Monday, May 9, 2011

We're still all doomed

The purveyor of all things doomy, Morgan Kelly, was back at the weekend. Following on from his November article (blogged here) he paints a none too rosy picture of Ireland's economic future or the road taken to get us to our current position. He is particularly scathing of Patrick Honohan and his missed opportunity to cancel the bank guarantee when he was appointed.

Kelly does put forward a solution to the current mess that comes as a two-parter. Firstly Ireland walks away from the entire EU/IMF deal and foist the bank debts back on the ECB and secondly (or more specifically as a consequence of the first) Ireland immediately balances its budget.

The first part of the solution is easy. We stop drawing down any additional money from the EU/IMF, tear up the draft MOU that was circulated last week, close down NAMA and turn the ECB into the effective owners of the Irish banks. So far so good. This gets our debt back to a "reasonable" figure a bit north of €100B.

Now comes the hard bit. Because we will have cut off our line of credit from the EU/IMF and due to the outrageous margins the bond markets are demanding on Irish debt, we would have to immediately slash our expenditure to match our income. That means an overnight correction of about €20B give or take. This equates to about a 30% cut in all social welfare payments, public sector pay and pensions and a huge number of canceled procurements and service contracts with the private sector, not to mention a massive bonfire of quangos.

Ignoring the mantra of "The ATMs will stop working", which I seriously doubt would happen, the scale of the adjustment is massive: cutting job seekers benefit to around €135, child benefit to €100 and the contributory old-age pension to €160. It would also cut about €6B off the annual wage bill for the public sector, but assuming an average tax/levy rate of 20% (probably a low estimate) that would come back to less than €5B in savings. The knock effect of these cuts is further reductions in spending in the economy, thereby reducing even more the taxes raised through VAT and private sector employment which could end up in a further negative spiral of cutbacks.

Could the Irish economy survive such a shock? I don't think so but it is the only result possible if we ditch the bailout. Certainly the Irish people would find it very hard to swallow. But if given the choice between a lot of medicine now or a long, drawn out illness it is certainly worth weighing up.

The big question that remains unanswered, at least to me, is what way the bond market would react. At the moment it seems as though an Irish default is already priced into our yields. We are out of the market because they won't lend to us. The government line is that if we default then the market won't lend to us in the future either. So if we're frozen out anyway, then does a default matter? Won't there be some enterprising hedge fund that will see an opportunity in lending to Ireland in the future once our spending is roughly back in line? Obviously this lending would have to be prudent and for serious capital investments such as rail, schools and hospitals rather than re-inflating wages. But it certainly seems like such lending would be likely in the medium term.

The other question is how a default would affect the Euro in general, and Ireland's participation in it. On that I have no clue. Perhaps someone could enlighten me a bit on the topic. Can we realistically move to the Punt Nua and is that even an advisable thing to do unless we peg to Sterling? And if Greece jumps should we follow or is the game over?

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