Thoughts on Irish Contagion To Portugal and Reforming the Euro
A recent CNBC article highlighted for me why the Irish are being pressured to accept a bailout when they have repeatedly said they don’t want one yet. The problem is Portugal (and Spain). To the degree that the Irish situation continues to make waves, Portugal will be forced to accept higher yields. And with their austerity budget and high unemployment, this makes it that much harder for them to avoid a bailout as well.
Portugal’s cost of borrowing soared at a Treasury bill auction on Wednesday and unemployment hit its highest in at least two decades, highlighting the challenges facing the debt-ridden euro zone economy.
With analysts saying a bailout of Ireland now looks almost inevitable, they warn that Portugal will likely need to improve its competitiveness and find ways to boost economic growth to stop it being next.
The state statistics body said third-quarter unemployment rose to 10.9 percent from 10.6 percent in the previous three months despite a pick-up in economic growth in the period, and analysts saw no prospect of an improvement as austerity is likely to hamper growth next year.
"This will continue to put consumers — who are already being hit by rising inflation, higher taxes and lower public spending — under significant pressure," said Diego Iscaro, an economist at IHS Global Insight.
Many economists fear Portugal will slide back into recession in 2011 after this year’s projected expansion of 1.3 percent due to government austerity aimed at cutting the budget gap to 4.6 percent of GDP next year from 7.3 percent in 2010.
The government still predicts 0.2 percent growth next year.
Meanwhile, the average yield at an auction of 12-month bills spiked to 4.813 percent, up 155 basis points in the past two weeks and raising new questions about how long Portugal will be able to finance itself if borrowing costs do not drop.
All along, we have heard that these bailouts are about preventing contagion. To the degree Ireland is in a liquidity crisis (which I think it is, but Simon Johnson and Nouriel Roubini do not), then it makes sense to get this behind us as quickly as possible. In a worst case scenario, without an Irish deal, Portugal would be forced into a bailout as their debt costs soar and Irish banks continue to haemorrhage deposits, forcing Ireland into a premature bailout as well. Clearly, the EU is looking to prevent this. And that’s the reason even the UK has pledged seven billion ponds to Ireland’s bailout even though it is not a member of the Eurozone. (Of course, British banks are affected by the Irish situation and Alistair Darling had already worked this deal out in May when Greece was bailed out).
As to permanent remedies, we need to look to the euro zone’s structure. I think this is about the euro. For example, in 2008, I wrote:
As with everything in the EU: EU membership itself and the Maastricht treaty in particular, eventually any- and everyone could join. The Eurozone now comprises 15 countries: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain.
This union gives bond markets liquidity and obviates the need for foreign currency exchange, reducing costs. However, high growth Ireland and Spain are very different from Germany and France. Harmonizing these 15 economies will take decades, if it ever happens.
The politicians said they would harmonize through forcing fiscal discipline. You remember the Germans, in their arrogance, talking about strict adherence to a 3% deficit rule and penalties for slackers? They chided the Italians until they themselves broke their own rule and now no one talks about it anymore. Since then, it has been an orgy of deficit spending across Europe.
The Euro is flawed because it subjects countries like Ireland to an inappropriate monetary regime that cause their economy to overheat and bust. However, one cannot say the Irish economy would have maintained an even keel had they not given up the Punt. Just look a the mess in the UK, where the British have their own currency. So, don’t blame the Euro for a housing bubble.
However, at a minimum, interest rate policy could adjust more closely to the needs of the Irish economy with their own currency. This is the price paid in order to be part of the Euro.
–Did joining the eurozone bust Ireland?, Jul 2008
Some don’t see the euro at the centre of this. For example, Philippe Legrain writes in today’s FT that sceptics looking at the euro to blame for the problems of Ireland are being "simplistic". He makes my point about the property bubble in Britain and includes Iceland and America as well. He claims that the Irish should have clamped down on an out of control bubble and raised taxes to generate even larger fiscal surpluses to cool the overheated economy. Fair enough, the Irish and the Spanish both should have clamped down on property excesses; I will agree. However, in an open economy with huge amounts of liquidity sloshing around, it is difficult for countries to tamp down on these things. And it is even more difficult when you have no monetary policy levers. On the other hand, it’s not credible to say the Irish needed more surpluses.
