Fiscal Austerity: The cases of Ireland and Spain

Paul Krugman looks at Ireland and Spain for evidence that fiscal austerity reassures markets —

The countries responded differently, however. Ireland quickly embraced harsh austerity; Spain has had to be dragged into austerity, and still faces major political unrest.

So, how’s it going? …  if by “markets impressed” you mean a CDS spread of 226 basis points [Ireland], compared with 206 points for Spain; not to mention a 10-year bond rate of 5.11 percent, compared with 4.46 percent for Spain.

Thus more austerity in Ireland, but worse CDS and bond spreads than Spain.   No reassurance.  What follows is a little more country context for the Irish case, with the basic points being that Prof. Krugman is correct, but some additional information is needed to explain outcomes in the two countries.

First, on the austerity itself, when we talk about austerity, we’re assuming some level of effort in terms of raising taxes and cutting expenditure to achieve deficit reductions.  In 2009 in Ireland, the year that steep cuts began, the deficit was about 12 percent of GDP.  In 2010, with previous cuts now implemented and new ones added, the deficit was, er, about 12 percent of GDP.   In 2011, with 2 years of cuts to build on and more to come, the deficit is projected to be, drum roll please, 10 percent of GDP.

So what’s going on?  First, some of the fiscal effort has gone in preventing even worse outcomes if no cuts had been made.  That’s how bad the cratering of the Irish public finances is.  But another conclusion is inescapable: the cuts themselves have been contractionary and have made deficit reduction harder to achieve, both in terms of higher unemployment benefits and lower tax revenues.  Our department of finance is now clever enough to set revenue projections that can be achieved, but that doesn’t disguise the fact that revenue is down even on 2009 levels, when the decline in growth was at its worst.  In other words, Krugman is right: this is a plain old contractionary fiscal contraction that is working against its own side effects to achieve its objectives.  The road is falling, not rising to meet us.

Let’s now return to Krugman’s broad question of why markets think that there is more Irish fiscal risk.   The simple answer: bank sector strategy.  There are two issues here.  The first is that, leaving aside deficit numbers, the government has taken on new risk in its approach to the banking sector.  The National Pension Reserve Fund, which was supposed to ring fence money for public sector pensions from 2025 onwards, is now a major equity investor in the walking wounded of the Irish banking sector.  Equity positions in banks are a tad risky.  Even when it’s public money.

Furthermore, the toxic property stuff from these banks has been dumped into the National Asset Management Agency (at a knockdown price) and paid for with borrowed money.  If a private fund was borrowing to invest in distressed banking assets, it would be seen as potentially profitable but risky proposition.   No reason why the markets should view a public entity doing the same thing any differently.

But wait, there’s more.  Up above we mentioned a 2010 Irish budget deficit of 12% of GDP.  Well the European Commission took another look at those numbers and decided that it should have been 14%.  And that relates not to the above interventions, which are in Eurostat accounting terms neutral, because any public money went to buy actual assets (equity stakes or loans).  No, the revision was due to the money that is going into a hole, to meet the obligations of dead banks/building societies whose liabilities are guaranteed by the Irish government.  It is past payouts for those purposes that Eurostat got classified as outright public expenditure for 2010, and there have been more of those payouts in 2010 already, and more to come.  In total, it will be about €25 billion.

Now, we have our New York Times/IMF accredited expert on Spain right here on this blog in the form of Edward.  So maybe he can tell us that the Spanish fiscal and banking stew is as poisonous as Ireland’s.  But I doubt it.  Instead, the bottom line on Krugman’s comparative question would be: Yes, Irish austerity has not worked, but it hasn’t worked both for the standard Keynesian reasons and because it is being swamped by quasi-sovereign risk from the banking sector.  Maybe, just maybe, if you avoid the bottomless pit coming from the latter, standard fiscal austerity might have a chance.  Here’s looking at you, Lithuania.

UPDATE: National Review’s Stephen Spruiell says Krugman is presenting the CDS comparison selectively and that Ireland’s CDS spread doesn’t look so bad given the size of its deficit.  But of course the size of the deficit makes it more difficult to argue that the austerity is effective.  And Karl Whelan notes that bond spreads — which is where debt dynamics are actually being determined — have deteriorated significantly for Ireland in the last few weeks.

