Working Paper Series, UCD Centre for Economic Research 12/02
A popular narrative amongst European policymakers is that Eurozone members facing problems in the bond market are paying the price for past budgetary excess. Fiscal consolidation in these countries is seen as the principal remedy for the crisis. It is clear however that Ireland's problems derive mainly from a banking bust exacerbated by weaknesses in the design of Europe's monetary union and the policy response of both the Irish authorities and the European Central Bank. From the Euro's inception in 1999 up to 2007, both debt and deficit ratios in Ireland were comfortably within the Stability and Growth Pact ceilings. The gross debt ratio was only 25% of GDP at the end of 2007. The Stability and Growth Pact was the only macroprudential measure in place at Eurozone level, and Irish adherence reflected public finances flattered by a credit-fuelled property bubble. The banks experienced intense liquidity pressures in September 2008 and the Irish government provided a blanket liability guarantee. The banks were in reality badly insolvent, the bank guarantee has cost 40% of GDP and Ireland was forced from the bond market and into an EU/IMF programme just over two years later. There can be no presumption that it will emerge, and re-enter the bond market, on schedule at the end of 2013. This paper argues that the incomplete design of the currency union, with free capital movement and trans-border banking, but no centralised banking policy, contributed to the Irish debacle. The absence of bank resolution and any centralised system of liability insurance threw the burden of bank rescue on sovereigns. Countries in currency union are vulnerable to sovereign default, since they must borrow in what is, in effect, a foreign currency. Resort to official lenders enjoying seniority, combined with ECB insistence on sovereign repayment of bank senior bondholders, even in banks insolvent many times over, has undermined confidence in Irish sovereign debt. Closer fiscal union may prove necessary if the Eurozone is to survive. To avoid future sovereign debt crises, there is also a need for centralised bank supervision and resolution, as well as for a centralised system of liability insurance for banks. What happened in Ireland shows that sticking to purely fiscal rules is no guarantee of solvency for the sovereign in a currency union with inadequate mechanisms for the prevention and resolution of banking crises.