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.
Two of the biggest headaches for the UK banking authorities have been the two Edinburgh-based banks, Royal Bank of Scotland and HBOS. But Scottish taxpayers will not face the consequences for these failures alone, since the sterling area has centralised bank supervision and a centralised approach to resolving banking problems, wherever in the UK they may occur. In the euro area, each member state must supervise its own banks (which the Irish certainly failed to do) but must then, it would appear, ensure, at the cost of each country's taxpayers, that bank creditors are made good without apparent limit. The result of this doctrine, pursued doggedly thus far by the European Central Bank, is that European financial institutions which lent to non-sovereign entities in Ireland will now be made whole by Irish taxpayers, creating an enormous international fiscal transfer. It is entirely likely that the No-Bondholder-Left-Behind policy so beloved of the ECB will involve transfers out of the Irish Exchequer and into other European countries exceeding comfortably the accumulated discretionary transfers into Ireland since the country joined the EU back in 1973.
With hindsight, the decision to abolish Ireland's currency required a far higher degree of discipline in financial sector management than was realised at the time. It is not true that no warnings were given about the twin bubbles in bank credit and in public expenditure, but they were ignored and the consequences have been very punishing for Ireland. But the eurozone banking crisis is not confined to Ireland. There had been little evidence of budgetary indiscipline in many countries until recession struck, but there is widespread evidence of lax bank supervision. Last Thursday the latest episode in the AIB saga played out in the High Court and it is clear that substantial further capital injections may be needed. But I hope it is sobering for the ECB to reflect that this is the same AIB which, in the summer, passed a stress test that was more stringent than the ECB's much-vaunted test across the European banking system, which several banks failed. Let's be clear about this. There is to be a further round of stress tests in the New Year. If these tests are done properly this time, lots more banks will fail. The reason is that asset quality was not assessed harshly enough last time round and the ECB has lost further credibility with the markets.
Because the Irish banks were in worse condition than the generality of their European peers, and because the Nama process and the Irish stress tests have been less indulgent of the banks than the ECB version, the Irish banks have experienced severe outflows of deposit resources and have had to resort to liquidity support from the ECB. This is the next serious design flaw in the euro system, the ambiguous remit of the European Central Bank as lender of last resort to distressed banks. The ECB, perhaps unfairly, has been accused of threatening to withhold liquidity and of bullying the Irish Government. The lender-of-last-resort function, in what is a European and system-wide crisis, appears to be vaguely defined and the conduct of liquidity provision by the ECB has been excessively uncertain. There are bound to be suspicions of political interference in a Central Bank whose actions appear to be so arbitrary.
The euro is, of course, a political project and there is nothing necessarily wrong with that. But since the onset of the crisis the absence of political will to address the European banking crisis has exacerbated economic damage. Both the UK and the US have shown greater clarity in identifying and resolving the bust banks, while the game plan in Europe has been described as kicking the can down the road.
Crisis management often requires a little buying of time, but it is almost two-and-a-half years since the balloon went up and the European system is contemplating yet more stress tests.
The textbook procedure in resolving a banking crisis is to quantify the losses rigorously and then get the pain distributed as quickly as possible. If banks have made disastrous loans on a large scale, then bank shareholders need to get hit, followed by bank bondholders, followed by unguaranteed depositors if there be any such.
In Europe, the political leadership, particularly the German chancellor, appears happy to contemplate default on sovereign bonds yet to be issued while protecting bank bondholders to a degree which may force some countries into defaulting on sovereign bonds already issued. Why should those who lent to governments be put at risk to protect those who lent to incompetently managed banks?
Should the sovereign bond crisis spread to Portugal and Spain in the New Year, these issues can no longer be ducked, and it will be time to bite the bullet and make bank bondholders accept haircuts, as they have had to do in similar situations before.
Meanwhile, let's welcome Estonia to our poorly designed, poorly managed and poorly led currency union, and hope they don't come to regret it.
Colm McCarthy lectures in Economics at University College Dublin. He has headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, aka An Bord Snip Nua