Who is to blame for the Irish crisis? The question goes to the heart of Ireland's current situation and offers guidance to policymakers in Britain who wish to avoid a similar fate. David Howden argues that the blame lies both with the European Central Bank, which created perverse incentives for investment through low interest rates, and with the Irish investors who reacted to those incentives.
Ireland has secured €85bn in emergency funding for the time being. This loan will enable it to keep playing a dangerous game for a while longer. While the bailout may appear to be a positive development to some, the strings that its creditors will no doubt increasingly attach to it will hamper Ireland’s independence moving forward.
The more pressing question that we may ask is whether accepting the money was the best action to deliver Ireland to a prosperous future. If Ireland’s ailment was indeed a lack of liquidity, a short-term loan may indeed be just what the doctor ordered. Unfortunately, today’s crisis is anything but one of liquidity. What plagues Ireland, and the rest of Europe’s periphery, is not a lack of liquidity but a more damaging lack of solvency. Short-term loans will provide little relief from this long-term problem.
What is needed instead of an analysis of the current problems is adeeper reflection of the true nature of the problem at hand. Philipp Bagus’ new book “The Tragedy of the Euro” provides just what the doctor ordered.
Bagus provides the story and reasons for the formation of the common currency. Through auspicious beginnings, the creation of the European Monetary Union has wrought severe consequences far beyond what its founders imagined. While these consequences are now fully apparent, only an understanding of their source will allow us to avoid the mistakes of our past.
Today we should focus on two aspects that Bagus’ book makes clear.
The first is the common interest rate policy that the ECB enacts in Frankfurt. While one nominal interest rate swept over the whole of the Eurozone, divergent inflation rates created wildly different real borrowing rates. Ireland, as well as its Southern European neighbors, is at the heart of the high-inflation periphery of the Eurozone. Indeed, as inflation raged in this periphery compared to the relatively stable European core countries, Irish residents were exposed to lower real interest rates than most had ever seen in their lifetimes.
The result was an artificially induced boom in interest rate sensitive investments. The effects on the housing market – from Dublin to Donegal – are more than apparent today. The culprit was not some sort of irrational optimism sweeping the island of Ireland; this was a classic case of an Austrian business cycle – a credit induced boom causing an unsustainable change in investment and consumption patterns (see here, here and here). This time it is at the hands of the ECB.
To preempt a rebuttal, and to paraphrase American economist Tyler Cowen (no relation to Brian Cowen, to my knowledge at least), it was still Irish investors who made these bad investments. Regardless of who made the interest rates as low as they were, it was still the hands of Irish citizens that spent the money – wisely or not.
Cowen uses an example of the government subsidizing the cost of bananas to illustrate his point. If bananas are artificially cheap and you purchase piles of them and pile them on the roof of your house and your roof collapses under the crushing weight, who is to blame? While it is no doubt obvious that the blame can only lie at the hands of the person who bought the bananas, we may do well to ask what happened to the incentive structure that normally stops a person from crushing his roof with excess bananas.
Irish investors are not without blame in the current crisis. A surplus of cheap credit was made available to them. This could have been used wisely or unwisely. It just turns out that most of it was used in nonproductive manners. Mea culpa, the Irish can plead.
That being as it may, what is done is done. Ireland’s roof has collapsed and it must now search for a way to stop it from happening again. As long as the Irish inhabit Ireland we will probably not see an end to using cheap credit when it is made available. Given the similar reactions all over the world to the global liquidity gusher that occurred at the hands of the world’s central banks over the last decade, I do not think that any other nationality could evade such a consequence either.
That leaves us with removing the other cause – the ECB. Removing the common interest rate policy from the European Union would remove the incentive structure that resulted in such crises in the Eurozone’s periphery. An Irish exit from the Eurozone would undoubtedly cause some short-term pains – an adjustment to the Irish pound would entail a massive recalculation by Irish entrepreneurs. It would however remove the imbalances and skewed incentives that fostered such an artificial boom to develop in the first place. By saying slán to the euro, the Irish will be setting in place a strong foundation to rebuild their house upon.
Understanding how the European Central Bank was formed, operates and is influenced politically is instrumental to understanding the current malaise that engulfs Ireland. No Irish person should feel qualified to comment on the current crisis that inflicts their homeland without understanding the root issues at stake. Philipp Bagus’ “The Tragedy of the Euro”, is the single best resource that one can read to understand the causes, consequences and cure for the recession plaguing the European continent today.