This is a slightly longer version of an article that appeared in the FT.
Euro-phobes can scarcely contain their joy at the Irish crisis – proof positive, in their eyes, of the folly of the single currency. But while the euro-zone certainly needs reform, the notion that the euro is to blame for Ireland’s travails is simplistic.
Even many of the euro’s supporters now regret that in the boom years the single currency permitted huge capital flows from Germany and other surplus countries to Spain, Portugal, Greece, Ireland and other deficit countries. These imbalances, conventional wisdom has it, are unhealthy – and the EU is drafting new rules to limit them.
Yet enabling capital to flow from one member country to another without exchange-rate risk is a key advantage of the euro. If only this were possible globally, emerging economies would not feel compelled to accumulate huge reserves to protect themselves against crises – instead of being net lenders to rich countries, these fast-growing economies could be net recipients of investment funds. When integrated financial markets work well, they offer investors higher returns, businesses cheaper finance and a better allocation of capital all around.
The problem is not that savings flowed from Germany to Ireland and other economies on Europe’s periphery. It’s that they mostly funded property bubbles rather than productive investment. The blame for that lies with herd-like investors, flawed banks and foolish governments, not the euro. After all, America, Britain, Iceland and other non-euro countries all had huge property bubbles too.
Granted, joining the euro involved slashing interest rates in Ireland – and cheap borrowing helped fuel the property bubble. But at a macro level, the Irish government could have tightened fiscal policy – in effect, run large budget surpluses – to dampen the boom. At a micro level, it could have limited banks’ reckless property lending – through higher and counter-cyclical capital requirements, for instance – rather than encouraging it with tax breaks.
Ireland’s property bubble was particularly big. The value of all the houses in the country quadrupled in the ten years to June 2006 and construction swelled to an eighth of the economy. The price of a typical Dublin house shot up more than fivefold – and has since nearly halved. Such a property crash is inevitably painful. But it need not have led to a sovereign debt crisis. Ireland’s public debt was only 25% of GDP on the eve of the crisis, the lowest in the euro-zone.
The government’s fatal mistake was stepping in to guarantee not just all the depositors of Irish banks but also all their bondholders. Now the bust banks’ huge losses are dragging down the Irish state with them. Had Britain’s recession worsened, the UK government might have ended up in a similar situation.
Only cheap finance from the European Central Bank has kept those bust banks on life support, until now. Outside the euro, Ireland would doubtless have suffered Iceland’s fate: its currency would have crashed and its central bank would have run short of foreign funds to keep its banks afloat. Far from precipitating the crisis, the euro has given Ireland vital breathing space. More’s the pity that the government has failed to make good use of it.
It’s true that, outside the euro, Ireland would doubtless now enjoy a weaker currency. That could boost exports and hence growth. But in very small open economies, devaluations tend to feed through rapidly into inflation, so the competitive boost might not have been that great. In any case, Ireland has already slashed wages and prices to restore competitiveness – in effect, an internal devaluation. And if it wished to cut unit labour costs further, it could reduce its high payroll taxes and replace the revenues with higher VAT or a tax on land values.
Leaving the euro and reintroducing the punt is certainly not a solution, since Ireland would be incapable of repaying its euro-denominated debts in devalued punts. Nor, on its own, is an EU or IMF “bailout” – in fact, a loan at punitively high interest rates. That would merely postpone what is now a solvency crisis.
Irish taxpayers should not be bled dry to pay off investors – among them, European banks and American hedge funds – who took a punt on lending to Irish banks. Those creditors should take a haircut (or lose their shirts).The way forward is a debt restructuring – a polite word for an orderly default – with the EU and/or IMF providing a bridging loan until Ireland has eliminated its budget deficit. Ironically, it is Germany’s proposal that bondholders should take a haircut in future that has brought matters to a head. It’s such a good idea that it should be implemented now.