With the 10-year yields heading towards 8 percent and the 5-year CDS cost surpassing Argentina’s, Ireland has very definitely lost the confidence of potential lenders. Morgan Kelly’s Irish Times article offers an explanation: the combination of the cost of bailing out the banking system and the dismal underlying rate of nominal GDP growth makes it impossible to avoid a default.
While the situation is clearly critical, I do not agree with Morgan’s starkly pessimistic conclusion of default inevitability. Given how influential his analysis is, however, I think it is useful to recap the argument using the IMF’s fiscal-space model as an organising framework (see here). The model shows that default results when a country’s debt to GDP ratio passes a critical point. This critical point depends on gap between the nominal interest rate and the nominal growth rate and also the economic and political capacity for generating a primary surplus (a country’s fiscal space is then the gap between the debt to GDP ratio and the critical point). It is easy to see how continued creditworthiness might be beyond a country’s capacity when facing the combination of a very high bank bailout cost and a very low underlying nominal growth rate.
Morgan argues that this is the case for Ireland. But I do not see things as being as dire as he makes out. Even taking his high €70 billion estimated cost of the bank bailout, a large gap between the nominal interest rate and the nominal growth rate of 4 percentage points means that the bailout cost would add €2.8 billion to the required primary balance (just under 2 percent of GDP). This could well push a country over the edge, but it hardly seems decisive. Moreover, Morgan argues that Ireland cannot afford a nominal interest rate greater than 2 percent. To get an interest-growth gap of 4 percent, this means that the nominal growth rate would be just negative 2 percent. While I share his concerns about the effects of Ireland’s balance sheet recession on growth, I think a medium-run nominal growth rate of positive 2 percent is actually still quite conservative. But this means the nominal interest rate could be as high as 6 percent and still yield the 4 percent interest-growth gap assumed above. Of course, this is all just illustrative, but the bottom line is that there is a clear enough path out of this crisis provided the political will is there.
But do we have the political will? This is where I have become more pessimistic watching an apparent failure to prioritise the national interest by our political leadership – government, backbenchers, opposition, independents, social partners. Unlike Morgan I think default is avoidable. That would make it even more of a shame if it happens. I remain hopeful that we will all get the message.