As the bailout of Ireland begins in earnest, many in the media are asking “What went wrong?”, and coming to some dubious answers. The circumstances are well known. Ireland saw a long boom before the financial crisis. That boom was accompanied by a large rise in house prices and a boom in building construction. After the financial crisis and ensuing world-wide recession, many Irish banks were bailed out by the government or nationalised. The Irish government practised austerity policies, increasing taxes and reducing expenditure. But, as the cost of the bailouts increased, so did the budget deficit.
Many commentators are now claiming that Ireland’s membership of the Euro was the underlying problem (for example, Peter Oborne. In this argument many sound economic ideas have been mixed with careless ones.
One argument is that if Ireland had not been part of the Eurozone it would have been able to devalue it’s currency. It’s true, that if Ireland still had the Punt then this would be possible but not as significant as many people believe. In today’s world with floating fiat currencies controlled by central banks there is no clear concept of “devaluation” any more. The economic prospects of the region encompassed by each currency and the policies of the central banks are taken into account by the exchange rate market, and the exchange rate fluctuates minute by minute. This means there are two different arguments. The first, which focuses on the private sector, is that when a country enters recession the value of it’s currency falls allowing a growth in exports. This is a dubious argument, but whatever its merits it could not have seriously improved the financial situation of the Irish banks or the Irish government. The second argument is that in a crisis the state’s central bank may create money and use it to pay debts and finance bailouts.
A modern state can easily create new money without having additional assets. If Ireland had kept the Punt, it’s own fiat currency, then the government could have bailed out the banks using newly created money. But, that would simply be a hidden tax. Inflation would ensue then holders of money and money-substitutes would see the real value of those assets fall. Holders of assets denominated in money such as loans and bonds would see those fall in value in real terms too. The tax would be paid by the people through this loss of purchasing power. Any permanent increase in the stock of money must lead to inflation, though there may be a time lag until it becomes noticeable. A temporary increase could only be achieved by withdrawing money from circulation afterwards, and that could only be done with taxation. That governments can create money to get themselves out of sticky situations is beneficial to governments, but not to the people they’re supposed to serve.
Critics of the Euro also claim that the Eurozone currency area could not have worked. According to this view the ECB must run monetary policy to suit the core Eurozone countries. But interest rates that are a good fit for Germany and France will cause problems in other Eurozone countries. There is some truth in this. In the years before the crisis, the ECB ran low interest rates to stimulate the northern European economies, particularly Germany and France which were struggling with rigid labour markets. A side-effect of that policy was the building booms in Southern Europe and Ireland which weren’t sustainable. Though there is some truth in this view, it’s still confused. The idea that labour market problems can be successfully compensated for by reducing interest rates is from Keynesian economics. The idea that central banks reducing interest rates to excessively low levels causes unsustainable booms is from Austrian economics. These views can’t be mixed because they come from conflicting theoretical starting points. It isn’t possible that Keynesian economists are right in France and Germany but Austrian economists are right in Ireland and Portugal. In my view the ECB’s low interest rates may have been an attempt to stimulate the Northern European economies, but that policy wouldn’t have worked under any circumstances. The ECB’s policy came at a cost to Ireland and the Southern European countries when the property bubbles burst, but that cost doesn’t reflect any benefit to the Northern European countries.
It’s true that a Central Bank faces greater problems if the currency area that it regulates spans many countries with different conditions. But, as we have seen, Central Banks can’t avoid recessions and crises even if they only regulate the currency of a single sovereign nation.
Many countries have found themselves facing the consequences of the bad decisions made by Central Banks. Ireland isn’t unique in that respect. What makes Ireland unique is the extraordinary lengths that the government have taken to support banks and property developers. In September of 2008 the Irish government guaranteed for two years all bank accounts with Irish banks and almost all loans to those banks. This September, when that guarantee was due to expire, it was extended for another three months. The government decided that rather than risk paying out on that guarantee they would bail out banks as and when they needed it. They nationalised the worst-affected bank – Anglo Irish Bank in 2008. So far, through several bailouts Anglo-Irish Bank has cost the Irish government €22.9 and the other banks have cost ~€10.1, though the extent of losses hasn’t been fully recognized and will probably be much greater. It is these debts that have caused Ireland’s budget deficit to rise much more than those of other countries.
There have been many rumours about corruption in the Fianna Fail and in Anglo-Irish bank. The actions of the former board of Anglo-Irish bank are under investigation by financial regulators and the police, the former CEO has been declared bankrupt. There are close links between the ruling Fianna Fail party and many property developers, that was the subject of jokes long before the crisis. The previous Taoiseach Bertie Ahern was investigated for receiving bribes from property developers. I think there’s probably some truth in these allegations of corruption. But the politicians that form the government had many ways they could abuse their power for personal gain. A politician has many ways he can make a little on the side without bankrupting his country.
