These are certainly testing times for the euro currency. Some countries are learning the harsh realities that they no longer control two of the traditional weapons in the armoury of government to deal with economic problems – Monetary Policy and Exchange Rates Policy.
There is a whole economic literature on the subject of optimal currency areas. The features which make countries good partners for a common currency are close integration of their markets for capital, labour and trade and reasonable similarity in economic conditions among the members, so that economic shocks, if they do come, tend to affect all the economies in a similar way. If there is this level of similarity and integration between economies, the surrender of these policy weapons is not a huge sacrifice because the economies move in sync and the common policy tends to suit all the members reasonably well.
When the euro was being formed, its impetus was political as well as economic. Its architects were conscious that countries needed to meet certain requirements in order to be able to prosper in the common currency area. However, the requirements were defined very narrowly, concentrating only on the public finances and the inflation patterns of applicants. These were taken as crude indicators that the economies involved were compatible.
Disciplines Ignored
The gains that a common currency brought were very significant, both economically and politically. The barriers to trade caused by exchange and the risks of currency fluctuations were wiped out at a stroke. It was much cheaper to raise funds for investment in large common euro pool. The success of the project depended of course on governments understanding the disciplines that the new regime involved. And that is where the Irish government came spectacularly unstuck. The cheap money drove an unregulated property boom and the government sat back complacently as the resulting cost inflation steadily eroded our export market share.
The difficulties of vulnerable Member States have been aggravated by the loose monetary policy positions adopted by both the US and the UK. They have been content to let interest rates plummet and their exchange rates follow them downwards. Lower interest rates have stimulated domestic demand while devaluation has promoted exports. For Ireland, the added complication is that these are Ireland’s main trading partners. Ireland is not alone in seeing huge deficits on the public finances emerge. Portugal, Italy, Greece and Spain are all in the same boat. The strain on these Member States can be seen in the premiums that their governments have to pay to borrow internationally. Greece is the worst outlier in paying almost 3% more than Germany. Ireland is next at 1½% and the others are paying a premium of roughly 0.8%.
A New Stabilisation Fund?
Successful single currency areas usually have some sort of stabilisation fund to deal with situations where one region in the zone is suffering disproportionately to others. Typically, a single currency area is a single nation or a federation of states. Here the stabilisers are deeply engrained in the instruments of welfare policy, of regional policy, through the pooling of tax revenue, and the solidarity that goes with common nationality and citizenship.
This crisis may force Europe to start to develop its own stabilisation mechanisms. Casual controls on fiscal policy which were the enforcement mechanism of Maastricht clearly are not enough. The ECB is itself providing stabilisation mechanisms through its willingness to provide liquidity to the banks of Member States in return for suitable collateral, and to back bank restructuring schemes like NAMA. However, they are only bridging mechanisms, giving Member States breathing space to correct their underlying problems.
Abandon the Euro?
Ireland is faced with the difficult task of having to mimic a devaluation by reducing its cost structure. Some, like David McWilliams, have argued that it would be much simpler for Ireland to simply leave the euro and allow our currency float down till we regain export competitiveness. However, his argument is simplistic.
• Our banks would face a run as international investors pulled their money out, and the taxpayer would be on the hook because of the guarantee provided by government.
• If Ireland does not honour our debts to creditors denominated in euro, this will represent a default doing enormous damage to our reputation and capacity to trade internationally.
• The cost of borrowing which now stands at 1½% higher than the interest rates in Germany would surge to at least 5% or 6% with knock-on effects for business and mortgage holders.
It is important also to bear in mind that devaluation only works to the extent that it fools people into taking a cut in their living standards that they would not otherwise be willing to accept. Devaluation is not a magic bullet, and in our circumstances is far more likely to ricochet into a self-inflicted wound.
For Ireland a far safer course is to create a policy environment in which people see that the short-term sacrifices in their living is matched by a credible strategy to reinvent the economy and deliver a fair Social Contract. To make this happen,
• We must have a comprehensive action plan to tackle our cost structure. It can’t be just focused on cutting wages alone. A concerted policy must also address excessive costs in the boardroom, in professions, in rents, in rip-offs in our shops, in State charges, in monopolies and public utilities.
• We must show how we can transform key infrastructures that will provide a platform for jobs growth (as Fine Gael has done with New Era).
• We must show how we can harness the talent in the public service to tackle difficult problems at a time of falling resources.
• We must commit to the goals of fairness in a New Ireland – Faircare in Health, Pension Security that is fair to all, the right to reskill throughout your working life– an authentic Social Contract instead of the garish success that characterised the Tiger years.
