Archive for November 17th, 2010

Irish Woes and the EU

Do a google search on “Irish economic success” and you’ll find a lot of articles and stories about Ireland as the success story of Europe, turning around an economy that was one of the most troubled in Europe back in 1970 to one with stellar growth rates and low unemployment as the new century began.   Those stories end about 2007, when the Irish economy started to slow.   Even then, the attitude was that thirty years of growth had catapulted Ireland into one of Europe’s elite economies; a few tough years are normal given the business cycle.   Now, however, Ireland stands at the brink of economic disaster.  Bond yields have soared to nearly 8% and Ireland is literally running out of money.

Since they are part of the Eurozone, they can’t simply “print money” (so-called quantitative easing), so they’re in a bind.   Ireland’s unemployment rate is now 14%.    They economy is in a downward spiral, the foreign investment that helped their boom is now fleeing.  Ireland stands at the brink of default, hoping for a bailout from the EU.   The EU did bail out Greece, but in relative terms Greece is a small economy.   Moreover, though that bailout seems to have worked, the political backlash, especially in Germany, was immense.

The problem for the EU is that while it remains inconceivable that the Euro will fail or the EU will break up, the union is not popular with its citizens.    For the first time youth satisfaction with the EU is low, historically the young have been the most supportive.    Overall only about half of EU citizens feel the organization is benefiting their country.   Now, that doesn’t mean they want to dismantle it — that is the stuff of fantasy for Euroskeptics and conspiracy theorists — but new initiatives to spend taxpayer money to “save Ireland” will harm any government that supports such a move.    So what next for Ireland and the EU?

The EU could decide to bail Ireland out despite the political risks.  This could even lead to governments supporting a bail out being voted out of office, and reward Ireland’s economic mismanagement.  To be sure, at the time it appeared Ireland was doing the right thing, mimicking the kind of economic boom the US was having.    The real estate market was soaring, and investment income increased rapidly.   Ireland was leveled by the same tsunami that hit the US 2008, with considerable contagion from the US.   Still a bail out would be an acknowledgment of the difficulties of having a common monetary policy with diverse fiscal policies and internal regulations.

So what would happen if the EU let Ireland fail?   What if Ireland went bankrupt?   The cost would not borne by the taxpayers, but rather by the bond holders.  Unfortunately, these bond holders are primarily European and especially British banks, which themselves would be put into crisis by such a move.    This could ignite a financial catastrophe throughout Europe.   Moreover, what about Portugal and Spain, two other problem countries?   Russia already has announced its not buying any more Spanish debt, and many analysts say its only a matter of time before those countries go into crisis.

If the EU let Ireland fail, the message would be loud and clear: the EU is not going to bail out economies in a financial crisis.   That would immediately initiate a sell off of Spanish and Portugese bonds, whose yield rates would rise as investors would see them as far more risky then they currently do.   At that point, Spain and especially a small country like Portugal might need to consider leaving the Eurozone — they’d want the monetary tools to handle their crisis that the ECB (European Central Bank) is not extending.

In other words, despite the political unpopularity of bailing out Ireland, not doing so has greater systemic risk — a potential banking crisis and new crises in Spain and Portugal — and perhaps even Italy.   Bailing out Ireland will be hard to stomach, especially for the Germans, but might send a signal to holders of Spanish and Portugese bonds that the EU and the ECB is not about to let member states fail or go become bankrupt.  Germany’s finance minister did suggest bond holders had to share the cost, one of the reasons bond yields have increased so rapidly.  But that’s better as part of a long term reform, not an ad hoc response to crisis.

Euroskeptics often get giddy about the idea that the Euro will fail.   That’s not going to happen, at least not unless things get much, much worse.   The costs and complexity of undoing the Euro are immense, and the risks are huge.   Moreover, it’s not like the dollar is in an essentially strong position.  High US debt (public and private) and the large growth of the money supply due to quantitative easing and low interest rates should be producing an extremely weak dollar.     Yet the Euro still costs $1.35, historically a good exchange rate.    This gives the ECB room to pump liquidity into the system to try to ease the economic burden.   With inflation low, the ECB still do a lot, even if it can’t do what Ireland’s central bank would do if there were no Euro.

So expect a bailout of Ireland — and of Spain and/or Portugal if necessary.   But also expect this to lead to a complete overhaul of the European financial system in 2013, when major reforms are planned.   This crisis has shown a weakness in the Euro-model, and the dangers inherent in unifying economies of such diversity.  But it’s less a deadly blow than an important learning opportunity, both for the EU, and the states in trouble.   Moreover, this should halt a rapid expansion of the Euro eastward, as bankers and politicians in both East and West need to be sure that when the Euro expands dangers of crises like these one are minimized.

Just as the EU turned out to be far more exposed to the US financial crisis in 2008, any financial meltdown in Europe would cross to our side of the Atlantic.   That means the US has an interest in making sure the IMF helps the EU deal with this.  In a globalized economy, myopia is deadly.