The Meaning of Ireland's Collapse

When Ireland's real estate boom busted, the banks shuddered, and the government stepped in, guaranteeing private debt twice as valuable as the country's economy. The result is a full-blown disaster, the most notorious debt crisis since Greece required a bailout early this year.

The IMF and European Union have come together to offer Ireland more than $100 billion, enough to cover the country's borrowing costs for the immediate future to keep the country from defaulting on its debt.

What's the meaning of this implosion? Here are two interesting takes.

It proves the failure of supply-side economics, says BusinessWeek's Chris Farrell:

In the 1980s and 1990s, Ireland started cutting taxes, and in the 1990s and 2000s it was growing at a phenomenal rate. The top marginal tax rate on personal income went from 65 percent in 1984 to 42 percent by 2000. More importantly, the corporate tax rate was cut in stages from 50 percent in 1986 to 12.5 percent by 2003. Ireland posted an average growth rate of more than 7 percent a year from 1997 to 2007, the quickest pace among the 30-plus members of the Organization for Economic Cooperation and Development. Ireland was the Celtic Tiger, the Irish Miracle.

By now, everyone in the global economy is aware that the Celtic Tiger has been declawed and the Irish Miracle a mirage. Ireland is an economic and financial disaster with a government budget deficit for 2010--including the cost of bailing out its banks--at 32 percent of gross domestic product.

This is an interesting but insufficient explanation. A fine paper explaining Ireland's Credit Bubble, linked to within the BusinessWeek piece, pins the Irish collapse on a failure of bank prudence -- a familiar story to US readers where rampant private lending, rising property values, and historic consumer debt inflates the economy before finally giving way. The concept of tax rates doesn't appear once in the paper. That doesn't mean that ultra-low rates didn't play a role in attracting risky capital into Ireland, but the Irish Central Bank could and should have curbed Ireland's appetite for debt, no matter what the marginal tax rates were.

Another theory says Ireland proves that distinguishing between public and private debt in crises is worthless, writes Alen Mattich in the Wall Street Journal:

In Greece, the massive burden of domestic debt threatened to bring down the economy not just because it threatened to squeeze the Greek taxpayer dry (were the government ever to manage to enforce its tax laws), but also because domestic banks were holding a massive supply of that same debt. A sovereign default would have wiped out Greek banks' assets, crushing the country's financial sector.

In Ireland, the problem worked the other way around. When Ireland's banks were threatened by depositor runs during the early days of the credit crunch, the government stepped in to guarantee the sector's liabilities. A huge burden of private-sector Irish debt suddenly became public.

To understand why this is such a problem, cast yourself in the role of international investor. You need surefire ways to evaluate the dependability of a country's debt if you're going to buy it. One year, you look at countries like England, Ireland, and Spain and see low public debt levels. Good bet! But suddenly, Ireland's private debt bubble explodes and the private debt bubble becomes the country's public debt crisis. And Ireland's public debt crisis becomes Germany and Britain's bailout. In short, one country's private guarantees become another country's public guarantees.

That's the crisis beneath Europe's crisis. In the Eurozone, each country is responsible for the survival of its members states. That means when Ireland and Greece go south, the effects ripple across the Eurozone. In the short term, the EU's only move is to slow down the break up of its peripheral states. But in the long run, the peripheral states might have no choice but to break up the EU.