By Colin Barr
July 19, 2010

The Irish are finding a bit of belt-tightening can’t pay the freight for a giant bank bailout.

Moody’s downgraded Ireland for the second time in a year Monday. In a familiar refrain, the rating agency pointed to deteriorating government finances and weak growth prospects as the country cleans up after a massive real estate bust.

Ireland’s economy contracted 7% last year, and the nation’s debt load as a share of economic output could quadruple by the time the crisis peaks, Moody’s said.

“Today’s downgrade is primarily driven by the Irish government’s gradual but significant loss of financial strength, as reflected by its deteriorating debt affordability,” said Moody’s Dietmar Hornung.

A major contributor to that loss of strength is the rising cost of propping up the banking sector. The government moved aggressively during the crisis of 2008 to backstop lenders such as Allied Irish Banks

, adopting policies including a blanket deposit guarantee that kept funds from fleeing the country.

The moves succeeded in stabilizing up the banks, but at a staggering cost. Moody’s said Ireland has already committed to spending some 25 billion euros ($32 billion) to recapitalize the banks and free them of some of their bad loans.

That doesn’t sound like much, given that the United States at one point had extended 10 times that amount in support of Citigroup

. But Ireland’s expected outlay amounts to 15% of last year’s gross domestic product – and Moody’s warns that the figure could yet rise should another bailed out bank, Anglo Irish, need more support as it expects. (Update: Earlier, I mistakenly wrote Moody’s thought Allied Irish might need more support.)

The rating agency says that in a moderately stressed scenario the government’s losses could approach 25% of last year’s GDP, and notes that “the uncertainty surrounding final losses would exert additional pressure on the government’s financial strength.”

For comparison’s sake, 25% of last year’s GDP here would be $3.56 trillion.

The grim tidings come in spite of the aggressive moves the Irish government has taken to set its house in order after a long and wasteful property bubble. The government has raised taxes and slashed public sector pay in a bid to restart the economy.

“Ireland attacked its problems pretty aggressively pretty early,” Barry O’Leary, who runs the Irish trade promotion group IDA Ireland, told Street Sweep in May. He says falling construction costs and dropping wages will restore competitiveness to an economy that grew bloated during the boom, which will boost Ireland’s appeal to big multinationals seeking access to European markets.

But that sort of investment may remain muted with the rest of Europe up to its ears in debt as well, and many investors aren’t willing to wait around to see what happens.

The spread on 10-year Irish bonds over their German counterparts was nearly 3 percentage points Monday, which is nearly double the spread seen in April before the latest round of sovereign debt-related stress.

Meanwhile, unemployment has hit 13%, compared with 10% in the rest of the European Union. Financial services and construction, two of the growth drivers during Ireland’s long boom, “will not contribute meaningfully to overall growth in the coming years,” Moody’s said Monday.

That leaves the Irish, like so many others, searching frantically for something that will contribute to overall growth.

“It’s going to be a long haul no matter what,” said O’Leary.

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