October 26, 2009
In his first public speech since being made governor of the Central Bank, Patrick Honahan – one of the finest economists we have ever produced – sounded almost apologetic about our overvalued currency. He made the point that if we still had the Irish punt, our exchange rate with sterling would be 1.18 and getting stronger by the day.
The overvalued exchange rate is a crucial part of economic policy, but it is never discussed publicly. We trade in a currency that is sky-rocketing against our two main trading partners, Britain and the US. Nowhere in economic literature is there a theory that says a small open economy that is going through a severe recession will get out of it by having an overvalued currency.
In fact, the opposite is the case. We need a hyper-competitive exchange rate. We need an exchange rate that allows companies to export, rather than making it difficult for them. Yet the finest minds in Ireland are doing the opposite.
There’s little point talking about the smart economy and export-led growth if small companies can’t compete because our exchange rate is madly overvalued. This is the elephant in the room, so let’s recognise it.
The governor’s speech went on to say that, in the past, when we had higher unemployment because wages got out of line, pushing the exchange rate way too high, we simply devalued to compensate.
This is something that almost every ‘normal’ economy has done in the past (and is still doing) when there is a competitive problem – whether it was Finland and Sweden in the early 1990s, the Asian tigers in 1997/8 or Britain and America now.
In all cases, devaluations worked. The countries that didn’t devalue when in a crisis, such as Germany and France, have shown a disturbing tolerance of persistently high and enduring unemployment. I believe this tolerance of mass unemployment – to borrow the governor’s term – is a ‘fetish’.
There is an economic choice that countries make. Either you use your exchange rate to become competitive, or you use unemployment to grind down wages, so that you become competitive by putting people out of work who wouldn’t be out of work if you simply changed your exchange rate. In the process, you preside over an internal financial civil war over who is going to make the most sacrifices in order to become competitive again.
Honahan then said that, because of the euro, ‘‘it is crucially important to recognise that the old automatic stabiliser of real wages – depreciation of the exchange rate – has been put out of action (and for good reason)”.
The good reason is his addition. This idea that devaluations are so obviously redundant as to have no place in discourse has become commonplace in Irish economics.
The same logic in 1993 argued that a devaluation of the punt would be a disaster. The entire economic establishment (I know, because I was an economist in the Central Bank at the time) said that devaluation would lead to permanently higher interest rates, higher unemployment, lower growth and higher inflation. This, I assume, is the ‘good reason’ the governor is referring to.
Well, guess what happened after the 1993 devaluation? The economy took off and unemployment fell dramatically.
Exports exploded, interest rates fell precipitously, capital flooded into our country and inflation fell. It is difficult to see the professor’s ‘good reason’, not least because the devaluation worked perfectly.
Everything that economic textbooks said would happen, did happen. It ushered in the golden age.
Honahan refers fondly to the subsequent post-devaluation period from 1993 to 2000 and suggests that he would like to see the economy return to the state it was in 2000. Irish productivity was extremely high and, as he says himself, ‘‘Irish wages were arguably super competitive around 2000’’.
Honahan implies that, after 2000, it all went wrong, which is why he urges us to get back to 2000.Well, guess what was the big event of 2000?We had just joined the euro.
Joining the euro marks the beginning of the economic and financial delinquency that has led us to this horrible mess.
Almost from the off, the currency started to rise dramatically against our main trading partners. On average during 1999, the year we joined the euro, one old Irish punt got you 77 pence sterling. If we still had the punt we’d get Â£1.18 today – that’s an appreciation of 41pence in ten years.
This is a whopping appreciation of 53 per cent. Is it any wonder that our exports to Britain collapsed in the past ten years? Even so, it still remains our biggest trading partner. We have also seen the same appreciation against our other non-euro trading partners.
Just to get an idea of what that means, consider that we export â‚¬85 billion in total, of which less than â‚¬25 billion goes to eurozone countries. So two-thirds of our exports go to countries that our currency has appreciated hugely against, making us uncompetitive. For what gain?
If you have an appreciating currency and it is credible, your interest rates should reflect this. So, are we getting this euro premium? Well, no. British and US interest rates are much lower than ours and, worse still, we are penalised even within the euro.
Last week, the state paid 5.79 per cent for a 15-year bond issuance of â‚¬7 billion. The Germans are paying just above 3 per cent for the same money at the same maturity in the same currency!
Our ten-year bond is yielding 4.9 per cent – which is way over the German rate. What this means is that the market doesn’t believe us. The market believes that something negative is going to happen here in Ireland, which makes us risky. What could that something be?
This brings us back to the banks. The markets believe that Nama will not lead to a recapitalisation of the economy and, therefore, the recession will continue. Their analysis is based on simple incentive structure, which the corporate treasurers of our bust banks are faced with.
With Nama, the banks are getting money from the ECB at 1 percent, yet they can then buy Irish government bonds yielding 5.79 per cent. Why would they bother lending to a SME trying to export when they can get a free almost 5 per cent without ever lending a cent to a risky business? What would you do if you could get a risk-free trade of 5 per cent without even opening your doors?
Yes, you’d take the Nama money and invest it into the Irish bond market, thank you very much. But it isn’t really free money, because someone pays, and that’s us, the taxpayers.
Let’s take a bank treasurer who decides to buy Irish government bonds with the Nama money. If all the banks did this and re-invested the profits, they would invest the â‚¬54 billion and would get â‚¬87 billion.
This is total interest of â‚¬33.2 billion paid directly to the banks to finance the government.
To finance the Nama bonds at 1per cent, they’d have to pay â‚¬5.4 billion, but investing this in the government bond market gives them a clear after-financing profit of nearly â‚¬28 billion. To pay this amount, the 2.1million workers in the country would each have to pay an extra â‚¬1,583 in tax per year.
The banks can make a fortune in transfers from the taxpayer without ever lending to an exporting SME. This is what they will do. Why would you lend to an exporting SME when we are presiding over an exchange rate arrangement which is making it impossible to export?
Last Thursday night, I presented the Entrepreneur of the Year awards. I met dozens of brilliant people who are trying to do something about this recession, trying to employ people and get on with the business of fighting back.
Yet our establishment is betraying them, doing everything in its power to strangle them by sticking to an exchange rate in which no one believes. As unemployment heads for 500,000, you couldn’t make this up.