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

Ireland's Austerity Budget May Not Prevent Sovereign Debt DefaultDespite 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.

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.

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I kind of recall some tall skinny dude with a really saggy beard and an awfull way of dressing including the wearing of a diaper upon his head stated ' ....that we would bankrurpt the west " and it seems he-they are succeeding ! While we go off to kiss the backsides of these Islamic terrorists - they proceed to work to bring down western civilization ! Wake up before its to late . Remember Mohammed did not die for our sins - Jesus Christ did.

December 08 2010 at 5:20 PM Report abuse +1 rate up rate down Reply

Ireland like so many other countries, have enjoyed U.S. foreign aid gratuities for years longer than was made possible by the generous absent-minded taxayer who was much too busy trusting U.S. leadership to do the right thing. So here we are looking at Ireland and so many other European countries, overly burdened with painful debt, no longer sure if good ole Uncle Sam can weather the current ugly economic storm and once again be the urgently needed rescuer. Unfortunately, all that proves logical, warns that the coming year and more to follow, will bring harsh times far more crushing than thought possible. It's all so very sad.

December 08 2010 at 5:14 PM Report abuse rate up rate down Reply

Banks need to stop taking advantage of people and countries, greed has caused banks to lend far too much and charge way too much intrest. The banks will have to charge 2 percent intrest and forgive 60 percent of the principle debt. Investors should be happy if they even get that.

December 08 2010 at 5:11 PM Report abuse rate up rate down Reply
1 reply to ultraz2's comment

I understand that it against the Moslem religion to charge or receive interest - qguess we nust be headed in that direction- courtesy of Osama bin Laden ( he who wears a diaper upon his head )

December 08 2010 at 5:25 PM Report abuse rate up rate down Reply

They had a special on this at donsmithshow.com awhile back. They have the best conservative site on the net.

December 08 2010 at 5:07 PM Report abuse +1 rate up rate down Reply
Kerry Kissinger

This is not about capitalism; rather, capitalism trumped by misguided government policy. For the Irish pols to try to save face by guaranteeing the loan shortfalls of Irish banks, they have assurred themselves of disaster. The Irish citizens are now on the hook for the bank's loses because of the decisions of a few misguided politicians. The US had better take a hard look at this, since we could be headed in the same direction if our debt holders begin to lose faith in our ability to pay back our loans. We could end up paying more in interest than our defense budget. Medicare and Social Security will have to take a hit when that happens. Why aren't more people demanding that Congress act on the Deficit Commission's recommendations?

December 08 2010 at 4:52 PM Report abuse +2 rate up rate down Reply

Too much money handed out to too many people who haven't earned it....welfare, indigent, et al. Ireland is a microcosm of what has been going on internationally for decades....with no end in sight. What used to be a decent level of unemployment insurance pales compared to todays figures, what used to be a level of support for child welfare, disability, etc., pales compared to todays figures. As long as we continue to support these efforts with a mentality that says the recipients should have a standard of living closer to those people that actually go out and work for a living....and commensurately support those that don't...we are on a downward spiral that cannot last !

December 08 2010 at 3:15 PM Report abuse +3 rate up rate down Reply

they can never climb out...they are owned by IMF

December 08 2010 at 2:57 PM Report abuse rate up rate down Reply

Our federal deficit is what % of our GDP? Each year the 1040 booklet shows the % of our taxes needed for the interest on our debt, but I don't think it gives % of GDP.

December 08 2010 at 2:53 PM Report abuse rate up rate down Reply
1 reply to gbyron60's comment

ca 8.5%

December 08 2010 at 3:00 PM Report abuse rate up rate down Reply

This is an example of what can be wrong with capitalism. As a system it is without morality as the only thing of importance is profit and apparently at any cost. There needs to be balance in the system, a couterweight to the natural tendencies of the system. That counterweight is regulaton and oversight, two things that the pure capitalist decry as "socialism". It is a misuse of the term.

December 08 2010 at 2:53 PM Report abuse +1 rate up rate down Reply
1 reply to nuevepaul's comment
Kerry Kissinger

Sorry, the oversight was in place; the politicianss just ignored it and went ahead and guaranteed the loans. They trumped capitalism with misguided government policy. It has little to do with capitalism.

December 08 2010 at 5:06 PM Report abuse +1 rate up rate down Reply

The real question is What happened to all of this money??? On the way up someone other that the banks took alot of profit on the realestate that was sold. Yes the banks loaned the money and took fee's but someone else took alot more in profit on each of these houses that sold. And yes the banks need to take a haircut but there is someone out there that need to be skined.

December 08 2010 at 1:22 PM Report abuse +3 rate up rate down Reply
1 reply to sah5151's comment
Kerry Kissinger

You are absolutely right! However the politicians have left them off the hook by guaranteeing the debt. The question is, why did the pols do it? Was it ego or stupidity or denial or all three?

December 08 2010 at 5:04 PM Report abuse rate up rate down Reply