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Analysis/Comment Last Updated: Sep 15, 2010 - 2:21:54 PM


Ireland exiting the euro and the risk of setting the Irish economy on fire
By Michael Hennigan, Founder and Editor of Finfacts
Nov 17, 2009 - 7:12:55 AM

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Green: EU countries using the euro: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain

Mauve: EU countries not using the euro

Leaving the euro may seem like a daring but serious option for responding to Ireland's economic travails. However, thebeguiling fix would likely risk setting the economy on fire and at best, long overdue reform would have to be eventually considered. Besides, while devaluation is the text book solution for restoring competitiveness, the Irish economy is unique in the world, according to an agency of the US Department of Commerce, in its dependence on US firms. These firms have made the Eurozone our principal trading partner.

In May 1998, William Hague, leader of the UK Conservative Party warned that membership of the euro system was irreversible. He said: "One could find oneself trapped in the economic equivalent of a burning building with no exits."

Hague's comments were an echo of a paper published by Harvard University economist, Martin Feldstein, in 1997, in which he said: "The American experience with the secession of the South may contain some lessons about the danger of a treaty or constitution that has no exits." In January 1999, in the first month of the euro, the former chairman of President Reagan's Council of Economic Advisers and his wife Kathleen Feldstein, wrote in an article in The Boston Globe: "Although Ireland would now benefit from an increase in interest rates to rein in its explosive growth, the major continental European countries want lower interest rates to stimulate their slowing economies and prevent even higher unemployment.

The divergence of appropriate economic responses has already had a negative effect on Ireland. In the run-up to the start of EMU on Jan. 1, Ireland has had to cut its reference interest rate from 5.5 percent to 3 per cent, the predominant rate set by the German Bundesbank. The decrease in interest rates has exacerbated an already overheated economy in Ireland."

Even in a relatively small economy such as the UK's, an interest rate to control property inflation in the south-east of England, may not be appropriate for companies in its industrial heartland. However, the potential Achilles' heel of the euro system is that member countries retain full control of fiscal policy while there are no serious sanctions for countries which breach the budget deficit and public debt limits.

Nevertheless, in the decade since the launch of the euro, the European Central Bank (ECB), based on the template of the German Bundesbank, has established its credentials for being "fiercely independent," in the words of its current president, Jean-Claude Trichet. It has been tested by fire in recent years and responded to the financial crisis with a bold, determined leadership.

The Eurozone has survived and now has a population of almost 330m compared to 305m in the US. Its share of world GDP (gross domestic product)  - - a measure of annual economic output - -  was 15.7 per cent in 2008 compared with a US share of 20.6 per cent.

The Eurozone is going to get bigger in the coming decade and while Irish-owned exporters have failed to take advantage of the common currency area in the past decade, where else in the world are there better opportunities than on Ireland's doorstep and with no currency risk?

A measure of how much an economy is dependent on external trade is provided by the ratio of exports to an economy's annual GDP.

In 1973, when Ireland joined the then European Economic Community, its export ratio was 21.4 per cent. By 1993, it was 51.1 per cent; 79 per cent in 1999 - the year of the euro's launch  - - and it is forecast to be 93 per cent this year.

By contrast, a comparable developed country, New Zealand, had an export ratio of 11.3 per cent in 1973 and 22.9 per cent in 2008.

However, New Zealand is the home of the world's biggest dairy products company, Fonterra, which is responsible for about 25 per  cent of its total export earnings and over one third of international dairy trade - -  selling in 140 countries and providing direct employment for over 10,000 in New Zealand.

Foreign-owned companies, mainly American, have been responsible for Ireland's exports boom in recent decades. Irish-owned firms account for only about 10 per cent of Ireland’s annual exports.

In 1973, 55 per cent of total Irish exports went to the UK and the percentage is almost 20 per cent today. However, more than 50 per cent of current exports from Irish-owned firms - - mainly producers of food and drink - - are to the UK market. The countries Germany, France, Benelux, Italy and Spain collectively represent a GDP 3.9 times the size of the UK, yet the non-food exports by Enterprise Ireland clients companies to these countries, is 40 per cent of that of the UK. Exports by Irish-owned firms to China in 2007, were 6.7 per cent of total exports from Ireland to China.

Economist David McWilliams, who advocates leaving the euro and engineering competitiveness via a devalued new punt, has written: "It is worth remembering that our boom was triggered by a forced devaluation in 1993."

In his new book, he compares bankers to drug pushers but his own fix for the economy is not based on credible facts.

The boom was triggered by the influx of the cream of America's world class companies not by a 10 per cent devaluation, in January 1993. Besides, a paper published by the Central Bank in 2005*, shows that the trend of exports from Irish-owned firms in the period 1990-2002, hardly changed.

