Ireland retains its full taxing powers, which will allow it to service its debts

IS IRELAND broke? Short answer: no. Long answer: The Government should be able to service its large debt because the external debt of Ireland is rather low, about 20 per cent of GDP.

The net external debt of Ireland can be measured easily by summing past current account balances. Since the country has run a surplus for many years, the sum of the current account balances over the last 20 years amounts only to about minus €30 billion, about 20 per cent of the Republic’s GDP of €150 billion.

Greece and Portugal, by contrast, have foreign debt which, at about 100 per cent of GDP, is four times higher than Ireland’s.

Why is foreign indebtedness more important than public debt – which is much higher now in Ireland than in Portugal?

The reason is that EU states retain their full taxing powers. This has a simple corollary if one takes a country with a high public debt but no external debt.

In this case, the public debt must be held by residents and the Government can always ensure the service of its debt by some form of lump sum taxation, such as a wealth tax.

For example, the Government could just pass a law which forces every holder of a government bond to pay a tax equivalent to 50 per cent of the face value of the bond or tax interest payments. The value of public debt would thus be halved, much in the same way as it would be if the Government ordered the Central Bank to double the money supply, which would presumably lead to a doubling of prices.

The nature of the tax needed to pay off public debt might be different if the public debt is held by pension funds because in this case the Government would have to tax either pensions or expropriate in some other ways these funds. This might be politically painful, but for the country it just represents a transfer from one set of residents (and voters) to another one. The workers and pensioners who have to pay higher taxes and see the value of their pensions reduced will of course object to being fleeced for the benefits of the holders of public debt, the rentiers. But if income and wealth are not too unevenly distributed, many will be at the same time both taxpayers and rentiers.

Moreover, this internal redistribution would not alter the consumption possibility of the entire economy and thus does not require an increase in exports or a reduction in overall consumption.

The key point thus remains: as long as a government retains its full taxing powers, it can always service its domestic debt, even without access to the printing press. However, this is not the case if the public debt is held by foreigners because the Government cannot tax them.

The government of a country whose public debt is held by foreign residents cannot simply expropriate them. It is thus foreign debt which constitutes the underlying problem for the solvency of a sovereign.

Things get of course more complicated if a large part of public debt is held by foreign residents but domestic residents have large foreign assets. If the government debt of a country with a balanced net foreign asset position is held by foreign residents its citizens have to hold net foreign assets of an equivalent amount. In principle then a government can still always service its debt by taxing away the foreign assets of its citizens.

However, in this case the Government faces the temptation to default on its foreign debt while its citizens can still enjoy the returns from their foreign assets. This temptation will be reinforced the more difficult it is for the Government to tax the foreign assets of its residents.

The importance of this point was illustrated by the case of Argentina where the country as such did not have a large net foreign debt. The private sector had large foreign assets while the government had about the same amount of foreign liabilities.

However, Argentina went bankrupt with little net foreign debt because wealthy Argentines had spirited their assets out of the country, and thus out of the reach of the government, while the poor Argentines refused to pay the taxes needed to satisfy the claims of the foreign creditors.

However, when the foreign assets of the country are held not by households, but by institutions, such as pension funds, they can be taxed. This seems to be the case for Ireland. If there is a political way there should be a way for the Government to service its debt.

Another indicator of the relatively comfortable solvency position of Ireland is that the external adjustment is already almost completed. This year Ireland should record a smallish current account surplus so that there is no immediate need for further cuts in consumption.

By contrast, in Greece and Portugal, external balance will require a further fall of consumption from 2010 levels of close to 20 per cent. This reduction is the key political difficulty, and the reason why financial markets doubt that these countries will be able to service their much higher foreign debts.

Ireland has been able to achieve this external turnaround relatively quickly because even during the boom years it maintained a relatively high domestic savings rate. Most of the egregious waste in construction investment was thus financed by domestic savings. By contrast, in Portugal and Greece the consumption booms were almost completely financed by foreign capital inflows. As these inflows turn around, the households in these countries must sharply reduce their consumption levels. In Ireland some reduction in consumption was also necessary, but it has already taken place and a large part of the external adjustment came through less waste of resources in construction.

It thus appears Ireland should face more of a liquidity than a solvency problem. The key task for policymakers should be to delever the economy as quickly as possible by mobilising the large foreign assets of the private sector to reduce the need to take on further, expensive, public foreign debt via the European Financial Stability Facility.

Daniel Gros is director of the Brussels-based Centre for European Policy Studies