Friday 23 June 2017

Dan O'Brien: Even in hindsight, joining the euro was the least bad option

The euro is a particularly imperfect arrangement and one that could end in a traumatic divorce (Stock photo)
The euro is a particularly imperfect arrangement and one that could end in a traumatic divorce (Stock photo)
Dan O'Brien

Dan O'Brien

Academic economist Frank Barry has revisited the debate around joining the euro in a new paper*. After 18 years of euro participation he ponders, among other things, what might have happened if Ireland had retained its own currency.

It is easy to be sceptical about the single currency now. At this juncture the costs of the euro for Europe appear to have outweighed the gains. The euro crisis, ongoing in one form or another for seven years and still unresolved, has proved to be an excellent transmission mechanism for financial contagion, most notably in the 2010-12 period. It has also poisoned many relationships in Europe and resulted in one member country coming to have a worryingly hegemonic role.

More widely, its failures and perceived failures have undermined the wider European model of regional co-operation. One could even argue that Brexit would not have happened if the euro had not been created, or more precisely if the euro crisis had not eroded the credibility of the European project (the 52:48 margin of the British referendum was, after all, very tight).

But for all that, it still seems to me that once the project was launched, Ireland, even in hindsight, was right to have joined. That conclusion is arrived at less because the euro has delivered many benefits, but because the alternative would have been worse. That view is based on two legs: first, that the property bubble would have happened anyway; second, that the eventual crash would have been worse if Ireland had retained its own currency.

Consider the roots of Ireland's property/credit/construction bubble. It is often said that the fall in interest rates that accompanied the launch of the euro led to excessive lending.

While this happened, it does not appears central to the creation of the property bubble. Credit growth did surge at the end of the 1990s and into the new century, but it had fallen back to safe levels by 2001. At that point there was no sign of anything being seriously out of kilter in the Irish economy.

With the benefit of hindsight it is clear that Ireland's bubble began inflating in 2002-03, five years after the launch of the single currency. What really drove Irish credit growth at that time was not a fall in interest rates or lower exchange rate risk, but a surge in global financial flows.

What is important is that these flows were international, not a function of the euro. That was to be seen in the hugely increased capacity of many European economies - non-euro and euro - to sustain levels of foreign borrowings that market participants would not previously have countenanced.

For national economies, foreign borrowings are best measured by the balance of international payments. The biggest deficit countries in Europe by 2008 - Iceland, Georgia, Bulgaria and Sebria - were running imbalances in excess of 20pc of GDP. None was in the euro. Deficits in the weakest and bubbliest euro-area economies were considerably smaller.

When the international financial bubble burst in 2008, non euro-area countries were the first to face real crises in Europe. Iceland was neither in the EU nor the euro, but it was in an IMF bailout before the end of the year. It was followed by Hungary, Latvia and Romania, all EU members but not eurozone countries. Some time later euro-area countries Greece, Ireland, Portugal and Cyprus were also bailed out. Given that so many diverse countries got into trouble for broadly similar reasons, it is hard to blame a currency which only some of them shared.

The second argument against Irish participation in the euro is that having an independent currency allows more rapid adjustment in a slump. While this is true in theory, matters are more complicated in practice. In Ireland's case, having had the punt would likely have made things worse.

The bursting of a domestic bubble at a time of international financial meltdown would almost certainly have been accompanied by a collapse in the currency, just as Iceland experienced. That might have helped recovery in the medium term, but the short-term effect would have made the recession even worse than the one actually experienced.

There are two separate reasons for believing this. First, Iceland's recession from 2008 was accompanied by soaring inflation. This eroded real incomes by 40pc. Ireland, at the same time and by contrast, experienced a fall in the price level which helped offset the decline in incomes caused by the recession but which did not hamper the regaining of competitiveness, as seen in the strong export performance in the years after the crash.

The second reason an independent currency in 2008 could have made the recession worse is capital controls. So great was the rush to get money out of Iceland that controls were imposed to prevent the currency falling even further. Almost a decade on, those controls have not been fully lifted.

There is no reason to believe that Ireland would not have had to resort to such controls if the punt had been the national currency. As the Irish economy is a more open than Iceland's, capital controls would have been more damaging. It is, for instance, hard to see how Dublin's International Financial Services Centre would not have suffered severely, and perhaps terminally, by eight years of Icelandic-style capital controls.

While there were advantages for Iceland in having its own currency and not being subject to the constraints of the euro (mis)management structures, it is instructive that the three Baltic economies, all of which suffered savage collapses in 2008-09, went on to adopt the euro. They did so in the full knowledge of the structural flaws of the euro and the consequences these could have. Their debates on joining are not discussed in Prof Barry's paper, arguably a significant omission.

Exchange rate regimes are like marriages - none is perfect. The euro is a particularly imperfect arrangement and one that could end in a traumatic divorce. If that happens then the experiment will certainly have been a mistake, not only for the continent collectively but also for the countries that adopted it.

* http://www.ssisi.ie/Single_Currency_Debate_of_the_1990s_in_Retrospect_SSISI_v8.pdf

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