May 13, 2001

Heresy to question our stake in EMU

Posted in Celtic Tiger ·
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Over time our membership of EMU will lead to less stability, security and more variations in inflation

‘We are in the euro area for the long haul because we realise that they can offer us a kind of security and stability and a low inflation environment that, for us in the long run, is a very good package. You must take the rough with the smooth.’

Central Bank Governor, Maurice O’Connell, May 2001

In the week the Nice Treaty spin machine cranked up a gear, our Central Bank governor explained that although our interest rates are far too low, our commitment to EMU (the reason interest rates are too low) is totally rational. His comments were made before Thursday’s reduction in interest rates that drove the cost of borrowing to an even lower and, presumably in the governor’s mind, even more inappropriate level. Perplexed already? That’s only the start.

The interview with the governor makes interesting reading not because of the type of intellectual inconsistency that is sometimes required to rationalise the reasons why Ireland is in EMU, but more for what it reveals about confused thinking at the highest official level in this state.

The governor asserts that “you have to take the rough with the smooth”. Why should you? We don’t run our lives on such arbitrary whims, so why should we run our economy like that?

Most of us don’t wake up every morning resigned to the fact that some supernatural fate will determine the course of the day. In fact, we actively try to avoid getting into situations where uncontrollable destiny plays a role. Since Adam, man has tried to understand risk, quantify riskiness and act accordingly. Controlling risk allows us to put the future at the service of the present, and has been one of the main driving forces of human creativity, enquiry and wealth creation. Yet here we have the governor of the Central Bank apparently flipping a coin.

Imagine if the fund manager who is managing your new special savings scheme told you that although his investments at the moment didn’t make sense even to him, you need not worry because in the long run everything would be grand and “you had to take the rough with the smooth”. Would you give him your money?

Similarly, when the guardian of our financial system — the governor of the Central Bank — takes a quasi-religious approach to the economy believing in fate, spirits and destiny rather than risk management, policy choices and hard finance, it is time to get heretical.

Heresy is just what questioning Ireland’s future in Europe has become. The apparent religious attachment to all things European by almost all political parties is quite shocking.

Looking back, there can be little doubt that the EU has been good for Ireland economically, politically, socially, legislatively and culturally. And for the more high-minded, visionary and federalist of continental European politicians, Ireland has also played a positive role in the European project.

However, acknowledging the symbiotic nature of a past relationship should not prevent us from questioning whether the future will be so rosy.

Looking back at the quotation, we see he contends that EMU will give us security. Presumably he means economic security. This is a bizarre thing to say. If he means that our wealth will be protected by the single currency, there appears to be little evidence of this. If a single currency alone protected and fostered wealth creation, then there would be no poor mezzogiorno in Italy, no north/south divide in Britain, and Andalusia would not be considerably poorer than the Basque country. There are clearly other forces at work.

Over the past 15 years, Ireland’s economic cycle has become increasingly correlated with the Anglo-American business cycle, rather than that of continental Europe. Given the dominance of the Anglo-American world in our trade, investment and demographic flows, it seems hard to sustain the governor’s view about security.

A second problem is not just that we have dominant links with the Anglo-American world, but also that our economy works like theirs, rather than the continentals’. Take the effect of interest rates. The impact of a cut in interest rates typically relies on how much debt there is out there, whether it is at fixed or variable rates and whether those rates are short or long term. Strong home ownership and house price inflation further amplify the impact of interest rate movements.

In continental Europe, people borrow at long-term fixed rates, house prices generally do not move rapidly in response to falls in interest rates, largely because home ownership is not nearly as widespread and the idea of paying out 40 per cent of your post-tax income on a mortgage is laughable. Therefore, short-term interest rate changes which are heralded as ‘good news for homeowners’ in Ireland hardly register on the continent, where they take a long time to work into the economy, and any delayed impetus usually comes from the corporate sector.

It is easy to see why a fall in interest rates has a magnified effect in Anglo-American economies, and when rates are rising there is a significant depressing effect. Europe does not work like this. Given this dichotomy, it is hard to uphold the governor’s (and the rest of the political elite’s) second assertion that EMU will add to stability. This is nonsense.

First he seems to accept that on interest rates, Europe offers the wrong policy for Ireland at the moment. Either he believes that the ‘wrong’ policies bring stability which by definition makes them ‘right’, or he is happy to punt long and suggest that although it is not apparent to us mortals now, in the long run he knows what he is doing. (More evidence of religious hocus-pocus over substance?) Unfortunately for us, the numbers suggest that EMU will lead to more instability, not less. As long as our economic cycle is wedded to that of the US, EMU will mean that our interest rates will be low when they should be high and high when they should be low. Unless, of course, the governor looks forward to a time when there will be no cyclical disparity between the EU and the US, which is hard to see without a massive drop in the dollar. Incidentally, such a drop in the dollar was (somewhere else in his interview) one of the most serious threats to our economy. Woolly thinking or fuzzy math? Take your pick.

Finally, the governor asserts that EMU will keep inflation low in this country. This is daft. Irish inflation is determined by the exchange rate, and movements in the euro exchange rate versus sterling and the dollar. The exchange rate itself is determined by the extent of growth in the Anglo-American economy vis-a-vis Euroland.

If the US is booming the dollar will rise against the euro. This will make our economy grow faster, because we export to the US, and when times are good at home, US companies invest more abroad. However, the falling euro will also increase prices in an already growing economy. In contrast, if the US is stagnating, we suffer even more than most and with the dollar falling and Euro rising, we will suffer more deflation to exacerbate things.

It is more accurate to forecast that EMU will make Ireland susceptible to bouts of inflation followed by deflation, rather than a sustained period of price stability.

In direct contrast to the governor’s assessment, it is much more likely that over time our membership of EMU will lead to less stability, security and more variations in inflation. Granted, we have a policy problem. A quick glance at Hague and his bunch of ‘save the pound’ weirdos in Britain tells us how not to play this one. However, let’s not try to spin flannel to the population about the merits of our present policy when a good Leaving Cert economics student could blow the government’s arguments out of the water.

Honesty would be a much better policy. We are about to have a referendum on Europe, and what was that Lincoln said about fooling all of the people all of the time?