David McWilliams offers his solution to Ireland’s problems by suggesting the abandonment of the Euro. It is true that Ireland can only become competitive again by repricing itself, whether through deflation or devaluation. However, the Maastricht Treaty outlines no route for countries to leave the monetary union.
The transition mechanism is the most difficult aspect of the debate, but a topic which has remained relatively untouched so far by any commentators. First of all though, note that devaluation is no panacea.
According to the IMF, total gross indebtedness of Irish residents (the State, the banks and the non-financial personal and corporate sector) stood at €1,671 billion at the end of 2008. It should be stressed that this is external debt, id est money that would be owed by Ireland after the devaluation and denominated in foreign currency. Devaluation could add hundreds of billions to the real burden of this debt, with the vast majority of it being private.
Other ancillary concerns include: loss of political credibility and influence, transactional costs in trade, exchange rate uncertainty for businesses, short-term brain drain and emigration. Increased real fuel costs will definitely hurt Irish citizens – possibly considerably given our dependence on imported energy. There are also the costs of conversion to the new punt within the economy, which are not insignificant to any degree.
Furthermore, the new currency could be open to aggressive manipulation by speculators. Although this is difficult to predict in the current financial climate, it could have disastrous consequences for investor confidence.
The main benefit would be increasing economic activity in the state, as Irish labour becomes competitively priced. Irish exports would become attractive and relatively less expensive. This would also happen within the euro, but probably only after a long and painful period of deflation and unemployment.
This is an important point. Deflation will increase the real burden of Irish debt anyway, as the government’s liabilities will only start to be paid back in earnest once the country is back working again. Note that much of the money has been raised through sale of long-term bonds.
Thus, the Irish people are faced with a mountain of real debt either way. Within European monetary union, the real burden increases gradually until deflation reprices Irish labour – hitherto suffering high unemployment. With abandonment, the real burden explodes immediately but with an accompanying boost in economic activity and employment right now. It might sound good, but is the latter option even possible?
The Maastricht Treaty certainly doesn’t think so. There would be nothing to stop a sovereign state disagreeing. The main obstacle is preventing capital flight. Since the measure will be introduced in order to initiate a devaluation, nobody will want to hold their assets in the new currency. This poses the biggest threat to the practicability. Any sensible individual will shift their euro savings to another bank until after the change-over, outside the state.
Irish banks couldn’t survive such a bank run, and this would precipitate insolvency. Higher interest rates couldn’t possibly compensate for the currency devaluation risk, as savers would much rather wait until after devaluation to convert. The banks also couldn’t borrow in the inter-bank markets, because these debts would be denominated in another currency.
Consequently, the Irish banks would be paying exorbitant rates to compensate for default risk, while the real burden of this debt exploded with devaluation. Lack of available capital in the financial markets and the existing risk of default compounded make this an expensive impossibility.
The alternative is that the Irish government borrows this money, possibly from other central banks. The scale of the borrowing would be enormous, and the credit-worthiness of the Irish government is questionable even now. This seems difficult to imagine, even though they would be paying most of this money back after devaluation. The catch is extremely high interest rates to attract money into the country, which creates entirely new problems for the nascent economy.
Tax-payers would also be losing billions on the deal, in real burden of repayment. External euro-denominated debts and liabilities would also have to remain as such. Irish banks would be losing yet more money through devaluation on their net external liability, which is not insignificant. The tab is picked up by the tax-payer.
Meanwhile the markets would only trust the new currency if they believed that the devaluation was a singular event, but this is contingent on the devaluation being sufficient. If it was underestimated even slightly, the capital markets could produce a financial crisis, as happened with Mexico in the 1980s. This is not unlikely given the scope for political interests to prevent sufficiently harsh devaluation.
Another suggestion include the simple reintroduction of the punt as legal tender at a fixed conversion rate (through measures like public sector pay and taxation), and deserves consideration. There is also the Argentine model, whereby the banking system is intentionally destroyed through redenomination.
Ireland is confronted with a painful period of high unemployment, deflation and falling purchasing power of consumers. It may endure for many, many years. Meanwhile, the attractiveness of our exports to our major trading partners, the US and the UK, is depreciating along with their respective currencies. The worst is yet to come. It might be time to start seriously considering all policies in the state’s arsenal.
Republished as “The Price of the Euro” in Trinity News (1st of December, 2009).
© The Free Marketeer 2009