Much of the pessimism about Ireland’s predicament has centred on the challenge of stabilising the debt to income ratio. Undoubtedly this will be challenging, with good outcomes on nominal GDP growth and fiscal adjustment capacity required. Of course, it has been made much more difficult by the massive bank losses the State has had to absorb. But I think a focus on the stabilisation challenge misses a critical issue, which is regaining market access at a high if stable debt to GDP ratio (probably somewhere in the region of 120 percent of GDP).
Martin Wolf’s column from last week provides a useful starting point for a diagnosis of the problem – an article that garnered all of one comment on the blog (from DOCM). It draws on Paul de Grauwe’s insightful work on the susceptibility of countries in a monetary union to a debt crisis (see here), where a country without its own currency and central bank to act as lender of last resort is vulnerable to self fulfilling expectations that it will not be able to roll over its debts. The EFSF/ESFM/ESM were put in place to help fill this LOLR gap, but have so far proven to be a poor substitute. It is understandable that Germany and other likely net funders want to eventually reinstate market discipline, and so demand losses are borne by private creditors as part of any new bailout. It is also understandable that they want to protect themselves from losses under the permanent bailout mechanism (the ESM) by demanding preferred creditor status. But it is becoming increasingly evident that crisis-hit countries will find it extremely hard to regain market access with a half-hearted LOLR facility in place given any doubts that they will not be able to pass a debt sustainability test under the ESM.
The official funders have to be willing to take on some additional risk if a mutually damaging combination of default and ongoing dependency is to be avoided. One element is to clarify the way the debt sustainability test will be applied. A current problem is that austerity measures weaken growth, thus making it harder to pass the test. A useful amendment would be to assess growth in the debt sustainability calculation assuming a neutral fiscal stance. Another useful amendment would be to set a ceiling on the size of any haircut, thereby limiting the uncertainty faced by potential new investors.
As a quid pro quo for these amendments the government could offer to speed up the fiscal adjustment (along the lines recommended by the ESRI in its Spring QEC). Of course, more fiscal adjustment is the last thing the economy needs as it struggles to pull out of recession. Yet a quasi-permanent loss of creditworthiness and dependency on unreliable official support looks to be the bigger threat, as it saps confidence and undermines the perception of the economy’s stability. Those resisting fiscal discipline must realise that the situation changed profoundly when Ireland’s creditworthiness disappeared in the second half of last year. Some observers are putting forward the same fiscal policy prescriptions as they did when bond yields were around 5 percent. They must see that the ground has fundamentally shifted.
It is hard to see how further public sector pay cuts could not be part of any balanced additional adjustment. A credible new regime for long-run fiscal discipline is also essential.
The government should take the offensive in pointing out the incoherence of the current international support approach, while avoiding playing a self-defeating grievance card. What is needed is a hard-headed look for a mutually advantageous set of policies that allow Ireland to shed its dependency. The first step is a proper diagnosis of creditworthiness challenge.