Wednesday, November 24, 2010

The Celtic Tiger is Museum piece?

Sample this paean about the Irish economic model (in the context of which model Europeans should follow) by the high-prophet of globalization and other global mega-trends, Thomas Friedman, in July 2005

"It is obvious to me that the Irish-British model is the way of the future, and the only question is when Germany and France will face reality: either they become Ireland or they become museums. That is their real choice over the next few years – it’s either the leprechaun way or the Louvre... As an Irish public relations executive in Dublin remarked to me: "How would you like to be the French leader who tells the French people they have to follow Ireland?" Or even worse, Tony Blair... the other day Mr. Blair told his E.U. colleagues at the European Parliament that they had to modernize or perish."

For some years now, the Irish economic model, the Celtic Tiger, had been lauded as the way forward for other Europeans. The three major strands on which the Irish model stood were - focus on higher education and attracting knowledge-based industries, ultra-low corporate tax rates (at 12.5%, it is the lowest in Europe - France 34%, Germany 30%, and Britain 28%!), and financial market liberalization that went beyond even the US.

However, from hindsight, as the ongoing events highlight, apart from the first, the other two were mis-guided policies that have played a major role in taking Ireland to the precipice. Banks, which issued loans recklessly during the real estate boom, have accumulated losses of about €70 billion, almost half the country’s economic output. The low corporate tax rate, which effectively turned Ireland into an on-shore tax haven, also meant a dramatic drop in the country's tax revenues when recession took hold. The country's fiscal deficit is now at a stunning 32% of GDP and public debt is set to cross 80% of GDP. Unemployment at 12% continues on its upward climb. The country is set to experience its third consecutive year of economic contraction in 2010.

The bursting of the sub-prime mortgage bubble in the US and the global financial market meltdown that followed have devastated the Irish economy. Its real estate market crashed in an even more spectacular manner than in the US, leaving the Irish banking system in shambles. It also triggered off an economic recession that ravaged the government's fiscal balance.

The Government first stepped in with a bailout, guaranteeing the debts of the bankers. When this appeared to have little effect, in order to impress the "confidence fairy", the Irish government announced a savage fiscal austerity program. However, after some initial enthusiasm among the bond-vigilantes, the reality set in. The bond-vigilantes have rewarded the Irish austerity programs with a resounding thumbs-down - Irish 10-year bond yield is at 8.35% and the spread with 10-year German bond is has been steadily widening 544 basis points, and the 5-year Irish CDS spread has shot up to 523 points.

Early this week, after its fiscal austerity program failed to rouse the "confidence fairy", Ireland followed Greece in formally applying for a rescue package. The EU and the IMF are working on a $109-123 bn package to help Ireland bailout its banks, reschedule its debts, and thereby prevent a sovereign bankruptcy. The funds will come from a rescue mechanism worth roughly $1 trillion that was set up in May by the EU and the IMF to help euro zone countries spiraling toward default.

The bailout is expected to support the failing Irish banks and also enable the Government to repay its debts and run regular activities without having to approach the ballooning bond markets for the coming three years. About €15 billion is likely to go to backstop the banks, while €60 billion would go to Ireland’s annual budget deficit of €19 billion for the next three years.

The bailout to reschedule Irish debts will invariably be criticised as merely delaying the inevitable default. Critics will point to Greece, whose bond yields and CDS spreads have continued to climb despite the bailout and measures to rein in government spending.

Adding weight to this view is the magnitude of losses suffered by Irish banks, most of which have been taken over by the Government. The gravity of the debt crisis being faced by the Irish Government is borne out by its staggering primary deficit in excess of 10% of GDP. This means that even without paying interest on their debt Ireland will still spend more than it collects in taxes.

In the absence of any of the traditional channels - currency depreciation or lowering interest rates or even inflation - to emerge out of a recession and sovereign debt-crisis, the propspects for the Irish economy looks bleak. The strong austerity dose and the prevailing economic weakness among its EU partners only amplifies the problem. All this means that growing or exporting its way out of debt looks remote and some sort of actual debt relief or reduction becomes the only sustainable option.

In the circumstances, a partial default, by way of an organized restructuring of debt would have forced bond-holders to accept a haircut on their investments and reduced the amount of money owed. Coupled with fiscal tightening, it would have stood a more realistic chance of success. However, this approach also carries with it considerable perceived dangers.

Primarily, the fears of investor panic and another round of financial market collapse is the biggest deterrent against traversing this path. The possibility that imposing bond haircuts can make future market access expensive or impossible for an extended time and can create serious contagion effects elsewhere is another reason to not embrace debt-restructuring.

Finally, the fact that creditors are banks belonging to the major European economies may also be another factor behind it. In the euro zone, more than 2 trillion euros in sovereign debt belonging to Greece, Ireland, Spain and Portugal is held largely by German, French, British banks and, in the case of Greece, local banks and pension funds.

In any case, contrary to Thomas Friedman's prediction, after two years of financial and economic tumult and untold social suffering, it is the Celtic Tiger economic model, along with its current Government, that looks set to join the collection at the National Museum of Ireland! Ireland today looks like a Paradise Lost or a miracle turned mirage!

Update 1 (26/11/2010)

Portugal passes a fiscal austerity plan to bring down its deficit and reassure the debt markets. The budget plan for 2011 is aimed at re-assuring nervous lenders that the country could avoid a bailout by meeting its deficit-cutting targets. The plan is expected to cut Portugal's budget deficit from 9.3% of GDP last year, to 7.3% this year, and 4.6% in 2011.

Spain, with a budget deficit of 11.1% of GDP last year, too has pushed through austerity measures including spending cuts. However, given its size, Spain has emerged as Europe's "too-big-to-fail" country.

Meanwhile, Ireland has successfully resisted pressure from other EU members on any increase in its ultr-low corporate tax rate of 12.5%. The country is heavily dependent on foreign direct investments (FDI). About 70% its exports and 70% of business spending on research and development comes from FDI. Foreign-owned firms pay workers about $7.1 billion each year and provide one in seven of the country’s jobs, either directly or indirectly. Multinationals paid about 5 billion euros in corporate tax to Ireland last year, more than 50% of all corporate tax receipts.


Scoremore said...

The recent irish protest involved 120,000 irish citizens just before the irish pm agreed to the bailout. There's another protest scheduled on Nov. 27th and another in December. Just because the MSM isn't reporting it, it doesn't mean that the people aren't revolting.

Anonymous said...

hmmm...time to rethink about Friedman..falls flat here