Thursday, September 2, 2010

Ireland's Doldrums

. Thursday, September 2, 2010

How's this for a public works campaign:

The jobless will now be "requested" to work "in the community" or else they will lose their unemployment benefits. Those who fail to show up or miss hours will be struck off the dole under the plans, reports the Irish Independent. ...

Everyone is on-board for the plan in these straitened times, it seems. Even Irish trade unions have given the government’s plan a guarded welcome.

Meanwhile, in July Moody's downgraded Ireland's debt, in August S&P followed suit, credit default swaps are spiking, and sovereign debt has nearly quadrupled since the start of the crisis.

Ireland was one of the first countries to impose harsh austerity measures. Krugman has claimed that the fact that Ireland has not seen a turnaround is evidence that the "Confidence Fairies" are mythical beasts:

But since austerians were claiming bond market approval as a sign of its policy success, it is worth pointing out that dutiful Ireland looks as if it’s entering a runaway debt spiral, while malingering Spain is looking considerably better.

Peter Boone and Simon Johnson argue that this is the opposite way to look at it:

Ireland’s three main banks built up loans and investments by 2008 that were three times the size of the national economy; these big banks (relative to the economy) pushed the frontier in terms of reckless lending. The banks got the upside, and then came the global crash in fall 2008: property prices fell more than 50 percent, construction and development stopped, and people stopped repaying loans. Today roughly one-third of the loans on the balance sheets of major banks are nonperforming or “under surveillance”; that’s an astonishing 100 percent of gross national product, in terms of potentially bad debts. ...

These debts need to be added to the fiscal deficit, which also remains dangerously out of control. This year the government will run a deficit of 15 percent of G.N.P., and with nominal G.N.P. falling, it could well remain that high next year, even if the government cuts spending by the 2 to 3 percent of G.N.P. currently envisaged.

In other words, the Confidence Fairies have not materialized because the debt has spiked sharply. In response, the Invisible Bond Vigilantes have pushed CDS spreads upwards, and demanded a much higher risk premium in exchange for loans. Or, as Krugman puts it:

Now, this isn’t a clean experiment: Ireland had an even bigger bubble than Spain did, so you could say that’s the issue.

Yes, you could. In fact, saying anything but that is a distortion of the facts. This isn't about fairies; it's about fundamentals. Irish bond spreads keep rising because their balance sheet continues to worsen. This is exactly the sort of behavior you'd expect from vigilantes, or updating investors.

Jim Stewart argues that Ireland should renegotiate its commitment to the financial sector, threatening to default if creditors don't accept writedowns on the order of 50-90%. After all, the thinking goes, why should Irish taxpayers pay for the mistakes of private bankers?

A third and less costly option is to negotiate with all bond holders and purchase bonds, not at face value but at some fraction of face value. Writing down the 2009 balance sheet value of Anglo Irish debt by 50% would reduce balance sheet liabilities by €8.7 billion. Writing debt down to 10% of face value (a generous value in the event of liquidation) would reduce balance sheet liabilities by €15.6 billion.

(Note: Anglo Irish is one of the large Irish banks that was effectively nationalized by the government)

This represents a huge writedown. The interesting political economy question is, at whose expense? If Ireland is saving money by not paying back the full value of their debts, then someone else is losing an equivalent amount of money from the same transaction. So who's losing? Other banks and financial institutions, mostly in core European countries like Germany, France, and England. These institutions are still stressed of course, and writedowns from some Irish banks could affect the solvency of many others, as the knock-on effects move through the system. In a worst-case scenario, this could lead to another series of runs like that in 2008, necessitating even stronger intervention by European governments.

What is the likelihood that voters in Germany continue to support the PIIGS through emergency stabilization funding if the PIIGS continue to try to shift domestic adjustment costs onto their neighbors? I'm not sure where the breaking point lies, but it surely must exist. In other words, austerity may be the only political option for Ireland even if it were not the only economic option. Bond vigilantes aren't the only constraints that Ireland faces.


Ireland's Doldrums
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