Why the Irish Crisis Is Going Global

Includes: ERO, EU, IRL
by: Rick Newman

You may not have to worry about Ireland in a week, or a month. But at the moment, the Emerald Isle is causing global investors a whole lot o' anxiety.

On the surface, it's reminiscent of the problem Greece had with its unmanageable federal debt early this year, which shook world markets, ended a global rally in stocks and ultimately led to a $146 billion bailout by the European Union and the International Monetary Fund. Greece spent more money than it took in for years, papered over the gap, and essentially became insolvent when it could no longer borrow the money needed to finance its debt.

Ireland is on the brink of insolvency too, which has helped drive down the S&P 500 stock index by nearly 4 percent over the last few days. But unlike Greece, Ireland is a relatively wealthy country, with per capita GDP of nearly $38,000. That's 21 percent higher than per capita GDP in Greece, and in the top third for European countries. Low corporate tax rates and a skilled workforce have made Ireland a haven for some of the world's biggest companies. And its public debt, about 65 percent of GDP, is far below Greece's crushing load, which is 126 percent of GDP. Ireland's debt levels are even lower than those in France, Germany and the United Kingdom.

But Ireland has one huge problem that may soon make it a supplicant to its European brethren: A failed banking sector that Ireland's government can no longer rescue on its own. Ireland is in the midst of a real estate bust that could trump even the ruinous downturns that turned parts of southern California and Nevada into suburban ghost towns, with home-grown banks stoking it all. Now, those banks are trying to manage catastrophic losses. The Irish government has effectively nationalized the nation's biggest banks by guaranteeing their debt, which would be akin to the U.S. government taking over Citigroup (NYSE:C), Bank of America (NYSE:BAC), J.P. Morgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC).

That means the Irish government is also on the hook for the losses those banks endure—which have risen far beyond initial estimates, and may have a lot farther to go. So far, the Irish government is obligated to cover losses amounting to 175 percent of Irish GDP, which is becoming an unsustainable burden. "If the Irish banks go down, the Irish government also goes down," says economist Jacob Kirkegaard of the Peterson Institute for International Economics.

As estimates of Irish bank losses have gone up, pressure has mounted on Ireland to do something decisive--and panicky markets may now force a solution. Ireland wants the European Central Bank to continue lending money to Irish banks at low interest rates, but the ECB has different ideas. Inflation has been creeping up in Europe, and the central bank said recently that it wants to end its program of pumping liquidity into banks, not continue or expand it. Cutting off those loans to Irish banks could force defaults, which the Irish government would have to cover or essentially be in default itself. Germany, meanwhile, wants to hurry a bailout of Ireland, to prevent worries about sovereign bonds from spreading to Portugual or Spain, which would be a much bigger problem.

A European bailout of Ireland would be manageable, and probably cost less than the Greek rescue. But Ireland doesn't want it, because the EU and IMF would force austerity measures onto the island nation that could effectively end its appeal as a business-friendly nation with a high standard of living. Since Ireland is wealthier than other European nations that would essentially be lending it money, social programs would end up gutted, and taxes would soar. And Ireland's 12.5 percent corporate tax rate—one of the lowest in the developed world—would almost certainly go up, taking what's left of the roar out of the Celtic Tiger. If multinational businesses abandon Ireland, it could fall quickly down the list of Europe's most prosperous nations.

The standoff is what worries the markets, since a protracted bailout battle darkens the clouds over Europe's other deeply indebted nations. Portugal and Spain aren't in serious danger of default at the moment, but as Ireland's cost of borrowing goes up, so does the cost of borrowing in similarly stressed nations. That gets passed through to businesses operating in those countries that do need to borrow money—and they could face more urgent funding needs than their own governments in the weeks ahead. That's how Ireland's problems ripple outward to other indebted governments, the real economy and ultimately to the global stock markets.

A bailout might seem tough to swallow in Ireland, but it would most likely calm global markets. Moody's Analytics points out that there's plenty of money available for a bailout, and also that the ramifications of a sovereign default are so severe that even nationalistic politicians would never let it happen. "We still believe the probability of default by a euro zone member state within the next two years is not significant," Moody's (NYSE:MCO) wrote in a recent analysis.

Kirkegaard of the Peterson Institute sees three possible options. One is that a large bank, probably in Asia, could sweep in and buy up the Irish banks, if it got sufficient guarantees against losses by the Irish government. Prognosis: Unlikely. There's also a tiny chance that the European Central Bank will change its policy to accommodate Ireland. But that's even more unlikely.

What's most likely is some kind of Irish bailout, with tough negotiations over when it happens and the conditions Ireland must agree to. Ireland will fight hard to put off a bailout—at least until parliamentary elections on Nov. 25—and to retain its right to make its own fiscal decisions. But Ireland's luck may be about to run out, with other European nations likely to insist that Ireland face austerity measures at least as tough as those in Greece. Maybe tougher. "That would have very signficiant long-term growth implications for Ireland, and other eurozone countries know that," says Kirkegaard. "But given the politics of bailouts, that simply doesn't' matter." After all, there may be other bailouts that need to be addressed.

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