Why Ireland is the new Northern Rock

Ireland is turning into the Northern Rock of the government debt crisis, a potential tipping point for institutions around the world.

Little doubt remains that the recent rescue of Greece was not a one-off. The European Union (EU) and possibly the International Monetary Fund (IMF) will almost certainly have to bail Ireland out.

In late 2007, the markets suffered a similar panic when the sub-prime crisis ravaged British consumer bank Northern Rock. The incident helped prove the crisis was not only an American problem.

At roughly the same time, international banks revealed sub-prime’s impact on “safe” areas of their balance sheets. Asset-backed securities (ABSs) with subprime components but AAA ratings suddenly crashed in the financial markets.

Authorities stepped in to provide banks with emergency lending, but not enough to prevent the likes of Northern Rock failing.

In late 2010, the government debt crisis has proved identical. The year started with worries about the eurozone and specifically Greece.

Writing in the Financial Times, Wolfgang Munchau, the president of Eurointelligence, compared the euro to an ABS, with pristine tranches like Germany and sub-prime equivalents like the peripheral eurozone countries and Greece. (article continues below)

The European Central Bank (ECB) was forced to provide emergency lending on a 2007 scale to keep Portuguese, Irish, Greek and Spanish (Pigs) banks afloat, as well as other European institutions that held their debt.

Just as 2007 led into the disasters of 2008, however, the unfolding comparison suggests 2011 may be even worse than 2010.

As 2011 approaches, America may be starting to realise the rest of the world sees it more or less like Europe

Until the early days of 2008, the vast bulk of the EU was in complete denial about the credit crunch. To most of its members, the crisis was a product of Anglo-American capitalist excess which just happened to have landed some ABSs on continental balance sheets.

As 2011 approaches, America may be starting to realise the rest of the world sees it more or less like Europe. It is running gigantic deficits and public debts compared with its GDP. Squabbling in the centralised legislative bodies has made it almost impossible to agree on a way of reducing them.

The emerging world is rightly furious with America. Extrapolating from IMF and CIA figures, emerging markets own American treasury debt in such quantities that it would be difficult for them to sell their holdings without a crash.

The value of this debt is now eroding every day as yields are not keeping pace with emerging market inflation and growth and emerging market currencies are rising strongly against the dollar. America’s quantitative easing can only make matters worse.

As the buying power of the developing world’s currencies increases, emerging markets are having to turn themselves into consumer cultures virtually overnight. Brazil’s manufacturing sector is already predicting a contraction in activity owing to competition from imports, for instance.

If local currency rises make emerging market exports too expensive, whole swathes of their industries will be in crisis.

Emerging markets will have to sell some of their dollars and American government debt and deploy the proceeds to restructure their economies.

Governors like Ben Bernanke at the Fed should not be simply doing their job with broken monetary tools and hope everyone else does theirs

In China, consumers will have to sell some of their savings, which are bound up to a worrying extent in the country’s property bubble.

The quantity of emerging market dollar holdings – up to $4.5 trillion (£3 trillion) – far outweighs the $600 billion the Fed is throwing at the market, or America’s $131 billion reserves.

The crisis scenario looks frighteningly possible for 2011 or the year after, but across the developed world, central banks can still avert it by telling governments to wake up.

Governors like Ben Bernanke at the Fed should not be simply doing their job with broken monetary tools and hope everyone else does theirs.

They should be instructing politicians and voters to cut public sector debt and stimulate the private sector, probably with massive tax and social security breaks on any investment which creates jobs.

Developed world currencies would stabilise, emerging markets would be placated, debt markets would cool off and the pace of economic rebalancing would slow.

Nor would this be an unpopular option, in America at any rate. Most Americans are terrified by their political leadership and the scale of their national debt.

As with Ireland, it is governments, and the institutions that lend to them, that are now the key problem for the global economy.