To explore Ireland’s chances of avoiding default, the tool of choice has been simulations of debt dynamics under various assumptions about growth rates, interest rates, primary balances and the direct costs of the banking bailout. Various domestic and international commentators have usefully produced such analyses, but they can be hard to compare given the combinations of assumptions involved. Unfortunately, there is still a lot of confusion about our chances of stabilising the debt ratio. An additional complication is that in their recent “Information Note on the Economic and Budgetary Outlook” the Department of Finance did not report their assumptions for interest rates and the primary balance. This makes it hard to do a clean sensitivity analysis of the DoF’s projections.
In a brief note (available here; associated spreadsheet here), I use a simpler decomposition of the change in the debt to GDP ratio than normal, but link the analysis closely to the DoF’s baseline case. Under their baseline, they project the debt ratio will peak in 2012 at 106 percent of GDP before falling to 101 percent of GDP in 2014. However, there is concern that the growth projections are too optimistic: 1.75%, 3.25%, 3.00%, and 2.75% for real GDP growth from 2011 to 2014. For some reason they do not report nominal growth rates for 2012 to 2014. However, the decomposition allows us to infer the nominal growth rate assumptions.
To test the robustness of the DoF’s projections, I examine a quite pessimistic growth scenario with just 1 percent real growth and 1 percent inflation (GDP deflator) in each year out to 2014 holding the projected deficits as a share of GDP at the DoF target levels. Under these assumptions the debt ratio is not stabilised — though we still come surprisingly close. Encouragingly, however, a sustained additional adjustment in the deficit equal to 1 percent of GDP in 2011 would stabilise the ratio at 112 percent of GDP in 2013. Moreover, combining the low growth scenario with a 10 percent of GDP increase in the starting debt ratio due to a higher bank bailout cost, we still have the debt ratio peaking in 2013, but at the higher level of 121 percent of GDP.
While the challenge of bringing the deficit down and avoiding explosive debt dynamics (and ultimately default) is daunting, I see these simulations as reasonably hopeful. Even under a quite pessimistic scenario on growth and banking costs — there may be views on whether it is pessimistic enough — the gross debt ratio is stabilised at what should be a manageable level for a high-income country. This also does not take into account our cash reserves and assets in the Naional Pension Reserve Fund, amounting together to 28 percent of GDP. Provided we have the political capacity to make the needed adjustments, the path through the crisis without default and back to creditworthiness is clear enough.