Euro zone: Sticking with the euro
Anthony Foley, senior lecturer in economics, DCU Business School does a cost-benefit analysis of leaving the euro and decides ‘Non’.
One of the policy options available to Ireland is to break with the euro. It is possible that we might be asked to leave the euro as part of some grand design to preserve it as a currency for other euro zone members but in the context of this article we are assuming that it would be our own independent (and unwelcome to euro members) decision to leave. Is it in our best interests to leave? We need to decide on the new currency arrangement. There are negatives associated with the available alternatives. Up to 1979 we had a fixed one-to-one link with sterling. Before the introduction of the euro in January 1999 our punt was linked to other European currencies with occasional realignments. The abilities to print one’s own currency and to change its value against other currencies are substantial economic policy instruments. The economic impact of Ireland’s exit from the euro depends on the terms of the exit, the nature of the new foreign exchange rate arrangement (would we rejoin sterling, would we float, would we follow the euro with a lower valuation?) and the reasons for the exit, eg to boost exports or to facilitate a default.
Previous case for exchange rate arrangements
From its establishment, the State was committed to a fixed parity exchange rate with the pound sterling. This reduced the competitiveness of exports and unusually for a country moving from protection to export-led polices in the in the late 1950s, we retained parity. In the 1970s we discussed breaking with sterling because the fixed exchange rate tied us to the “weak” economy of Europe and imported the high UK inflation rate. It was also believed that our future export growth would be towards mainland EU economies. Consequently we aligned the currency with some of these economies in a European Exchange Rate Mechanism. The new exchange rate with sterling was a depreciation relative to parity. On 29/3/79 the punt/sterling exchange rate was parity for the last time. On 26/7/79 it dropped below 0.90 sterling and on 5/11/80 it dropped below 0.80 sterling. In January 1993 the Irish punt was devalued by 10% within the exchange rate mechanism with then minister for finance, Bertie Ahern complaining that the German authorities had failed to give adequate support to the punt . . . shades of current opinions? The euro was established in January 1999 as an accounting currency although the punt had been relatively fixed to the European currencies for many years before that except for the occasional realignments. Ireland’s exchange rate policy has been relatively inactive.
It is a little ironic that we broke the sterling link to avoid being hitched to the “weak” economy in Europe and now we are unhappy that the euro links us to the “strong” economy in Europe.
European Central Bank assistance
Let us assume an “unfriendly” departure from the euro in which the European Central Bank (ECB) no longer plays a role in our economy. This would create an immediate and major problem. The ECB currently provides about €100bn in liquidity funding to Irish banks. This is largely to replace an outflow of deposits from the Irish banking system. Were this to finish, Irish banks would face a severe liquidity problem. A new Irish central bank could print money and replace the €100bn but the domestic and international financial markets are likely to put less faith in the value of local currency funding. This would lead to a loss of confidence in the banks with additional removal of deposits and questions about viability. Of course, if the ECB agreed to continue its financing, this problem would not arise.
The ECB has also provided Nama with low interest loans to purchase impaired bank loans. Would it continue this generous approach if we left the euro?
The ECB has also been buying Irish government bonds to support their price. If we were active in the financial markets, ECB buying of government securities would help to lower the interest rate.
Exchange value of the new Irish currency
It is reasonable to expect that the new Irish currency would be of lower value relative to the euro than the current implicit “one Irish euro equals one German euro”. The Government could attempt to set a particular rate but ultimately the market would decide. We will name the new Irish currency the “punt nua”. An above parity value would hurt export performance and worsen economic activity and would not be sustainable. There would be a substantial exchange rate risk attached to the punt nua. Allied with concerns about default and sovereign debt the value of the punt nua would drop well below parity.
Impact of devalued ‘punt nua’
We examine the possible impact of a devalued punt nua. There would be also a devaluation/depreciation against other currencies. The direction of impact of a devaluation is quite certain but the quantitative impact is less definite. Irish exporters could lower their price in foreign markets while still obtaining the same amount of punt nuas to cover domestic costs because the foreign exchange is worth more punt nuas or they could leave the price unchanged in foreign markets and take the increased number of punt nuas to enhance profits or reduce losses. Lower prices would increase the volume of Irish exports, increase GDP and increase employment. The quantitative effect will depend on the price elasticity of demand. This refers to the proportionate increase in export volume that can be expected from the proportionate price reduction
Import prices will increase and will reduce import demand and also allow some of the imports to be replaced by domestic producers. The impact will depend on the price elasticity of demand for imports. Energy imports would be fairly resistant to price increases and their quantity would be reduced by a small proportion. Other products such as consumer goods and printing, for example, would be more responsive to improved Irish cost competitiveness. On balance, we should expect the lower value of the punt nua to improve domestic production and improve the profit/loss situation of exporters. These are the positives. The negative is the higher prices of imports and their impact on living standards, costs of production and domestic inflation.
