Sunday 23 November 2014

Dan O'Brien: Threat of second bailout still has not gone away

There are three major foreseeable risk factors ahead that could lead to us requiring rescue funding again, writes Dan O'Brien

Published 01/12/2013 | 02:30

PROTEST: A riot policeman on duty during demonstrations over austerity measures in Athens in 2010

WE HAVE lived in extraordinarily uncertain times over the past half decade. Despite this, many people, including some very clever people both at home and abroad, proclaimed with great certainty last year that Ireland would not exit its bailout this month. They had many good reasons to believe that a second bailout would be needed before the first one had formally ended. But they had no reason to be so certain in that view. It is good for everyone that they have been proved wrong.

That Ireland is the first euro area country to have successfully weaned itself off rescue funding is unambiguously good. Having to resort to a second bailout would be unambiguously bad.

But resorting to a second bailout is a real possibility. Most of the reasons that gave rise to the belief that an on-schedule exit was impossible have not gone away. There are three major foreseeable risk factors over the next two years.

One is domestic. If the economy does not grow at a decent clip, the State's already-huge debt mountain will get bigger, not smaller, as per government and troika projections. If it grows much bigger, those who lend to governments will conclude – sooner or later – that it is unrepayable and will stop adding to it. It would then be back to bailout.

What are the prospects of sustained recovery?

There have been many false dawns since the crash. Economic forecasters have, year after year since 2009, predicted recovery within a 12-month time frame. The optimists may be proved wrong again, but there are unquestionably more strengths and fewer weaknesses now than at any time since the crash. Last week brought the best news yet.

The single most important health indicator in the Irish economy is how the number of people at work is changing. In the third quarter of the year, 23,000 more people were working than just three months earlier (the increase was even bigger when not adjusted for seasonal factors, such as temporary hires by the hospitality industry during the peak of the tourism season).

Astonishingly, this increase was in line with average employment increases during the Celtic Tiger era, when jobs were growing on trees and Ireland was a world leader in employment growth. Indeed, the increase was so big that one might have questioned the statisticians' figures but for the Department of Finance's entirely separate income tax numbers for the third quarter, which show an increase of over five per cent on the same period a year earlier. That is corroboration enough that people are getting back to work in significant numbers.

Nor was the latest good news on employment a one-off. Since the number of jobs in the economy hit a post-crash bottom in the middle of last year, there has been uninterrupted, sectorally wide-ranging and accelerating employment growth. By comparative standards, no peer country has notched up a rate of jobs growth to match Ireland's over the past year.

But good and all as the news on jobs is, it does not mean that a return to sustained growth is guaranteed. First off, developments in the labour market better reflect past conditions than future prospects. More importantly, there are still ferocious headwinds facing the economy, including insufficient bank lending, at least one more contractionary Budget and high household and company debt. It is perfectly possible that these factors will halt forward momentum over the next few years.

The second factor that could push Ireland back into bailout territory is a reigniting of the euro crisis. If that were to happen, those who lend to governments would take fright. All the weak states in the eurozone periphery could expect the same dash to the exits by bond traders that has happened in the past.

Despite the large number of potential triggers for renewed crisis, political leaders have moved at a snail's pace to complete a banking union, too many politicians and officials have been lulled into a false sense of security by 18 months of financial market calm and other issues have come to crowd the EU agenda.

Even the EU institutions have lost focus on the existential threat to the euro. Members of the unwieldy 23-man governing council of the European Central Bank are in open disagreement about the actions their institution should take. On a visit to Brussels last week, it was clear that many in the European Commission are most focused on the new intake of commissioners due to take office next year, while MEPs are going into campaign mode for next May's European parliamentary elections. More generally, there is more chatter in the Brussels bubble about who will get the many top EU jobs that are becoming vacant next year than there is about reinforcing the euro's fragile foundations.

Those in Brussels who are focused on the crisis are resigned

to others' complacency. They know that only when matters become too serious to ignore does movement take place. They also find some consolation in the genuinely positive developments of recent months.

The eurozone as a whole has emerged from recession. After Ireland this month, Spain looks set to exit from its partial bailout, designed to allow it sort out its banks, on schedule in January. Its economy appears to have stabilised and its public debt levels – at less than 100 per cent of GDP – give it some leeway. Across the Iberian border, Portugal has experienced a sudden and unexpected turnaround since last spring. It is due to exit its bailout in six months. It still has a fighting chance, albeit a small one, of making it.

But huge weaknesses remain. Europe's banking system is structurally unsound and some of its governments are, like Ireland's, at or near the limits of debt sustainability. A continent-wide health-check of European banks will take place over the next year. If big holes are found in their balance sheets and if the governments in the countries in which they are headquartered can't raise the money to fill those holes, panic will surely ensue.

If weak banks don't spark more panic, then weak states could do the job. There is no shortage of candidates, but Italy looms above all others. It is one of the 10 largest economies in the world and its government owes more than €2trn. It is still in a recession that has become the longest on record in the post-Second World War era. Even before the crisis, it was barely growing. Its economy has since shrivelled and is now the same size it was at the turn of the century. The numbers at work are at a 10-year low and still falling. Its public debt has risen above levels many believe are sustainable for a slow-growing economy and rapidly aging country. Italy is close to the edge.

The third big risk is that the international financial markets, upon which the State is once again fully dependent, end their buying spree and start selling. The chances of this are considerable.

Despite the worst half-decade of economic growth in living memory, many financial market indicators across the developed world are hitting record highs. Despite a huge rise in public debt, the cost of borrowing for some countries is at or near all-time lows. The Irish State's borrowing costs are just one example. Interest rates on government bonds are currently around the same level as in 2006 even though public indebtedness is between four and five times higher than it was then. This makes no sense.

The fundamentals simply do not support these financial market developments in relation to Ireland or most of the rest of the rich world. Historically high assets prices are better explained by irrational optimism and the bubble-inflating effects of American money-printing. As the ECB explicitly warned last week, once its counterpart in Washington starts winding down its money-printing operations, the bond market will be affected. The best that can be hoped for is that the correction, when and if it comes, will be minor rather than major.

If the Irish economy grows at a decent clip, if the euro crisis remains merely chronic and does not again become as acute as it did during the 2010-12 period, and if the bubble in the international bond market deflates slowly and without panic, Ireland's bailout experience should be confined to a single episode. That will require no little luck.

Sunday Independent

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