Friday, November 19, 2010

Irish Vs. Greek Debt Crisis

There are some similarities between the Greek crisis earlier this year and the current Irish crisis.

Both involve euro area countries with large deficits who initially saw interest rates rise because of the large deficits, but then the increase in yields got a life of its own and became self-reinforcing. The increase in interest rates was itself seen as a reason to drive yields up further (as the perceived risk of default increased), something which in turn drove up yields yet further and so on.

Yet there are some differences:

One is that  while the Greek crisis involves long time fiscal mismanagement with systematically too large deficits even during the boom, the Irish crisis is instead a case of a bursted property bubble that has created big problems in the banking system. Indeed, Ireland actually had a surplus during the boom. However, that surplus was of course largely based on revenues from the property bubble.

A related difference is that Ireland last year actually had a debt level below the euro area average (65.5% of GDP versus 79.2%). This year's massive deficit will probably push it above the average, but it will still be significantly less than Greece and some other countries.

A third related difference is that whereas the bulk of the Greek deficit is structural, the Irish deficit this year is mostly a result of the one time factor known as the bank bailouts. This means that even without either austerity or recovery, the Irish deficit will drop dramatically in the coming years once the recapitalization of the troubled banks are finished with.

Indeed, history shows that bank bail-outs aren't just one time outlays. Often some or even most of the outlays are recovered once the bank which is taken over recovers. This means that the Irish deficit could be dramatically reduced very quickly.
A fourth difference is that Ireland has more to lose from a IMF-EU rescue package. In Greece, there was no real disadvantage in taking that package because the austerity measures was needed anyway (though they arguabley chose to rely too heavily on tax increases and too little on spending cuts) and because it lowered their cost of borrowing. While Ireland too needs more austerity measures (preferably spending cuts) and can lower its cost of borrowing, theere is a risk that the other EU countries might condition aid on an increase in the Irish corporate income tax rate.

Such a tax increase would probably reduce and not increase Irish tax revenue, as it would make multinational companies attribute less of their profits and to a lesser extent it will also reduce real investments in Ireland. But it will probably lead to higher tax revenues in other EU countries, which is why they push for it.