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24 November 2010updated 27 Sep 2015 5:40am

Why the Irish bailout may not work

Ireland needs debt relief if it is to avoid economic collapse.

By George Eaton

Ahead of the final details of the likely €85bn (£72bn) bailout, Ireland’s government is due to present a four-year austerity package made up of €15bn of spending cuts and tax rises.

The rationale behind the austerity measures is clear: Ireland has a budget deficit of 32 per cent and its national debt has gone from 25 per cent of GDP in 2007 to almost 100 per cent. But here’s the rub: if and when it becomes clear that the austerity package will reduce economic growth, the market will quickly lose confidence and the cost of borrowing for the government will rise yet again. As the cost of borrowing rises it becomes even harder for the government to meet its commitments, which leads to still higher borrowing costs. It’s an unvirtuous circle.

The bailout is designed to resolve this Catch 22, but will it work? The US economist and Nobel laureate Paul Krugman suggests not. He points out that rather than an agreement to absorb Irish banks’ losses, the bailout is simply a commitment to lend Ireland funds at more or less safe market rates. As a result, he argues that European policymakers have mistaken a crisis of insolvency for one of illiquidity. He writes:

…the bailout will only work if the vicious circle is at the heart of the story — as opposed to being a symptom of the fundamental unsustainability of the austerity-and-full-repayment strategy. That is, it will work only if Ireland is the fundamentally sound victim of a self-fulfilling panic. And that’s a hard claim to make.

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The alternative? Debt relief. Without this, he warns, Ireland still faces a “an enormous debt load, made worse by deflation and stagnation”. Judging by this, it’s time for everyone to get round the table again.