Ireland: Keynsianism's Worst Nightmare

Question: what keeps Paul Krugman up at night? Answer: not being able to perform fiscal stimulus because of a skittish bond market. Unfortunately for the Irish, this is the situation they now find themselves in. As Krugman explains:

to satisfy nervous lenders, Ireland is being forced to raise taxes and slash government spending in the face of an economic slump — policies that will further deepen the slump.

And it’s that closing off of policy options that I’m afraid might happen to the rest of us.

And how did the Irish get in this predicament? Again back to Krugman:

On the eve of the crisis Ireland seemed to be in good shape, fiscally speaking, with a balanced budget and a low level of public debt. But the government’s revenue — which had become strongly dependent on the housing boom — collapsed along with the bubble.

Even more important, the Irish government found itself having to take responsibility for the mistakes of private bankers. Last September Ireland moved to shore up confidence in its banks by offering a government guarantee on their liabilities — thereby putting taxpayers on the hook for potential losses of more than twice the country’s G.D.P., equivalent to $30 trillion for the United States.

The combination of deficits and exposure to bank losses raised doubts about Ireland’s long-run solvency, reflected in a rising risk premium on Irish debt and warnings about possible downgrades from ratings agencies.

Hence the harsh new policies. Earlier this month the Irish government simultaneously announced a plan to purchase many of the banks’ bad assets — putting taxpayers even further on the hook — while raising taxes and cutting spending, to reassure lenders.

Luckily for the United States, our banking sector isn't so outsized that our too-big-to-fail institutions are too-big-to-save. Small comfort. And the United States' government debt-to-GDP ratio is at a lower starting point than that of most European nations, so we have quite a bit more runway than our friends across the pond. Still, if the PPIP is as inefficient and ineffective as its critics fear, then every day could seem like St. Paddy's Day: we'll have run up too much debt to save the banks to commit to any other spending, cutting vital counter-cyclical programs at the worst moment. Again, back to Krugman:

For now, the United States isn’t confined by an Irish-type fiscal straitjacket: the financial markets still consider U.S. government debt safer than anything else.

But we can’t assume that this will always be true. Unfortunately, we didn’t save for a rainy day: thanks to tax cuts and the war in Iraq, America came out of the “Bush boom” with a higher ratio of government debt to G.D.P. than it had going in. And if we push that ratio another 30 or 40 points higher — not out of the question if economic policy is mishandled over the next few years — we might start facing our own problems with the bond market.

Not to put too fine a point on it, that’s one reason I’m so concerned about the Obama administration’s bank plan. If, as some of us fear, taxpayer funds end up providing windfalls to financial operators instead of fixing what needs to be fixed, we might not have the money to go back and do it right.

And the lesson of Ireland is that you really, really don’t want to put yourself in a position where you have to punish your economy in order to save your banks.

The brouhaha over the AIG bonuses will be remembered fondly as a time of sober judgment if we turn Irish, and bail out the bankers, while cutting services for the public at large. But even this obvious political reality seems unlikely to change policy towards the banks - after all, it's much easier to simply cross your fingers and hope the banks can earn their way out of this crisis a la 1982, than take serious steps to restructure them. Japan circa 1995, here we come!

Ireland Takes One for Germany

Here's Ambrose Evans-Pritchard at his gloomy, apocalyptic best describing the danger of Ireland falling into a debt deflation cycle not seen since the 1930s. As Evans-Pritchard notes, the most tragic part of this slow-motion trainwreck is that it does not have to happen: if the ECB aggressively cut rates, and Ireland had monetary sovereignty to devalue its currency, then they could perhaps settle for a lost decade instead of an outright depression. Unfortunately for the Celts, the Germans exert de facto control over the ECB, and the Germans are far too worried about the potential inflationary pressures of quantitative easing to pursue such heterodox monetary policies. Apparently memories of needing a wheelbarrow of cash to pay for a loaf of bread scar a nation's collective psyche for generations. From the Telegraph:

If Ireland still controlled the levers of economic policy, it would have slashed interest rates to near zero to prevent a property collapse from destroying the banking system.

