Why Ireland's Austerity Budget Isn't Likely to Prevent a Default

Ireland's Austerity Budget May Not Prevent Sovereign Debt Default
Ireland's Austerity Budget May Not Prevent Sovereign Debt Default

Despite the widely expected approval of an austerity budget by the Irish government, the long-term solvency of Ireland is still in doubt.

Simply put, the losses that must be covered by Irish taxpayers are larger than the nation's economy can support. The current government deficit is a staggering 32% of the nation's GDP, a post-war European record. The Irish government collected 31 billion euros in tax receipts while spending 50 billion euros on its normal services, then exacerbated its debt burden with a 45 billion euro bailout of Irish banks.

In comparison, Greece's deficit is 16% of its GDP, and the deficits of Spain and Portugal are about 10% of their GDPs. The deficit limit for members of the euro common currency is 3%, which means Ireland's gap is more than 10 times the acceptable level.

But even the huge government bailout of Irish banks -- itself equal to about 30% of Ireland's entire GDP -- is only a down payment on the total losses accumulated in the collapse of Ireland's formerly red-hot real estate market. The European Union bailout is expected to total another 100 billion euros -- fully two-thirds of Ireland's GDP. German banks alone are owed 114.7 billion euros by Ireland.

As an example of the steep losses suffered by real estate developers and property owners, commercial properties that were once valued at 2.8 billion euros are now estimated to be worth 700 million euros -- a decline of 75%. There are about 700,000 active mortgages in Ireland, and experts estimate that 100,000 of them are currently underwater.

Austerity Plan Leans on Lower-Income Workers

While the EU and Ireland's political leadership are putting a brave face on Dublin's austerity plan, the amounts of money owed and the high interest rates being demanded are crippling. The plan calls for Ireland to cut annual spending by 4.5 billion euros (15% of all tax revenues) and raise taxes by 1.5 billion euros.

These tax increases and deep cuts will subtract a large chunk from household incomes (and 3.7% from the nation's economy). As households tighten their spending, business revenues and taxes paid will all decline as well. Yet the planners are working from the rosy projection that the Irish economy -- and tax revenues -- will continue growing through four or five years of austerity, an assumption that beggars belief.

The tax increases will hit lower-income workers hard. More than 45% of the workforce is currently exempted from income taxes because workers don't pay taxes on income below 18,300 euros. The budget aims to raise the percentage of workers paying income taxes to 60% through a reduction in tax credits.

In short, a substantial piece of the bailout will be paid for by households that currently earn 20,000 euros annually -- about $26,000.

Creditors Avoid Any Losses

At the same time, Ireland's creditors -- mostly large U.S. and European banks -- aren't giving an inch. The key European and International Monetary Fund donors stress that the loan package will become available only if Ireland passes severe austerity measures now.

Not only are the Irish taxpayers on the hook for every euro of debt but the European Central Bank and the IMF are demanding they pony up a hefty interest rate of 5.8%. Compare that to the rates U.S. and European banks have paid to borrow from the Federal Reserve: less than 1%. The current Fed funds rate for short-term borrowing by banks is 0.19%, while six-month rates are 0.35% domestically and 0.6% for Eurodollar deposits.

Clearly, a major disconnect separates the superlow rates banks can pay to borrow billions of dollars from the Federal Reserve and what the Irish taxpayers will be paying to their creditor banks. The interest alone will be a significant burden on the Irish economy. By 2014, interest payments on Ireland's public debt (estimated to reach 120% of GDP) will be 10 billion euros -- roughly one-third of all tax revenues.

Adding insult to injury, the Irish government is expected to deplete what remains of its reserve pension fund to cover the bailout costs.

A High Risk of Default -- and Contagion

Citicorp Chief Economist Willem Buiter recently issued a report concluding that six European countries are in or on the brink of insolvency -- i.e., at high risk of sovereign default. He summed up Ireland's plight by dismissing the EU bailout: "Accessing external sources of funds will not mark the end of Ireland's troubles. The reason is that, in our view, the consolidated Irish sovereign and Irish domestic financial system is de facto insolvent. The Irish sovereign cannot from its own resources 'bail out' the banks and make its own creditors whole."

Other analysts see a substantial risk of Ireland's de facto insolvency triggering a contagion that will spread to the other overindebted nations on Buiter's list: Portugal, Spain, Italy, Greece and Belgium.

From this perspective, the widely cheered EU bailouts will only delay Ireland's bankruptcy because they increase the nation's total debt burden while reducing its GDP and greatly adding to the cost of servicing those debts. In this scenario, interest as a percentage of GDP rises each year.

How Ireland Got in Such Dire Straits

How did Ireland, and indeed all the other global economies that are suffering from burst real estate bubbles, get into such a mess? I've prepared a chart to help explain the way in which cheap, easy-to-borrow money combines with rising asset prices and tax revenues to create a "virtuous cycle," in which higher property values leverage higher debts.

Heavily leveraged speculative funding ends up going into increasingly risky, marginal investments -- what are known as mal-investments. When the cost of the rising debt burdens exceeds the capacity of borrowers to service the debt, the cycle reverses: Plummeting property values reduce equity, while the debt remains the same. When the central government takes on all the private losses from insolvent banks, the burdens of paying back the debts falls to the taxpayers.

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Unfortunately, the taxpayers have also seen their wealth slashed by the collapse of the asset bubble, and their incomes have fallen as the post-bubble economy shrinks.

In a corporate bankruptcy, shareholders and creditors -- bond- and debt-holders -- suffer substantial losses. In today's parlance, they "take a haircut." When national governments assume all the debts incurred by private lenders and borrowers, the bond and debt holders don't take a haircut -- they expect to get back every dollar or euro.

That isn't how capitalism is supposed to work. But what's unfolding across the globe, from Washington, D.C., to Dublin, is a version of state capitalism: Private lenders are free to rake in billions in profits when times are good, but when the debts go bad, they unload their loses onto the backs of the state, and ultimately, the taxpayers.

The problem with this form of state capitalism is that saddling taxpayers with these staggering debts ends up shrinking the economy and crushing individuals' ability to spend and borrow for their own benefit. As spending and income decline, so, too, do tax revenues, further reducing the government's ability to pay the heavy interest payments. And that cycle that can eventually lead to sovereign default, as it seems likely to do in Ireland.