It’s ideas rather than corruption that have created such a great crisis for Ireland. The government thought that the resources the state could lay claim to were inexhaustible. They believed that if the state guaranteed bank accounts that this guarantee alone would satisfy the markets. The Finance Minister Brian Lenihan once called the guarantee the “cheapest bailout in the world so far”. The government forgot that the power of the state isn’t magical. A government can transfer the liabilities of banks onto the taxpayers, but they can’t abolish them. Back in 2008, the government were worried that the failure of a bank would harm Ireland’s reputation, but in the long run their cure was worse than the illness.
As Phillip Booth wrote, the first step the Irish government, the IMF and the EU should take is to end the guarantees.
Robert – I think your analysis is fair enough as far as it goes. But one thing you overlook is the impact of monetary union on Ireland once the eurozone was created. The main consequence of this was to open up European credit markets to Irish banks at seemingly no interest or exchange risk risk to lenders/bond holders.
The result was a transformation – in literally just a few years – from an Irish banking system that sourced most of its loan funding internally (domestic deposits etc) to one in which up to 60-70% of funding came from outside Ireland (it may have been higher at the peak – I don’t have precise numbers to hand).
Of course there were domestic factors as well – corrupt politicians, inept bankers and weak regulators – not all eurozone members went on the same borrowing binge.
Nevertheless it wasn’t the loss of the devaluation option that did the most damage, but the sudden access to eurozone (mainly German) credit. Another lesson in what happens when monetary policy is driven by political ‘visions’.
I haven’t heard of you or your website before. I’ll bookmark it. Something I should have mentioned in the article is that I live in Ireland, in Limerick. I’m from England though.
I’ll reply soon.
Gerard O’Neill wrote:
> I think your analysis is fair enough as far as it goes. But one
> thing you overlook is the impact of monetary union on Ireland once
> the eurozone was created. The main consequence of this was to open
> up European credit markets to Irish banks at seemingly no interest
> or exchange risk risk to lenders/bond holders.
> The result was a transformation – in literally just a few years –
> from an Irish banking system that sourced most of its loan funding
> internally (domestic deposits etc) to one in which up to 60-70% of
> funding came from outside Ireland (it may have been higher at the
> peak – I don’t have precise numbers to hand).
> Of course there were domestic factors as well – corrupt politicians,
> inept bankers and weak regulators – not all eurozone members went on
> the same borrowing binge.
> Nevertheless it wasn’t the loss of the devaluation option that did
> the most damage, but the sudden access to eurozone (mainly German)
> credit. Another lesson in what happens when monetary policy is
> driven by political ‘visions’.
I agree that the Irish banking industry dealt badly with the great rise in funds available to them as a result of the euro.
But, I don’t think that availability of more savings can ever be a bad thing by itself. There are perhaps a few circumstances where it could be. Hayek believed that a short term rise in savings followed by a fall could provoke this. Perhaps it can, through account falsification have a similar effect to central bank money creation. Also, banks may fail to deal with maturity transformation well.
But, I don’t think that this necessarily means that common currencies are a bad idea. Rejecting them in this case means making funds for investment more expensive, because of concerns about the cycle. Remember that if a gold standard were implemented then there would not have one interest rate per country there would be a “gold zone” interest rate.
I agree that we should criticise the political aims of the Eurozone and it’s prevention of currency competition. But, I don’t agree with the idea that there is one correct interest rate per country. The interest rate is a market price. Like any other market prices there are regional variations. But, if the market eliminates those regional variations it’s hard to claim that this is detrimental.
In the long run I think each countries economy and banking system must become accustomed to being part of the global credit market. That doesn’t mean that every economy must become used to the behaviour of central banks, but it does mean that they must become used to the natural ebb and flow of savings. We can’t let a situation come about where governments deny their countries the benefit of capital flows because they don’t think those countries can deal with them.
Austrians often talk about the “hangover” from the “binge” of the boom. By analogy central bank induced low interest rates are like alcohol or drugs. Certainly we should avoid those. But international capital flows are really not the same, they’re more like someone offering you a curry after you’ve lived all your life eating potatoes. Yes, you may not be able to stomach the curry the first time around, but it’s probably best that you try it and become accustomed to what the rest of the world has to offer.
Hi there Robert,
Thanks for the article. If I may, I think that the idea that low German/French interest rates being more appropriate for these economies but not for the peripheral can be integrated into the Austrian frame work.
