Ireland and the Austerity Model

Ireland is the model for austerity in Europe. They have bailed out their banking system, cut government deficits, and are attempting to stop the growth of government debt levels. Now, bailouts are not austerity. Rather, it's how Ireland got into this mess in the first place.

After joining the Eurozone, their economy boomed as Ireland wooed global corporations and governement invested heavily in higher education. Unfortunately, the loose-credit policies of the ECB had side effects, the greatest of which was a housing bubble. This took down Ireland's banks, requiring national guarantees of all deposits. Right from the start, Ireland's policymakers took bold, decisive action, and they continue to do so. This transfer of debt from the banking system to the government pushed debt totals to unsustainable levels. Enter the austerity. The government has cut back spending strongly even in the face of declining GDP. Tax receipts have declined. There is only one question left? Will it work?

Or, will tax receiptsand GDP fall faster than deficits? This would become a debt spiral. Unfortunately, it may not even get there, since even the mere idea of a debt spiral may cause investors to refuse to roll over existing debt as it comes due, or lend for operating expenses.

The Financial Times is reporting that a Barclays report had a sickening effect on the Irish bond market today. After yields on two-year bonds jumped half a point to 3.63%, the ECB took the drastic step of buying bonds on the open market to stop the drop in prices. Prices move inversely to yields, so a jump from 3.13% to 3.63% implies an approximate fall in price of 16%. In the bond market, this is apocalyptic. The risks are clear: the ECB is already bailing out Ireland. It may not be long before a full-fledged crisis erupts. Since Ireland is the poster-child for the benefits of the European austerity program, their failure will put into question the ability of Greece, Portugal, Spain, and possibly even Italy to pay off their debts.

How the CBOE Volatility Index (VIX) can be under 22 boggles my mind. Rosenberg says the pullback in Treasuries is a buying opportunity. I'm inclined to trust him because he's been spot on regarding Treasuries all year, but I need to think more about the implication of a possible Geithner-sponsored dollar devaluation through trade sanctions on China.