Saturday 25 November 2017

Endgame is drawing close for beleaguered eurozone

With the eurozone crisis having spread to both Spain and Italy, the single currency endgame is now being played out. With Irish bond yields and the cost of insuring Irish government debt back up at close to record levels, the market is betting against this country being part of a new, slimmed-down eurozone.

Ever since Ireland was forced to unilaterally guarantee bank deposits and bonds in September 2008, EU leaders have been playing catch-up in their handling of the eurozone crisis. Instead of getting to the heart of the problem -- the lack of a common treasury and fiscal policy -- they have opted for a seemingly endless series of stop-gap "solutions".

While putting off the evil day might have seemed like the politically rational course of action at the time, we are now paying the price. Deficiencies in the eurozone architecture that could have been rectified at relatively modest cost three or even two years ago, will now be much more expensive to put right.

The sums now being spoken of to "fix" the eurozone are truly mind-boggling. At the time of the first Greek bailout in May 2010, the EU established the €440bn European Financial Stability Fund, aka the bailout fund. When matching funds contributed by the IMF are added that gave the EFSF a lending capacity of €750bn.

Although such an apparently huge sum was more than sufficient to finance the Irish, Portuguese and two Greek bailouts, it is hopelessly inadequate to fund either a Spanish or Italian bailout.

Analysts now reckon that the combined EFSF/IMF lending capacity will have to be massively increased. Figures ranging from "only" €2 trillion to as much as €3.5trn have been bandied about as being necessary in the event of any Spanish and Italian bailouts. A €3.5trn EFSF could only be funded by Germany and would represent a proto-eurozone treasury, with the power to dictate national budgets, in all but name.

Would Germany be prepared to pony up that sort of cash, which would, of course, threaten to tarnish its own Triple A credit rating? Even if it was, would the peripheral eurozone countries be prepared to accept the loss of economic sovereignty implicit in such a move? The answer to both questions is almost certainly "no".

With the market for credit default swaps, the financial instruments bond investors use to insure against the risk of default, now pricing in a 42 per cent haircut on Irish bonds over the next five years, some sort of Irish debt default/restructuring is now inevitable. Also this week, Spanish and Italian bond yields climbed over the 6 per cent threshold reached by Irish bonds just a few weeks before our November 2010 bailout as the markets made it clear that both of these countries will require bailouts, and soon, if the eurozone is to survive.

Which is probably why it won't, at least not in its current form. Far more likely is that the eurozone will shrink to a tight Germanic core, a sort of D-mark Mark II. That's what the foreign exchange markets are indicating with the euro, despite all of the recent turbulence, still trading at over $1.40 and at almost 87p sterling.

Will we be part of a new, slimmed-down eurozone? Almost certainly not. Any Irish debt default/restructuring is likely to involve stiffing the ECB -- which has directly lent the Irish banks almost €100bn with the Irish Central Bank, effectively the ECB's local subsidiary, having lent them a further €50bn -- on a massive scale. This would quickly render our continued membership of the euro untenable, that is if we hadn't been ejected already.

And that might be no bad thing. While we have been repeatedly assured that our leaving the euro would represent the end of civilisation as we know it, I'm not so sure. Yes, leaving the euro would push up Irish inflation and nominal interest rates, but it would also cut the real value of Irish wages and debts.

Would not the quick, sharp shock of devaluation be preferable to a decade or more of grinding deflation? Cast your mind back to the 1992-3 currency crisis when we were told that devaluing the punt would cause the sky to fall and interest rates to soar. Instead, the sky stayed in place and interest rates fell, ushering in the greatest boom in recorded Irish economic history.

While our circumstances are much worse now, is it not at least possible that the conventional economic wisdom is equally wrong this time around? Stranger things have happened.

Sunday Indo Business

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