The debate begins

Michael Burke: The Open Letter is being discussed over at Irish Economy.

Two interesting counter-thrusts, which are not entirely new. One is that the government's slash and burn approach has stemmed the rise in long-term interest rates. Philip Lane says, "If the government had not undertaken a sizeable fiscal adjustment, the spread on sovereign debt would surely be much higher than the current elevated level and the upward movement in interest rates (influencing the funding costs for the banking system as well as for the government) would have had an even more contractionary impact on the economy.”

But, as previously argued here, this does not accord with the facts. Government austerity policies have widened Ireland’s yield premium over other Euro Area borrowers.

This can be established by comparison with a host of European sovereign borrowers, all of whom adopted reflationary measures in 2009. The most obvious comparator is Belgium, which (by dint of having higher debt and lower deficits) had almost exactly the same 10-year yields as Ireland for well over a year before the crisis occurred. They were within a bps or two of one another.

The Belgian authorities engaged in significant reflationary measures- Ireland had its own unique contractionary experiment. The yield spreads began to part company precisely when Ireland adoped the first of the austerity packages in late 2008. From a zero yield premium over Belgium, this diametrically opposed policy has pushed out the yield premium to 77bps currently, and has been over 100bps. Even in its own terms, the Irish government policy of ‘reassuring the financial markets’ has failed utterly.

The second argument, also familiar to readers of this blog, is that Irealnd's uniquely severe fiscal position ruled out borrowing to invest. But Ireland's fiscal postion wasn't unique, although the response was. It has made matters wose.

The Irish slump was a year earlier than that of the Euro Area as a whole. Ireland’s budget deficit was 7.2% of GDP in 2008 (net general government borrowing). That is not qualitatively different from the Euro Area average the following year, when their recession kicked in. The average deficit that year was 6.4% of GDP, with France a whopping 8.3%. However, the overwhelming bulk of those countries adopted fiscal stimulus packages, with France one of the biggest of all (hence the scale of the short-term blowout in the deficit). So, Ireland's fiscal position did not preclude borrowing to invest, only its polices did.

The EU Commission forecasts French net GGB this year at 8.2% in 2010 and falling to 7.7% in 2011. Similarly, Belgian GGB is expected to be 5.9%, 5.8% and 5.8% (incidentally, one of the reasons that Belgium is a useful comparator, aside from previously identical yields, is to overcome criticisms that the this does not apply to a small open economy, or to lay the yield blowout at the door of Ireland's bank bailout; Belgium is 2nd in the Euro Area behind Ireland for both).

For the Euro Area as a whole, the profile of GGB forecasts is 6.4%, 6.9% and 6.5% out to 2011, whereas Ireland’s is 12.5%, 14.7% and 14.7%. The Euro Area adopted fiscal stimulus; Ireland a Thatcherite slash & burn. The Euro Area is expected to stabilise and lower its deficit. Ireland’s deficit is expected to increase and then ’stabilise’ at that higher level.

The architects of slash & burn need a Plan B, soon, and a little top-up of investment, ‘financed’ by more slash & burn won’t pass muster.