It is not many years since Europe’s leaders and central bankers regularly congratulated themselves on what a success the euro had been, commonly taking a few swipes at the famous US economists who predicted it would all end in tears.
Sadly, many of the potential flaws those dismal naysayers flagged have turned out to be important, even if it took a number of years for the most serious fault lines to appear. The idea that a single interest rate would work well for so many widely differing economies always seemed questionable, and the tensions caused by sharing a currency are now well understood.
Cormac Lucey's Plan B: How Leaving the Euro Can Save Ireland argues that the Republic's membership of the euro was the key factor underlying the country's boom and bust, and he proposes exiting the euro to cure the economy. The book is concise, informative and provocative, but I'm unconvinced by Lucey's policy prescription.
I have difficulty believing Plan B's argument that the Republic would have avoided a housing bubble and construction boom if the country had stayed outside the euro. There was a strong global element to the cheap finance and plentiful credit of the euro's first few years. The US and UK also had low interest rates and significant housing-fuelled business cycles over this period, so an alternative monetary policy that would have linked Irish interest rates to the British or American rates would not have produced a different outcome.
Lucey argues that staying out of the euro would have allowed the Central Bank of Ireland to pursue a much tougher monetary policy and thus restrain the housing bubble. But this raises the questions of who would have run this alternative Central Bank, how they would have supervised the banking sector and how they would have interacted with the government of the time.
I think it stretches credulity to expect that a Central Bank of Ireland run by John Hurley, with Patrick Neary responsible for banking supervision, and reporting to a government led by Bertie Ahern would have pursued a strict policy designed to keep the cost of credit high and to discourage growth in borrowing. Even without an interest-rate instrument, the government and Central Bank of Ireland of this period had plenty of tools available to discourage credit growth, from tougher capital requirements to the abolition of property tax-incentive schemes, and those in charge chose not to use them and instead to rejoice in how the boom was getting boomier.
Lucey is aware that Irish governments have a long record of making poor macroeconomic decisions, and, despite his position as a former adviser to Michael McDowell, his book directs plenty of ire at those in “Official Ireland”. Still, he would prefer to see monetary policy set by the occupants of Official Ireland than “a Europe that is run by technocrats, fearful of democracy and resentful of its own people”. An alternative viewpoint might be that our own technocrats haven’t always covered themselves in glory.
Leaving the euro would likely involve redenominating Irish government bonds into a new, devalued currency. This would effectively be a form of sovereign default. Lucey argues that reducing the debt burden via default is a key benefit of plan B because Ireland’s current public debt is unsustainable.
But debt sustainability is in the eye of the beholder. Irish government bonds currently trade at historically low interest rates, reflecting international confidence that these bonds will be repaid in full. Indeed, the share of Irish output currently taken up by interest payments on this debt, at about 5 per cent, is half of the level that prevailed in the mid 1980s, when the Republic had its own currency. If Ireland did not default on its public debt then, one would question why it would do so now.
In any case, events in Greece have shown that it is feasible for countries to default on their public debt and remain in the euro – so the debate about public-debt sustainability is something of a red herring when considering whether to leave the currency.
For these reasons the economic benefits of plan B really come down to the potential gains in competitiveness that would stem from a large devaluation of the new currency. The book is clear and detailed on the legal, political and economic complications that a euro exit would entail, but Lucey views the benefits of the large devaluation as outweighing these costs. I’m not convinced.
Devaluation is by no means cost-free. In an economy as open as the Republic’s, a huge fraction of the goods that people buy are imported, and a big devaluation means a jump in inflation and a large fall in real wages. This is a feature of, not a bug in, Lucey’s plan B. The idea is that by reducing the real wages they pay their workers, Irish firms would become more competitive and this would gradually reduce unemployment.
Thanks to the Republic’s membership of the European Monetary System in the 1980s and 1990s we have some evidence of the effects of currency devaluation on the Irish economy. My assessment is that the competitive gains from devaluation are undone relatively quickly as higher inflation passes through to wage costs. Indeed, in many European countries dissatisfaction with repeated cycles of devaluation and inflation was one of the main incentives for joining the euro.
Set against the relatively well-known and short-lived benefits of devaluation, the costs of leaving the euro are complex and unknown but potentially large. The Republic might have to leave the EU were it to give up the euro, and capital controls would likely have to be introduced. To the extent that a unilateral and unexpected decision to leave the euro and default on public debt would be seen as unnecessary and disruptive to other economies, there could also be considerable reputational damage. For an economy heavily dependent on international trade and foreign direct investment, the damage would likely be very large.
Lucey acknowledges that there is little political interest here in unilaterally leaving the euro. Despite its flaws, opinion polls show the euro is still viewed positively by a large majority of Irish people. But Plan B is correct in many of its criticisms of the problems caused by a one-size-fits-all monetary policy, and his prediction that the euro may break up should be taken seriously.
For example, if enough countries in the euro area were to recover to the extent that the ECB were to start raising interest rates even though Spain and Italy remained depressed, politicians in those countries may decide to give up on the euro. In that scenario it may be hard to keep the euro together as a common currency, and Irish politicians may have to dig out their copies of Plan B to figure out what to do.
Buy this book
for €10 at
[ irishtimes.com/bookshopOpens in new window ]
.
P&P free within Republic of Ireland
(Normal RRP €12.99).
