A friend asked me this question, and this is my attempt at a reply.
1. What is the problem? There are two parts to the problem. First, that Ireland has guaranteed the liabilities of its banking system. Second, that it needs to have a depression to restore its competitiveness vis a vis Germany.
2. Guaranteeing liabilities is a way to stop a bank run. Banks borrow short and lend long — that is their function — and so they are vulnerable to self-fulfilling runs. That is the kind of thing that a guarantee can prevent.
2.1. Guaranteeing liabilities is not a way to make an insolvent bank solvent. There are two ways to do that: a) decrease liabilities (partial default), and b) increase assets (by injecting capital, pretending assets are worth more than they are, swapping rubbish for quality, or halting technically-driven selling of quality assets).
2.2. The American banking system was saved with a bit of default (Lehman), capital injections from the TARP, and halting technically-driven selling. The stress tests then demonstrated to the market’s satisfaction that this had worked.
3. Option b seems unavailable in Ireland. The losses of the banks will be more than the government can bear, it is too late for pretending, the government would have to swap rubbish for quality and again doesn’t have the capital, and technically-driven selling of quality assets is not the problem. Capital injection from a third party remains a possibility but appears unlikely.
4. This leaves option a — partial default. What would happen then? Irish bank lending would plummet and the economy would be starved of credit — but that is happening already. Irish banks would be shut out of wholesale markets — again, already happening — I believe they are dependent on the ECB for short-term financing. Foreign banks would take a capital hit, but that isn’t really the concern of Ireland. Finally, everybody would make a lot of noise for a while.
4.1. The banks could then be restructured and eventually pick up lending again — the Iceland route (which seems to be working).
5. Nonetheless, the Irish government is set on option b. As you rightly say, that simply means that the need to default is shifted from the banks to the government.
5.1. I presume the banks own a large amount of Irish government debt. In that case, a government default would further impair the capital of the banking system. Further, depositors would lose confidence in the government guarantee and start a run. Hence, the banks would go bust anyway.
5.2. The sovereign default route has been made harder by taking EFSF funds. The government has swapped debt for which there is a well-established bankruptcy procedure — i.e. bonds, and default — for cobbled-together Euro-chimaera loans on which it is effectively impossible to default.
5.3. 5.1 and 5.2 together mean that the government is locking itself into an unsustainable situation. This will only make the explosion bigger when it comes.
6. Iceland is seeing export growth and on the way to recovery. This shows that bank restructuring is not Armageddon.
6.1. This has been achieved partly because the currency has fallen.
6.2. Ireland cannot devalue its currency because it is locked into the Euro. Therefore it needs deflation. A bank restructuring would hasten deflation and is thus part of the solution.
6.3. A more pleasant solution would be to leave the Euro. The reason that this is normally impossible is that it would precipitate a run on the banking system as depositors both foreign and domestic moved their money to other Eurozone countries in order to benefit from the expected devaluation of the new currency. This would still be a problem if the banks had partially defaulted — they would still need some depositors. There would also be a question mark over continued ECB funding.
6.4. Euro exit is therefore only possible on two conditions: restrictions on capital outflows, and an agreement with the ECB to continue to provide funding until the Bank of Ireland takes over.
7. The best solution for Ireland is therefore partial bank default.
7.1. Ireland should immediately repay the EFSF, rescind its blanket bank guarantee (perhaps while continuing to protect small depositors), and restructure its banks.
7.2. This should be combined with Euro exit, but only if the necessary conditions can be met.