Are Ireland and Portugal out of the woods? An updated version

This post is an updated version of the previous one, addressing some of the points raised by Wolfgang Munchau in this article published since in the Financial Times.

Ireland and Portugal have, recently, tested the water of the money markets with some success. Portugal has issued 5-year bonds and Ireland is in the process of converting its unbearable promissory notes into long-term bonds, to be sold to the private sector. In addition, Ireland managed to secure the consent of the ECB’s Council to restructure the hated Promissory Notes that added a hefty 20% to its debt-to-GDP ratio back in 2010. So, on face value, two of the so-called ‘program’ Eurozone countries, wards of the EFSF and the troika, are returning to the markets.

But does this mean that they are out of the woods? Is there, in other words, any justification in saying that these two countries are closer today to exiting their ward-of-the-troika status than they were last July, before Mr Draghi’s pronouncement that he will do all it takes to save the Eurozone? The answer to both questions is, I am afraid, a resounding ‘No!’ To see why this is so, it helps to remind ourselves (a) what it means to be ‘out of the woods’, and (b) what Mr Draghi’s OMT program is and how it is affeting Italy and Spain and, through them, Ireland, Portugal.

To begin with, to be ‘out of the woods’ ought to mean a capacity to finance one’s state without relying on direct or indirect state financing by any of the troika’s branches. It means that Dublin, Lisbon, Rome, Madrid can run their own fiscal policy without the direct supervision of the troika and without reliance on the troika’s willful actions to secure the sustainability of that fiscal policy. It will be my claim, below, that none of the ‘fallen’ Eurozone states (Ireland, Portugal, Spain and even Italy) are nearer this ‘happy ending’ today than they were in July 2012.

A brief history of OMT, its nature and function

The bond market calm that broke out recently is entirely due to Mr Draghi’s OMT (outright monetary transactions) program announcement last September. What was the purpose of the OMT? Put simply, to address the utter incapacity of the EFSF-ESM bailout fund to bail out Italy and Spain. After Germany’s rejection of any suggestion that the EFSF-ESM should be allowed to borrow more money, or that the ECB’s balance sheet should be used to lever up the EFSF-ESM’s funds, it became abundantly clear that, as Spain and Italy were being brutalised by money markets shorting their bonds, there was no way that their combined 3 trillion euro debt could be stabilised. It was at that point that Mr Draghi had to step in, somehow, to plug that gap and, effectively, signal to bond traders that further shorting of Italian and Spanish debt would lose them money.

Thus the OMT was born. It constituted a simple threat, by the ECB, that (if need be) the ECB would purchase as much short term Italian and Spanish debt from the Italian and Spanish banks as it was necessary to burn the short-sellers of Italian and Spanish bonds. Unable to mention Italy and Spain explicitly, Mr Draghi’s OMT specified that the program concerned countries that retained full access to money markets; in other words, that it did not apply to Greece, Ireland and Portugal (which left only Italy and Spain on the menu). This condition killed two birds with one stone: It signalled that which Mr Draghi wanted to signal vis-à-vis Italy and Spain (that the OMT was meant as a stop gap measure to fill in the funding hole due to the EFSF-ESM’s incapacity to bail out Italy and Spain) and, moreover, it left a window open for concocting an alternative to a new official bailout loan for Ireland and Portugal (once their first loan agreement expires).

Markets responded instantly by taking several steps back. While OMT financing was also conditional on Italy and Spain to be placed under troika supervision, under a full troika program, bond traders refrained from testing Mr Draghi’s commitment for two reasons: First, because of the Beauty Contest effect (i.e. each bond trader believed that average opinion among bond traders was that, for the time being, it does not pay to mess with Mario) and, secondly, because Mr Draghi and the EU hinted at a willingness to consider Madrid’s and Rome’s existing austerity policies as a de facto troika program, at least in the short run.

