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Paul Krugman recently argued on his blog that since Ireland faces higher government bond yields (5.27 versus 4.68 percent) and credit default swap (CDS) rates (226 versus 206) than those of Spain,1 financial markets are not recognizing or rewarding Ireland's early and decisive fiscal austerity measures. The inference he draws is that in their belt-tightening, Ireland and other countries may be overreacting to the example of Greece. This seems a strange argument for several reasons.
First, it assumes that the assessment applied by financial markets to the risk of Spain or Ireland government finances can be reduced to the issue of timing, a simplified view of their complex risk assessments, although the global financial crisis has revealed how having too much faith in financial markets' risk assessments is dangerous.
Second, this argument also assumes that Spain and Ireland are quite similar, which is not the case. True, both countries ran prudent fiscal policies prior to the crisis, relative to their eurozone peers and hence both have relatively low general government gross debt burdens today—64 percent of GDP for Ireland and 53.2 percent of GDP for Spain in Q4 2009. Both countries suffered a collapse of their domestic housing markets, too.
On closer inspection, however, the two countries differ dramatically. The domestic saving rate is higher in Spain,2 enabling the Spanish government to finance its debts more from domestic sources. Only 28 percent—or just over half—the Spanish general government gross debt in Q4 2009 was foreign debt. The corresponding Irish foreign debt was 47 percent of gross debt, or 70 percent of total general government debt.3 This means that in Q4 2009, Ireland had a foreign debt share of general government debt of close to the level of Greece (77 percent of its 114 percent of GDP gross debt was held by foreigners).
The biggest difference between Ireland and Spain, however, lies in the foreign debt profiles of their private sectors. This is—together with data from the three other PIIGS (Portugal, Ireland, Italy, Greece, and Spain) countries—illustrated in table 1.
Table 1 shows that the Spanish external private sector debt at 133 percent of GDP is higher than Greece, which was at just 57 percent in Q4 2009. Similarly, Portugal's external private sector debt was at 149 percent of GDP, and Italy was at a somewhat lower level but just a little higher than Greece. However, all the other PIIGS country levels are dwarfed by the huge external private sector debt in Ireland—a staggering 918 percent of Irish GDP in Q4 2009.
Taking into consideration how governments will in extremis often be liable for their country's private bank debts, the same differences emerge. Stricken and possibly facing bankruptcy in Q4 2009, Greece had a total combined gross public sector (general government plus monetary authorities) and private bank foreign debt of 154 percent of GDP, while Portugal is even higher at 177 percent. At the same time, both Spain and Italy have “expanded public sector” foreign debt levels significantly below that of Greece—105 and 89 percent of GDP respectively. By this measure, Ireland has foreign debt levels far in excess of all the other PIIGS—at 489 percent of GDP in Q4 2009—of which well over 300 percent was of short-term maturity.
Similarly total Irish public and private foreign debt in Q4 2009 amounted to nearly 10 times the Irish GDP, far in excess of Portugal's 219 percent combined total, Greece and Spain's 165 percent and Italy's 115 percent.
Given the mountain of debt weighing down on Ireland compared to Spain, the higher Irish bond yields are hardly surprising, irrespective of the timing of their austerity measures.
The real mystery is over why financial markets currently seem so preoccupied with rumors of a possible imminent Spanish request to gain access to the European Union's new €500 billion European Financial Stability Facility (EFSF), or even a new IMF-led bailout? The disproportionate focus on such rumors in the financial markets seems unjustified by Spain's relatively low total foreign debt profile, especially compared to Ireland.
Perhaps it could be argued that such focus derives from Spain's high unemployment rate and dysfunctional labor market institutions, which protect insiders and leave outsiders vulnerable. No doubt the Spanish labor market, with unemployment rates of around 20 percent—far higher than in any other OECD country4 and significantly higher than Ireland's rate of 13 to 14 percent— requires urgent and thorough reforms. Imminent Spanish government action on this matter is long overdue.5
But while unemployment rates are an important economic indicator, it is crucial to note that the rate measures the number of jobless persons, as a percentage of the total labor force, which includes people totally outside the active labor force—for example, those on early retirement, disability, in school, or those not looking for work at all.6
A better reflection of a country's ability to employ its entire working-age population productively is the ratio of total employment to the population of working age: in other words, the number of jobs divided by the total number of people of working age, which is defined as the age group of 15–64 years in Eurostat statistics.
On this metric, the latest available comparable data from Eurostat indicates a far smaller difference between Spain and Ireland than does their unemployment rates. In Q4 2009, the total Spanish employment rate from 15–64 years of age was a very low 59 percent. Yet that rate was only 1.6 percentage points lower than Ireland at 61.6 percent. Moreover, OECD predictions for Spanish and Irish employment rates for 2010 and 2011 suggest that total Irish employment rates will drop below those of Spain later this year.7 As a result, with close to identical employment rates, it seems hard to justify a much more bearish view on Spain than Ireland in the short term.
To be sure, Spain faces plenty of policy challenges—its labor markets need reform, its pension system must be revamped, additional austerity will clearly be required in 2011 and its savings bank sector needs consolidation. But it's not obvious why there is so much focus on its perceived economic weaknesses in financial markets right now—especially compared to Ireland.
Could it be that Spain must pay for being World Cup favorites, while Ireland—not playing in South Africa—is simply ignored? If that is true, then of course Spain's disappointing defeat against Switzerland should end this unwanted attention.
A better solution to the issue of unwarranted market nervousness about Spain, however, would be for the Spanish authorities to lead the way in Europe on transparency and immediately publish the results of stress tests of their banking system.
Such a move—which might be imminent—would be the most effective cure to lingering financial market doubts about Spain's solvency, and put irresistible pressure on other national European banking regulators to follow suit. By publishing its banking stress test results, Spain would thereby push for the solution to Europe's biggest economic risk right now—the uncertainty surrounding its undercapitalized banking system.
Notes
1. Data for June 14, 2010. See Irish 10-year bond yields; Spanish 10-year bond yields; 5-year Irish CDS rates; and 5-year Spanish CDS rates.
2. Direct comparisons of domestic household saving rates between Spain and Ireland are complicated by the fact that Organization for Economic Cooperation and Development (OECD) data is reported on a gross basis by Spain and a net basis by Ireland. Gross Spanish household saving rates in 2009 were 18.8 percent of household disposable income, while net Irish household saving rates were 9.3 percent of household disposable income. See OECD Economic Outlook #87 Annex Table 23.
3. See foreign debt data at Joint External Debt Hub. The euro to dollar exchange rate applied is the Q4 2009 average rate of 0.677 (or 1.477 dollars per euro).
4. See OECD harmonized unemployment rates in OECD Economic Outlook #87 Annex Table 14.
5. Ibid, table 13.
6. In US labor market data, the latter is known as so-called “discouraged workers.”
7. See OECD employment rates in OECD Economic Outlook #87 Annex table 20.
