The European Central Bank has taken a drastic step to stop contagion from Ireland: unlimited three-month liquidity at 1% for banks.

Trichet said the ECB will keep offering banks as much cash as they want through the first quarter over periods of up to three months at a fixed interest rate. As he spoke, ECB staff embarked upon a new wave of purchases, triggering a surge in Irish and Portuguese bonds.

Despite the initial shock and awe of such a move, cooler heads ask whether more liquidity can cure a solvency problem, at which point they realise that the Irish problem – like the Greek problem – will eventually be back with a vengeance. Here’s why:

The Telegraph wrote that the ECB had stopped the rot for now but the crisis is far from over. This is a very harsh verdict for a central bank that has just used up its top trump card (unlimited cheap liquidity). The reason for this verdict, according to Prof. Barry Eichengreen of Berkeley, can be summed up as follows: loans to insolvent debtors, when such loans are the only option, are nothing more and nothing less than a Ponzi scheme, and we know how all such schemes end. Or in other words, if the “rescue” of the insolvent Irish sovereign has not reduced their debt outstanding or interest payments, but on the contrary makes the debt mountain even less affordable due to the austerity-induced contraction, is Ireland more insolvent or less insolvent after being “rescued”? Hence the markets are pricing in the high probability of an eventual Irish default restructuring, keeping Irish bond yields at high levels:

A solvency problem postponed is a problem made intractable

The Irish “programme” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130% of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan.

According to the deal, not just interest but also principal is supposed to begin to be repaid after a couple of years. At that point, Ireland will be transferring nearly 10% of its national income as “reparations” to the bondholders, year after painful year.

The inevitable populist backlash

This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB, and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor.

Do Mr Trichet and Mrs Merkel have a contingency plan for this?

Infeasibility of a wage-cutting exit plan

Nor is the situation economically sustainable. Ireland is told to reduce wages and costs. It must engage in “internal devaluation” because the traditional option of external devaluation is not available to a country that lacks its own national currency.

But the more successful it is at reducing wages and costs, the heavier will be its inherited debt load.

Public spending then has to be cut even more deeply. Taxes have to rise even higher to service the debt of the government and its wards such as the banks.

This in turn implies the need for yet more internal devaluation, which further heightens the burden of the debt in a vicious spiral. This is the phenomenon of “debt deflation” about which the Yale economist Irving Fisher wrote in a famous article at the nadir of the Great Depression.

There is more in the naked capitalism post from which the quote comes, including what should have been done about the situation and why it was not done.