How the Shadow Banking Sector is Wrecking the Irish Economy

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Peter Bofinger is someone I’ve been reading and reading about in the last couple of days as the trouble at mill continues with Ireland’s bank debt, Germany’s stance on legacy assets and Kenny’s rewriting of history to suggest that the Irish government didn’t unilaterally provide a blanket bank guarantee before the EU could scramble together an EU wide solution to the immediate banking crisis in late 2008.

According to his Der Spiegel bio Bofinger has been a ‘member of the government-appointed German Council of Economic Experts known colloquially here as the “Five Wise Men” since 2004’. So, as a key adviser to Merkel his opinion carries some weight.

So in the current context it’s worth being aware that Bofinger pointed out in November 2010 that Ireland’s bailout was in effect a bailout of German banks.

SPIEGEL: According to the Bundesbank, German banks with 166 billion euros are the biggest creditors of Ireland, of which nearly one hundred loans to Irish banks. How dangerous is the Irish financial crisis for Germany?

Bofinger: The situation is very threatening. The federal government has a vital interest have to secure the solvency of the Irish state and its banks.

SPIEGEL ONLINE: The Irish Finance announced discussions on an EU bailout package. Germany should now also save Irish banks?

Bofinger: The rescue of Irish banks also means the rescue of German institutions.The demands of foreign banks to Irish debtors amount to about 320 percent of Ireland’s gross domestic product. One has to ask the question of whether the Irish government would ever be able to stand up for such a high debt.

Again in November 2010 the Irish Times reported his comment that Ireland has no alternative but to increase its corporate tax rate.

The reaction to that at the time was to say that Ireland shouldn’t make itself ‘uncompetitive’ by increasing corporation tax in order to pay back German banks that lent recklessly in the first place. However, this argument conveniently sidelines so much about the type of services that Ireland provided German banks in the first place. It instead falls back on the narrative of competing national interests and how increasing the corporation tax rate here would undermine Ireland’s ability to dig itself out of its problems.

However, his argument is fleshed out in another Spiegel piece from December 2011 where he recommends that “debt-ridden countries like the United States, Ireland and Japan need to raise their taxes to a similar level to Germany”.

Here is in a nutshell:

“But is it even possible for national governments to balance their budgets within the foreseeable future? For the OECD countries with the largest deficits — Ireland, the United States and Japan — the problem is clearly on the revenue side. These countries have government revenues which only amount to about one-third of gross domestic product (GDP), putting them at the bottom end of the OECD scale. Conversely, Sweden and Finland — both countries with high taxes — belong to the countries with the lowest budget deficits.

If Ireland, the US and Japan managed to increase their public revenues to the level of Germany (43.2 percent of GDP), it would achieve a great deal.”

I think that table in itself is worth several posts but I wanted to move on to the following section, where he delves into recent German economic history:

“From an economic perspective, there is no reason not to use this approach to balance government budgets, assuming that the tax increases are not made abruptly. The example of Germany in the 1990s shows that it is absolutely possible for a country with high taxes to make ends meet during an economic crisis.

At the time, then-Chancellor Helmut Kohl increased the top rate of income tax to 56 percent (including the so-called “solidarity surcharge” which is levied on top of income tax) in order to finance German reunification. Government revenues reached levels of around 46 percent of GDP. Nevertheless, average economic growth in Germany in the 1990s was 2.1 percent. That was more than twice as high as in the last 10 years, when it was only 0.9 percent — even though the center-left government of former Chancellor Gerhard Schröder, which was in office between 1998 and 2005, massively lowered taxes on high earners and companies.”

The example of Germany in the 90s reminded me of a point made by Conor during his talk at the Exchange in Temple Bar last week that prior to that I hadn’t fully appreciated. Here’s the slide in question, which shows IFSC companies by nationality in 1991.

After pointing out the Irish banks were the largest beneficiaries of the new 10% rate introduced in 1987 for IFSC companies, he asked why was it that German banks were the second largest.

The answer is in the quote from Bofinger above. It’s because German banks were avoiding the increase in tax that Helmut Kohl has imposed in order to pay for unification and Ireland helped them to do that.

There is no doubt that Ireland’s relationship with German banks is complicated, although some of that relationship is very straight-forward. For example, we can see how Ireland bent over backwards to facilitate German banks like Depfa to the point where the Irish government was willing to create legislation specifically to allow them to restructure their business in Ireland and avail of our minimal tax, minimal regulation regime. As Finance Dublin described the plans in 2000

“Under the plans, the German parent group is preparing to split its public sector finance and property businesses into two separate divisions by 2002, as an interim step to becoming two completely independent banks.