The Irish central bank would be a founder member of the "money printing" club, leading the way towards quantitative easing a l'outrance.

Irish bond yields would not be soaring into the stratosphere. The central bank would be crushing the yields with a sledge-hammer, just as the Fed and the Bank of England are crushing yields on US Treasuries and gilts.

Dublin would be smiling quietly as the Irish exchange rate fell a third to reflect the reality of trade ties to Sterling and the dollar zone....

Brian Lenihan, Ireland's finance minister, said the economy would contract 8pc this year on top of the terrifying 7.1pc drop in the final quarter of last year.

But what caught my ear was his throw-away comment that prices would fall 4pc, which is to admit that Ireland is spiralling into the most extreme deflation in any country since the early 1930s. Or put another way, "real" interest rates are rocketing.

This is torture for a debtors' economy. You can survive deflation; you can survive debt; but Irving Fisher taught us in his 1933 treatise "Debt Deflation causes of Great Depressions" that the two together will eat you alive.

Don't blame the victim. Ireland has been betrayed twice in this saga. Once by New Labour, which led Dublin to believe that Britain would join EMU at the same time – covering Ireland's dangerously exposed flank of Sterling trade.

It was betrayed again by the European Central Bank, which opened the monetary floodgates early this decade to nurse Germany through a slump, holding rates at 2pc until late 2005, despite flagrant breach of the ECB's own M3 money targets. Fast-growing Ireland and the Club Med over-heaters were sacrificed to help Germany. They were left to cope with credit bubbles as best they could.

Ireland struggled. Construction reached 21pc of GDP – a world record? – compared with 11pc in the US at the peak. Mr Lenihan hopes to shield banks from the calamitous consequences by creating a buffer agency. It will soak up €80bn to €90bn in toxic debt – or 50pc of GDP.
He borrowed the plan from Sweden's bank rescues in the early 1990s, but overlooks the key point – it was not the bail-out that saved Sweden's financial system, the country recovered only by ditching its exchange peg and regaining its freedom of action.

Without that sort of liberation, Ireland's property slump will grind on for years and more multinationals will join Dell in decamping to cheaper plants in Poland. Ireland risks a deflationary slide into bankruptcy.

Of course, it is not the job of the ECB to set policy for Dublin's needs. But it would at least help if Frankfurt began to set policy for Europe's needs. Has the ECB noticed the collapse of industrial output in Spain (-24pc), Germany (-23pc), Italy (-21pc), France (-14pc)?

If Europe fell into depression, would the ECB notice? Don't answer.

Accountability

What happened to accountability? There's a disturbing lack of it among our elites today. If you're a politician or pundit who told the public we'd be "greeted as liberators" or needed to go to war in Iraq so that Arabs would learn to "suck on this," then you are still considered a credible commentator - by other elites - on what we should do in Iraq today. If you're a bank executive and you've mismanaged things so badly that your bank needs a bailout to avoid bankruptcy, then you are just the person to navigate your firm back to health (while still shelling out million dollar bonuses to yourself and employees, of course). If you're a financial news channel that constantly hyped up the bubble and had its anchors simply repeat whatever CEOs told them, then you are still considered the first stop for financial analysis.

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And if you're a conservative think tank that touted countries that embraced the type of laissez-faire reforms you champion, only to watch those countries self-immolate two years later...then you are still the go-to source on economic policy for Republicans. From Krugman:

And wide-open, loosely regulated financial systems characterized many of the other recipients of large capital inflows. This may explain the almost eerie correlation between conservative praise two or three years ago and economic disaster today. “Reforms have made Iceland a Nordic tiger,” declared a paper from the Cato Institute. “How Ireland Became the Celtic Tiger” was the title of one Heritage Foundation article; “The Estonian Economic Miracle” was the title of another. All three nations are in deep crisis now.

If you thought Iceland, Ireland, and Estonia were model economies, why should anyone take your economic advice seriously? It would be as if liberals hyped the success of central planning in communist economies...in 1988.