Thus, Italian and Spanish bond yields collapsed despite a colossal deterioration in the real economy’s fundamentals for both these countries. And as their bond yields fell, a rally of all bonds began throughout the Eurozone aided and abetted massively by Mrs Merkel’s decision to proclaim that Grexit was off the table, until further notice at least.


The universal fall in bond yields was of particular importance to the Dublin government. Lest we forget, Ireland’s government has for some time been desperately seeking to show the Irish people some tangible evidence that its ‘model prisoner’ strategy was paying off. That Ireland would receive a good behaviour bond from the ECB, in particular with regard to the hated Promissory Notes,[1] and that, soon, it would be able to throw off the ignominious label of being a member of Bailoutistan, of being a ‘program’ country alongside disgraced, failed states like Greece. The OMT offered Ireland a great opportunity to bring an official end to its official fallen state status while, at once, it gave Brussels, Berlin and Frankfurt a golden opportunity to proclaim their first victory – or as Karl Whelan put it in his 2012 paper on Promissory Notes and the case for their re-structuring: “It is the firm hope of Ireland’s Eurozone partners that Ireland, which is widely praised for its willingness to implement austerity measures, be able to access sovereign debt markets by 2013…. A reduction in the funding burden associated with the promissory notes represents a relatively simple way to take such a step.” p.22

The logic was indeed simple: Ireland’s crisis was not substantially different to Spain’s. Its sovereign debt became unsustainable when the real estate sector imploded, exposing its banks to a mountain of debts which were then transferred onto the state’s shoulders. If OMT made it possible for Spain to pretend that it retained full access to the money markets, why could Ireland not maneuver itself, with the ECB’s assistance, into a Spain-like situation: of remaining a ward of the troika after officially, at least, exiting its EFSF program?

What made this easier, in the Irish case, was the fact that some fund managers, Franklin Templeton being one of them, had already wagered a great deal of cash on Ireland managing to become a northern Spain. It is for this reason that Irish spreads had already fallen below Spain’s some time ago (since the hedge and mutual funds’ purchases of Irish debt constituted a considerable percentage of Ireland’s outstanding bonds).

So, taking advantage of the combined OMT-effect and hedge/mutual fund wagers-effect in suppressing its bond yields, the Irish government went to the ECB with an offer the ECB could not, ultimately, refuse: “We are going to offer you a splendid chance, at no cost to the ECB, to proclaim your first success in the fight to end the crisis. Just allow us to stretch our Promissory Notes repayments into the future, while keeping steady the inter-temporal value of our payments to the creditors of our defunct banks.[2] That way, the ECB can say that it has not concurred to the monetary financing of the Irish state while our promissory notes will be converted into long term bonds and sold to the private sector. And why will the private sector buy them now at affordable interest rates? Because if they do, Ireland can be proclaimed to have regained access to the markets, in which case Ireland is suddenly perfectly eligible for the OMT program: a member-state with full access to money markets and a pre-existing troika program. Immediately, bond traders will cease and desist from shorting Irish bonds even if we try to sell a large number of fresh ones. As for the icing of the cake, from the ECB’s perspective, the ELA will be used far, far less, allowing the ECB to claim a return to normality in that regard too.”

The ECB’s recent announcement of its agreement on the conversion of Ireland’s promissory notes into long term bonds concludes this deal: The Irish taxpayer will continue to be burdened with huge, unsustainable long term debts taken out by bankers who are now defunct and who should never been backed by the Irish state. Austerity-driven self-perpetuating recession, and the resulting stalled recovery, will remain the order of the day. The fact, however, that Ireland’s sovereign debt is unsustainable and that its largely self-inflicted austerity has failed will, from now on, be hidden behind an OMT-created façade. The troika will continue to be the effective government of Ireland and the Irish state will continue, just as it has been since September 2010, to require the direct interventions of the ECB in order to maintain its ‘market access’. All that has changed is the rhetoric, which now rewards Dublin with the Pyrrhic victory of claiming, with a little more self-confidence, that “it is not Greece”.

