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PIIGS to the Slaughter

by Andrew Stuttaford
The Irish debt crisis portends worse to come

Checking into a roach motel often seems like a straightforward decision.        

 Signing up for the euro, the shiny new currency supposedly saturated in German fiscal rectitude, not only pleased Ireland’s paymasters in Brussels (the country has benefited hugely from lavish dollops of EU “structural” assistance) but offered Dublin the prospect of riches far closer to hand than the end of the traditional rainbow. The combination of EU aid (amounting in some years to as much as 3 percent of GDP), domestic frugality, shrewd supply-side reforms, and (those were the days) a timely currency devaluation had already given birth to a Celtic Tiger nourished on export-led success. But that beast was now set to burn very bright indeed.

And so it did. Money poured in, bringing the traditional speculative excess in its wake. So far, so normal: Usually such festivities are brought to a more or less timely close by both external and internal pressure. Inflation heats up, the currency buckles, interest rates rise, fiscal policy is tightened, bank lending is reined in, and everyone is soon back on their best behavior — until the next time.

Joining the euro meant that much of this script was jettisoned. Market signals were muffled by membership in a unified monetary system in which one size truly did not fit all. In particular, Irish interest rates, determined primarily by the needs of the eurozone’s sluggish Franco-German core, were kept far too low (on average, they were negative in real terms between 1998 and 2007) for a roaring economy growing at an annual average rate of 6 percent between 1988 and 2007. Throw in a poorly regulated banking system, endemic cronyism, vast infusions of foreign cash (euro membership had dramatically reduced currency risk), a lending war led by the remarkably reckless Anglo Irish Bank, the genuine housing needs of a large new immigrant population (a striking phenomenon in this land once known for its emigrants), and briskly increasing wage rates, and the stage was set for a gigantic property boom. What could go wrong?

Just about everything; and it went so badly that (finally) doing the right thing may have made matters even worse. When the global financial crisis erupted and the Irish economy slumped (GDP fell by 7.1 percent in 2009 after a 2 percent decline the previous year), real-estate prices fell (they are now some 35 percent below their peak, and weaker still in Dublin), and the banks came down with them. The government’s response bore some resemblance to the approach taken so successfully by Sweden during a not-entirely-dissimilar banking crisis in the early 1990s. This included guaranteeing most of the liabilities of the country’s troubled banks (and troubled they were — by 2007, property-related lending accounted for some 60 percent of their loan books) and transferring toxic assets to NAMA, the National Asset Management Agency, a state-run “bad bank.”

But Ireland’s banking sector was far larger relative to its GDP than Sweden’s had been, and so was its real-estate bubble. The Irish government has also had to contend with a far less favorable economic climate, a difference made even more damaging by the fact that the Irish tax system is unusually sensitive to changes in economic activity. Tax revenues fell by almost 14 percent in 2008 and by 19 percent in 2009, bringing yet more misery to the republic’s previously respectable but swiftly deteriorating public finances.  

Recovery from a mess like this is never plain sailing, but one way to lessen the pain is to arrange a currency devaluation (Sweden let the krona fall by 20 percent in late 1992) to give exporters a break. Unfortunately, membership in the eurozone had closed off that option. Ireland was thus stuck with an overpriced currency, an overpriced workforce, and a rapidly growing hard-money debt burden that could not be inflated away. All that was left was “internal devaluation.” That’s an ugly name for an ugly cure generally revolving around extraordinarily brutal public-sector austerity. The aim is to restore both the state’s finances and the nation’s international competitiveness, and it’s just what Ireland had been attempting since 2008 with a series of increasingly bleak budgets intended to reduce the deficit by over $19 billion.

Internal devaluation is a bitter pill to swallow even when it works, but when it doesn’t . . .

And in Ireland it may well not. As it has lurched its way through 2010, the government has fed ever more money into the country’s devastated banks (most notably the now-reviled Anglo Irish Bank), effectively canceling out the savings being generated by the austerity program and pushing the estimated 2010 public-sector deficit to some 32 percent of GDP (it would otherwise have been around 12 percent). This renewed the market’s worries about Ireland and, ominously, other fiscally fragile eurozone members. Exacerbating the rising tension, the European Central Bank appeared to be continuing with its effort to scale back the short-term support it had been extending to the eurozone’s financial institutions — support that was widely assumed to be vital to many banks in most or all of the notorious PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Perceptions of sovereign and banking risk were converging, not unreasonably so given the way that governments were standing (either explicitly or implicitly) behind their countries’ banks. To take one example, when Fitch cut Ireland’s rating from AA- to A+ this fall, it specifically cited the mounting cost of the bank clean-up.

