Thursday, July 01, 2010

Ireland's fiscal experiment

Paul Krugman and National Review's Stephen Spruiell have been e-duelling about whether Ireland's experience shows that tight budgets work. We've outlined our position here and here. Anyway, Spruiell takes another run at it today noting that relatively non-austere Spain seems headed for another ratings downgrade and that its credit default swap spreads, which once looked somewhat better than Ireland's (part of Krugman's argument) now look just as bad. And in addition, since Ireland's crash was worse and the economy was more constrained by the Euro, the outcomes don't look great but would even have been worse without the austerity.

So to repeat and augment what we've said before.

First, credit default swap spreads on their own don't tell much of a story. Actual debt problems are driven by the yields needed to sell new debt. Right now, Ireland is selling 8 year bonds at 5%. Germany sells at 2.3%. That's not good for an economy that is still shrinking in current value terms (one quarter's growth in output not withstanding).

Second, the most direct measure of whether budget cuts are working is, er, whether they actually cut the deficit. Ireland has yet to show that it can do that. Yes, it can cut relative to the "it would even have been worse without the cuts" scenario. But that doesn't change the ugly economics of borrowing 12-15% of GDP a year.

But finally (and this is something that the a lot of the outside scribblers on Ireland miss) -- the big story is the banks. Ireland could achieve all the budget stringency in the world and it doesn't change at all the massive exposure to the banking sector through the liability guarantee and the bailout of the nationalized Anglo Irish Bank. It's excessive deference to lenders to Irish banks, and not lenders to the government, that has Ireland in so much trouble. It's doubtful any fiscal policy -- stimulus or shrinkage -- can overcome that kind of exposure.

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