be written down, while Ireland also imposes fiscal austerity. This way the burden on Ireland is reduced, but both borrower and lender still pay a cost. Not only that, as it currently stands, the Irish have no incentive to improve their situation and pay back the debt, as I will explain.

First, however, let's compare this situation with the post-WWI world. The Allied nations had borrowed immensely from the US to pay for the war. At the end of the war the Allied nations sought to link reparations from Germany to the war debts they had with the US, but the US refused to write down the debts, which was part of the reasons reparations on Germany were so high. On the matter of reducing war debts Calvin Coolidge famously said "They hired the money didn't they?" These war debts and reparations were a terrible burden on post war Europe. Still, the debtor nations sought to have the war debts reduced.

In 1923 Britain, in a desire to be as responsible as it could, accepted a deal with the US to settle the debts at 80 cents on the dollar. The French waited longer and eventually settled in 1926 at 40 cents on the dollar (ratifying the settlement even later in 1929). Italy also waited and settled the debts at 24 cents on the dollar. [Source: Lords of Finance] The takeaway here should be twofold: that an overly burdensome debt will likely eventually be written down, and that the longer you wait the greater the chance of a lower write down.

At the time J. M Keynes encouraged Britain to wait longer for a better deal "in order to give them [the Americans] time to discover that they are just as completely at our mercy as we are at France’s and France at Germany’s. It is the debtor who has the last word in these cases."

Keynes was exactly right on this. It is better to write down a debt and receive a part of it then have the debtor  default and realize even less. With too much debt, high unemployment, ands severe austerity and tax hikes, what incentive do the Irish have to work harder and pay back the debt? They would be better off making the situation worse and forcing either a default or a write down of the debt. That is, they have an incentive to be disruptive, or even destructive. Ireland may well go for Katastrophenpolitk, much as Germany did with reparations. As the situation gets worse in Ireland, it will fuel things getting worse in the EU, which will encourage the EU to move to write down debts, which would benefit Ireland.

This is nothing new, it is the classic debt overhang problem. If the economy in Ireland grows then it is not the Irish people who will benefit, since so much will go to pay off the debt. The Irish people will have to deal with lower wages, higher taxes, and still have to make the debt payments. The benefits accrue to the bondholders and not the "equity holders"--the citizens of Ireland. So you would expect the equity holders to "under invest"--work less. Better for the Irish people to be disruptive, worsen the situation, and force the EU to write down debts. This is the essence of Katastophenpolitk.

But this is a terrible outcome for everyone, worse still because as we saw with Britain, France, and Italy, its likely that the debt will be written down in the end anyway. On the way, however, we will have a languishing Irish economy, as well as other European economies. We will have growing resentment towards the EU, growing nationalistic feelings, growing conflict. Katastrophenpolitik is a form of brinkmanship: pushing the situation to the verge of disaster in order to gain an advantage. Ireland is being overburdened with debt, if the situation get worse in Europe then this debt will be reduced, so let's make things worse! Is this the strategy we want for Europe?

No!

Better for the debts to be written down now, as reasonably as possible, without having to go through the damage to European unity. It seems overwhelmingly likely that the debts will be written down anyway, so why not do this sensibly? It is alright to risk the European Idea for something, but to ruin it for nothing?