Two years ago this week, the government issued a blanket guarantee of the liabilities of the six main Irish banks to prevent the collapse of the domestic financial system. The radical decision has brought the country to its knees before the bond markets.

As uncertainty about the ultimate cost of the bailout pushes the price of Irish borrowing to record levels, there is ongoing concern that the state itself will ultimately need to be rescued, just as the banks were. The banking sector and the sovereign now appear locked in a deadly embrace from which neither can afford to let go.

When the guarantee was announced on 30 September 2008, finance minister Brian Lenihan claimed it was the cheapest way of resolving the financial crisis with minimal risk of collateral damage to the wider economy. It would also buy precious time to deal with capital requirements of the guaranteed banks without making hasty decisions that would end up costing taxpayers more.

"This [the guarantee] was supposed to have bought us time, but two years later we're in the same place," said John Finn, managing director of Treasury Solutions, a corporate finance consultancy in Cork. "The fact that they can't quantify the black hole is spooking the markets. There is a concern about the banks infecting the sovereign. When there is uncertainty, markets assume the worst."

The spread – or difference in price – between 10-year Irish government bonds over their German equivalent hit a record high in the middle of last week just after the National Treasury Management Agency (NTMA) borrowed another €1.5bn in a bond auction. The debt issue brought to nearly €20bn the amount the NTMA has raised this year to meet the ballooning budget deficit and the growing bill for recapitalising an over-indebted Anglo Irish Bank.

When all is said and done, our general government debt will be equal to the total production of the Irish economy for one year. That excludes off-balance sheet costs, such as Nama and the estimated €40bn it will finally take to recapitalise the banking sector – both of which represent the public assumption of private liabilities.

"We've gone from unsustainable private-sector borrowing to unsustainable public-sector borrowing," said Matt King, global credit strategist for Citigroup, who was in Dublin last week to brief clients on the outlook for corporate and sovereign debt. "If sovereign credit fears really start to develop there is scope for contagion and corporate credit really does badly in that environment."

Hedging cost peaked

The spread between Irish bonds and German bunds remained at elevated levels last week rather than narrowing, as most commentators expected, following the successful auction. The cost of hedging against an Irish default, using volatile derivatives known as credit default swaps, also peaked. Bank shares tumbled, as did their cost of credit, which has become closely linked to the sovereign which backs most of their funding.

Fear about the ultimate cost of bailing out the banks and the continued liability exposure to the state from the guarantee are all affecting Irish prices for the worse in the capital markets. There are also concerns about the long-term damage to the economy from cutting so much from government expenditure to narrow the budget deficit. Far from being the cheapest resolution to the crisis, the guarantee has proved to be one of the most expensive in global banking history.

"In fairness to the government, it's not as if we've been here before. They were under pressure to come up with something. If Brian Lenihan had been longer in the job he might have been more comfortable standing up to some of the voices around him. Maybe he might have done things differently," said Alan McQuaid, chief economist with Bloxham Stockbrokers.

The government's hope is that when it produces the final cost for cleaning up Anglo Irish it will help cool things off in the bond market. While the NTMA has successfully reached its fundraising target for this year through successive debt auctions, it will still need to tap the markets for funding for next year and subsequent years. "One would think that when the final number for Anglo emerges it will give clarity. The market likes certainty and I would imagine you would see a fair bit of movement in Irish bond [spreads] when the number emerges," said one senior Dublin-based financial analyst.

But even when the tally for the Anglo rescue is known, the state will still need to address the massive budget deficit – which was 14% of gross domestic product in 2009. Even though Ireland has pledged to bring its deficit back down to the euro-zone maximum of 3% by 2014, the NTMA will have to keep refinancing in the markets as it pays down the debt it has built up.

"If we did a deal with Anglo [bondholders] in the morning, we'd still have a deficit problem," Finn said.

Juggling too many balls

Market watchers are worried that the government has taken on too much responsibility and the amount of money the country has to pay back may be just to much to handle.

"The bond market is telling you that you are juggling too many balls at once. It is impossible to be throwing an endless amount of money at Anglo Irish Bank and at the same time implementing fiscal austerity [measures] and still hoping to generate economic growth [which] will get your budget back in balance. Something has to give. We are not going to manage this unless we do something," McQuaid said.

He added that the government may soon find itself in a situation where it will have to take a tough decision on whether to do a deal with Anglo bondholders on subordinated debt. While the government may fear the consequences of being seen to default on its obligations, the country can't afford to keep borrowing at elevated levels. The risk is that continued wide spreads in bond price will send a signal to investors that Ireland isn't a safe country to lend to, and funding will dry up. In the long term, the risk is that high interest rates will simply be unaffordable without unrealistic levels of growth.

"The key question is if [you] have paid 5.75% or 6%, what is the long-term likelihood of growth at that level," said Citigroup's King. "That's where these horrible self-reinforcing processes come in. If you start paying 7%, you're almost certainly not fine. The higher the yield, the more investors are going to look at it and say 'I don't know if they can afford to pay, it's not sustainable'."

Removing the uncertainty about the final cost of doing away with Anglo Irish in its current form may calm the bond markets somewhat and cut the price Ireland has to pay its creditors for future borrowing. But Irish taxpayers are still going to have to bear the massive cost of all that has happened in the two years since the guarantee was put in place.

"No matter what happens, you are still looking at a tight budgetary situation in the current year. It is still going to be taking money out of the economy. You are looking at fairly tough measures for the next few years," Bloxham's McQuaid says.

'The paradox of thrift'

Ireland has so far won praise internationally for raising taxes and cutting spending over the last two years, but the country – along with its troubled euro-zone cohorts in Greece, Spain and Portugal – might experience what John Maynard Keynes called "the paradox of thrift". When actors in an economy – households, banks, companies and the government – all try to save, demand plummets and the economy stagnates. In that situation, we could still get access to credit, but it would become harder to pay it off.

"There is the risk that although you'll get austerity one way or another, it's not guaranteed that with austerity you'll avoid default," said Citigroup's King. "The risk in Ireland where households are so indebted is that the government is not really the problem. There is too much debt in the private sector. I do feel in multiple EU countries we'll have all these cuts and we'll still have a recession and the end will seem further away."