The response to Brian Lucey’s article has been quite astonishing (over 300 comments at last count!). Although clearly we don’t all agree, the debate has been enlightening – and entertaining – thanks to Brian and the many excellent participants on this site.
But with all the excitement over default, I think we passed over too quickly the important set of IMF fiscal policy papers that Philip linked to on Wednesday. The papers provide a useful analytical perspective on Ireland’s fiscal challenge, which could frame a more productive discussion on fiscal (and indeed banking) policy.
Figure 1 [p. 8] in the Fiscal Space paper is something only an economics nerd could love. But it is worth the investment if you have some background in economics.
While not always consistent across the papers, the empirical messages that emerge are quite positive for Ireland. The Default paper suggests there is relatively little to be gained by restructuring the debt and also that there is capacity to absorb a substantial total bank bailout cost. The Fiscal Space paper introduces the idea of a limit on the debt to GDP ratio before situation becomes unstable. Even under quite harsh assumptions, the analysis shows that the limit is around 150 percent of GDP for Ireland, suggesting a greater degree of fiscal space than many commentators and investors assume.
(For both papers, a key variable is the gap between the real interest rate and the real growth rate. Unfortunately, the two papers use two very different numbers for Ireland. The default paper puts it at 0.4 percentage points; the Fiscal Space paper at 3.2 points. An intermediate number somewhere around 2 percentage points is probably not a bad assumption, indicating more fiscal space than noted above.)
If these papers give a realistic picture of Ireland’s fiscal capacity, then the question arises as to why Irish bonds are being hammered. Patrick Honohan took flack for saying the market rates were “ridiculous.” But the IMF economists seem to agree that default risks are being overestimated for advanced economies.
A more positive message might be that the fiscal fundamentals are not in as bad a shape as many imagine, and there could be high returns to some attainable improvements in policy. There is no excuse for the delay in bank resolution legislation that could help put a floor under the costs of bank rescue, for example. And although the government has taken some hard political decisions to curb the deficit, it is hard to understand the unwillingness to follow best practice and make explicit commitments to future fiscal policy actions (a phased introduction of a property tax, legislated future increases in retirement ages, etc.)