Nov 25th 2010 | from PRINT EDITION
RESCUING banks can be like filling a bath with the plug out. It won't work if water flows out faster than it pours in. Central banks have learned this lesson again and again through history and Ireland may prove yet another case study.
Life is made even more difficult for central banks when they are trying both to rescue their banks and maintain an exchange-rate target. That was true under the gold standard. Back in 1890 Baring Brothers needed a capital infusion of £4m (about £400m, or $640m, in today's money) when the Bank of England had reserves of less than £11m. There was talk of the suspension of gold convertibility but Britain was rescued by loans of £4.5m from France and Russia.
In the interwar period, the collapse of Credit-Anstalt caused similar problems for Austria. Acting as lender of last resort, the Austrian central bank increased the money supply by 20% virtually overnight. However, far from restoring confidence, this caused a run on other Austrian banks and on the currency; the national bank lost more than a third of its gold reserves. An international rescue effort was able to lend Austria just $15m, less than half the gold lost.
The Credit-Anstalt example is still relevant today. Austrian depositors were making a rational decision to withdraw their money. They feared that the government lacked the resources to stand behind the bank. Either the bank would be allowed to fail, or Austria would lose the link to gold, or both. It made sense to move their deposits to a bank where the banks and the gold link were more secure.
The idea that the euro area is an updated version of the gold standard has been much discussed. Barry Eichengreen and Peter Temin have argued* that fixed-exchange-rate systems "intensify problems when times are bad", especially when surplus countries insist that the deficit countries bear all the burden of adjustment.
The banking crisis is creating more parallels. The money to plug a hole in the Irish banks' balance-sheets can come only from four sources: central-bank reserves, printing money, taxpayer funds and foreign loans. The Irish government has â?¬1.4 billion ($1.9 billion) of foreign-exchange reserves: not enough. Nor, as a member of the single currency, can the Irish central bank create euros. The Irish government has thus pursued the taxpayer option by transferring the banks' debts onto its balance-sheet. But it has clearly reached a limit in creditors' willingness to supply funding at a reasonable yield, and may have reached the limit of taxpayers' willingness to pay the eventual bill.
So that leaves money from abroad. The Irish banks were already dependent on the European Central Bank (ECB) for funding; in a sense, the bail-out package is designed to shift this aid from the ECB to the IMF and European governments. But the bath problem remains. There is much talk that the ECB's purchase of Greek government bonds, for example, has merely allowed wealthy Greeks to move their money to Cyprus and Luxembourg.
Shifting money out of a weak banking system seems like a no-brainer for customers. Within the euro zone, there is no currency risk involved and interest rates are set at the same level across the region. For a corporation or charity there is a reputational, as well as a financial, risk involved in holding your money in a troubled bank; think of the opprobrium that affected British local councils that held money in failed Icelandic banks.
Indeed, mini bank-runs helped spark the current crisis. In a recent announcement, Bank of Ireland said that it had lost â?¬10 billion of corporate deposits in the third quarter. David Owen, chief European financial economist of Jefferies International, an investment bank, says that the deposits of non-residents in Irish banks were nearly â?¬203 billion in September, a figure larger than the â?¬166 billion held by domestic residents and than Irish GDP.
Some â?¬179 billion of deposits belong to customers from outside the euro zone, including many from Britain who were attracted by the Irish government's guarantee, offered back in 2008. Those customers may be alarmed by the headlines about the health of Irish finances and by speculation about the break-up of the euro. The longer the crisis remains unresolved, the greater the temptation to move deposits will become.
* "Fetters of Gold and Paper". NBER Working Paper No. 16202, July 2010.
Finance and Economics
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