Tuesday 12 December 2017

Welcome, Estonia, to flawed euroland

Europe needs to stop buying time and instead make bank bondholders accept haircuts, believes Colm McCarthy

Estonia will become the 17th member of the eurozone on January 1. Only Finland among its Baltic EU neighbours chose to join when the currency was established back in 1999. Watching the plight of Greece, Ireland and Portugal over the last nine months, those EU countries which opted out can be excused for feeling that they made the right choice. The fact that the UK chose to keep its own currency was understood at the time to be a factor which diminished the attractions for Ireland, but the decisions of Denmark and Sweden to stay out were perhaps more instructive. These were small and peripheral countries too, which baulked at the more-or-less irreversible decision to abolish the national currency.

The currency union which Ireland chose to join has turned out to be poorly designed, poorly managed and poorly led. It has become fashionable to argue that monetary union cannot succeed without fiscal union, that is, a common tax and social welfare system requiring budgetary transfers from the richer to the poorer regions. The UK works this way, hence the large budgetary transfers to Northern Ireland. But it is not the absence of fiscal transfers that has created the crisis in the eurozone. Indeed it has had nothing to with it and would be of limited assistance in dealing with the fallout. It is true that Greece got into trouble because of undisciplined budgetary policies over many years and the failure of the EU Commission to detect that this was happening. (The directorate at the EU Commission which failed is, of course, the same one now charged with supervising the EU programmes in Greece and Ireland and promised a large increase in resources and powers). But the Irish resorting to external official bailout was not due to budgetary indiscipline but rather to an extraordinary bank credit bubble undetected by either domestic supervisors or the European Central Bank. This has exposed a fundamental flaw in the design of the eurozone, namely the absence of centralised bank supervision.

The emergence of a fully integrated European money market, free of exchange rate risk, in a world awash with cheap credit, exposed weaknesses in bank supervision in many countries. Under the eurozone as designed, the detection of problems in the banks, and their rectification once detected, was left to the member states. This has turned out to have been a disaster for Ireland, since the Central Bank and Financial Regulator failed to spot the bubble, failed to do anything about it and then compounded these errors by misleading the Government as to the scale of the problem once the bubble burst. The result was the ill-advised blanket guarantee of bank liabilities which led directly to the loss of the State's access to credit.

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