DON´T BLAME THE EURO FOR IRELAND MESS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING)

Don’t blame the euro for Ireland’s mess

By Philippe Legrain

Published: November 17 2010 14:08

Sceptics of the euro see the Irish crisis as proof of the single currency’s folly. But while the eurozone needs reform, the notion that the euro is to blame for Ireland’s travails is simplistic.


Even many euro supporters now regret that in the boom years the currency permitted huge capital flows from Germany and other surplus countries to Spain, Portugal, Greece, and Ireland. These imbalances, conventional wisdom has it, are unhealthy – and the European Union is now drafting 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 this were possible globally, emerging economies would not feel compelled to amass huge reserves to protect against crises and could be net recipients of investment instead. 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 Europe’s periphery. It is that they funded property bubbles rather than productive investment. But 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 did slash Irish interest rates, creating cheap borrowing that fuelled the boom. But at a macro level the Irish government could have tightened fiscal policy – in effect, run large budget surpluses. At a micro level, it could also have limited banks’ property lending – through higher, counter-cyclical capital requirements for instance – rather than encouraging it with tax breaks.


Ireland’s property bubble was particularly big. The value of its housing stock quadrupled in the decade to 2006, with construction swelling 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 per cent of gross domestic product on the eve of the crisis, the lowest in the eurozone.


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 Irish 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 is true that, outside the euro, Ireland would 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 value added tax 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 International Monetary Fund “bail-out” – in practice, a loan at punitively high interest rates. That would merely postpone the crisis.


Irish taxpayers should not be bled dry to pay off investors – among them, European banks and American hedge funds – who gambled on lending to Irish banks. Instead those creditors should take a haircut, via a debt restructuring with the EU or IMF providing a bridging loan until Ireland has fixed its budget deficit. Ironically, it is Germany’s proposal that bondholders should lose out in future that brought this crisis to a head. It is such a good idea that it should be implemented now.


The writer is author of Aftershock: Reshaping the World Economy After the Crisis


Copyright The Financial Times Limited 2010.