Preparing Ireland for a post-euro economy

In advance of an online debate, economist Brian M. Lucey asks what would happen if Ireland was forced out of the single currency?

With each passing week it becomes increasingly clear that under present arrangements the euro cannot continue. We have persistently seen political dithering of the worst kind, with the resulting policy vacuum being taken up by the European Central bank (ECB).

Although one can criticise the ECB for many of its activities (not least the bewildering refusal to contemplate the other side of the fence in relation to Anglo Irish Bank, the bank that toppled Ireland's economy) it is to its credit that it has at least stepped into the breach.

However, of all of the European institutions it is probably the least democratic — as is the nature of independent central banks. Every ECB action, no matter how well-meaning, further undermines the democratic legitimacy of the euro. Trust in the ECB has declined and will continue to do so. In any case, ECB intervention in bond markets has at best only a temporary effect, and it is ultimately up to governments, at both national and European level, to implement policies that will restore fiscal discipline.

The action in recent weeks has focused on Italy. Previously, countries that have found themselves locked out of the financing markets have been small, and therefore their problems were sustainable, non-systemic and manageable. Not this time. Italy is simultaneously too big to fail and too big to save. Italian public debt is the third-largest, in absolute terms, in the world: it has to refinance €200 billion in the next year. Its GDP is the eighth largest in the world. And yet we have now seen that Italy is, in effect, locked out of the bond markets, at least for anything approaching sensible rates.

We also see this week that, despite there being no formal mechanism for doing so, it has been suggested by leading European officials and politicians that countries can exit the eurozone. It is highly probable that an exit by any country would lead to a cascade, resulting in the effective breakup of the euro. What then for Ireland?

Plans for all possibilities

The first thing that must be said is that hopefully the government has a plan. After all, governments should plan for all eventualities. Planning to deal with an eventuality is not the same as willing it to happen and failure to plan can be catastrophic. Sadly, history suggests a coherent, competent and analytically sound plan is not likely to be found in the county's department of finance.

Secondly, in the event of the euro breaking up, which may be as a result of the cascade outlined above or perhaps due to the German political system not being able to persuade itself or its constituents of the need to foot the bill, there will be significant winners and losers in Ireland.

The first decision that would have been made by the government would be whether or not they would allow a freely-floating currency (which would almost certainly depreciate significantly and immediately), or to put in place some form of managed float. While depreciation would be attractive, in that it would be a boost to exports and therefore assist in putting the country back on a growth path, it would also result in imports becoming more expensive. A third of Irish imports come from the United Kingdom, and in all likelihood the new Irish pound would be weaker than sterling. It would also likely be weaker than the dollar, which given the country's extreme dependence on imported oil would result in significant increases in the price of petroleum based products.

All of these would rise in price, bringing inflation and penalising both businesses and consumers.

The country would also have to very quickly move to achieve a surplus instead of a primary deficit in government finances. This would be necessary in order to pay down the accumulated national debt. When you consider the pain the country is going through in order to reduce its deficit to three percent over four years it is hard to imagine the wrenching dislocation that would be required to achieve a primary surplus over the span of just a couple of years. And yet, that is precisely what would be required.

Ireland would have to offer significantly higher rates on its debt to potential investors than is the case even now, not least because they would almost certainly be facing into a much more inflationary environment. Bond yields (see here and here for example) are in large part driven by fundamental economic factors.

Losing money

External euro-denominated liabilities would also create losers. External in this context means outside of Ireland. Mortgages, bank loans, any liabilities within Ireland would be converted to the new pound. It is the liabilities in euros to institutions based outside Ireland that would be messy. The most likely option would be that these would be denominated into the currency of the country where they are located. Thus a loan taken out in Germany would be converted into Deutschmarks, which would result in a very significant increase in these liabilities.

Conversely for multinationals with money on deposit in Ireland, and this amounts to billions of euros, any hint that these would likely be converted into a weaker currency would result in their being withdrawn. This in turn would exacerbate the existing credit crunch. The only feasible solution would be harsh exchange controls and a degree of financial repression for a time — hardly something that will be popular with either voters or business.

Another possible area of concern is the country's banks' dependence on ECB funding, which although declining, remains high. Absent the ECB, the Central Bank of Ireland would have to step into the liquidity breach, further exacerbating inflationary fears. On the positive side it would be much easier to restructure the outstanding payments due on Anglo Irish Bank promissory notes.

It is debatable whether or not Ireland should have joined the euro. At the time I was in favour, more from the perspective ot political economy than pure economics. I felt at the time that on balance European politicians were more likely to behave in an economically sensible manner than Irish politicians, and that the requirement for fiscal discipline as part of a monetary union would be useful for Ireland.

Unfortunately this faith was misplaced on both sides.

Brian M. Lucey will be discussing “Planning for a post Euro Economy” in an online debate Wednesday November 15 at 11.30AM (12.30CET). He blogs at BrianMLucey.wordpress.com and writes a fortnightly column for the Irish Examiner newspaper.

Image by MrB-MMX. CC licenced.