Is it the sheer size of its contingent liabilities that is driving Irish spreads? Finance Minister Brian Lenihan thinks so via the Irish Independent:
"There is no doubt in my mind that while the announcement on the banking sector in September was not disbelieved by the markets, it wasn't fully believed either because there is a wait and see policy of seeing whether it is an accurate account of exposures in the banking system," the minister said.
Or is it German Chancellor Angela Merkel's recent rhetoric? According to the Irish Times, since her most recent statement on private haircuts, "All stakeholders must participate in the gains and losses of any particular situation", officials are readying the European Financial Stability Facility for possible tapping by the Irish government:
The Irish Times has established, however, that informal contacts are under way between Brussels, Berlin and other capitals to assess their readiness to activate the €750 billion rescue fund in the event of an application from Dublin.
The EU quashes this rumor.
Or is it that "markets" just don't buy the Irish fiscal austerity reduces the Irish budget deficit story? According to the Irish Independent, this is th e opinion of Nobel laureate Joseph Stiglitz (mine, too, by the way):
“The austerity measures are weakening the economy, their approach to bank resolution is disappointing,” Stiglitz, a Columbia University economics professor, said in an interview in Hong Kong today. “The prospect of success is very, very bleak” for the government’s plan to resolve the problem, he said.
What's driving spreads? They've come off a bit today, but they're still just under 600 basis points over German bunds as of 6 a.m. this morning. Furthermore, the EU came out with a statement that reiterates the exclusion of outstanding debt on any new restructuring mechanisms:
..does not apply to any outstanding debt and any programme under current instruments. Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements.
The answer is, it's probably a mix of the three above. Markets are starting to price in an insolvent government balance sheet, which will ultimately lead to default - some call Ireland's sovereign balance sheet insolvent but still liquid .
I side with Stiglitz, that ultimately its deficit reduction plan will reveal the axiom that is the three-sector financial balance: if you don't have a surge of external income, then the private sector and the public sector cannot simultaneously increase savings.
Exhibit A. The year of austerity - and even harsher and more front loaded austerity is on the way - has proven to squash growth prospects for the Irish economy compared to the average, which is the Euro area.
The chart illustrates the index of quarterly GDP, as reported by Eurostat. The Euro area data is current through Q3 2010 (only on a "flash" basis), while the Irish GDP figures are available through Q2 2010. These numbers are not annualized; but as of Q2the Irish economy is running 11% below its Q1 2008 level of GDP, while in Q3 the Euro area as a whole is producing just 2.7% short of its Q1 2008 level.
But the Irish government is sticking to its plan. Recently the Central Bank of Ireland published its quarterly report, where it simultaneously downgraded the growth forecast and announced that further action will be taken to bring the government deficit to 3% of GDP by 2014. Since then, the government announced deficit cuts that exceeded those originally planned by a factor of two. Seems fishy to me.