Ireland's debt downgrade underlines Osborne's folly

by Ed Bowsher on 25 August 2010  |  0 comments
Tweet

The Irish government pushed through big spending cuts over the last year. The theory was that lower government borrowing would reduce fears of a debt default and keep interest rates down. The theory has been proven wrong in practice.

Last night we learned that Standard & Poor’s (S&P) has cut its rating on the Irish government’s debt. In other words, S&P is saying that Irish government debt is riskier than it had thought previously. According to the agency, there’s a higher chance that Ireland will default on its debt – not a big chance as the rating is still relatively  high at ‘AA-‘, but the chance of default has risen nonetheless.

As a result, the prices for Irish government bonds have fallen. That’s not surprising. If the Irish government is a riskier bet, it has to pay a higher rate when it borrows to compensate for the extra risk. And that pushes up the cost of long-term borrowing in Ireland across the board.

So why should us Brits care?

Well, George Osborne and the Coalition sold their austerity budget on the grounds that bond markets were worrying about the UK’s ability to pay back its debt. If that worry persisted, there was a danger that UK borrowing costs would rise. So, according to the government, Osborne’s budget was essential if we wanted to keep interest rates low and avoid a UK government debt crisis.

When the Irish government pushed through some very tough austerity measures in 2009, it used the same arguments. Those cuts have happened, but the ratings agencies have still cut Ireland’s debt ratings. 

Now, I admit, this is mainly because the balance sheets of Ireland’s banks are in such a mess. And those balance sheets would still be messy regardless of what the Irish government had done in 2009. But this week’s debt downgrade shows that austerity budgets aren’t a catch-all cure for the problems that have followed the financial crash in 2008.

And the really crucial point is that austerity will almost certainly slow down economic activity. That means lower tax receipts which, in turn, only makes a government’s debt situation even worse.

I fear this is the fate that awaits the UK.

And it’s a problem regardless of whether we’re heading for deflation or inflation over the next two or three years. If we have deflation, the economy will be very weak and the austerity measures will have contributed to us reaching that state.

If low interest rates and money-printing lead to high inflation, the government’s tight fiscal policy will restrict the Bank of England’s room for manoeuvre. The Bank won’t want to put up interest rates if economic activity is already very sluggish, and so it could wait too long before making its anti-inflation move.

Depressing.

If you’re interested in reading more about why fiscal austerity is a dumb move, check out Paul Krugman’s blog on the New York Times website.