The sad truth behind the shadow play

German and, in particular, Bundesbank objections to both the OMT and the deal on Ireland’s Promissory Notes was based on the ‘standard’ fixation with ‘moral hazard’. Would such ‘non-standard’ measures not cause Italy and Spain to think of exploiting Mr Draghi’s announcement or their ELA facilities to bail out their banking systems, without dragging themselves through the bed of nails that Ireland rolled over? What overcame these ‘fears’ was the thought that the OMT program’s announcement and consent to stretching Ireland’s Promissory Notes’ burden into the future would deliver the troika the grand political trophy of having Ireland (and perhaps Portugal) out of the EFSF-program frying pan, with an official announcement that ‘pain works’ and returns the righteous to the money markets. An added bonus is, of course, that very few astute observers will notice that, having escaped the EFSF-program frying pan, Ireland and Portugal will fall into the fire of OMT-led austerity.

In conclusion, Mr Draghi’s OMT has undoubtedly succeeded in addressing a sequence of political headaches:

  • How to avoid telling the German electorate that Spain, Ireland, Portugal and, eventually, Italy will need gargantuan fiscal assistance that the EFSF-ESM was incapable of providing.
  • How to break the news to them, months before the German federal election, that Ireland, Spain and Portugal, in addition to Greece, will require fiscal financing ad infinitum.
  • How to tell the Irish people that their suffering had no tangible effect.

All these questions are now answered in one, brief, liberating sentence: Ireland has escaped Bailoutistan and Spain has been prevented from entering it. Even Portugal has issued some five-year bonds! Bring on the champagne!

But as the champagne corks are liberated, and the merriment’s din fills our ears, it is worth maintaining a connection with reality. And the reality is particularly stark: There has been no progress whatsoever! Indeed, the Eurozone crisis is getting worse the calmer the bond markets seem and the more confident  the commentariat is becoming that Ireland and Portugal are out of the woods. If the resolution of the Euro Crisis was all about replacing EFSF-ESM funding with the ECB, without decoupling the banking from the debt crisis and while a vicious asymmetrical recession is eating into the heart of Europe, then of course the Crisis is over. Alas, it was never about that. And so the good ship Eurozone sails on, taking water in at an increasing rate that drowns more and more of those below the decks, while its first class passengers, pacified by a cunning captain, are downing the champagne.

[1] Guarantees offered by the previous government to two failed banks, which involved annual repayments by the taxpayer to failed bankers and their creditors as cruel and unusual as the annual tribute sent to Crete by the Athenians (i.e. Athenian boys and girls to be devoured by the Minotaur).
[2] Following the initial edition of this post, Wolfgang Munchau published an article in the Financial Times that contests my claim that the inter-temporal value of the Promissory Notes was held constant. He writes“This is monetary financing for all intents and purposes. The whole structure of this agreement is so convoluted that newspapers do not report all the relevant details. As always, convolution has a purpose. It renders legal what would otherwise not be, and it allows for obfuscation.” I agree, complexity is pressed, yet again, into the service of subterfuge. My point here is based on the same source as Wolfgang’s: The excellent paper by Karl Whelan, entitled ELA, Promissory Notes and All That  Whelan writes on p.20: “…the current schedule would mean that IBRC will be able to pay off its ELA debts (with presumably all other debts long gone) in 2022. At that point, the government could wind up the IBRC and simply cancel the remaining payments. Note here that the total amount of promissory note payments in this example would be €37 billion. The additional €11 billion in payments scheduled after 2022 just wouldn’t happen.” If we take into account that the Irish government, as Whelan says, would not honour Promissory Notes beyond 2022, since by that time the IBRC’s debts to the ELA will have been repaid, the new long-term bonds’ inter-temporal value will be equivalent to that of the Promissory Notes’ present value.