Sunday, November 21, 2010

Ireland's troubles can be blamed on its government

The "Celtic Tiger" has gone astray and is now seriously considering a bailout from the EU or more widely.   Such a bailout will be embarrassing for a country and economy that was booming and considered a successful role model for economic growth.   However, whilst it looks like  "just another government bailing out banks" let's understand why this has happened, and why the Irish government is bothering to save the banks.

First is that the Irish banks were flooded with cheap credit because of the Euro.  Unlike other fiat currencies, the supply of Euro is set not by a national central bank, but the European Central Bank, which is largely driven by the three major Euro economies - Germany, France and Italy.  Monetary policy in the age of fiat currencies is driven by management of inflation, so it has been economic growth and inflation in Germany primarily, but also the other large economies that has driven interest rates with the Euro.  For Ireland, which has had economic success partly on the back of economic reform and low rates of company tax, this has meant inflation of assets and consumer prices. 

In an age of national fiat currencies, governments tighten monetary policy to reduce the supply of credit and control inflation (although the only inflation measured is consumer prices, which neglects inflationary speculation of property).   Ireland had no such instruments, so "enjoyed" a boom fueled by cheap credit.  That cheap credit fueled a bubble of investment, largely related to property.  Many companies relocated because of the lower corporation tax, and Ireland's infrastructure improved significantly (telecommunications, electricity, water, roads and airports all upgraded significantly, as well as public transport in Dublin).  Ireland's government borrowed to fund this and expenditure on health, education and welfare.

The bubble can be blamed on three key sets of players.  Firstly, the European Central Bank for continuing to maintain low interest rates for the Euro, expanding credit and helping to fuel loose credit for Irish banks.   Secondly, Irish banks for taking these cues to lend and fuel the property boom.   Lending was imprudent, not by all banks, but by enough to create a bubble of bad debt not only for property, but businesses based on the wider economic bubble.   Thirdly, the borrowers.  Those people and businesses who chose to ride the wave of the property bubble.  They sought quick capital gains, they borrowed on the basis of the same chimera.

Yet when things started to look shaky elsewhere, the Irish Government made the most foolish move of all, it decided to prevent a run on Irish banks by providing a government guarantee for all deposits, debts and investments.   The purpose being to shore up the banking system by attracting investment and deposits from elsewhere, the result being to make Irish banks far less interested in being prudent and shifted the liability from bank shareholders and debtors to Irish taxpayers.

Now that bubble has burst, and the Irish government is to get a €100 billion bailout from the EU.  A bailout that is worth a staggering €16400 per person.

Meanwhile, the Irish government is to engage in further austerity, cutting spending significantly.   The Austrian government has already complained about the low corporation tax wanting Ireland to be forced to increase taxes (which make it more competitive against the many higher tax Eurozone economies).   The Irish government has been resisting this quite rightly.

It has been suggested the Irish government should abandon this guarantee of the banks and abandon the Euro.  Allister Heath says it shows the treaty on the Euro is worthless.   Of course the dimwitted Labour Party in the UK says it is the fault of the Irish government's austerity measures from last year, which is a bit like blaming a heart attack on the stress of going to the doctor.    It is claiming the UK could face the same crisis, demonstrating how astonishingly out of its depth it really is.

Sadly the medicine Ireland needs is to abandon the Euro, maintain its low tax policies and swallow the price collapse in property, and the end of several of its banks.  The government probably has to guarantee bank deposits up to a certain level, but withdraw its guarantee for future deposits or liabilities for banks it does not own, and privatise the ones it does.   It needs a new relationship with the EU which is not one of dependency, but one which only embrace the open flow of goods, services , investment and people. 

However, it has wider repercussions whatever happens.  Some in the Eurozone say the real need is to strengthen EU control of national fiscal and taxation policies, that in fact the crisis in Eurozone countries can only be managed by a more centralised EU - which would be an economic disaster and politically unpalatable.    The alternative of the end of the Euro has already been described by EU Council President as risking the end of the EU.

Frankly, bring it on.  The EU has been the transformation of a sound project to remove barriers between European countries into a statist socialist monolithic unaccountable super-state which seeks to regulate (and tax if it could) European citizens into a pablum of mediocre non-competitiveness with each other.   The more it is in crisis, the better it will be in the long run for European citizens, or rather the ones that don't work for the EU and aren't the recipients of its ill gotten largesse.

The Irish will resist pressure for Brussels to control its government spending and taxation policy, the stronger Eurozone countries will get fed up bailing out those others who have been profligate with government spending.   Something has to give.

6 comments:

Jeremy Harris said...

I don't understand what is keeping both Ireland and the UK in...

55% of UK citizens want out of their loose association and the Irish have rejected the Lisbon Treaty - twice if memory serves... There are seemingly votes in getting out as well as all the other benefits of increased economic sovereignty...

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goldtracker said...

What gets me is that they continue to think that bailouts are the answers to all the woes. From what I can see, the dominoes are continuing to fall and people are getting crushed.

Lindsay Mitchell said...

Thanks Scott. I needed to understand what happened to Ireland better. Is it true that much of the business the low corporate tax attracted has since abandoned them?

libertyscott said...

There has been some abandonment, but it is unrelated to the financial crisis. Ireland has faced competition from eastern European new EU Member States which combine the same low taxes, with lower labour costs, lower levels of regulation (legal frameworks that were designed from scratch) and the same advantage of open access to the rest of the European markets.

Ireland still has good fundamentals, but the banking sector guarantees have been a disaster along with the Euro.

Tony said...

Excellent article.

Being in the European Free Trade Association (EFTA) is beneficial in terms of trade and investment - it's a large single market without the overhead of EU membership.

Membership in the EU brought a lot of benefits to Ireland - the recent infrastructure growth was at least partially due to generous EU grants.

This is not the case anymore -- as you point out -- Ireland is facing tough competition from the eastern European new member states (both for business and for EU handouts).

Being in the Euro is a disaster (the Irish economy is very different to the German economy which has dictated the Euro monetary policy). I'm struggling to see long term benefit to Ireland being in the EU either.

As they've accepted the bail out I suspect Ireland have sacrificed much of their autonomy and may not be able to make the decision to bail out themselves anymore....

Far better may have been to let the banks collapse, that would have been messy but it's pretty grim in Ireland now. I'm not sure which option would have been worse in the long term, but letting the banks collapse would have at least mitigated the moral hazard.