What you need to know about Ireland, and what to do about it
WASHINGTON -- The rapidly unraveling Irish debt crisis is stark evidence that the consequences of the 2008 financial meltdown will take years to play out. It is a reminder that the United States has a major stake in Europe’s handling of this problem. It highlights the dangerous mismatch between the reassurances bond purchasers need to keep funding sovereign debt in the short run and the long-term desirability of financial markets being more prudent in their lending to profligate governments. And it underscores the damage recent German economic chauvinism has done to the delicate diplomatic dance needed to manage such crises.
To manage this crisis, and to ensure that there is not another European sovereign debt crisis in six months, Europe needs to move rapidly to implement sovereign debt restructuring plans backed by massive financial resources raised jointly, not from the reluctant Germans. In response to the implosion of its real estate market in the wake of the financial crisis and the threatened failure of major lending institutions, the Irish government nationalized three banks, backing them with a $61-billion (45-billion euro) bailout. Such expenditure of taxpayer funds, combined with a 7.6 percent contraction of the economy in 2009, has pushed the Irish government’s deficit to a daunting 32 percent of GDP.
Budget cuts have yet to staunch the bleeding, and more belt-tightening is expected in December. While the government if fully funded through the middle of next year, if it were to borrow today, it would have to offer bond purchasers a prohibitive 5.9 percent premium over what Germany would have to pay on ten-year bonds. To ease financial market concerns about repayment, the European Union, the European Central Bank, and the International Monetary Fund are scrambling to piece together a rescue package. So far Dublin has been reluctant to request a bailout lest the precedent make it a suspect borrower for years to come.
Both other Europeans and Americans have reason to worry. European banks have half a trillion dollars in outstanding loans in Ireland, nearly more than three times European exposure in Greece, which the European Union eventually agreed to bail out earlier this year. But it is crisis contagion that has some economists worried. Portugal, which has done even less than Ireland to deal with its economic woes, has to tap financial markets early next year. Failure to contain the Irish crisis could undermine Portugal or even blow back on Greece, where the budget deficit continues to grow despite its earlier rescue package and budget cuts.
All this raises new concerns about Europe’s struggling and disparate recovery. Germany grew by only 0.7 percent in the third quarter of 2010, Spain did not grow at all, and Greece’s economy shrunk by 4.3 percent. If Irish loans begin to go bad, weak German banks, which have nearly $139 billion in Irish exposure, would take a hit. This would be bad news for the United States. America’s recovery is premised on rising exports. Historically, that has only been accomplished during a period of a weak dollar. Since June, the dollar has strengthened by 17 percent against the euro.
Since Europe is one of the biggest buyers of American exports, the Obama administration’s goal of doubling U.S. exports over the next five years is in jeopardy. In bailing out Ireland, Europe faces a conundrum. Much of the current flurry around the Irish debt situation was triggered by German insistence that any European government bonds issued after 2013 would contain provisions ensuring that the buyers of those bonds would lose some of their principal if the issuing government ever got in trouble again. In the Greek crisis, taxpayers picked up the bill for the bailout, not bond holders.
This makes political sense. And it would force bond buyers to demand higher interest rates to cover their additional risk, disciplining governments to borrow less. But even talk of some future arrangement has spooked financial markets today. The perceived arrogance of the German government in this crisis has also not spurred confidence in Europe’s ability to cooperate.
Berlin has suggested Dublin raise its corporate tax rate to boost revenues, and, not coincidentally, curb its competitive advantage in attracting business investment. Nor did Germany’s recent refusal to cooperate with the United States on reducing global trade imbalances endear it to Washington.
Brussels and Dublin are likely to stitch together a bailout, with help from the IMF and the implicit support of Washington. But the Irish crisis is a reminder that Europe is involved in a slow-motion train wreck. Before Portugal or Greece, again, becomes a problem, this time threatening Spain and Italy, IMF and Washington support should come with stings attached. Europe needs to rapidly put in place rules requiring bond holders to pay the price of post-2013 bailouts, to remove the uncertainty that is currently destabilizing markets.
Moreover, it needs to create a European Monetary Fund that is sufficiently large enough to convince speculators they will lose money if they bet against the European Union’s ability to bailout its member governments. And it needs to be able to issue large quantities of European bonds—backed by EU as a whole--to fund that effort, as a first step in creating a long-overdue common European fiscal policy. At the recent G20 summit in Seoul, Europeans, especially the Germans, rightly lectured the United States about getting its house in order. Now it is time for the Europeans to take their own advice.
Bruce Stokes is a Senior Transatlantic Fellow of the German Marshall Fund of the United States.
The views expressed in GMF publications and commentary are the views of the author alone.