The Case Against Austerity

For those pushing for austerity in the U.S., lets take a look at one real-life (perhaps more extreme) example of austerity in action... Ireland.

First the initial case for Irish austerity, which seems to match some of the sentiment we are hearing in the U.S. (per The National):

"Ireland is seen as having done better than most others in restoring market credibility," said Eurasia Group analyst Jon Levy. "There are still some worries but the feeling is they have done better than most and with a reasonable degree of internal consensus.

"Ultimately, Ireland's trade unions say they know deficit reduction is vital if Ireland is not to be priced out of international bond markets like Greece, but they want a greater burden to be paid by the rich through higher taxes.

So austerity would be good for bonds? Lets see the other side of the initial argument... Paul Krugman from April:

Let me also say that Ireland’s recent policy moves — raising taxes and cutting spending in the face of a severe recession, so as to reassure nervous lenders — are an extremely disturbing omen. Iceland was one thing; but now another advanced economy, with a 7-digit population, has hit the limits of anti-recession policy.

Lets see how it has turned out. Marketwatch details:

Ireland proved unable to shake off rising sovereign-debt fears Thursday, with bond yields jumping as investors reacted to indications some Anglo Irish Bank bondholders may not get all their money back and official data showed the economy contracted unexpectedly in the second quarter.

The yield premium demanded by investors to hold 10-year Irish government bonds over German bunds topped 4.3 percentage points Thursday, the highest on record and up from around 4.1 percentage points on Wednesday. The cost of insuring Irish government debt against default hit a new record Thursday.

The spread on five-year Irish credit-default swaps was seen at 490 basis points in late morning action, up from around 460 on Wednesday, according to data provider Markit. That means it would cost around $490,000 a year to insure $10 million of Irish debt against default for five years, up from $460,000 Wednesday. The spread hit 500 basis points for the first time earlier in the day, Markit said.

Source: Barclays Capital

Spain Downgraded... Ireland to Follow?

Last week I detailed the struggles Spain is working through, specifically a tumbling housing market and frozen credit markets. Throw in Spain's dependence on the ECB to enact policy across the Eurozone and no flexibility with their currency (i.e. the Euro) and it's not surprising they were under pressure. This ultimately led to S&P's placement of Spain on negative watch and days after my post, S&P downgraded Spain to AA+ from AAA (per the Irish Times):

The cut in Spain’s rating to AA+ from AAA, a level Spain had held since late 2004, sent the euro to a session low against the dollar as investors feared Portugal and Ireland would suffer the same fate after receiving SP warnings.

As detailed on Across the Curve, the debt of "have nots" in Europe (including Spain and Ireland) continue to sell off:

Yields on Italian Spanish and Greek bonds have widened by 7 basis points, 4 basis points, and 10 basis points respectively against Germany. Irish bonds have widened by 26 basis points versus Germany.

In looking at Ireland, we see a country that like Spain depended on the financial sector and an asset bubble to fuel growth. While the Irish economy boomed through mid-2007, the money supply grew even faster, at a rate of between 15-30% annually from 2004-2007. This added fuel to the fire and created an asset bubble of mammoth proportions. According to Professor Morgan Kelly (i.e. the Irish Dr. Doom, who like the Roubini is looking smarter EVERY day):

Back in 2000, lending to construction and real estate made up only 8 per cent of Irish bank lending, much like other European countries. Now it has risen to 28 per cent. By comparison, just before the Japanese bubble burst in late 1989, construction and property development had grown to a little over 25 per cent of bank lending.

Now, we see that process in reverse. When credit ran dry, the bubbles (both housing and economic) popped. The economy, in desperate need of liquidity to help slow the unwind, has seen its money supply (in terms of M3 which literally doubled from July 2004 - August 2007), decrease year over year at a rate of more than 10%. Back to the Irish Times:

Ireland's economy will contract faster than most EU economies this year and its budget deficit will be the highest in Europe in 2010, according to new forecasts published by the European Commission. Brussels predicts Irish economic output will fall 5 per cent in 2009, unemployment will rise to 9.7 per cent and the deficit will reach 13 per cent of gross domestic product (GDP) by 2010 in the face of the world’s worst recession since the second World War.

Just to see how different the situation can be with a country that has control of their money supply, below is a chart detailing that of the UK. While the UK had its own asset / credit bubble, they had a more controlled increase in money supply (a still too high for the time 10-15% vs. Ireland's 15-30%), but importantly they have been able to increase this level to almost 20% as the economy has become in desperate need of liquidity.

Source: CSO