Friday, 26 November 2010

Scary numbers - debt dynamics in Ireland

I thought I would review some of the debt dynamics for Ireland. It turns out that within a common currency area there is a twist on the normal dynamics that would apply.

Let's start with a little algebra. General government debt as a percentage of GNP will grow as interest accrues (r) and a the government run a deficit before interest (primary deficit) and it will be deflated by the rate of nominal growth in our income (GNP)

Using some mathematical manipulation we can see that the debt to GNP ratio will only stabilise or fall if the government runs a primary balance which is larger than the sum of the difference between Irish real growth and Euro real interest rate, plus the difference between Irish inflation and Euro inflation, all scaled by the ratio of debt to GNP.

When this is normally done for an economy the inflation terms simply cancel one another out - the inflation rate at which the economy grows is the same as the ex post inflation premium paid through interest. For Ireland and indeed any Eurozone country, this is no longer the case. What this is saying is that we are borrowing on terms that reward lenders with an inflation risk premium that relates to the currency of issue, the Euro. However, Ireland will need to service the nominal repayments out of a tax base that will rise only with domestic inflation. A nasty twist for Ireland at this juncture, when one might anticipate a significant ongoing real exchange rate depreciation - in common English; falling Irish prices relative to Euro prices.

So from this relationship we can play with scenarios.

I plug in numbers that would represent a pessimistic scenario relative to official plans.
  • Very weak medium term growth of 1%
  • Real Euro interest rates of 3% (5% minus 2% Euro inflation)
  • Deflation in Ireland relative to the Eurozone (zero inflation here, 2% in Eurozone)
  • All multiplied up by 150% which represent our debt to GNP
Under such assumptions Ireland would need to run a primary balance of 6% of GNP or greater. Our tarting point is a deficit of about 10% of GNP. We would need a fiscal adjustment 16% of GNP or more to stabilise our debt. And the kick is that if we allow the debt to GNP ratio to rise further the surplus we need to run on our primary balance becomes larger - i.e with debt at 200% of GNP that 6% required primary surplus becomes an 8% primary surplus. Ouch.

I think the worry is that the more we deflate (Irish inflation lower than Euro inflation) the bigger the fiscal adjustment needed. And the bigger the fiscal adjustment the more deflation we bring. A viscious cycle that leads to national bankruptcy.

Let's not underestimate what the stakes are with the decisions we will be making over the next weeks.

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