Tourism should be a substantial beneficiary from a devalued punt nua. Tourism tends to be price sensitive and cost competitiveness matters greatly. A devalued punt nua would make Ireland more attractive to tourists from those countries whose currencies have increased in value against the punt nua.
Unfortunately, there are also monetary effects which are mainly negative. At the moment there is no exchange rate risk in lending to Ireland. When doubts about our solvency are gone and we resume participation in financial markets the independent, standalone Irish currency would carry a risk. Consequently there would be an exchange risk premium on lending to Ireland which would increase interest rates. This will apply to bank and commercial borrowing from abroad as well as to sovereign borrowing. The economy has substantial foreign borrowing which is denominated in euros and other foreign currencies. Repayment of this debt and the payment of interest will be in foreign currencies. Therefore more domestic currency units will be needed to fund a given foreign payment due to the lower value of the new currency.
The monetary impact will depend on the expectations for the new currency. If the new currency was expected to continually appreciate there would be economic benefits. However, if as is likely, the currency would be expected to depreciate to have regular devaluations depending on the exchange rate regime, the monetary effects would be negative.
The changeover mechanism
A changeover to a new currency would have operational costs as did the original changeover. The original changeover went very smoothly and we could expect the same with a new changeover in terms of the operational issues. The original changeover converted all punt accounts, prices and values to euro at the rate of one punt being equivalent to €1.27. The new changeover would involve two adjustments. The domestic euro values would be converted to punt nuas and the punt nua would have a specific value against the euro and other currencies. If a break with the euro was expected, it is likely that there would be a capital flight until the new currency and its domestic and exchange values were established.
Costs and benefits of joining the euro
The economic arguments in favour of joining the euro in 1999 included the elimination of costs of obtaining foreign exchange, the removal of exchange rate uncertainty which would encourage international trade, the likelihood of lower interest rates, the expected focus on mainland EU for export development, price transparency which would help consumers and competition, participation in what would be a strong reserve currency, low inflation arising from a strong European central bank, avoidance of competitive devaluations/depreciations and reduced costs of holding foreign exchange reserves. These are substantial benefits, especially for an exporting economy such as Ireland.
There were also substantial arguments against joining the euro including the loss of the significant policy instruments of exchange rate adjustment and interest rate determination, the different phasing of the Irish and European business cycles, the likelihood that policy actions will be determined for the large European economies and will be inappropriate for Ireland, the substantial trade and other economic links with the USA and the UK which would be outside the euro area and the possibility of inflation control dominating macro policy to the exclusion of other objectives. In 2003, the UK and North America absorbed 40% of Irish merchandise exports compared to 43% for the rest of the EU (including some non-EU members). In 2009 the shares were UK/NA 38% and rest of EU 45%. 27%. 27% of service exports went to the UK/NA in 2009 compared to 37% to euro area countries. On these export figures, the euro area economies are a bigger market than UK/North America. However, the euro exports are mainly from multi-nationals and the UK is a particularly important market for indigenous exporters.
Default and exchange rate adjustments
Breaking the link with the euro would free the economy from the ECB policy requirements to avoid default. If this is the aim, it must be considered in light of the possible loss of ECB support. In several respects, the use of the exchange rate as a policy instrument represents the failure of domestic policy. A devaluation to restore cost competitiveness is only necessary because domestic costs have been allowed to increase more than in the trading partners. Devaluation might more easily be used to lower incomes in a less than transparent way that direct incomes policies. Default should be considered on its own merits.
Exiting the euro and getting a devalued currency relative to our trading partners is an attractive option to boost exports and to a greater extent, tourism. However, the negatives that could arise such as threats to ECB support, likelihood of increased interest rates, exchange rate and general uncertainty, increased costs of trade, the possibility of capital outflows, and the very large role of euro economies in merchandise and services trade suggest, to me, that, it is best to stay with the euro.