All this made October a terrible month for German chancellor Angela Merkel to demand that the European Stability Mechanism, which is scheduled to replace the current European Financial Stability Facility in 2013, include a provision requiring private holders of government debt to share in the pain of future sovereign bailouts. The provision is common sense. To call for it at a time of jagged nerves over European sovereign risk was not. Merkel’s comments related only to arrangements that might be put in place in the future, but given her frequent tirades against “speculators” and Germany’s key role in funding any bailouts to come, many in the financial markets worried that they might herald an attempt to change the ground rules well before 2013 — and not in a way that would be in the interests of bondholders. Yields on PIIGS bonds rose, while money continued to drift away from Ireland’s banks, and investors from its debt. Theoretically, the country still had enough money to meet its financing needs until mid-2011, but, if panic was to be headed off (at least temporarily), its government had to be persuaded to accept the bailout that it was desperately claiming not to need.

The risk posed by spreading financial contagion was simply too high, and not just for Ireland. The European Financial Stability Facility, which was created for the eurozone with such fanfare (there was talk of shock and awe) at the time of the Greek bailout, is not large enough to rescue Ireland and Portugal and Spain, the next two countries most likely to be hit should confidence fall any farther. Dublin caved. An outline rescue package was announced on November 21. The full details were released a week later. The total package will amount to $110 billion, including an immediate $13 billion injection of fresh capital into the banking system. In an unanticipated development, Ireland will chip in $23 billion from its pension reserve fund and various other pots of money. The balance is set to come from the International Monetary Fund, from the European Financial Stability Facility, and from three non-eurozone countries, the U.K., Sweden, and Denmark. The whole thing is conditional on the passing of yet another Irish austerity budget, one that contains an additional $20 billion in tax increases and spending cuts. These cuts, when added to the earlier bouts of slash-and-burn, amount to roughly 20 percent of GDP.

At the same time, more details were given of the planned new European Stability Mechanism, but — not insignificantly — with (some) dilution of Angela Merkel’s proposal for sharing the burden of future bailouts. It was also agreed that Greece should be given an extra four-and-a-half years to repay its emergency financing from earlier this year. Ireland, however, will no longer be obliged to contribute to Greece’s bailout. On a brighter note, and over the objections of some in the rescue party, Ireland was allowed to retain the 12.5 percent corporate tax rate that has served it so well.

The republic’s governing coalition, a dying partnership between the centrist Fianna Fáil and the Greens, has to pass the new austerity budget within a few days with a parliamentary majority of only two and without much popular support. In a clear warning sign for the general election now set for January, Fianna Fáil received a November 25 by-election shellacking from Sinn Féin, a party frequently described as the political wing of the IRA. The EU’s mandarins like to claim that their “ever closer” union is burying Europe’s old nationalisms. That’s not how it looked in Donegal South West that weekend.

Despite this, Ireland’s mainstream parties recognize that the deficit needs to be reduced soon — even if they disagree on the specifics of the rescue package. At the time of writing, things are very fluid, but the best guess is that the budget will probably squeak through, albeit with a great deal of shouting. If it doesn’t, there’s a clear risk that financial chaos will soon engulf some or all of the PIIGS, and, no less dangerously, the banks that have lent so much to them. Even if it does go through, don’t expect too much. The distinctly downbeat market reaction to both the initial announcement of an Irish bailout (yields on the PIIGS’ government debt rose; the euro fell) and its later confirmation reveals a widespread belief that this rescue is not the end of the story.

It’s not. More bailouts undoubtedly lie ahead, and, in the case of Greece and Ireland, so does a debt restructuring (that’s the polite word for default) at some moment when it is judged that the financial markets can cope with the news. So long as these countries are yoked to the euro, there is no feasible alternative. Their domestic demand will be crippled by the processes of internal devaluation. Their export sectors will be hobbled by a hard currency. Under the circumstances, they will struggle to grow their economies at a pace fast enough to reduce their debt burdens to manageable levels. There are good reasons the yield on their debt continues to rise.

Meanwhile, Brussels, apparently unshaken in its belief that one size can be made to fit all, will try to impose unified fiscal and budgetary rules across the eurozone. If this succeeds, it may reassure restless German voters that there are credible limits on the amount they will be asked to pay to support European monetary union. That the implementation of such zonal discipline will, if carried through, also deepen European integration is even more to the Eurocrats’ point. That it would doom a large swath of the continent to years of subpar growth is just too bad. The European project must move forward!

Splitting the single currency into a “northern” euro for Germany and those of its neighbors that want to come along and a “southern” euro for the rest is one more congenial, if risky, alternative route to take. It would retain important elements of the status quo while paving the way for the devaluations that the PIIGS so badly need. But to take this path would be an admission of defeat too humiliating for the EU’s leadership to accept, at least for now. And if that’s off the agenda, so, even more so, is a return by the nations of the eurozone to their old currencies.

The final alternative, for an Ireland or a Greece to exit the euro on its own, would involve national bankruptcy, the collapse of much of the domestic private sector, and Lehman Part Deux.

It’s not always easy to check out of a roach motel.

– Mr. Stuttaford is a contributing editor of National Review Online.

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