Irish bond crisis brewing

November 4, 2010, 4:48 PM UTC

Don’t look now, but another crisis seems to be brewing in Ireland.

While we were wringing our hands on this side of the Atlantic over the launch of QE2, bond investors resumed their flight from an economy that once was one of Europe’s best growth stories but now appears to be on the road to a third straight year of economic contraction and quite possibly a humbling IMF bailout.

Time to wonder about these again

The yield on 10-year Irish bonds recently soared past 7.6%, which is nearly triple the rate prevailing here. The cost of insuring against a default on Irish debt has set a new record every day this week, recently reaching $575,000 annually for every $10 million of debt protection, according to market data provider Markit.

The proximate cause of this selloff is the European Union’s decision under the leadership, such as it is, of Germany’s Angela Merkel to make it clear to bondholders that the EU won’t bail them out in the event of a bond default. While that is a laudable stand in the abstract, the decision has had the effect of scaring investors away from the debt of weaker sovereigns such as Greece, which is already on International Monetary Fund life support, and Ireland, which appears to be heading there — at a time when they have big enough problems of their own.

Ireland, after all, is struggling to say the least to rebuild a debt-fueled economy from the global meltdown of 2008. Unemployment has tripled from its bubble era lows to a recent 13.8%, and isn’t expected to drop below 10% until we’re perhaps halfway into this decade. After showing some modest employment growth earlier this year, the Irish economy has again fallen into decline. And  you think Ben Bernanke has his work cut out for him.

“Jobs were also cut again in October as Irish service providers adjusted their workforces to declining workloads,” Markit said in its monthly survey of economic activity Thursday. “Employment decreased at a solid pace that was the sharpest in six months.”

The weakening economy and the rising costs of bank bailouts now threaten to unhinge whatever recovery is taking place, putting further pressure on a backpedaling government to cut even deeper. But what is the alternative? The harsh reality for contracting, deficit-ridden countries is that ultimately there isn’t one, suggests University College Dublin economist Colm McCarthy.

Ireland won’t need to borrow in the market till early next year, but McCarthy writes that the prospect of a failed auction is all too real — which means the government must cut an eye-watering budget that much deeper or risk the consequences.

“Those who object to a tough Budget on the grounds that it will weaken an already weak economy are whistling in the wind unless they can identify a less deflationary option,” McCarthy wrote this week in a widely cited op-ed piece. “It is not that we are living beyond our means: we are living beyond the willingness of lenders to lend.”

This sort of reckoning appears far off yet for the United States, but recall that in March the market was still focused on the Fed’s exit strategy, long since forgotten, and had not yet come to grips with the depth of the problems in Greece and the other peripheral states. The reappearance of the crisis mentality is not a welcome development but it will be worth keeping an eye on in coming days.