European debt worries

TYLER COWEN directs us to a disconcerting story:

Ireland's troubled banking system became the latest flash point in Europe's continuing economic crisis, as the government said it would split up the weakest of its major banks to stave off a run by depositors.

Irish Finance Minister Brian Lenihan, days after meeting European Union officials, said state-owned Anglo Irish Bank Corp. would be divided into a government-backed bank that would hold customer deposits and an "asset recovery bank" holding the bank's increasingly bad loans. The asset-recovery bank could be sold in whole or part down the road. Mr. Lenihan said the cost of the restructuring would be announced in October.

Megan McArdle quips:

It's not a good sign when the government has to intervene to prevent a run on a bank that is already owned by the government

Here's a bit more from the original piece:

Nervous investors on Wednesday briefly drove the price of financial insurance against an Irish government-bond default higher than the record, according to one data provider. Markets expressed relief after news of the decision to split the bank, with the price of the insurance then declining to $370,000 a year to insure $10 million of Irish bonds for five years, according to another data provider.

The premium Ireland pays over Germany, the euro-zone benchmark, to borrow from investors in the bond market fell significantly after the bailout news, but it remains near the highest level since the euro was introduced in 1999.

There are a couple of things to take away from this. One is that this is pretty good evidence that austerity won't magically produce growth and market confidence. Ireland's been relatively aggressive at trimming its spending, and yet bond yields are rising. And the other is that with problems still looming in the banking sector, a nasty dynamic can take hold. Amid a struggling economy, indebted banks fail to maintain public confidence. This can put pressure on governments to provide additional support for the banks, increasing market concern about sovereign debt. And to combat this, governments pursue austerity, which makes life tougher on the banks.