Why The Irish Debt Crisis Could Be Worse Than Spain, England, And Even Iceland

Here are some quick thoughts on what’s happening in Ireland. The Irish situation is mostly about the collapse in the economy due to a huge run-up in private sector debts. This has been complicated by Iceland-style bailouts for an outsized banking sector. As a result of this socialisation of banking sector losses, Ireland is facing a sovereign debt crisis since the euro zone framework has eliminated Irish currency sovereignty.

As background, read Ambrose Evans-Pritchard’s post Ireland faces double dip, mulls restructuring of junior bank debt and the links post from this morning.

When thinking about the Irish sovereign debt crisis, there are five countries that come to mine for comparison sake. Here’s a quick run-through of parallels and differences.

  1. Spain: The biggest parallels I see for Ireland are with Spain. Spain is the perfect example of a country that never should have joined the euro zone. Both countries had budget surpluses in the run-up to the financial crisis. But they both suffered from euro zone rates that were too low during the property bubble. Their economies overheated and crashed, leaving behind a mountain of debt, unfavourable wage rates and huge overinvestment in the property sector. Moreover, the strictures of the Euro mean currency depreciation vis-a-vis European trading partners is off the table. In 2008, I said Spain and Ireland might regret joining the eurozone for this reason. I still believe this is the case because the euro leaves internal devaluation, austerity and depression as the only logical solutions to their problems. The reason Ireland is now fifth for highest government default probabilities in the world and Spain is not has to do with the Iceland-style bailout of the Irish banking system in general and Anglo Irish in particular (see here). You would see the same in Spain if it decided to socialize banking losses in this way because it cannot credibly guarantee these losses without using printed money.
  2. The UK: Note, the critical factor in Ireland which makes its problem most acute is the banking sector bailout. But, it has also embarked on austerity measures, which in the medium term lower GDP and increase budget deficits, thus worsening the problem (see here). The UK is now embarking on Ireland-style austerity. This is misguided because the UK is not tied to the euro and cannot suffer the types of liquidity problems Ireland is now experiencing. I agree with this Guardian article that Ireland’s austerity measures show us how not to do it.  The UK will probably double dip as a result of following in Ireland’s path. And given its ownership of RBS and Lloyds and it outsized banking sector, a double dip’s impact on property prices would be devastating to the budgetary outlook.
  3. The United States: Last summer I made the California – Ireland parallel because of the euro. What are potential options to monetise the problem given this impediment? Gold-backed IOU’s and central bank debt purchases are two options I said could be considered in extremis.
  4. Germany: Germany is in a much better position than Ireland. But both countries are good exporters. What is interesting is that the both the Germans and the Irish are showing fairly soft manufacturing data of late and that is worrying for the sustainability of the euro zone’s weak recovery. The euro has traded up to USD1.30 and above after the worries about the sovereign debt crisis faded this summer. Unless, the euro zone can affect a competitive currency devaluation (perhaps by buying up weaker euro zone sovereign debt), I don’t see the export machine as a sustainable release valve. In my view, this means that Germany will find its brief export boom fading.
  5. Iceland: I hate the Iceland parallel. I touched on it before but the gist of it is that Ireland’s banking sector is too large to credibly bail out via its national government alone. When Iceland attempted to socialize its three largest banks’ losses, the banking crisis became a sovereign crisis very quickly and depression ensued.  Iceland did have the currency release valve, however, and Ireland does not. Watch the Anglo Irish situation and property prices for a sign of where this is headed. Right now evidence suggests extend and pretend is ongoing in Ireland, which keeps property prices from crashing further. But, if prices decline further, expect to see loss estimates for Anglo Irish rise dramatically. Also see Too big to rescue and The largest European banks by assets for a European-wide view of national banking sector sizes.

I see the Irish problem as symptomatic of economic weakness  throughout the developed economies and not just something that is specific to Ireland. I hope these comparisons demonstrate why.

Update: The Europeans should see the Irish debt crisis as a wake-up call. Bailouts and debt guarantees aren’t going to cut it; the problem goes much deeper.  A recent parallel in the sovereign debt crisis goes to bear Stearns and Lehman Brothers.  The Greek situation was the Bear Stearns event. We should be looking for permanent solutions to avoid a Lehman Brothers.

I have been saying that the Greek crisis was a Creditanstalt-style event in this particular downturn. Creditanstalt metastasized into a global banking crisis. We do not want to see the same thing here. What will be necessary is some combination of defaults, haircuts, internal devaluation, bailouts and money printing with the emphasis on the former yet-to-be taken remedies over the latter quick fixes.

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