12 thoughts on “Fiscal Austerity: The cases of Ireland and Spain

  1. “The road is falling, not rising to meet us.”

    Irish idiom doesn’t really translate, does it? Good post, depressingly accurate.

  2. I’ll argue that by moving aggressively, Ireland is likely to resolve its banking and real estate issues more quickly than Spain. The CDS trading particularly is being driven by short term thinking.

  3. Just a quick note to say that CDS is a very poor indicator of market sentiment. Its adoption by generalist commentators is one of the worst things that has happened in recent months because it rarely means what they think it does – ultimately, it is too derivative to accurately reflect credit risk.

  4. I don’t see Ireland moving aggressively to resolve its banking and real estate issues. All they have done, since the initial plunge to stop the run on the banks, has been to offload the crap into NAMA, basically just shift the problem onto the public sector balance sheet.

    When the Swedes nationalised the banks in 1992, they didn’t just set up a bad bank – they deliberately picked the bits of the banking sector that were capable of recovery and LIQUIDATED THE REST.

    The politics of this suggests that the banking and real estate issues are not solved, will not be solved, and that there is no political will to solve them. Imposing cuts on the public sector? Plenty of will for that.

  5. Ireland has a black hole of 250% of annual GDP, whereas Spain does not have something like that. Nobody has even idea about size of Irish bank liabilities abroad.

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  8. In support of Alex’s oomment:

    It appears to an outsider that Ireland is doing the same thing the US has done: socializing bank losses, but privatizing bank profits. It is a direct result of a ruling elite captured by big money interests (and unions, in the US) who see average citizens as rubes to be fleeced.
    Banks in the US (and I assume Ireland) are almost all insolvent (if normal accounting standards were not being ignored). On that basis, they should be liquidated (shareholders wiped out, boldholders made as whole as possible, as in any, non-political (not GM) bankruptcy) and then the franschise resold as IPO to recover as much for taxpayers as possible. A nation needs a banking system, not any particular bank.
    Austerity must also be embraced because all Western nations are insolvent also. First wasteful spending must be cut (military yes, but mainly pork), govt employees salaries must be slashed (grossly overpaid in US), and entitlement spending cut (pensions cut across the board but progressively to shield the poorest, medical copays increased, etc.) I am, by the way, a pensioner and I should have to share some of this pain.
    Austerity without compassion will destroy social cohesion. Failure to bring govt spending into line with tax income (and keep it there) will destroy nation. Increasing taxes will only speed up the death spiral of punishing productive citizens and rewarding drones.
    Finally, the stinking corpse of Keynesian thought but be finally be seen for what it is and Hayak’s prescription of economic freedom and personal responsibility (with a small social safety net) embraced to allow future generations to escape the crushing debts we are selfishly imposing upon them.

  9. ” Now, we have our New York Times/IMF accredited expert on Spain right here on this blog in the form of Edward. So maybe he can tell us that the Spanish fiscal and banking stew is as poisonous as Ireland’s. ”

    He already did, when discussing these:
    http://spaineconomy.blogspot.com/2008/01/cedulas-hipotecarias.html

    Unfortunately can’t use the search thingy properly to link a few others. But he has been warning for some time about the cajas.

  10. Krugman in another partisan exercise. No one serious can say anything at this time.
    Ireland apparently was(is) in a bigger hole.
    But if a Spanish Bank goes down everything can change.

    Zapatero was pretending that Spain was okay so it is not yet suffering with effects of the cuts that has to make.

  11. Ireland appears to have become quite the political football in the US, particularly with the two WSJ and NYT articles on Tuesday reaching almost exactly the opposite conclusion about its growth prospects.

    The big point that Krugman et al seem be missing is that they are making a comparison, not a counterfactual. As an econometrician would say, there are plenty of fixed effects going on there, as mentioned above total debt levels for example. Therefore, you need to look at progress over time. If you look at which country has the more benign trend in spreads over the past six months, your answer changes.

    Or as a friend of mine put it:
    “Anybody knows that belt-tightening is an unfortunate necessity to stave off bankruptcy and not a measure to end a recession so it makes little sense to look for growth on the back of it. It’s like noting that a guy who cut back his credit card spending because he couldn’t afford the payments hasn’t had an increased standard of living as a result.”

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