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, howâ€™s it going? …Â if by â€œmarkets impressedâ€ 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.Â Â No reassurance.Â 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.Â In 2009 in Ireland, the year that steep cuts began, the deficit was about 12 percent of GDP.Â In 2010, with previous cuts now implemented and new ones added, the deficit was, er, about 12 percent of GDP.Â Â 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?Â First, some of the fiscal effort has gone in preventing even worse outcomes if no cuts had been made.Â That’s how bad the cratering of the Irish public finances is.Â 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.Â 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.Â 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.Â 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.Â Â The simple answer: bank sector strategy.Â There are two issues here.Â The first is that, leaving aside deficit numbers, the government has taken on new risk in its approach to the banking sector.Â 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.Â Equity positions in banks are a tad risky.Â 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.Â If a private fund was borrowing to invest in distressed banking assets, it would be seen as potentially profitable but risky proposition. Â No reason why the markets should view a public entity doing the same thing any differently.
But wait, there’s more.Â Up above we mentioned a 2010 Irish budget deficit of 12% of GDP.Â Well the European Commission took another look at those numbers and decided that it should have been 14%.Â 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).Â 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.Â 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.Â In total, it will be about â‚¬25 billion.
Now, we have our New York Times/IMF accredited expert on Spain right here on this blog in the form of Edward.Â So maybe he can tell us that the Spanish fiscal and banking stew is as poisonous as Ireland’s.Â But I doubt it.Â 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.Â Maybe, just maybe, if you avoid the bottomless pit coming from the latter, standard fiscal austerity might have a chance.Â 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.Â But of course the size of the deficit makes it more difficult to argue that the austerity is effective.Â And Karl Whelan notes that bond spreads — which is where debt dynamics are actually beingÂ determined — have deteriorated significantly for Ireland in the last few weeks.