2010 May 23 Sunday
Ireland Debt Seen Rising To Unsustainable Levels

Out of the PIIGS nations Ireland gets less attention since the crisis in Greece has focused attention on southern Europe. But econ prof Morgan Kelly takes a look at why Ireland is in trouble and finds the government take-over of failed Irish banks was done in a way that assures Ireland's sovereign debt burden will reach levels similar to Greece.

This debt would probably be manageable, had the Irish government not casually committed itself to absorb all the gambling losses of its banking system. If we assume – optimistically, I believe – that Irish banks eventually lose one third of what they lent to property developers, and one tenth of business loans and mortgages, the net cost to the Irish taxpayer will be nearly one third of GDP.

Adding these bank losses to its national debt will leave Ireland in 2012 with a debt-GDP ratio of 115%. But if we look at the ratio in terms of GNP, which gives a more realistic picture of the Ireland’s discretionary tax base, this is a debt-GNP ratio of 140% – above the ratio that is currently sinking Greece. Even if bank losses are only half as large as we expect, Ireland is still facing a debt-GNP ratio of 125%.

When the banks were taken over the Irish government did not just make whole depositors. The government also bailed out bond holders. That seems incredibly foolish. Why'd they do that?

If Kelly is correct then Ireland faces a future where at some point the market will demand far higher interest rates for Irish sovereign debt than the Irish government can afford to pay. At the same time, the bail-out for Greece just kicked the Greek problem into the future by 2 or 3 years.

I am wondering how the European sovereign debt crisis (and the coming US sovereign debt crisis) will resolve itself. Ross Douthat sees expanding state power in the US and Europe. IN Europe in particular the emotional bonds across nations seem much shallower than the emotional bonds across US states. So I see pretty severe limits in the willingness of the Dutch, Germans, and other more affluent and financially sound European states to bail out the other states.

At the same time, the European Central Bank seems unlikely to inflate away all the debt. Inflation has better prospects in America than in Europe. So default still seems like the most likely outcome in Europe. The question then arises: Default in the euro zone or default while exiting the euro zone? Will Greece, for example, default on its debt and yet still remain in the euro? Or will it default and bring back the drachma currency at the same time?

I also wonder in event of default whose decision will it be on whether Greece leaves the euro? Will the Greek government decide? Or will the Germans and some nations allied with them decide to eject a nation that dares to default? Will the Germans see a default as an opportunity to eject a nation which does not share its economic values with regard to currency soundness and public finance?

The avoidance of either default thru inflation or explicit default seems a very remote possibility. European welfare states already face aging populations and over-promises on entitlements.

Share |      By Randall Parker at 2010 May 23 09:25 AM  Economics Sovereign Crises

Black Death said at May 23, 2010 2:10 PM:

The Germans, who have the largest economy in Europe, will not tolerate large doses of inflation. During the 1920's, Zimbabwe-type inflation occurred in Germany - it took a basket of marks to buy a loaf of bread. The savings of the middle class were wiped out. This contributed to the rise of Hitler. The Germans, who were never too enthusiastic about the Euro, will go back to the Deutschmark and maybe even abandon the EU before they will assent to lots of inflation.

MarkyMark said at May 23, 2010 5:38 PM:

I'm not so sure that we won't see inflation.

Germany is faced with a series of unpalatable options. One of them has to be chosen.

1.) Continue to write cheques to bail out Southern Europe and their reckless spending habits. This is dynamite politically in Germany and Germany has its own fiscal woes. I can't see the German people putting up with this year after year.

2.) Restructure the components of the EMU (European Monetary Union) so that the weaker members leave. In the short term European leaders are petrified that a sovereign default or suggestion of currency reform would trigger a "Lehman moment" and to the collapse of the fragile banking system. It would also potentially signal an end to the post-war european project of ever closer political and economic integration in Europe. European leaders will use the crisis to increase centralisation rather than returning power to the constituent countries and regions.

3.) Inflation is the only option left. Germans no doubt still have a cultural memory of the disaster that is hyper-inflation but mild inflation is appealing seductive to many groups. It lowers the real value of debts and thus bailing out the banks and reckless borrowers and, perhaps most importantly, governments which have taken on huge amounts of debt. It lowers the value of the Euro which boosts European exports (beggar thy neighbour). Savers and the prudent bear the cost of inflation but these costs are hard to pin on any particular politician (as compared to tax rises and spending cuts). Inflation is just too tempting to resist. They can't say so openly but that is what they will aim for. The European Central Bank will just quietly monetise the debt through various complicated mechanisms that 99% of the people don't understand. There will be no shortage of economists who will re-assure that there will be no inflation (recession, excess capacity, etc). Everyone likes the early stages of inflation. It enables the can to be kicked down the road, defeats the deflation bogeyman and gives the appearance that everything is back to normal.

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