A Rising Tsunami Capsizes All Boats?

President Kennedy said, “A rising tide lifts all boats,” to describe how an improving economy helps all economic agents.  The financial crisis of 2008 proved that the converse may be true as well; a tsunami of economic destruction capsizes all in its path.  The impact of the financial crisis on the Irish economy illustrates the destructive power of the crisis.  Ireland can be viewed both as a country and as a “state” within the European Union.  To add dimension to the comparison, I will briefly describe the governmental structure of the European Union and compare its economic size to United States and the size of the Irish nation to a state within our union.  Finally, I will suggest tentative lessons that voters in the United States might learn in dealing with the aftermath of our own financial tsunami. 

To paraphrase the CIA World Fact Book, the European Union less than a federation but more than a trade union.  It is beginning to show characteristics of a nation.  Like the United States, it has executive, legislative and judicial branches but their authority to impose policy on its constituent countries is much more limited than in the United States.  There are 27 countries in the European Union and these countries have a combined GDP of $14.43 trillion (Purchasing power parity, 2009 estimated), and population of 492 million.  The GDP of the United States is $14.12 trillion (Purchasing power parity, 2009 estimated), and its population is 310 million. Describing Ireland’s economy requires a bit of national accounting detail.  Peter Boone and Simon Johnson explain that Ireland used the tax code and a low corporate tax rate of 12.5% encouraging many global corporations to establish “ghost” corporations that do not produce goods or services in Ireland (“Irish Miracle — or Mirage?”) but do manage to avoid taxes in their home countries, including the United States.  Most international comparisons use GDP as the common measure.  Boone and Johnson suggest that researchers use GNP, a similar measure for most countries, to adjust for the tax haven affect.  For Ireland, GNP is at least 20% lower than GDP.

Ireland’s stated GDP is $172 billion, approximately the same as Alabama which ranks 25th among the states.  It has a population of 4.6 million, approximately the same as North Carolina which ranks 25th among the states.  Its per capita GDP of $37,000 would also rank 25th among the states.  Using Boone’s and Johnson’s adjustment of 20%, Ireland’s GNP is about $138 billion, just a little bigger than Iowa’s, which is the 30th largest state in the union.  Its per capita GNP is approximately $29,900, a little lower than Mississippi’s, the state with the lowest per capita GDP.  

A commercial building boom in Ireland paralleled our housing boom during the first years of the new millennia.  The boom turned into a bubble, distorting prices, misallocating resources and setting the stage for the financial tsunami.  Built on cheap credit and reckless lending standards Ireland’s three largest banks’ assets grew to 2.5 times Irish GDP.  The bubble burst.  Commercial property values fell 50%.  Good loans turned bad, crashing onto banks’ financial position, upending assets, and drowning profit in a sea of red ink.   

The Irish government became the first country to bailout its banks with a promise to guarantee all bank liabilities setting the stage for a fiscal crisis.  Today, one-third of bank loans are non-performing or under surveillance but bank creditors are protected by the government’s bailout so long as the government can fulfill its promises. 

Prior to the financial crisis, Ireland seemed the poster child for prudent and responsive government.  The national debt to GDP ratio stood at 25% in 2008, among the lowest of developed nations.  When the crisis hit, the government cut public sector wages and increased the tax base.  But the poster child was posterized.  Attempts to balance the budget proved fruitless as declining revenues and increasing social welfare obligations widened the budget deficit to 11.7%, one of the biggest deficits in the world.  The fiscal tsunami caused by the bailout overwhelmed the  government’s debt repayment capacity as the national debt to GNP ratio will climb to a projected 97% in 2010 and 109% in 2011. 

The EU, International Monetary Fund, and to a lesser extent, the U.S., have bailed out the Irish government to the tune of $113.  The bailout is relatively small, but will increase the indebtedness of countries that have extended aid to Ireland.  Some worry that Portugal and then Spain will ask for bailouts, and that Spain may be too big to save.  Currently, the financial crisis has created a tsunami that has toppled Greece and Ireland, and threatens other weak states in the EU.  Continued bailouts could threaten the EU itself. 

Is the United States in a better financial situation than Ireland or the E.U.?  Our budget deficit stands at 10% of GDP and our national debt to GDP, at 53% and climbing rapidly.  While it looks as if TARP may have “saved” the soundness of our financial system, some financial risk has been transferred from the private sector to the public.  Like many European countries, our future deficits from generous social programs like Social Security and Medicare programs threaten to swamp the budget and raise the national debt to unsustainable levels.  There are three solutions that will increase the sustainability of these programs.  We can raise taxes that fund them, cut benefits to recipients, or alter their structure to make them more efficient. 

Like countries within the EU, our federal government may decide to bailout financially strapped state and local governments.  Several states have debt to GDP levels that are comparable to Ireland’s prior to the financial bailout.  Kentucky’s, Rhode Islands’, Massachusetts’, and New York’s ratios are projected at 27.51%, 27.02%, 26.74%, and 26.18%.  States are unlikely to engage in funding financial bailouts with debt, but many have large, unfunded obligations that could push them towards insolvency.  If the federal government starts to bailout states, they will create a moral hazard.  Knowing that their state may be bailed out, state legislators will grow fiscally lax.  The United States is in the early stages of a fiscal crisis.  It can be avoided but fiscal discipline will be required.