Elements of eurozone membership certainly contributed to the property boom, and to the deteriorating drift in wage competitiveness. Low interest rates and the removal of exchange rate risk facilitated the boom; the insensitivity of the exchange rate and of interest rates to domestic developments removed a traditional external constraint or at least warning sign…Specifically, real interest rates 1998-2007 averaged minus 1 per cent, compared with over 7 per cent in the [a pre-euro system designed to reduce intra-european exchange rate volatility] ERM period (even excluding the crisis of 1992-3) and 3¾ in the floating rate period between the two. The fall in nominal interest rates was even steeper. No wonder long-lived assets like residential property, capitalized at permanently lower discount factors, seemed and were appropriately valued more highly than before. The problem was to determine just how much higher. EMU [economic and monetary union] introduced that element of uncertainty.
Up to 2003, the property boom was financed without significant recourse to foreign borrowing, but after then the banks started to borrow heavily from abroad. This was an effortless undertaking thanks to the removal of currency risk and went essentially unnoticed by analysts, the focus of policy attention having shifted away entirely from balance of payments concerns. Unlike imbalances of the past, overborrowing did not lead to interest rate increases, again because currency risk had been altogether removed. Only when credit risk became an issue after September 2008 did the financial markets belatedly sound a warning sign.
Much the same could be said of wage rates. As shown by Honohan and Leddin (2006), the former tendency for deviations in wage competitiveness to correct themselves (error correction model), detectable in previous data, was no longer evident after EMU began. The regime once again tolerated a larger movement awayfrom equilibrium before warning signals sounded.
Those interested in this tragedy should read the whole thing.