Ireland's Emergency Budget Offers Bank Bailout

The Irish are famous for quite a few things. Tenors and poets spring to mind along with stout and whiskey. Gambling, though, is not associated with the Emerald Isle, except for horse racing. Yet the government of Ireland is laying a huge wager on fixing its banks as part of an emergency budget. Government debt will soar, and the nation's ability to service that debt is doubtful.

In his second budget in six months, Finance Minister Brian Lenihan acknowledge the reality that the Celtic Tiger is no more. The economy is likely to shrink by 8% according to him (and government ministers are always overly optimistic on such figures), while unemployment will reach 12.6% (a 13-year high) and price declines will hit 4%. So, he's cutting spending and raising taxes, and the budget deficit will still be 10.75% of GDP. The Fianna Fail party last lost a general election 27 years ago – if his plan doesn't work, or if the Irish feel it's too painful, that record will end.

It is the banking sector, though, that may be the government's real undoing. The Irish will not adopt the Swedish model where the government gets a stake in the banks that accept taxpayer funds, but it has left the door open to do so if further funding beyond this budget is needed. Instead, Mr. Lenihan's approach is to buy up toxic assets through a National Asset Management Agency. The total cost is estimated to be between €80 billion to €90 billion.

CNBC did an analysis of the ramifications of the plan. Based on Ireland's GDP and the size of the bailout, this is the same order of magnitude that would have the US government picking up an extra $7 trillion for the banks. When this happens, the interest rate Ireland will have to pay its bondholders will soar. Already, the Irish government bonds carry a 215-basis point (2.15%) risk premium over German government bonds. A year ago, that spread was just 40 basis points.

Now, there is a chance that this will work. If the government gets the bad assets at a decent price, a rallying property market in the future would result in a profit. The banks, though, need as much for these bad assets as they can get to strengthen their position (Moody's downgraded its ratings on 12 Irish banks yesterday to D from C). Should the government fail to pay enough, the banking system will take longer to recover. It is this dilemma that has prevented other countries from trying this approach.

This morning's Irish Daily Mirror's headline read "We're Screwed." One wishes the paper were wrong.

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