CURRENCY CRISIS:WHEN IRELAND joined the European Monetary System (EMS) in 1979 it was clear that the longstanding link with sterling would soon come to an end. The foreign exchange staff of the Central Bank hung a chain of paper clips outside the dealing-room door to represent the link with sterling.
Within a matter of days the Irish pound moved up with the Deutsche mark (DM), leaving sterling behind. The foreign exchange staff rushed out and symbolically broke the link of paper clips. It must be confessed that a cheer went up. At that moment, on March 30th, 1979, Ireland, for good or ill, hitched its wagon to the European monetary system.
Official Ireland prided itself on being pro-European but nevertheless there was a reluctance to leave the tweedy embrace of the UK with whom we still had considerable trading links. When the euro came along almost 20 years later, and the UK decided not to join, it created a dilemma for Ireland. On balance, however, it was decided that Ireland should join the euro on the assumption that Irish policy-makers would compensate for the effects of very low interest rates and the fact that devaluation of the exchange rate would no longer be an option.
In practice, however, politicians took their eye off the ball. Low interest rates led to a property bubble and excessive bank lending, and social partnership led to wage growth in Ireland which rapidly eroded our competitiveness.
The discipline needed to make the euro work for us was completely lacking. We had met most of the Maastricht conditions but as soon as we joined the euro, we “let ourselves go”. Whereas Greece could put some of the blame on the advice it received from Goldman Sachs, Ireland had no such excuse. Incredibly, this wasn’t the first time we got it wrong. We also indulged in fiscal laxity during EMS membership two decades earlier.
The alternative of not joining the euro, but going back into some kind of relationship with sterling did not appeal to those on the nationalistic side of the spectrum. It would have been a blow to national pride.
The experts in most countries knew that the euro concept was flawed, but politicians regarded the single currency as a powerful symbol of European integration. No doubt some leading figures saw the euro as a symbol of their own statesmanship. It is hard to understand why chancellor Helmut Kohl was so enamoured of the project since the Bundesbank was already de facto the central bank of Europe and the DM the leading currency.
Christopher Hitchens recently suggested that the sacrifice of the DM was a “generous act”. That may be the case but other motivations, deriving from war-time memories, have also been imputed. Historians will have to judge. It is interesting to note that chancellor Helmut Schmidt was the main driver of the EMS in the 1970s. Following in this tradition, Helmut Kohl was extremely proactive in creating the euro. Most other heads of state merely went along with him. Maybe some of them felt it was a good opportunity to neuter their own troublesome central banks – but not of course their treasuries.
The technical flaws of the euro have been well documented – the lack of a fiscal dimension, dissimilar structures in different economies, a one-size-fits-all monetary policy, and inadequate co-ordination of banking regulation. Some attempt was made to compensate for these deficiencies. Cohesion funds were one example, albeit little more than tokenism. There was also a belief in some quarters that the single currency would help bring about symmetric structures in the different economies over time. But how long would it take for a country like Greece to develop economic structures similar to those in Germany? It was never going to happen within a reasonable timescale.
What exactly was expected of the euro? The EU countries already had a free-trade area and a single market. These developments surely delivered more than 90 per cent of the economic gains of European integration. It was a relatively easy matter to convert one currency into another. It was most unlikely that exchange-rate risk was impeding trade between European countries. From an economic perspective, the euro was simply the frosting on the icing on the cake. The benefits were bound to be low and the costs high – potentially very high indeed.
A few experts worried about the “free-rider problem”. Some countries might be fiscally irresponsible – and not have to fear a run on their currencies. They might not have to suffer the harsh discipline of the global markets because the latter would assume that the errant countries would have the protection of the system as a whole. Concerns about the free-rider problem led to a “no-bail-out” clause in the European treaties. As part of this provision, the ECB was prohibited from lending directly to countries. There were particular concerns about Italy, given its size, and its record of lira devaluations, fiscal deficits and frequent tax amnesties.
To cope with this problem, the Stability and Growth Pact was introduced, mainly at the instigation of Germany. Under this pact countries whose deficits went above 3 per cent of GDP could be fined. This of course was ludicrous. No sovereign state was going to pay a hefty fine to the EU Commission, and indeed there were occasions when both France and Germany reacted badly to being critiqued under this pact. The euro “design team” were obviously beginning to get cold feet, and to realise rather late in the day where the flaws in the euro might ultimately lead.
There is little doubt that the euro’s pedigree was flawed. That is not to say that it was pre-destined to fail. If countries had behaved appropriately the monetary union could have worked. Property crashes and fiscal irresponsibility were not inevitable. The failure of banks and their regulators were not written in the stars. But once the problems arose it was virtually certain that the financial markets were going to punish the offending countries – which could not devalue, lower interest rates or rely on the ECB to print money.
Punishment by the international markets is probably made even more severe than it would normally be. There are three reasons for this view. First, global savings are tight. This is unlike the situation in the early 1980s when banks were awash with petrodollars. Second, the US is taking the lion’s share of global savings, especially from China. Third, the rating agencies are trying to mend their tattered reputations by being tougher than ever on sovereign borrowers.
The survival of the euro is balanced on a knife-edge. It probably could be saved by major initiatives in relation to the size of the bail-out fund, the creation of Eurobonds, burden-sharing with bond-holders and ultimately money-creation by the ECB over and above the present limited policy of purchasing government debt. We were told that the Lisbon Treaty would facilitate decision-making but will it encourage countries to take radical measures and lay the ghosts of history?
Much will depend on the attitude of Germany. It is readily apparent that Germany relentlessly drove the creation of the euro and clearly still has a vested interest in its survival. It all depends on the balance of advantage, political as well as economic. If the currency does survive all EU countries will be bounced into a much tighter form of European integration, with a common fiscal policy at its centre.
The euro could survive in some two-tier form, though this is hard to envisage. It is doubtful if France could stand shoulder-to-shoulder with Germany using the same currency. There would be constant pressure on the euro which would only be eased if France joined the “ lower” group – in which case Germany would be the only country left with the full euro – which would then of course be the DM. There is little doubt that the DM would appreciate to the detriment of German exports. The US dollar would also appreciate. America, in fact, is the wild card that may ultimately “persuade” Germany and the ECB to save the euro. Although the euro was never very important on economic grounds, its collapse could nevertheless lead to the unravelling of the EU. Its survival, on the other hand, will lead to much closer integration – a major step on the road to a United States of Europe. It is a matter of great regret that such a momentous decision has to be taken in the midst of a crisis.
Michael Casey is a former chief economist with the Central Bank and board member of the International Monetary Fund. His book, Ireland's Malaise, is published by the Liffey Press