*SEE Chart 3 here: Home Truths on Irish Exports as Ireland faces a changed global economy in the decade ahead

When Ireland joined the euro, it needed to have a prudent fiscal policy but when the European Commission and ECB criticised the 2001 Budget, the congress of trade unions and employers' group IBEC, strongly supported the tax cutting strategy of the then Minister for Finance, Charlie McCreevy. One year ahead of a general election, an Irish Times poll also showed strong public backing for McCreevy and Taoiseach Bertie Ahern.

Meanwhile, the Irish Central Bank relied on pleading letters to the banks to rein in lending, while its counterpart in Spain, also a member of the euro system, was insisting that Spanish banks set aside additional provisions to have a safety cushion in the event of a downturn.

The experience of Iceland shows that outside of the euro system, during an international credit boom, only fantasists could believe that Ireland's reckless fiscal policy, would have been countered by an assertive central bank willing to oppose the politicians.

Iceland currently has an annual inflation rate of 9.7 per cent and a benchmark interest rate of 13 per cent.

Some 57 per cent of Iceland's goods exports comprise its own marine products and thermal energy resources enable it to produce and export aluminum.

So devaluation helps as it did Argentina, when it massively devalued in 2001 and defaulted on almost €100bn worth of foreign debt.

Argentinean exports of metals, wheat and beef, boosted by demand from China and financial support from Venezuela, benefited as devaluation has a fast pass-thru on commodities. In contrast, the benefit of lower prices on finished products, comes much slower. It's only "armchair experts" who believe that developing new overseas markets for finished products or services, is an easy task.

Between 1890 to 1940, Argentina's economic output exceeded Brazil's. Today's Argentina's bigger rival is viewed as a key emerging economy and Argentina, which succeeded in getting most of its foreign creditors to accept a 65 per cent "haircut" or discount on its debt, is now seeking to get agreement on holdouts.

There are no free lunches and Hugo Chávez’s Venezuela charges as much as 15 per cent on its loans.

In Ireland, the big US companies supported joining the euro a decade ago.

There is no evidence that these global companies would support Ireland exiting the euro now.

About 18 per cent of Irish merchandise exports and 15 per cent of service exports are to the US but Ireland is used as a significant profit centre by US firms because of the low corporate tax rate and patents can be parked in Ireland to receive tax-free income from other overseas locations. US firms transact a significant amount of their business in the world's second reserve currency - - the euro. Hedging against a small volatile currency is not likely to be in their interest.

While a secession would not prompt an ECB gunboat on the Liffey, there would likely be an economic collapse, at least initially.

Fieldstein and Hague were correct about exiting as once fear spread of an impending exit, funds would be moved offshore.

The end of the ECB lifeline for the banks, would surely bring them down.

Inflation would rise and then at some stage when an equilibrium value for the new punt was reached, mortgage borrowers would have to contend with maybe double-digit interest rates, while savers would be forced to convert their euros to lower value punts.

The business sector would be in turmoil as losses would have to be booked on euro debt and the governance system that is challenged with the smallest crisis, would have to put in place a siege economy.

Meanwhile, a country that is so dependent on foreign investment, would have a choice of a surge in its national debt or default. Against that backdrop, it would need a lot more than an IDA Ireland syrupy marketing campaign, to restore Ireland's reputation.

Costs would initially be lower, in the main trading currencies, but in the absence of reform, they would creep back up over time as high inflation would erode the advantage.

So why risk massive turmoil instead of creating a competitive economy within the huge Eurozone market?

In the year to August 2009, 42 per cent of merchandise exports from Ireland went to the Eurozone. In 2008, 37 per cent of service exports went to the common currency area. It could be bigger and why would it be rational to hoist the white flag when the market area will grow in size over the next decade?

Why does the government of a small country pay lawyers €2,500 - €4000 per day?;  Why are Irish doctors paid five times the equivalent of counterparts in the UK for delivering a flu jab? - -  and the questions could go on and on.

In a country of vested interests, whether it's the land rezoning bonanza enjoyed by farmers; cartel-type fees charged by the sheltered professional groups - - at a huge cost to the Exchequer and other private firms; the lack of transparency on public spending, which protects insiders and an unreformed public sector; there would be dislocation, strikes and resistance to loss of spoils in or out of the euro.

However, we could achieve the same desired result in improving competitiveness with better long-term gains, without risking setting the whole economy on fire, by exiting the euro.

Europe from the European Space Agency's Envisat satellite.  

Further background information from Finfacts articles:

The 2001 economic consensus that paved the road to economic ruin

Irish Central Bank declared its impotence before launch of the euro; Why Spain's biggest banks survived huge housing boom

IBEC delivers Irish tribal conservatism not needed radicalism

ICTU calls for return to 1980s era Irish income tax rates with combined top rate of 65%

Ireland: A "smart" economy in food better than pie-in-the-sky aspirations?- - including how New Zealand uses home advantage to sustain its position, as the world leader in the international trade of dairy products. 

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