How to stop Ireland’s financial contagion

If you merge 16 small open economies, you get a large closed economy. But here is the catch. If you assemble the leaders of the 16 small open economies, you get a roomful of 16 small-economy politicians. Economic governance through the European Council has proved always cacophonous and often incompetent. It is an institutional framework of finger-pointing. The Irish say they are not Greece. The Portuguese say they are not Irish. The Spanish finance minister said last week that Spain is not Portugal. There are no prizes for guessing what Italy is not.

This governance paradox lies at the heart of the eurozone crisis. It explains, for example, why in the middle of an existential banking crisis, there has been a debate about the Irish corporate tax rate. The French and Germans have argued that Ireland’s ultra-low taxes are distorting competition. The Irish say they need a low tax rate to attract foreign direct investment. It is hard to conceive of an issue that is less relevant to the current problem.

The task that needs to be solved now is to stop contagion of the Irish banking crisis. The channels are easy to figure out. The two largest creditors to Ireland are the UK and Germany, with loans outstanding of $149bn and $139bn respectively, according to data from the Bank for International Settlements. An Irish bank default would affect the German and British banking systems directly, and require significant domestic bank bail-outs.

A second channel of contagion would be via the capital markets, to Portugal. The biggest creditor to Portugal is Spain, itself in a precarious position with exposures of $78bn. A default of Irish banks would spread like wildfire. It has to be prevented.

The case for Ireland to take the money from the European Financial Stability Facility (EFSF) is overwhelming. The EFSF was set up precisely for that purpose. Contrary to what I expected, the EFSF has managed to find a way to offer loans with relatively low interest rates. The quid pro quo is a significant lower overall lending ceiling than what the official €440bn ($602bn) headline figure suggests. But even then, it is large enough to handle any conceivable Irish and Portuguese crisis. The EFSF is not large enough to handle any problems that might arise in Spain. In that sense, it is not an umbrella for the eurozone, but only for two of its smallest and most peripheral members.

Considering what is at stake, both for Ireland and the eurozone at large, it is absurd for Dublin to play hard to get. It is equally absurd for others to make an EFSF loan contingent on issues of tax policy. Last week negotiators from the European Union, the European Central Bank and the International Monetary Fund descended on Dublin for talks that will be difficult. Even as it indicated it would seek a deal on Sunday, the Irish government remained keen to avoid a humiliation. There are also political considerations by those who are guaranteeing the loans. The German parliament, for example, cannot be taken for granted. Also, we should be prepared for elements of structured finance, whose purpose, as ever, will be to obfuscate. Patrick Honohan, the governor of the Irish central bank, already hinted that a contingent standby facility might be all that was needed. Does “standby” not sound so much better than “bail-out”? As long as it stabilises the situation, we should not care.

I expect that the eurozone will get over this particular short-term funding crisis. The mechanisms to solve it are in place. But I am concerned about two medium-term developments, for which they are not prepared – not even close. The first is solvency. The EFSF can provide liquidity for Irish banks, but it cannot make them solvent. Ireland’s gross external debt stood at $2,131bn at the end of the second quarter, roughly 1,000 per cent of gross domestic product. As of the end of 2009, the net external debt position was 75.1 per cent of GDP, according to the economist Ricardo Cabral; better than Portugal’s, but still high.

To maintain solvency, Ireland and the other peripheral eurozone countries require a return to solid growth very soon. Kevin O’Rourke, professor of economics at Trinity College Dublin, raised an important point of principle last week. If you believe structural reforms are the key for higher growth then surely you cannot apply this argument to Ireland, a textbook example of a country that has implemented reforms. At a time of extreme fiscal tightening, moderate monetary tightening and weak global demand, I fail to see where Ireland will grow. Does Dublin really think foreign corporations would be lured by low corporate tax rates, and choose this moment to invest, given the current uncertainties? And can Ireland really produce a devaluation of sufficient size with sufficient speed to create an export boom at a time like this?

My second concern is the return of large intra-eurozone imbalances. The Organisation for Economic Co-operation and Development last week forecast Germany’s current account surplus would be heading back towards 7 per cent of GDP by 2012 – close to the pre-crisis record. We are planting the seeds for the next crisis, for which the EU has no institution, no facility and no task force.

munchau@eurointelligence.com

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