By Peter Boone and Simon Johnson
As Greece acts in an intransigent manner, refusing to act decisively despite deep fiscal difficulties, the financial markets look on Ireland all the more favorably. Ireland is seen as the poster child for prudent fiscal adjustment among the weaker eurozone countries.
The Irish economy is in serious trouble. Irish GDP declined 7.3% as of third quarter 2009 compared with third quarter 2008. Exports were down 9% year-on-year in December. House prices continue to fall. While stuck in the eurozone, Ireland’s exchange rate cannot move relative to its major trading partners – it thus cannot improve competitiveness without drastic private sector wage cuts. Yet investors are so pleased with the country that its bond yields imply just a one percent greater annual chance of default than Germany over the next five years.
Ireland’s perceived “success” is partly due to its draconian fiscal cuts. The government has cut take home pay of public sector workers by roughly 20% since 2008 through lower wages, higher taxes, and increased pension payments. As the head of the National Treasury Management Agency John Corrigan proudly advised the Greeks (and everyone else): “You have to talk the talk and walk the walk”.
So is Ireland truly a model for Greece and other potential problems in Europe and elsewhere? Definitely not – but it does provide a cautionary tale regarding what could go wrong for all of us.
Ireland’s difficulties arose because of a massive property boom financed by cheap credit from Irish banks. Irelands’ three main banks built up 2.5 times the GDP in loans and investments by 2008; these are big banks (relative to the economy) that 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 over 50%, construction and development stopped, and people started defaulting on loans. Today roughly 1/3 of the loans on the balance sheets of banks are non-performing or “under surveillance”; that’s an astonishing 80 percent of GDP, in terms of potentially bad debts.
The government responded to this with what is now regarded – rather disconcertingly – as “standard” policies. They guaranteed all the liabilities of banks and then began injecting government funds. The government is now starting a new phase – it is planning to buy the most worthless assets from banks and pay them government bonds in return. Ministers have also promised to recapitalize banks than need more capital. The ultimate result of this exercise is obvious: one way or another, the government will have converted the liabilities of private banks into debts of the sovereign (i.e., Irish taxpayers).
Ireland, until 2009, seemed like a fiscally prudent nation. Successive governments had paid down the national debt to such an extent that total debt to GDP was only 25% at end 2008 – among industrialized countries, this was one of the lowest.
But the Irish state was also carrying a large off-balance sheet liability, in the form of three huge banks that were seriously out of control. When the crash came, the scale and nature of the bank bailouts meant that all this changed. Even with their now famous public wage cuts, the government budget deficit will be an eye-popping 12.5% of GDP in 2010.
The government is gambling that GDP growth will recover to over 4% per year starting 2012 — and they still plan further major expenditure cutting and revenue increasing measures each year until 2013, in order to bring the deficit back to 3% of GDP by that date. The latest round of bank bailouts (swapping bad debts for government bonds) dramatically exacerbates the fiscal problem. The government will in essence be issuing 1/3 of GDP in government debts for distressed bank assets which may have no intrinsic value. The government debt/GDP ratio of Ireland will be over 100% by end 2011 once we include this debt.
Ireland had more prudent choices. They could have avoided taking on private bank debts by forcing the creditors of these banks to share the burden – and this is now what some sensible voices within the main opposition party have called for. However, a strong lobby of real estate developers, the investors who bought the bank bonds, and politicians with links to the failed developments (and their bankers), have managed to ensure that taxpayers rather than creditors will pay. The government plan is – with good reason – highly unpopular, but the coalition of interests in its favor it strong enough to ensure that it will proceed.
Investors may wish to remain pleased today with Ireland, but Ireland’s “austerity” – reflecting an unwillingness to make creditors pay for their past mistakes – hardly seems a good lesson for Greece, the eurozone, or anyone else.
Countries – like the US – with large banks that are prone to reckless risk taking should limit the size of those banks relative to the economy and force them to hold a lot more capital. If you thought the “too big to fail” issues of 2008-09 were bad in the US, wait until our biggest banks become even bigger – today the big six banks in the US have assets over 60 percent of GDP; there is no reason why they won’t increase towards Irish scale.
When Irish-type banks fail, you have a dramatic and unpleasant choice. Either takeover the banks’ debts – and create a very real burden on taxpayers and a drag on growth. Or restructure these debts – forcing creditors to take a hit. If the banks are bigger, more powerful politically, and better connected in the corridors of power, you will find the creditors’ potential losses more fully shifted onto the shoulders of taxpayers.
An edited version of this post appeared this morning on the NYT’s Economix; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.