Ireland needs help with its debt

“If I were you, I wouldn’t start from here.” Never can the punchline from the well-known Irish joke have been more apposite. The Celtic Tiger has collapsed under a mountain of bad debt. This raises questions about where responsibility for financial excesses should lie. That is an issue in the Irish election today. It should be one for all of Europe tomorrow.

Where is the Irish economy now? According to the International Monetary Fund, over the past three years the cumulative fall in real gross domestic product was 11 per cent, in gross national product 16 per cent and in real domestic demand 22 per cent. The rate of unemployment jumped from 4.6 per cent in 2007 to 13.3 per cent in 2010. The ratio of general government debt to GDP soared from just 25 per cent in 2007 to 95 per cent in 2010.

What caused this calamity? As Philip Lane of Trinity College notes: “There was a genuine Irish economic miracle, with very rapid output, employment and productivity growth during the 1994-2000 period.” Without entry into the eurozone, this might have petered out. But the fall in interest rates increased the risk that a credit-fuelled property bubble would emerge. So, indeed, it did.

Prof Lane observes: “The flavour of this boom was very different to the ‘Celtic Tiger’ years. In particular, it was dominated by a surge in construction activity.” Moreover, this “expansion in property investment was fuelled by rapid credit expansion”, not just to the household sector, but also to a “small group of property developers”.

The ratio of private credit to GDP jumped from around 100 per cent in 2000 to 230 per cent in 2008. Foreign lenders played a huge role in funding this boom: the net foreign liabilities of domestic banks went from 20 per cent of GDP in 2003 to over 70 per cent in early 2008.

The global financial crisis caused an immediate cessation in the capital inflows. In panic-stricken response, the Irish government guaranteed bank debt in September 2008. As the fiscal costs mounted, driven by the slump and the need to rescue the banks, what began as a financial crisis ended up as a crisis in public debt. It is not the first time an out-of-control financial sector has ruined the state. It will not be the last.

How has the crisis been handled? A crucial point is that this is not one, but three, crises: an economic collapse; a financial implosion; and a fiscal disaster. On the first, given the fall in demand and the need for fiscal contraction, prospects for recovery depend heavily on exports. On the second, the direct costs of recapitalising the system are set to be around 36 per cent of GDP, according to Goodbody stockbrokers. For comparison, the cost of the Asian financial crisis to South Korea was 31 per cent of GDP, while the cost of today’s crisis to Iceland might be only 13 per cent of GDP. On the last, according to the IMF, general government debt could be 123 per cent of GDP by 2014. A little over a third of this increase in the public debt ratio would then be a direct result of recapitalising the banks (see charts).

Such a crisis is beyond the ability of Ireland to manage without financial collapse and sovereign default. The banks have become dependent on the European Central Bank, while the Irish state was shut out of private markets, with spreads over German bunds reaching 600 basis points. Before August 2007, this spread had been negative. Markets had no inkling of what was coming.

Without finance from the ECB, the banks would have collapsed. Without external finance, the government would have defaulted. The package of support agreed at the end of last year was as much as €85bn ($116bn), or 54 per cent of 2010 GDP. The IMF noted that the high risks of its programme reflected “uncertain bank losses, a difficult debt outlook, despite an unprecedented fiscal adjustment, unclear growth prospects, continued market focus on peripheral European countries and an impending general election”. Markets agree: spreads over Bunds have barely fallen.

So what might a new government seek to do? Its degrees of freedom are, alas, limited. Even excluding recapitalisation of the banks, the primary fiscal deficit (before interest payments) was close to 10 per cent of GDP last year. Under the IMF programme, this is to be turned into a surplus of 1.5 per cent of GDP by 2015. Given the lack of access to private markets, the deficit would have to be eliminated even more quickly without the official assistance. Again, the debt overhang would be huge, under any plausible assumptions. Ireland is doomed to fiscal stringency for decades, given its poor growth prospects, at least in comparison with its Tiger years.

Apart from the Armageddon of a sovereign default, two partial escapes exist. The more trivial would be a reduction in the rate of interest on Ireland’s borrowing: a 1 per cent reduction in the rate of interest would save the state 0.4 per cent of GDP a year. That would be a small help, at least. A more valuable possibility would be a writedown of existing subordinated and senior bank debt, which currently amounts to €21.4bn (14 per cent of GDP).

The ECB and the other members of the European Union have vetoed this idea, fearful of contagion. Indeed, the assistance package was partly to prevent just such an outcome. Yet the idea that taxpayers should bail out senior creditors of massively insolvent banks at such risk to the solvency of their state is both unfair and unreasonable. If the rest of the EU is determined to protect senior creditors, it should surely share in the cost of doing so. Why should the taxpayers of the borrowing country pay all? The new Irish government should make this point firmly.

Finally, what are the lessons of this calamity? One is old: an out-of-control financial sector creates self-fulfilling euphoria and then panic, as Hyman Minsky warned. Yet this particular episode has at least two specific lessons for the eurozone, as well. First, entry can turn out to be a massive economic shock. Second, the view, popular in Germany, that tighter fiscal policy would solve all problems, is clearly wrong. Before the crisis, Ireland’s ratio of public debt to GDP was 40 percentage points less than Germany’s. True, Irish fiscal policy could have been tighter. But that would have made next to no difference to the outcome, unless it had been able to generate a large surplus in net assets. Indeed, with such a policy, long-term interest rates might have been lower and the asset boom even bigger.

Ireland’s fiscal calamity is not a cause of its crisis but a consequence. The big failure was the behaviour of private lenders and borrowers. That is what must be tackled. Start now.

martin.wolf@ft.com

More columns at www.ft.com/martinwolf