Irish plight about more than austerity

By J Saft
September 10, 2010

Ireland and its economic unraveling is not simply a test case of the stimulus versus austerity dispute, it is an illustration of the limits and pitfalls of the very popular strategy of keeping the banks ticking over, hiding under a desk and hoping for a strong recovery.

Previously praised for taking a tough fiscal stance which fans hoped would put it on a solid footing, Ireland now seems more vulnerable than ever. Concerns that the costs of the banking bailout will exceed the government’s ability to pay, even with European Union support, have battered Irish debt in financial markets.

The price of insuring Irish government debt against default hit a record on Wednesday, with markets extracting a premium of just over 4 percent of the amount being insured. Similarly the yield investors demand to hold 10-year Irish government bonds has increased greatly, hovering just around 6 percent, or 380 basis points more than German benchmark bonds.

Be in no doubt, numbers like these could eventually force a more profound crisis: Ireland can not go on indefinitely growing by 1 percent or so and paying 6 percent interest.

News that Ireland would split nationalized Anglo Irish Bank in two, an announcement that was not accompanied by a costing, did little to reassure financial markets. Nor for that matter can news that building society Irish Nationwide has issued 2 billion euros of government-guaranteed bonds to itself, planning to swap them with a pliant European Central Bank for actual money, be much of a confidence booster.

Most of the reporting on the Irish plight focuses on two issues: the costs of the banking bailout and the effects of a policy of fiscal austerity.

Clearly the view outside of the Irish government is that the bailout is going to cost a good deal more than had been advertised; property prices continue to sink and while Ireland returned to growth in the first quarter, it was growth of a tepid sort and not nearly strong enough to counteract the 14 percent or so peak-to-trough contraction.

The policy of austerity probably didn’t help, cutting demand and pushing property prices lower, hitting the value of collateral held by the banking system and raising the costs the government will have to bear.

It is far from clear, though, that even an expansionary policy in Ireland would have led to a much different result.
To look at Irish austerity in isolation is silly; it is a small open economy bobbing along in the global tide. For many years it was swept along in the direction of growth and excess, now the tide is going back out again and things are considerably tougher.

Ireland made a bet two years ago that if it kept its own finances tight enough global growth might come back and rescue the valuations that it was hiding in its banking system.

For that gamble to come good, Ireland needed a strong global recovery, one strong enough to compensate for what was happening at home.

So, what if the same forces which are driving down yields in the United States are driving them up in Ireland? U.S. yields are going down because investors feel that the economy there will be slow and will suffer disinflation, if not deflation. The same can be said for Germany, export miracle or not.

That translates into a lack of global growth, a lack that will be particularly nasty for Ireland, which almost regardless of its domestic policies needs a health global economy to have a fighting chance not to have to reschedule or require huge additional support from outside.

In that way, the rising Irish crisis is really telling us something about how markets are betting on global growth. It could well be that if the U.S. economy were booming back, Ireland would have been able to get away with its gamble.

This gets to the heart of the lesson from Ireland: like the U.S., it looked at the aftermath of a housing bubble and designed a policy that would only really work if the bubble did not deflate fully. It is telling that Irish banks have hemmed and hawed over foreclosures, just as Fannie Mae and Freddie Mac have been slow to deal with their inventory of loans which are never going to cure. This is likely a deliberate policy intended to support the housing market and banking system.

In some ways Ireland’s plan had a better chance of success — after all it is only a rounding error in the global financial system. How exactly U.S. house prices were expected to balance on a slightly lower cloud has never been property explained.

Both the U.S. and Irish gambles are still live, but both look shakier with each passing week.

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