Commentary September 30, 2010, 5:00PM EST

Time for a Debt Haircut

Ireland is struggling to cover its bank debt and U.S. homeowners are wheezing, too. Peter Coy says the next step should be debt writedowns

By Peter Coy

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There is no end in sight to Ireland's debt crisis, but here's one thing we know: The Irish will not get kicked out of their own country. No matter how many multiples of the nation's gross domestic product are owed to German and U.K. banks, sovereign foreclosure is not an option.

In most other respects, though, the state of Ireland is similar to the predicament that 1 in 5 American homeowners with mortgages find themselves in—owing more than their property is worth, so burdened with debt that the economy is stalled by their inability to borrow and spend as they used to. With homeowners, at least, there's foreclosure, which is devastating but creates hope that debtors might regain something close to a normal life, albeit as renters. Those determined to stay in their own homes need something lenders have thus far been reluctant to offer: a reduction in principal, a lessening of the debt. Another word for it is a haircut. The entire taxpaying public of Ireland, it turns out, needs the same thing done to the debts it acquired in saving the nation's reckless banks. A growing chorus of economists, including Carmen Reinhart of the University of Maryland, is making this argument. But policymakers have shown few signs of even considering it. Why?

The situation in Ireland certainly calls for dramatic action. In Dublin, a protester driving a cement truck emblazoned with the words "TOXIC BANK" rammed the ornate iron gate of the Irish Parliament early on Sept. 29. Later that day, inside the purple-carpeted chamber of the lower house, representatives from opposition parties grilled Prime Minister Brian Cowen over the enormous cost of bailing out Anglo Irish Bank, the shaky real estate lender Ireland was forced to nationalize in January 2009 after Irish land prices fell as much as 70 percent from their peak. "What you have done with this government has crushed the spirit of the people," said Enda Kenny, leader of the opposition Fine Gael party.

Ireland illustrates why governments need to make private creditors share the pain. The bursting of its real estate bubble left the country overwhelmed with bad debts and forced the government to impose painful budget cuts. Embracing austerity has won Ireland the praise of the European Union—and little else. The Irish economy shrank at an annual rate of 5 percent in the second quarter because the sharp reduction in government spending hasn't been offset by a jump in private spending. And its borrowing costs have surged. Investors now have to pay 4.7 percent of the face value of Irish government bonds annually to protect against the risk of default for five years, 12 times the cost for insurance on German bonds.

What's forcing up borrowing costs is the Irish government's fateful September 2008 decision to throw a blanket taxpayer guarantee over all the liabilities of Ireland's six big banks. Three have since been nationalized. Standard & Poor's (MHP) projects that the bailout of Anglo Irish alone might ultimately cost €35 billion or more. Measured against the size of the economy, that's comparable to a $3 trillion bailout for a single U.S. bank. On Sept. 30, after this magazine's deadline, the Irish government was set to present its plan for winding down Anglo Irish. Advance word was that the government still aimed to repay the bank's senior bondholders in full. "Burning" bondholders "would be an absolute, utter disaster," Dick Roche, a junior minister, told Dublin-based broadcaster RTE on Sept. 26.