The move to base this part of the bank in Ireland is linked to the proposed Irish ‘Pfandbrief’ project which would allow the issuance of ‘Pfandbrief’ bonds by banks in Ireland. Legislation for this is expected to be introduced next year.

DePfa-Bank Europe managing director, Dermot Cahillane, said that the plan to headquarter the public finance bank in Ireland was directly linked to this project but not dependent on it being approved. But he added that Irish pfandbrief would be a ‘natural refinancing product’ for the company.

While the running of the public sector bank from Dublin would mean a natural expansion of activities in Ireland, Cahillane said that there would not be a dramatic increase in employees in Ireland as international staff will be coordinated from Dublin.”

To show the Irish government is not embarrassed by the fact that it is willing to do whatever financial companies operating in Ireland want they even included Depfa’s name in the piece of legislation:

Central Bank Act 1971 (Approval of Scheme of Depfa Bank-Europe Plc and Depfa Bank Plc) Order 2002

Interestingly when Depfa got into incredibly serious trouble in 2008 it asked to be included in Ireland’s blanket bank guarantee. One reason it was rejected, the Irish authorities said, was justified on the basis that Depfa did not conduct business in Ireland.

So, even though it added nothing to the Irish economy and the restructuring provided no additional jobs, the Irish government was still willing to create legislation specifically for it, and put its name in the title. There is a sense that Ireland dodged a bullet when Depfa was bought by Hypo Real Estate in 2007. If they hadn’t Ireland might have been liable for the losses. The fact that this is uncertain illustrates the massive danger that the Irish Financial Services sector still poses. As it turns out the Central Bank of Ireland had to provide €17bn in Repo loans to Depfa in 2008. Although this ELA is provided through the ECB’s eurosystem of liquidity assistance these funds are ultimately guaranteed by the Irish state, as we know from the situation with Anglo Irish Bank.

But to return to my original point in raising Bofinger’s argument that Ireland could overcome its massive deficit problems by increasing corporation tax. Considering that many of Ireland’s deficit problems are associated with the bank debt that it incurred through the bonanza earned by German banks through the creation of the Euro, it is irksome that any extra revenue earned via a raising of corporation tax should go back to those banks rather than funding Irish schools and hospitals.

But the principal point remains as illustrated by the chart based on OECD data that Bofinger refers to and which I reproduced above. It would be far better for Ireland to deal with its deficit problem by increasing corporation tax rather than grinding the economy into the dirt through austerity.

What if raising it would lead to banks like Depfa leaving Ireland (it’s still here after all)? Considering how European and US banks operating without impunity or regulation in the IFSC (since 2004 elsewhere in Ireland) were at the root of the financial crisis this would surely be a great thing, would it not? Those Irish companies that pay corporation tax (20% of all CT is paid by Irish companies even though Irish companies also reduce their tax liabilities significantly), as well as long established ones and those that have deep infrastructural roots in Ireland wouldn’t. As Conor pointed out in the talk, most of the FDI into Ireland goes straight back out again anyway, so if these companies choose to no longer have a HQ here the loss would be minimal.

However, there is a deeper problem and the resistance to any move to change Ireland’s tax regime illustrate this.

The tax rate is largely irrelevant. Rather it is the ability of these banks and hedge funds to operate in a jurisdiction which has the cover of OECD and EU respectability but which provides them with the freedom and accommodation of a tax haven, one which has a Central Bank which legislation has ensured must actively promote the interests of the Irish financial services sector and a government that is prepared to create a tax regime based exactly on the requirements of that sector.

So, now Enda Kenny is claiming that “Ireland was the first and only country which had a European position imposed upon it”. The reference is to the pressure from the ECB, after the blanket nature of the Irish guarantee lapsed in 2010 not to default on the full payment of senior unsecured unguaranteed bonds. However, while it is beyond comprehension that Irish people should be liable for the debt that Irish and international banks accrued and that this must be restructured, there is also an official resistance to another “European position” which potentially would provide a more sustainable and better future for all Irish people.

That resistance is based upon the needs of that very small body of people who get paid by the financial services companies who use Ireland as a tax haven. In case you want to check in on them, given how their priorities are given to the detriment of everything else in Irish society, here’s where they live: