How to Survive on the Titanic: Ireland’s Relationship with Europe
Megan is Head of European Economics at Roubini Global Economics and previously worked as a senior economist with the Economist Intelligence Unit.
The prospects for the Eurozone do not look good. A number of weaker Eurozone countries – Greece, Ireland and Portugal – are being kept on life support by bailout packages with terms and conditionality that may well end up killing the patients. Italy and Spain are increasingly looking insolvent and will probably be forced to seek bailouts as well. Without growth in the region, a negative feedback loop of austerity and recession has already begun. In order to regain competitiveness and return to growth, a number of Eurozone countries are likely to opt to abandon the common currency. However, against this very grim backdrop Ireland has been held up by EU leaders as a bright light. The small, open economy has been a model student in terms of complying with the terms of its bailout agreement and hitting all of its targets. The EU, European Central Bank (ECB) and International Monetary Fund (IMF) (the so-called troika) see Ireland’s performance as a vindication of their response to the crisis, with competitiveness gains and economic growth reported in the first half of 2011.
But any good news in Ireland must be set against the enormous costs the country has had to bear. It experienced a depression in 2008–2010, the state has been saddled with the private debt of the banking sector, the public has seen five austerity budgets and counting, and unemployment has remained stubbornly high. For these reasons, since the beginning of the Eurozone crisis in 2008 the public, and more recently members of the Irish political elite, have increasingly questioned whether the benefits of Eurozone membership still outweigh the costs. This question will only increase in relevance if, as is likely, other countries drop out of the common currency in an effort to regain competitiveness. Ireland’s calculus in determining whether to stay in the Eurozone or exit is unique because of its reliance for economic growth on the output of multinational corporations (MNCs), many of which use Ireland as a springboard into the single market. To leave the Eurozone would be to risk deterring these MNCs by undermining Ireland’s position within Europe. It is in Ireland’s best interest to remain in the Eurozone in order to protect the country’s relationship with the EU and, therefore, its growth model.
Prospects for the Eurozone Are Grim
Before considering the prospects for Ireland’s relationship with Europe, it is necessary first to canvass the likely future of the Eurozone and EU. By the end of 2011, the region’s crisis had shown no signs of stabilising and had spread beyond weaker Portugal, Italy, Ireland, Greece and Spain (the PIIGS) and well into the core. Not only were Italian and Spanish bond yields shooting up to clearly unsustainable levels, but Belgian, Austrian and French bond yields had risen sharply as well. Meanwhile the prospect of weaker countries leaving the Eurozone was becoming increasingly likely.
Response a Bust
The crisis response by EU leaders so far has been lacklustre at best. The main component of the response for weaker countries facing unsustainable borrowing costs in the markets has been a bailout package from the EU and IMF accompanied by strict conditionality. The conditionality is meant to ensure measures are implemented to achieve two things: to boost the countries’ competitiveness and to rein in their fiscal dynamics. However, if we use these two objectives as our metrics for success, this plan has been a clear bust everywhere in the periphery except arguably in Ireland. Using unit labour costs as an indication of competitiveness, Greece and Portugal have seen their unit labour costs fall only very mildly, while Ireland has had its unit labour costs fall more sharply. Using budget deficits as an indicator of fiscal developments, Greece’s primary deficit (the government deficit excluding debt servicing costs) actually increased in 2011 compared with 2010. Portugal reduced its 2011 budget deficit by implementing a number of one-off measures but this will not work in the future, particularly as Portugal’s gross domestic product contracts. According to the troika’s quarterly assessment, Ireland was ahead of the budget deficit reduction targets in 2011 as stipulated by the bailout programme.
In the case of Greece, EU leaders went beyond providing a bailout programme with strict conditionality, allowing Greece to negotiate a voluntary debt exchange with its creditors, dubbed private sector involvement (PSI). According to the terms of this exchange, banks holding Greek government debt would agree to accept longer-dated bonds, effectively writing down their holdings by at least half. But the effectiveness of this strategy is questionable. While PSI helps to address a country’s debt stock problem, it does not address the flows of debt that a country like Greece will continue to accrue in the absence of structural reforms and economic growth.
Greece as a Model
EU leaders have gone out of their way to insist that Greece is a unique case. However, it seems much more likely that Greece will become a model for how to handle weaker countries in the Eurozone. At the time of writing (early 2012), Greece faces a stark choice in terms of how to return to growth. The country can either continue along its current path, implementing harsh austerity measures and savagely cutting wages and prices in an attempt to undergo an internal devaluation and regain competitiveness. This would involve tolerating up to a decade of recession or depression. Alternatively, Greece could abandon the Euro, reissue the drachma and see it devalue massively. The result would be a much faster boost in competitiveness and return to growth.
Leaving the Eurozone would certainly be painful and messy for Greece. However, some of the deterrents against leaving, such as the prospect of sovereign and bank default, seem increasingly likely even within the Eurozone, which impacts the cost–benefit analysis of Eurozone membership. Furthermore, it would be in everyone’s best interests – the core countries, the peripheral countries, the ECB, the IMF and Greece – for a Greek Eurozone exit to be as managed and negotiated as possible. It therefore seems likely that it will be handled much like a divorce. Greece and the EU would decide that they simply do not belong together, and the EU would offer bridge financing and take efforts to protect its own banking system as it facilitates Greece’s exit from the common currency.
Any managed exit by Greece wouldn’t take place in a vacuum. Once Greece exits, Portugal would likely face the same choice about competitiveness and growth. It too would choose to exit the Eurozone. Ireland would face the same decision, and while it may choose to follow suit it would be misguided to do so. This rippling wave of potential exits from the Eurozone would not stop with the three countries currently in receipt of bailout funding. Ongoing efforts to provide a backstop for the huge financing needs of Italy and Spain look insufficient to do anything more than buy some time. Eventually, these two countries will also face the same question as Greece: they can either return to growth via a decade of austerity and recession/depression or they can choose to leave the Eurozone in as managed a fashion as possible.
Changing the Rules of the Game
A break-up of the Eurozone as outlined above is very likely, but it is not inevitable. If a number of conditions are met, the common currency can stick together. First and foremost, the Eurozone must return to growth. For this to happen, the ECB must provide massive amounts of quantitative and credit easing. Second, the ECB must talk down the Euro aggressively so that it is at parity with the US dollar. However, given that the Eurozone is one of China and the US’s biggest export markets, it is questionable whether China or the US would tolerate such a weak Euro. Third, core countries would need to provide fiscal stimulus measures to trickle into the periphery. The chances of all three of these measures occurring simultaneously are extremely low.
Beyond these measures to stimulate growth in the Eurozone, EU leaders would need to fundamentally change the structure of the Eurozone so that it includes either fiscal transfers or joint assets and liabilities (in the form of Eurobonds). In late 2011, EU leaders (except for UK Prime Minister David Cameron) agreed in theory to treaty changes (dubbed the ‘fiscal compact’) that were touted as the first step towards fiscal union. At the heart of these changes is more fiscal discipline, with more automatic sanctions imposed on countries that miss fiscal targets. These are not steps towards fiscal union. Rather, the treaty changes proposed institutionalise the asymmetric adjustment occurring in the Eurozone, whereby the peripheral countries are forced to make all of the adjustment while the core countries do not adjust at all. Not only is this a surefire recipe for recession in the peripheral countries, but it also indicates how far EU leaders are from accepting fiscal transfers or Eurobonds.
Eurozone Break-Up the Death Knell for the EU?
According to the Treaty on European Union, a country cannot exit the Eurozone without also exiting the EU. But this is a legal technicality, not a practical, moral or ideological necessity. Legal impediments can easily be overcome by agreeing and writing new rules. The EU existed without a common currency before the introduction of the Euro. Those countries that are currently in the EU but do not use the Euro benefit significantly from the single market. It is in all EU member states’ best interests to keep the common market together, and consequently it seems likely new legislation to allow for this will be agreed.
Ireland’s EU Relationship: It’s Complicated
The Irish public has been increasingly ambivalent about EU membership for more than a decade. Previously, sentiment towards the EU was overwhelmingly positive, reflecting a wide range of benefits that were associated with membership. There were direct economic gains, both in terms of structural funds received from the EU as well as, crucially, the massive expansion of the market into which companies based in Ireland could sell. More generally, EU membership contributed to a national feel-good factor. It was seen as a way of emerging from the UK’s shadow to act on an equal footing with Europe’s major powers in the numerous EU policy areas requiring unanimous decisions.
However, Ireland is deeply protective of its sovereignty and anti-European sentiment emerged and hardened in response to EU treaty revisions that were perceived by many to encroach too far on Ireland’s right to make decisions for itself. This was highlighted in 2001 and 2008 when Ireland rejected the Nice and Lisbon treaties, respectively. Both treaties were subsequently approved at the second time of asking, but for critics of the EU these second votes were simply further evidence that Brussels was contemptuous of democracy at the national level.
Anger directed at the EU has intensified and widened since the eruption of the Eurozone crisis, largely in response to key terms of Ireland’s EU/IMF bailout, such as the ECB’s insistence that senior bondholders in Ireland’s zombie banks be made whole (repaid in full) by the taxpayer. There is now a clear dichotomy in Irish society and politics between those who argue that Ireland’s national interest lies in unilaterally breaking with the terms of the bailout, and those who argue that Ireland’s core interests lie in being anchored within European political and economic structures, even if the price is compliance with bailout rules that are perceived to be unjust.
The European question is an increasingly important driver of the country’s domestic politics. While the current coalition government of Fine Gael and Labour has not rocked the boat with Europe since taking office, on the campaign trail both parties sought to woo voters by adopting a more confrontational stance than usual. Moreover, the government’s relative meekness in office (the Minister for Finance, Michael Noonan, has repeatedly called for debt relief from the troika only to back down immediately when rebuffed) has seen it lose support to the populist left-wing nationalism of Sinn Féin, previously a fringe party with its roots in the Northern Ireland conflict, but now the second most popular party in Ireland according to one opinion poll in late 2011.
In order to lessen the attraction of Sinn Féin’s message of easy unilateralism, the government has sought to up the stakes by highlighting the risk that Ireland might end up outside the Eurozone. After EU leaders agreed in principle the terms of their ‘fiscal compact’ in late 2011, Minister Noonan announced that any Irish referendum on the changes would amount to a vote on whether the country would remain in the Eurozone.
Ireland’s Growth Model Tied to the EU
If even the finance minister is openly acknowledging the possibility of Ireland leaving the Eurozone, is that the best course of action for the country? The answer is no for two main reasons: an Irish exit is more likely than others to be disorderly and the risk to Ireland’s growth model from exiting is likely to be even greater than for other countries.
The longer Ireland continues to comply with its bailout agreement, the greater its debt burden becomes. If the Eurozone is going to fall apart anyhow, some would argue the Irish government should stop saddling itself with ever higher debts from making bondholders of zombie banks whole or repaying the promissory notes that were used to pour cash into those banks as the crisis was unfolding. This argument holds even more weight if Greece and Portugal default on their sovereign debt and choose to exit the Eurozone. If other countries are not repaying their bondholders, why should Ireland?
The answer to this depends in part on how the exit process is handled. I have argued that Greece and Portugal will agree with the troika that they are not meant to be in the common currency, and their exit will be managed and orderly. However, it is doubtful that the troika will agree Ireland should follow suit and leave the Eurozone. Ireland stands apart from the other bailout countries in that it has not only hit all of its bailout targets, but it shown some signs of a return to growth as well (albeit followed by further contraction). The EU has gone out of its way to praise Ireland for being a model student, complying with all the bailout rules and vindicating the troika in its insistence that austerity is the best path towards competitiveness and growth. It is unlikely the troika will turn around and accept that its plan for handling the crisis is misguided and that Ireland could potentially be insolvent.
It seems more likely therefore that an Irish exit from the common currency would have to be unilateral, without any transitional support from the troika. This would be messy and painful for any country. Eurozone exit would result in immediate sovereign and bank default, and bank runs would necessitate capital controls. Ireland would be frozen out of the markets at a time when it is running a primary deficit and needs immediate and ongoing funding for the government to continue offering regular services.
Because of the structure of Ireland’s economy, a unilateral Eurozone exit would be particularly disastrous. Ireland’s economy during the boom period in the 1990s and especially since the collapse of the property market in 2007–2008 has been heavily reliant on exports as a driver of growth. Ireland’s export sector is comprised primarily of multinational corporations (MNCs) that have established their European headquarters in Ireland. The most successful industries, which were relatively resilient even during the depression Ireland experienced in 2008–2010, are the computer services and the pharmachemical goods industries. MNCs are attracted to Ireland for a number of reasons: Ireland boasts a highly educated, English-speaking workforce; the corporate tax rate is only 12.5 per cent and Ireland can offer MNCs rock-solid access to the greater EU market.
This last factor is absolutely key. If Ireland were to unilaterally defy the terms of the EU/IMF bailout agreement and walk away from Eurozone membership it would inevitably raise questions in the minds of MNCs as to Ireland’s long-term position in a changing European order. Ireland would risk appearing to be a semi-detached member of a club in turmoil. This is not the ideal foundation on which to build a pitch selling the country as an ideal place to set up shop. Moreover, a unilateral Irish exit would lead to tensions with and resentment from other EU member states, which could manifest itself in a number of ways, including increased pressure to force up Ireland’s low rate of corporation tax.
The cost of repaying bank bondholders and official sector loans while undergoing harsh austerity is extremely high. But the cost of unilaterally deciding to exit the Eurozone would undoubtedly be even higher. Ireland would be frozen out of the markets with a primary deficit and without a prayer of getting continued funding from the other EU member states it had just burned. Against this backdrop, the country would then have to develop a new growth model that is less reliant on MNCs for growth. The Irish government would hardly be in a position to provide support for domestic demand, nor would banks be able to offer financing to small, indigenous companies that might fill any vacuum left by MNCs.
Stay the Course
The prospects for the Eurozone staying together are very grim, but this does not necessarily bode poorly for Ireland. Much more important for Ireland than its relationship with the Eurozone is the country’s integration in the wider EU market. The repayment of bank and official loans and continued austerity will weigh on Irish public finances and economic growth for years to come. This is indeed a heavy burden that might have been avoided – the Irish government had a number of chances to force a change in the terms of its bailout agreement. Having accepted the bailout terms thus far, however, it is in the country’s best interest to continue to comply with the rules set out by the troika. Claims that Ireland’s national interest lies in unilaterally leaving the Eurozone are woefully misguided. It is in Ireland’s best interest to stay the course and continue to protect its relationship with the EU by maintaining its relationship with the Eurozone.