What's up with Ireland

The news that is influencing world stock markets is the financial crisis in Ireland. This blog looks at the situation and what we can learn from it. First is the weekly recap from Vanguard.

Vanguard

As Americans paused to count their blessings this week, there was news to be thankful for on the economic front: The latest figures on GDP growth were revised upward substantially, and far fewer people filed for first-time unemployment benefits than had been expected. For the week ending November 26, the S&P 500 Index fell 0.9% to 1,189 (for a year-to-date total return of about 8.4%). The yield of the 10-year U.S. Treasury note fell 1 basis point to 2.87% (for a year-to-date decrease of 98 basis points).

Ireland

Below are segments from a Reuters article

Ireland promised on Wednesday to cut spending and raise taxes to combat its banking crisis and secure an international bailout. Irish Prime Minister Brian Cowen, whose government is close to collapse, unveiled a 15 billion euro ($20 billion) four-year austerity plan that he said would affect all Irish people.

"The size of the crisis means that no one will be sheltered from the contribution that has to be made toward national recovery," Cowen told a news conference. The plan includes thousands of public sector job cuts, phased-in increases in Ireland's value-added tax (VAT) rate from 2013 and social welfare savings of 2.8 billion euros by 2014, but does not touch the country's ultra-low corporate tax rate.

Dublin's 10-year bonds are trading far below their face value, at less than 75 cents in the euro. On Wednesday they yielded 9.23 percent -- a level at which Dublin could not realistically issue news bonds, and far above the 2.63 percent on the equivalent German bond. Ireland is expected to be pay about 5% on loans from the International Monetary Fund.

So what does this mean? Ireland can not afford to lend money at 9.23% which is the going rate. The reason it is so high is due to a default risk where investors need a much higher return based upon the poor fiscal condition of the country. In comparison to a country that is in good fiscal shape like Germany the interest rate is only 2.63%. So because of this default risk Ireland has to to pay over 3 times higher in interest.

What does Ireland need? They need to borrow money at a lower rate which is 5% from the International Monetary Fund, IMF. Now the people at IMF are only charging 2X of the rate at Germany so this is not really a great rate but a lot better than 9.23%. So the IMF will only lend the money at this lower rate if and only if the Irish government make enough changes in taxes and spending to reduce the risk of default. Today we read that an agreement has been reached so that the Irish government will get money loaned at a lower rate.

What does this mean for us?

* First, I feel sorry for the people of Ireland who now have to pay for bad fiscal policy of the past. These people will be paying higher taxes and getting less in return, it won't be fun to get through this.
* Taking this to a person level this is like a person who has been living beyond their means living on credit and now can not get more credit and it is time to pay.
* It appears that the monetary crisis in Ireland, as well as some other countries like Portugal and Greece, will be resolved and the IMF along with other EU nations will be able to handle this crisis.
* A government that has good fiscal policy get money at the lowest rate while a government that goes deeper in debt pays a higher rate.
* The old saying holds true, people who do not need a loan can easily get one and people who really need a loan many times can not get one.
* According to usdebtclock.org the United States that has about $14 trillion in debt, a federal revenue of about $2.5 trillion, federal spending of $3.8 trillion, and interest paid on the debt of $200 billion per year. If we had to borrow money at 5% this would increase the interest paid on the debt to $700 billion per year increasing federal spending to $4.3 trillion.
* If we have to pay an extra $500 billion per year in interest and we have to reduce our debt to get the money this means that we have to reduce our spending from $4.3 trillion to $2.5 trillion just to break even and not generate more debt. We would have to cut spending about 40% to get to even.

Ireland shows us where we are headed as a country, higher taxes of all sorts and reducing spending everywhere. The best thing that the government can do for us now is to focus on fiscal policy and get the debt under control now and not later. Quit talking about the Federal Reserve and start talking about raising taxes, not cutting taxes, and cutting spending. The longer we ignore this the worse it gets.