The one-off downward shift in interest rates that followed the adoption of the euro did not inflate a bubble

MANY IN the economics business in Ireland were sceptical about adopting the euro. Some now feel vindicated in their scepticism. Respected UCD economist Colm McCarthy is one.

Last weekend he wrote in the Sunday Independent: "Small EU member states which had the foresight or good fortune to stay out of the euro zone have been left in a superior position to those who went along with this ill-designed instalment of the Great European Project. Denmark and Sweden also had the option of abolishing their independent currencies. They thoughtfully declined the opportunity. There will come a time to reflect on how Irish policymakers got the country into this punitive[my emphasis] currency union in the first place."

I find these views puzzling, for two reasons. First, Colm’s choice of countries is curious. Sweden and Denmark stayed out of the euro and have done well. Their Nordic neighbour Finland joined. It has done well, too. The Nordics’ Baltic neighbour, Estonia, has just adopted the euro. Estonians are not unthoughtful people. Nor are Slovenians and Slovakians, the peoples of two other small countries that joined in 2007 and 2009 respectively.

Second, the creation of the euro may well have been a mistake, but there was nothing “punitive” about it. To suggest that European institutional structures were designed to punish anyone is, to my mind, a gross misreading of how the EU has worked over decades and, much more seriously, risks encouraging a victim mentality that is not underdeveloped in this country.

The euro certainly created policy challenges for its members – no currency regime is without its challenges. These were greatest for countries with limited trade links to the rest of the currency bloc, such as Ireland.

Successive governments largely ignored those challenges. Countries that changed domestic policy priorities to reduce the risks attached to euro participation, such as Finland, are sitting pretty.

Perhaps the common criticism made of euro adoption is that the decline in interest rates that accompanied it created the bubble whose bursting has so devastated this economy. This view has instinctive appeal but it doesn’t stand up to scrutiny. Trends in the aggregate foreign borrowing and domestic lending of the Irish banking system since the 1990s show this clearly.

As the chart illustrates, the large cuts in interest rates that accompanied the euro’s launch in 1999 fuelled already-high private sector credit growth around the turn of the century, but rates of increase soon decelerated sharply. By mid-2002 credit growth was running at a safe level of about 10 per cent. This continued for more than a year.

At that time the economy was still competitive and free of dangerous imbalances. The one-off downward shift in interest rates that came about as a result of adopting the euro did not inflate a bubble.

In the autumn of 2003 everything began to change. Almost half a decade after the launch of the euro, the bubble that did for the Irish economy started to grow.

The explanation for this is straightforward: Irish bankers decided that the Irish property market was such a good bet that they would channel not only domestic savings into it, but would borrow internationally to put foreigners’ savings into it too.

International financiers also thought the Irish property boom was a winner and opened the spigots.

As the chart shows, Irish banks’ foreign borrowings remained low and stable until almost five years into monetary union (no figures are available pre-1999). They then took off. By the time the height of the frenzy was reached, they had risen 10-fold. This had nothing to do with the euro and everything to do with an international financial system that came to misallocate capital in many ways.

In the years leading up to the financial crisis, market- determined interest rates were low and falling internationally (for reasons that remain subject to intense debate). Too-low rates were the manifestation of the under-pricing of risk.

Many countries – within and outside the euro – inflated bubbles with cheap imported capital. They were able to do this not because of the absence of currency risk, but because international financial market participants so badly misjudged credit risk (and regulators everywhere underestimated the dangers).

The result, among other things, is the unprecedented situation in which more than a dozen European countries are in receipt of IMF bailout funds. Most are not in the EU and are highly diverse - from Iceland to Ukraine. Two are in the EU but not in the euro - Latvia and Romania (and Hungary has just exited an IMF programme). Two are in the EU and the euro - Greece and Ireland. The euro clearly cannot explain this continent-wide phenomenon.

Given the availability of cheap funding internationally up to 2007, our obsession with property and ultra-light-touch bank regulation, it is very unlikely the behaviour of Irish banks would have been different in or out of the euro.

At this juncture, the single currency does not appear to have been a success for Europe as a whole. It has not generated much in the way of economic gains and its fragility has led to the most serious intra-EU political strains in 60 years of integration. But while monetary union looks to have been an integrationist bridge too far, it was not the cause of this economy’s woes.