Ireland's Problems Should Concern The U.S.

From AEI:

Ireland's Problems Should Concern the U.S. By Desmond Lachman

The Hill's Congress Blog

Wednesday, November 24, 2010











In 2007, Federal Reserve Chairman Ben Bernanke spent most of the year reassuring markets that the U.S. sub-prime mortgage loan problem would be contained. In an all too similar a manner, ECB President Jean-Claude Trichet now keeps asserting that Europe's sovereign debt crisis does not pose a significant threat to the overall European economy let alone to the global economy. U.S. policymakers would do well to disregard Mr. Trichet's sanguine remarks and brace themselves instead for a European economic tsunami that is all too likely to seriously derail the fragile U.S. economic recovery.



The essence of Greece, Ireland, Portugal, and Spain's present economic predicament is that these countries have run up very large internal and external imbalances within the most fixed of all fixed exchange rate regimes. Stuck within the Euro-zone straightjacket, these countries cannot devalue their currencies to boost exports as a cushion to offset the highly negative impact on their economies from major IMF-style fiscal retrenchment. As a result, these countries are all too likely to be mired in the deepest of economic recessions for many years to come. And as we are presently witnessing in Ireland, such grim economic prospects will severely test these countries' social and political fabrics.



Mr. Trichet downplays the systemic importance of the European periphery's sovereign debt crisis by emphasizing that the periphery constitutes only a relatively small part of the overall European economy. In particular, he keeps reminding us that both Greece and Ireland constitute less than 2 percent of the overall European economy while, even including Spain, the periphery accounts for less than 15 percent of the overall region's GDP. The crucial point over which Mr. Trichet disingenuously glosses is that, while Europe's peripheral economies might be relatively small, their governments are extraordinarily highly indebted. Indeed, Greece's sovereign debt alone amounts to over US$420 billion while that of Ireland is around US$200 billion.



Of yet very much greater concern, by provoking a European banking crisis, it would threaten to contaminate the rest of the global financial system in much the same way as did the Lehman fiasco in 2008.A Greek or Irish debt default must be expected to accentuate the sovereign debt difficulties in Portugal and Spain. This could bring into serious question the serviceability of around US$2 trillion of European sovereign debt, a magnitude that one would think should not be lightly dismissed for its potential impact on Europe's overall economy.



A further inconvenient truth that Mr. Trichet chooses to downplay is that the major part of the periphery's debt is held by the European banking system. This implies that a wave of sovereign debt defaults in the periphery would deal a serious body blow to the European banking system at the very time that the European banks are yet to fully recover from their 2008-2009 loan losses.



The potential severity of this problem is underlined by the disturbingly high exposure of a number of individual countries to the European debt crisis. According to data from the Bank for International Settlements, the European banking system's exposure to Greece, Ireland, Italy, Portugal, and Spain exceeds 20 percent of Europe's GDP, while that of the Dutch and French banks exceeds 33 percent of their respective GDPs.



The most likely trigger for the Euro's eventual unraveling will be in the periphery itself. The Greek, Irish, Portuguese, and Spanish governments already all have the most tenuous holds on political power. A deepening in their economic and financial crises could very well result in the ascendancy of more populist governments, which might be less willing to hew to the hair-shirt austerity programs being dictated by the IMF. Ireland's present political unraveling would suggest that this could very well happen as soon as in 2011.



An escalation of the European debt crisis would pose a real threat to the U.S. economic recovery. By weakening the Euro, it would seriously dent U.S. export prospects. Of yet very much greater concern, by provoking a European banking crisis, it would threaten to contaminate the rest of the global financial system in much the same way as did the Lehman fiasco in 2008. With the darkest of economic storm clouds gathering in Europe, this is no time for U.S. policymakers to be thinking of cutting back on policy support to the U.S. economy.



Desmond Lachman is a resident fellow at AEI.