Perhaps the biggest puzzle of Ireland’s 2+ years of economic crisis is the lack of progress on restructuring the banking sector, and in particular the reluctance to follow through on the implications of having guaranteed the liabilities of insolvent financial institutions. As with many of Ireland’s problems, there is no single explanation so in this post we focus on just one — a mindset in the Irish government that springs from the legal background of several of the principals in it.

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It’s worth noting a major difference in the narrative regarding Ireland’s crisis that is being told inside and outside the country.  Consider for example the recent speech of the European Commissioner for Economic and Monetary Affairs, Olli Rehn, in Dublin –

In the case of Ireland in particular, we need to recall that sovereign debt has not been at the origin of the crisis. Rather, private debt has become public debt. The financial sector has misallocated resources in the economy and then stopped working. It needs reform.

Similarly, the Wall Street Journal — for whom Ireland was always a low-tax favourite, is anxious to distinguish Ireland from Greece –

Ireland, by contrast, went into the crisis with a budget surplus, a debt-to-GDP ratio of some 27% and a strong record of recent growth that has left it one of the richest countries in the world. Ireland does have a serious problem with its banks, which are the source of its current and recent woes. A property boom and bust have left Ireland’s biggest lenders with billions in bad loans on their books.

At home though, the people are being told that that budget gap between ongoing expenditures and revenues is the key to the problem.

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“The British Government can rest assured that any just and lawful claims of Great Britain, or of any creditor of the Irish Free State, will be scrupulously honoured by its Government.”

That’s Eamon DeValera, writing as Irish Minister for External Affairs to the British Dominion Affairs Office in 1932.  DeValera was also leader of the recently elected Fianna Fail government, the party having completed its transition from a “slightly constitutional party” to being in power.  So let’s look at the ironies presented by the above statement in Ireland’s current context.

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Not seen on the newswires from the Federal Reserve retreat in Jackson Hole, Wyoming –

“The world of economics was rocked to its foundations yesterday when European Central Bank President Jean Claude Trichet urged countries to run huge structural budget deficits and massively pro-cyclical fiscal policy while creating huge contingent liabilities in their financial sectors.”

Because that’s not what M. Trichet actually said, or what the media took him to say.  But did he know that was the apparent implication of what he said?  Yes, it’s Ireland again, seemingly everyone’s favourite misunderstood episode of boom and bust.   It’s what Paul Krugman might call the Magical Foreigner syndrome.

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Some stories heard in rural Ireland this summer.  A farmer  goes into an embattled tractor dealer and reaches an understanding on the purchase of an expensive tractor.  The farmer then goes to his local bank manager to get financing to purchase the tractor; as agriculture is not doing too badly despite the recession, there is some hope.  But the bank has an unexpected response: we can’t give you a loan to buy that tractor, but we can finance one very like it — that we recently reposessed.  So banks are in the farm machinery business, at the expense of actual farm machinery businesses.

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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.

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