The Agenda

On Fiscal Austerity in Ireland

Alex Massie and Megan McArdle have both written terrific posts on fiscal austerity in Ireland. As Alex writes:

 

Perhaps Krugman is right that austerity is often a bad idea but it’s not been a bad idea for Ireland in the past and, anyway, given the peculiarities of Ireland’s current parlous situation it’s not clear that, for once, there was any compelling let alone palatable alternative.

This hardly means one need place any confidence in the men at the Ministry for Finance and their ability to dig the country out of the hole it’s in. But using Ireland as a pawn in some greater “Austerity Doesn’t Work” game doesn’t work either. Ireland might well be screwed regardless of what branch of painful thereapy it chose.

My colleagues at Economics 21 have elaborated on this theme. They’ve also described why the United States and Ireland are not in the same boat.

 

To appreciate Ireland’s plight, it’s helpful to compare it to America’s financial turmoil. From the end of 2006 to the first quarter of 2009, more than $7.25 trillion of U.S. household wealth evaporated due to the collapse of the housing bubble. The economic consequences of this wealth destruction were two-fold: household consumption growth stalled as less wealthy households saved more and borrowed less to fund additional consumption (cash-out refinancings); and the value of residential properties fell below the unpaid principal balance on millions of mortgage loans. As is now clear, the decline in household wealth was far less consequential than the spike in “underwater” mortgages. The value of residential real estate assets could no longer support the debt issued against them; the result was trillions of dollars of fair value losses for holders of household mortgage debt. These assets were held largely in the portfolios of leveraged financial institutions dependent on overnight sources of funds – repurchase agreements and commercial paper – that are susceptible to “runs” when investors rationally fear that the firm’s assets cannot cover its liabilities. As a result, the bubble’s collapse triggered a panic that effectively closed global interbank funding markets.

Although the problem was global in scope, national authorities were responsible for stabilizing their domestic financial sectors on a piecemeal basis. For the U.S., there was never any question about whether the federal government had the capacity to arrest the panic. At its peak, the liabilities of the U.S. financial system were $17.1 trillion (D.3), or about 118% of GDP. Even if one assumed that assets were worth 20% less than liabilities – a highly aggressive and unlikely assumption – the cost of guaranteeing all of the financial system’s liabilities would only be 23% of GDP, or equal to a one-time 50% increase in the debt-to-GDP ratio. Therefore, the implied guarantee of all financial system liabilities after TARP was highly credible.

Ireland, in contrast, had a financial sector with liabilities in excess of 400% of GDP and, unlike the UK and Switzerland, the Irish financial sector didn’t have the same level of diversification and international activity to serve as a cushion. So the country’s reductions in public expenditures on wages, etc., have been dwarfed by the cost of the financial rescue.

 

Large spending cuts can only succeed when they remove uncertainty and change private sector expectations about future disposable income growth and the cost of government. Ireland’s cuts failed to do that because they were dwarfed by the growth in the expected cost of the bank bailout. This means that the government’s implied cost to households and businesses has continued to grow despite the fiscal tightening. Implied government spending continues to grow.

The U.S. is in a very different situation. The TARP has largely been paid back. The losses from Fannie Mae and Freddie Mac are running at about 1% of GDP. The U.S. is not suffering from large increases in implied spending associated with an ongoing bailout. Over half of the increase in the budget deficit is attributable to discretionary outlays, which have pushed the government’s share of GDP to new records. Indeed, the reason the U.S. is likely to benefit so greatly from large reductions in federal spending is because of the growth in private sector investment likely to occur from taking the potential for confiscatory levels of taxation or an Irish-like debt spiral off of the table. Policymakers should not be misled by the Irish crisis. It is debt-financed government expenditures arising from a banking crisis that’s bringing down Ireland, not austerity. [Emphasis added.]

Megan has some additional thoughts.

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