What’s key in this is an understanding that the Spanish and the Irish were subjected to what for the Germans was an adequate monetary policy. But for the Spanish and the Irish it was highly inflationary, both in terms of asset prices and labor costs. I can see the leaders last decade, Bertie Ahern and José María Aznar now:
Citizens, we are running budget surpluses right now. And the economy is booming. But, I intend to commit political suicide because I recognize there is an asset bubble forming which will cause our surplus to turn into double-digit deficits in no time. Therefore, I am asking the legislature to tax you more so that we can forestall this problem. Moreover, I want to ask you workers to take pay cuts now so that you don’t have to later.
I hope that sounds about right because that is the only thing the Spanish and Irish could have done, locked into the currency union as they were.
–Beggar thy neighbour: Martin Wolf is singing from my songbook
How can one remedy this going forward? The only way to prevent these imbalances from building is to set up pre-funded fiscal transfers as automatic stabilizers as you see done within EU member states.
Over the long-term, the proposed European Monetary Fund makes sense. However, first and foremost, let’s call it a European Harmonisation Fund because this is the purpose – harmonisation.
For example, within the United States, I imagine there are substantial interstate capital account imbalances between individual states. Florida might have a substantial capital account surplus because of all of the retirees moving there. While New York could have a capital account deficit because of the financial sector wealth. (I don’t know if this is true. The example is just illustrative). But you wouldn’t hear New Yorkers screaming bloody murder about the profligacy of Florida. Nor would you hear the Floridians yelling about New York’s enormous current account surplus.
The point is the United States has more well-harmonised internal market because of the free movement of labour and capital, a common language and federal automatic stabilisers. This is what the Eurozone lacks. And this is why we can change the unbelievable EMF – and its inflammatory expulsion clause into the more believable EHF.
But the Germans are looking to the Maastricht criteria again for an EMF and wanting to exact a penalty from profligate spenders – even by denying them a vote. This is insanity. As I recounted above, Germany itself broke the Maastricht criteria and are over the mark on both deficits and debt-to-GDP RIGHT NOW. The Maastricht criteria had nothing to do with Ireland or Spain’s problems to begin with as they easily cleared both hurdles again and again before the crisis.
My view is that a pre-funded EU-wide automatic stabilizer and the threat of default will let countries know that they are not on their own but that profligacy will be met by market forces. This will also eliminate the politicising of economic problems when crisis occurs. This doesn’t have to be a Treasury per se but an automatic transfer system set up to aid countries when their economies fall into recession. Countries that could not make the grade in markets after receiving these funds would have to default and restructure. With this mechanism in place, no bailouts would be needed. If Europe is to save the monetary union, this is really the only way forward.
Source: National Economic Statistics – TradingEconomics
Irelands banks do not have liquidity problem. They are insolvent, and even if the central bank had being printing money the banks would still have problems. Irish property has been falling off a cliff and that is without any foreclosures. That is still to come. The total level of Irelands debts are unsustainable. The banks will need to write off billions and that will mean that Ireland is bankrupt as well, especially since they have failed to let the banks guarantees lapse.
Philippe Legrain is right that the Irish government should have raised taxes to restrain the bubbles, while they may not have had interest rates as a weapon (not a particularly good one in my opinion), they still had taxes. They also could have levied a sales taxes on homes, and higher capital gains taxes which would have been quite effective, especially discouraging speculation.
There was also the option of the Irish central bank demanding that the banks hand over some of their reserves to constrain the banks lending, which along with tough lending rules limiting loans as a strict multiple of capital would have be very effective at stopping the banks from over lending. It could even be used to target specific banks and sectors. So they could have clamped down on property speculation without harming lending to small businesses. The central banks could have restricted the banks other activities without using interest rates. It just meant smarter regulation was needed.
As for the UK contribution the £7 Billion is a lot less than the €146 Billion liabilities that the Irish banks owe to UK banks. An Irish bank default will hit both UK and German banks, which are close to insolvent without any Irish default. The Irish bailout is a concealed bailout for Europe’s banks at the taxpayers expense, and will ultimately fail because of the fundamentally excessive debts that Ireland simply cannot pay off, without consigning Ireland to two or three decades of stagnation. All this does is kick the problem down the road until possibly after another election. So the markets will attack Portugal and Spain and we will hear more talk of contagion.