How Ireland Got Its Groove Back - Austerity’s New Poster Child Tricks the Markets

The Irish have an expression, "to put on the poor mouth" -- meaning to exaggerate the severity of your circumstances in order to gain sympathy, charity, and perhaps forbearance. In the aftermath of the collapse of Ireland's construction bubble in 2007, the country did exactly that and received a package of loans from the European Union and the International Monetary Fund (IMF) that will last until 2014. For years, Dublin has sought to ingratiate itself to the European authorities, arguing privately that it would default on its loans absent a deal on the 64 billion euros of banking debt that past governments had run up.
At long last, Ireland is beginning to move beyond putting on the poor mouth. The country's prime minister, Enda Kenny, recently graced the cover of Time, accompanied by the headline "The Celtic Comeback," and the Financial Times called Ireland's finance minister one of the best in Europe. The nation's largest banks can borrow again on the open market. The interest rates on Ireland's sovereign bonds -- seen as key indicators of the probability of default -- are rapidly falling. Rating agencies such as Moody's and Fitch have upgraded their outlooks on the country and some of its banks.
The turnaround seemed nearly complete last summer, when the government held two successful sovereign bond auctions and planned many more for the next year. By late 2013 or early 2014, Ireland should no longer need the assistance it has received from the EU and the IMF. The economy is still growing slowly in terms of GDP, but it is far from collapsing. Exports have driven most of this growth, thanks to unit labor costs that have fallen faster than those of any other country in Europe. Irish banks are deleveraging -- dumping bad loans, basically -- in order to shrink their balance sheets down to a more manageable size. Ireland is still a haven for multinational corporations searching for low taxes and a flexible, young, skilled labor force. Once the threat of an outright default passed and property prices began to bottom out, international investors began buying up properties there. Unlike in Greece, there have been no major public protests or social disturbances.
Proponents of austerity have held up Ireland as the poster child for their agenda. Indeed, the country has gotten its fiscal house in order by raising taxes and slashing spending. When it comes to budgetary discipline, as the former European Central Bank President Jean-Claude Trichet said in May, "Greece has a role model. And that role model is Ireland."
And yet: Domestic demand has flatlined, and the government still needs to find 18 billion more euros to cut in its next three budgets. The total output of the country stands at around 160 billion euros -- only about 1.5 percent of the United States' total output. Ireland's debt-to-GDP ratio has reached a staggering 108 percent, and it is projected to rise to 122 percent by 2014, making default a real possibility. The ratio of household debt to disposable income is running at 210 percent, much higher than in any other developed country. Nearly 15 percent of the Irish public is without work, with more than half of those people having been unemployed for over a year. The state has pumped more than 64 billion euros into its wayward banks, which still refuse to lend. All this suggests that the prospects for a robust recovery seem slim. Even if demand somehow bounced back tomorrow, Ireland would still have enormous amounts of debt to repay, which will hamper growth for the foreseeable future. Ireland, in other words, may have reached only the halfway marker in its lost decade.
So why do the markets still believe in Ireland? For starters, when it comes to debt and default, Ireland often gets lumped together with the bailout recipients on Europe's periphery such as Hungary, Greece, Latvia, Lithuania, and Portugal. Compared with these basket cases, Ireland is in an altogether different class. That is not to say everything is rosy, but in the land of the blind, the one-eyed man is king.
Second, much of the consolidation in the interest rates demanded for Irish debt relative to that of the stronger European economies is coming from Irish banks buying the government's debt in a return to home-biased investment. In other words, rather than investing all over the world, Europe's banks are directing their funds toward their home markets, spurring demand for their own countries' bonds.
Finally, the markets assume that the Irish public will accept draconian austerity measures and suffer quietly, as it has for the past five years. Even in September 2009, when tens of billions of euros of guaranteed and unguaranteed bonds were paid back using future taxpayers' incomes, the Irish did not take to the streets. Austerity, however unpleasant, has been managed by the authorities to avoid large-scale public protest, and the worst has already passed. The 8.1 billion euros of spending cuts and tax increases expected over the next two years will pale in comparison to the 25.1 billion euros of cuts and tax hikes that the country has already endured.
The funny thing about sovereign debt is that a country's level of debt does not actually matter in the short run, as long as someone is willing to lend to it. Perception is everything. For this reason, Ireland's strategy of ingratiating itself to the European authorities and working to convince investors that its bonds are safe may prove wise. Ireland will almost certainly require further assistance of some kind after 2014, including a restructuring of the bank-related debt incurred by previous governments. But this fact somehow does not faze the markets.
Ireland may seem to be the latest model for those pushing austerity across Europe, but the continent's authorities should be wary of applying the lessons of the Irish experience to the next wayward country. Ireland is tiny, its government and populace are unusually pliant, and the scale of its housing boom and bust was unprecedented. The markets perceive Ireland differently than they do other countries and have been more likely to trust it. So the precedent Ireland offers its European neighbors is not exemplary but cautionary. Given Ireland's treatment by the markets, other countries in Europe may be more circumspect about asking for aid, even if it makes sense for them to accept it. Perhaps, for once, Ireland may save itself by refusing to put on the poor mouth; other European countries ought to think twice before doing the same.

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