Abandoning euro is a nil sum game


A decision to leave the euro zone would run the risk of Ireland being expelled from the EU, writes Jim O'Leary

MIGHT IRELAND abandon the euro? This question, the mere articulation of which would have invited ridicule a year ago, is now receiving some attention among international economic commentators. The reason is clear. A good, old-fashioned devaluation would be an obvious response to the awful conditions facing the economy, were this option available.

The same question is also being asked of other peripheral euro-zone members – Portugal, Greece and Spain – and has spawned the unlovely acronym “PIGS” as a descriptor of the group of countries concerned.

Meanwhile, the margin by which government bond yields among PIGS exceed their German equivalents has widened to an extraordinary degree. At the time of writing, the Irish-German 10-year differential was two percentage points, up from 0.15 of a point at the start of 2008. The last time it was close to its current margin was during the currency crisis of 1992-1993.

The argument for devaluation at a time like this is a familiar one. The economy must export its way out of the current mess – there is little chance of domestic demand providing the engine of recovery. To be in a position to do so, however, will require a big improvement in competitiveness, and to do so within a tolerable timescale will require a big improvement in competitiveness much faster than is feasible by way of superior productivity growth.

Essentially, there are two ways by which a country can engineer the kind of competitiveness gain that is needed: one is to devalue the currency, the other is to cut wages and salaries and other production costs. Where both options exist, the former is by far the more tractable because wage and salary earners tend to be much more resistant to cuts in nominal incomes than to the reductions in real incomes that follow devaluations.

In theory, Ireland could withdraw from the euro zone (although there is no provision for such a step under European law), reintroduce the Irish pound and devalue it. Devaluation is a tactic we’ve adopted before and with some success.

Part of the reason for that historical success is that devaluation has typically been followed by the abatement of currency speculation, stabilisation of the exchange rate and a substantial fall in interest rates.

Were devaluation feasible in current circumstances, however, it is highly improbable that this benign scenario would unfold. Indeed, the likelihood is that a relaunched Irish pound would attract hugely destabilising speculative attention and interest rates would rise, perhaps steeply.

In this respect, the evidence (from Iceland and elsewhere) strongly suggests membership of the euro zone has afforded Ireland a priceless measure of protection in recent months.

It might be possible to convince oneself that the undesirable interest rate effects of euro renunciation would be short-lived or that they would be outweighed by the competitiveness-related benefits. But this still leaves some formidable barriers, which are discussed in detail and with great lucidity by US economist Barry Eichengreen in The Break-up of the Euro Area, a September 2007 working paper.

The most intimidating of these barriers relate to the fact that pretty well all balance sheets in the economy, those of households, banks, the non-bank corporate sector and the government, are denominated in euro. If this remained the case, the effect of devaluation would be to cause acute and widespread financial distress and an unacceptably high level of ongoing foreign currency exposure for domestic residents.

The logic of devaluation therefore would call for balance sheets to be redenominated in domestic currency, which would meet strong resistance among creditors and might in a great many instances be subject to a successful legal challenge.

In addition, there is the huge technical challenge that would be posed by the transition from euro membership to a restored national currency. This would require a great deal of public planning and preparation (no easy tasks in themselves – particularly when the public administration system is already under acute stress). But it would also present a clear invitation to all those firms and individuals with domestic bank deposits to move their funds offshore in anticipation of recommendation and devaluation. The result would be that the banking system would grind to a halt.

The balance of the argument so far is tilted heavily against renouncing the euro, so heavily as to render the idea academic. And that’s before factoring in the political considerations, which are compelling in their own right.

A decision to leave the euro zone would be a repudiation of such a core element of the European project it would run the risk of expulsion from the EU.

It can be argued that joining the euro zone carries a duty to treat that decision as irreversible. This prompts the question of how generously the rights of membership might be interpreted at a time of acute difficulty. A strong case can be made for the proposition that the economy would not be in the parlous state it’s now in were it not for our adoption of the euro in 1999: we would not have experienced a property/construction boom of the magnitude that we experienced and we would not now be enduring a recession as severe as the current downturn.

Moreover, it can also be argued that these effects of euro membership were not fully understood when we joined.

There are grounds, therefore, as David McWilliams has suggested, for seeking special EU assistance to get us through our current and prospective problems. But the grounds for threatening to leave the euro should such a request be turned down are thin and treacherous.