Irish Woes Get Worse

It's hard to know what to say about Ireland's revelation that it expects the cost of cleaning up Anglo Irish Bank to come to a staggering 21% of GDP.  Profanity is too weak, really.  The total cost of the bank bailouts looks as if it will be well over a quarter of GDP.

Needless to say, as Tyler Cowen notes, this rather calls into question the notion that austerity is making Ireland's problems worse.  The size of the bank rescue may well turn out to be too large for the government to handle.  Yet the government has little choice.  Ireland is massively dependent on foreign credit, and if it flees--well, the second letter in the country's name might as well be a "c".  That means cutting the budget elsewhere to send a credible signal to the bond market--because without that credible signal, an even worse financial crisis seems like the most likely outcome.

Can Ireland pull this out?  I don't know.  25% of GDP is a mind-boggling sum for a small country to spend just on supporting its banks.  Alex Massie says that "the Irish economic elite is so out of touch with the views of the man on the Drumcondra omnibus" and channels Robert Peston to explain why:

Total foreign bank exposure to Ireland's economy is $844bn, or five times the value of Ireland's GDP or economic output. Of that, German and UK banks are Ireland's biggest creditors, with €206bn and €224bn of exposure respectively.

To put it another way, German and British banks on their own have each extended credit to Ireland greater than Irish GDP. Which doesn't sound altogether prudent, does it?

As for direct bank-to-bank lending, overseas banks have provided Ireland's banks with €169bn of loans, which is also greater than Irish GDP.

These are very good reasons.  But if they can't convince the proverbial man on the omnibus, they may not be able to muster the political will to see this through.

On the other hand, there's a decently compelling argument that this is a form of "big bath" accounting--offer a dire worst case scenario now, so that when it only costs 19% of GDP to bail out all the banks, you're a minor hero.  And Ireland has worked an austerity plan once before with some success.

The only thing that is clear to me at this point is that if Ireland can't make it, they'll have to bail on the euro.  That's not a happy thought for Ireland; in many ways, the country has benefitted greatly from its membership in the euro zone, and the EU more broadly.  On the other hand, the mismatch between the business cycles in the Irish economy, and those of France and Germany, had a lot to do with getting Ireland into this mess:  monetary policy was far too loose for Ireland's overheating economy throughout much of the last decade, and it's now far too tight during the bust.  If Ireland gets locked out of credit markets anyway, it's hard to see why she stays in the monetary union, when leaving would give her struggling workers a lot more breathing room.