The Interest Rate Obsession

By Eoin Fahy, Thursday, 24th March 2011 | 0 comments
A reduction of 1% in the interest rate paid by Ireland on the EU rescue package would reduce the country’s annual deficit by less than 3% of the total, yet it has become a near obsession in our political system. It’s time to focus on the other 97% of the deficit, and the banking system mess, and to stop obsessing about a relatively trivial issue which is important only in political circles.
 
The maths relating to an interest rate cut are not remotely complicated: there are no complex assumptions or workings involved. We are due to borrow €45bn from EU countries over the three year period of the rescue package. So a 1% cut in the interest rate would save €450m per year. 
 
Now €450m is a substantial amount of money, and if we can get it, great! But to listen to much of the debate in Ireland, and particularly the political debate, one would think that if only we could get a cut in the interest rate, we would be well on the way to getting our public finances under control, and would be in a much stronger position to deal with the problems in the banks.
 
Frankly, that is utter nonsense.
 
Let’s put that €450m in perspective:
  • The budget deficit this year – the gap between spending and revenue – is expected to be about €18bn. So the €450m potential saving would equal 2.5% of the deficit.
  • This year’s budget contained €6bn of austerity measures for 2011 alone, in tax increases and spending cuts. €450m is about 7.5% of that amount.
  • The four year National Recovery Plan builds in total budgetary cuts or tax increases of €16bn. That's 36 times the size of the €450m interest rate saving!
  • Total tax revenue this year will be around €32bn, so the €450m saving would be about 1.5% of that amount.
  • The Irish banks have emergency, short-term lending from the European Central Bank and the Central Bank of Ireland of around €150bn. While one is a stock and one is a flow, so the comparison isn’t entirely valid, it’s worth noting that the €450m is just 0.3% of that amount.
It's plain to see that the €450m interest saving is not much more than a rounding error in Ireland’s fiscal accounts. The upcoming banking stress tests, and the severe cuts still to come in the next few budgets, are vastly more important to Ireland than this side-show. 
 
Will the new government continue with the planned austerity measures? Will the banking stress tests mean that all of the €35bn set aside for bank capital will be used up? What will happen to the €150bn in “emergency” lending to the Irish banks, can it ever be repaid? Will Irish banks be allowed to default on some or all of their bonds?
 
These are the real issues facing Ireland over the next few weeks and months.

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