The rationale for this is that the German/French economies had low long bond yields even prior to the inception of the Euro, suggesting that their low interest rates were backed, to some extent, by higher real savings. Okay – the central bank should not be setting the interest rate centrally, but surely the reason that the periphery was worse-affected was that its interest rates post integration were further away from their (higher) neutral rates, than was the case in France and Germany.
Everywhere within a currency zone interest rates are closely matched. The differences between them are risk premia. Let’s say that countries A and B adopt the same currency. Prices in each country will not immediately even out, because there are many millions of prices involved and many of the arbitrage opportunities are difficult to exploit. But, the difference between the prices of borrowing are much easier to even out. Because such large sums are involved banks can afford the resources to use any small arbitrage. They can easily borrow in one part of the currency region and lend in the other. Mises discusses this in “The Theory of Money and Credit”, I’ll see if I can find the reference. So, when monetary union occurred that part of the savings-investment market that works through banking became pan-eurozone. If you look at the size of the transfers of debt within the eurozone that becomes clear.
Like any price the interest rate has a supply and demand portion. Savings is the supply portion, and investment is the demand portion. That means there can be two reasons for a low interest rate: large supply of savings or low demand for investment. We can’t really say which occurred in the Eurozone before the crisis, but I think it was a bit of both. I think investment demand was low because of the structural problems, the “real side” rather than monetary policy.
This leads to the view that the ECB may not have been doing any stimulating. That can be argued in the MET theory, if the ECB were keeping the long run trend of MV or NGDP stable (though not in the 100% reserve theory). But, in that case why wasn’t the trend sustainable, why was there a crash? It could be argued that there was an “intertemporal” problem; the banks didn’t maturity match well, so when the rest of the Eurozone went into recession they couldn’t access funds to support new loans. I think there’s some truth in this.
But, I think that the MV=PQ view doesn’t sum up the situation properly. The problem is that it’s about the money prices of output, not of everything traded. I think we should take the view that sometimes rises in asset prices are inflation. My view is that the ECB did create money beyond demand, and that it went into asset price inflation rather than output price inflation.
Finally some sense in the Irish argument. Most media commentators seem to have been brainwashed into thinking that devaluation is the panacea to a sovereign state debt problem but fail to think through the logical consequences of it. In short devaluing a currency by x% is equivalent to a haircut on the value of the bonds and a partial default by the same x%. As to the argument that devaluation brings instant competiveness this can only be true if wages do not rise as much as the loss of purchasing power which ensues due to the devaluation. In reality , though it is politically unpalatable as a country it is easier to regain competiveness by a mixture of austerity and lower salaries and remaining in the Euro than via a devaluation which brings about the same results by stealth.
The recent irish protest involved 120,000 irish citizens just before the irish pm agreed to the bailout. There’s another protest scheduled on Nov. 27th and another in December. Just because the MSM isn’t reporting it, it doesn’t mean that the people aren’t revolting.
In all this interesting and intelligent comment I did not see mentioned one obvious fact that is at the heart of the Irish (and British) banking problem. The banks lent to anyone; any developer, any individual, anywhere. Their sophisticated risk analysis models never asked the right “what if?” questions. Whatever happened to “due diligence”? Come back Mr Mainwaring all is forgiven!
To some degree I agree. But, in Ireland at least a lot of what happened was quite understandable.
Before the “Celtic Tiger” there had been decades of stagnation in Ireland, and that produced underinvestment in buildings. I live in Limerick I moved there from England five years ago, a friend who’s lived there all his life tells me that “Limerick was falling down” before the boom. Lots of English people would say that it’s “falling down” if they saw it now. Partly that reflects Irish preferences, they’re not as interested in having neat homes as the English are. But, it’s mostly the outcome of the long period of low growth from the approximately 1930s to the 1980s.
So, when prosperity arrived one of the first investments that people made was in property. In many ways this was very logical. Before the Irish government agreed the banking bailouts Ireland had a small national debt, and due to the 12.5% corporation tax rate it had better future prospects than other European countries.
That’s not to say that the banks shouldn’t have been more careful.
Part of the issue here, is whether banks really can be more careful if the funds they are getting for investment (from the central bank or from markets rises), especially in a situation with knowledge and insider trading laws. Let’s suppose that a banker believes that he will only have access to cheap funds for the next two years. That means that if he’s wise he won’t rely on funds being cheap for longer. But, he may be out-competed by his less wise competition who work on the assumption that there will be. Due to insider trading law there may be no way to for shareholders of the other bank to find out about it’s risky behaviour. Secondly, there is no way to tell how long a central bank will continue a particular interest rate policy for.
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