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Tuesday, 23 November 2010

New Open Europe briefing: What will the Irish bail-out actually solve?

22 November 2010  Open Europe
The Irish government yesterday announced that it would seek a bail-out from the EU and the IMF amid concerns over Ireland's banks and public finances.
Open Europe has today published a briefing looking at the different bail-out options on the table, arguing that none of them will solve the fundamental problems of either Ireland or the eurozone as a whole - although they can buy Ireland valuable time.

Open Europe's Director Mats Persson said:
"The real problem Ireland and other weaker eurozone economies are facing is how to regain competitiveness once stuck inside a monetary union, without the option of currency devaluation at their disposal. Temporary loans or stricter budget rules will do very little to solve this problem."

"A healthy Irish economy is clearly in the UK's interests but while there's a case for granting bilateral assistance to Ireland, any involvement in an EU-led bail-out completely lacks democratic legitimacy in the UK, particularly as such a bailout is legally questionable in the first place."

"In the absence of regained growth and competitiveness in Ireland and elsewhere, Britain will remain exposed to shaky eurozone economies and the single currency's inherent flaws in future. The UK government should now design an economic policy which assumes that the eurozone is unsustainable and work with EU partners to find a more viable monetary arrangement for Europe."

To read the briefing click here: http://www.openeurope.org.uk/research/irelandbailout.pdf

Key points
· Ireland's problems - while owing to several factors - have been locked in by the loss of competitiveness arising from its EMU membership. Since joining the eurozone, Ireland has lost over 27% in competitiveness relative to Germany, according to some measures. In many ways, the Irish debt bubble is a symptom rather than the cause of the real problem.

· Ireland is clearly in a better position to rebound from the current problems than Greece and Portugal, due to its relatively open economy. However, there are five reasons why a one-off bailout for Ireland will not solve the eurozone's problems - although it could buy Ireland some valuable time:

1. Temporary loans or greater budget discipline across the eurozone will do very little to help countries such as Greece, Ireland or Portugal regain competitiveness, the main problem these countries face.

2. In essence, what was asked of Greece, and soon Ireland, is two-thirds of a traditional IMF package - cuts in expenditure and increased taxes. However, the third, vital ingredient - currency depreciation - isn't permitted within a single currency. Instead, currency devaluation has to be replaced by so-called "internal depreciation", meaning even more squeezes to jobs and wages which aren't politically or socially affordable.

3. The ECB is likely to continue to pursue a German-style monetary policy, leading to an undervalued currency for Germany (fuelling German export-led growth) but an equally overvalued currency for the weaker economies such as Portugal and Spain (although Ireland itself could be helped by a weaker euro). This, in turn, locks in a multi-speed eurozone, with the same type of tensions we've seen over the last year coming to the fore again in future.
4. The politics of a loan bail-out and stronger supranational budget rules are unsustainable. The lending countries, most importantly Germany, can only sell a de facto debt union to their electorates if it comes with strict rules and terms. But such terms imposed from the outside seriously undermine the ability of the borrowing countries to democratically govern themselves.

5. The role currently being played by the ECB is untenable, both for political and economic reasons:

a) Politically, the ECB's decision back in May to start buying 'junk' government bonds from the secondary market has compromised its independence - which the Germans were promised would never happen. A bailout using loan guarantees from other EU states may allow the ECB to withdraw its emergency funding for now, but without a long-term solution the ECB is likely to be called on again to prop up ailing states.

b) Economically, the situation is unsustainable as well. The Eurosystem of eurozone central banks that underpins the ECB is leveraged 24 times[1], while the average hedge fund is only leveraged 3 to 4 times. A fall in assets of only a few percent would wipe out the ECB's reserves, which could lead to the ECB itself being in need of a "bail-out".

· There are no obvious long-term solutions that do not come with huge political and economic costs. The dilemma facing the eurozone remains whether it is to become a fully fledged United States-style fiscal and therefore political union with huge continuous transfers from the German-led bloc to those on the periphery - which would inflict serious damage on the German economy; or prepare for a messy divorce possibly in the form of a two-tier euro and even some countries exiting altogether.

· Germany is keen on a bail-out package for Ireland, as it wants to decrease Ireland's dependency on the ECB, replacing the current support measures with government-backed loans, which can be linked to specific demands, such as a restructuring of the banks or changes to the tax system. The ECB's generous liquidity supply also goes against the 'hard currency' philosophy that Germany was promised when giving up the Deutschemark in the 1990s and strikes to the heart of worries that the ECB is becoming a "bad bank" itself.

· The UK is hugely exposed to Irish banks and debts. However, the decision on whether the UK is involved in a bailout is largely out of the UK Government's hands because the EU bailout fund, partly underwritten by British taxpayers, can be activated by majority voting, meaning that Britain could be outvoted. This means that the EU rescue mechanism of which the UK is part completely lacks democratic legitimacy in Britain. The UK is also likely to provide bilateral support and contribute through its membership of the IMF. Reports suggest that the total amount guaranteed by Britain in an Irish bail-out will be in the area of £7 billion. However, in the absence of regained growth and competitiveness in Ireland, and the other weaker economies in the eurozone, the UK will remain exposed to future failure in EMU.

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