Explaining the Euro Crisis

Combining candid appraisals and assurances about Ireland’s recovery has been an predominant occupation for all my colleagues serving abroad since 2008.  For Korea, recent Irish experience resonates given their own ‘IMF crisis’ in 1997.  For a Korean audience though, even an informed one, the EU is something of a puzzle – its rationale and its functioning.  Add in an extra-dimension like the Eurozone and it can get very complicated indeed.  This speech attempted a compressed explanation of the European project, its roots in Western European geopolitics and the role of the Euro, with some insights into the impact of the crisis on Ireland; and finally what all this means for Asia.

The Euro Crisis: the EU, Ireland and Asia

 Sogang National University

Korea Society of Contemporary European Studies

 8 June 2012

I am delighted to be here today at Sogang University.  I want to thank my host Professor. Dr. Hae Jo Chung, President of the Korean Society of Contemporary European Studies for the honor of addressing you.  I wish to commend the Society here for the wonderful work they do in promoting awareness of Europe, and its rich academic and cultural life.

The European Union is a vastly ambitious European project.  The project was born of catastrophic conflict that left Europe devastated in1945.  A deep economic and political process of conflict resolution was called for if Europe was to escape from its recurrent pattern of violent and militaristic competition.

EU Origins

The European project emerged from a long and often tragic European history.  The European Community, now the European Union, was designed to deal with the implications of that history.  In dealing with that history, it has three objectives.

One is to specifically to avoid the history of European conflict repeating itself.  The second is to harness Europe to delivery for its people social and economic progress. The third is to act as a beacon of the rest of the world, promoting ideals in human rights, the rule of law, multilateral cooperation and development assistance.

In my remarks today, I wish to focus on Euro as the symbol of this ideal; the problems it has encountered as exemplified in the case of Ireland; and the likely route to recovery for Ireland, the European Union and of course for Asian economic prospects.

The European Project

For those with a view to the long hand of history, arguably the roots of the European project go back to the Treaty of Verdun, in 843 AD.  The three surviving sons of Louis the Pious, himself son of the founder of the European ideal, Charlemagne, divided the last incarnation of the Roman Empire between them. Charles the Bald becomes King of West Francia.  Louis the German becomes King of East Francia.  Lothair, becomes King of Middle Francia, also known as Lotharingia. West Francia become France.  East Francia becomes the Holy Roman Empire and one thousand years later, Germany.  Lotharingia is too disparate to survive and it becomes a plintered zone of local ambitions and conflict, eventually resolving into Holland, Switzerland and Northern Italy, with smaller parts splitting and adhering variously to France and German principalities.  The open planes of Belgium and north eastern France would become, in the classic description, the checkboard of history, including such famous engagements as Waterloo in 1815 and Verdun in 1916.

We have here the roots of the great dialectic between France and Germany that defines modern Western European history once Spanish power declines at the beginning of the modern age.  France centralizes early and becomes the dominant European power in the 18th and early 19th century.  The shock of Napoleon’s success propels Prussia under Count Bismarck to form modern Germany in 1871.  The competition between France and Germany for supremacy in Western Europe, the industrialization of military power, the collapse of the Austro-Hungarian and Ottoman Empires combined to produce the battlefield cataclysm of WWI and later the continental wide devastation of WWII.  Britain played the game to ensure no one great continental power emerged as a global rival, supporting Napoleon’s enemies just as it had Spain’s during its earlier rise, and later allying with France against the Kaiser.

After the catastrophe of WWII, European leaders knew they had to convert that dialectic from competition and war to cooperation and prosperity.  They achieved that by creating the European project, the outcome of which was to be a supra-national entity, part customs union, part common market, part political federation.  Between the Treaty of Rome in 1957 and the Lisbon Treaty of 2009, the EU took shape.  In the intervening decades, the European project brought not only peace but also unprecedented prosperity to its members.

Ireland shared in that success rapidly developing socially and economically.  Irish success was and is being driven by three factors: international Foreign Direct Investment; the attractions of doing business in Ireland; and access to the 500 million strong EU market.  From these ingredients, the Celtic Tiger of the 1990s was born.

Celtic Tiger

By the 1990s, the Irish economy had begun to accelerate, based on high inward investment, competitive exports and one of the top ranked business-friendly environments in the world.  In first half of the 1990s, GDP expanded by 6% per annum on average.  By 1995, it had reached double digits.  Unemployment plummeted from 16 per cent in1994 to 4 per cent in 2000 – essentially full employment for the first time in modern Irish history. Our workforce doubled to 2 million. Involuntary emigration, a fact of life for the previous 150 years, came to an end.  Our economic growth was driven by an educated workforce producing high value exports at competitive costs in a low tax business regime.  These economic fundamentals made the Celtic Tiger roar.

The Impact of the Euro

The Euro currency was created in 1999, the capstone of the European project and the most potent symbol of European unity.  Technically a monetary union, it was in essence a political commitment to the European ideal.  The impact of the Euro on Ireland was immediate and dramatic.  As a proportion of Gross National Product, private credit ballooned: in 1999 it was 110%; by 2004, 145% (€190bn); 2006, 200% (€305bn); 2008, 250% (€400bn).  Irish personal and mortgage debt doubled between 2004 and 2008.

Property Boom

The creation of the Euro facilitated the transfer of credit from within the core of the Euro zone (essentially France and Germany) to its “periphery”.  This was not only the natural outcome of classical economics whereby capital flows to higher marginal rates of return.  It was in a sense a privatization of the EU ideal of regional cohesion, the economic convergence of economic standards through the free movement of goods, capital and people.

The critical issue was whether the movement of capital represented prudent investment rather than a willfully blind and imprudent chase after higher margins of return.  The convenient and unexamined assumption that the Euro was governed by Eurozone joint-and-several liability meant that banks assumed zero risk in regard to their loans either to other banks or to other governments.  This assumption of zero risk would do great damage to the European banking sector.  Combined with financial deregulation, proprietorial and shadow banking, historically low interest rates and shareholder pressure, the Euro generated an unprecedented credit boom and expansion of banking exposure.

The Euro credit boom had a dramatic impact on property prices in Ireland.  They grew seven times faster than the consumer price index: This in a country where population density is one of the lowest in Western Europe and almost ten times less than in Korea.  As one commentator noted, “by 2007, Ireland was building half as many houses as Britain, which has 14 times its population.”  The building boom did not dampen house prices.  In 1994, the average house price was €74,000.  In 2007, it was €323,000.

Using cheap Euros pushed by aggressive lending practices on the part of banks in Ireland, France and Germany, the Irish started to buy Ireland from themselves, as one commentator pithily put it.  Average 2nd hand house price in Dublin went from 4 times to 17 times average industrial wage.  Bank loan books grew from 60% (1997) to 200% of GNP (2008).

Morgan Kelly, one of the few economists to warn of a crash, noted that “Irish banks were lending 40% more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and 75% more to house buyers”.  If up to the year 2000, Irish growth was export-led, thereafter cheap Euros, a flood of liquidity, property price inflation, a credit explosion, and a construction boom drove it.

Crash

We now know that neither financial markets nor the deregulated banking sector efficiently allocate capital resources.  Their purpose rather is to increase margins and profits.  They can be in fact intrinsically corrupt, as revealed by the well-documented use and abuse of collateralised debt obligations.  More to the point, in generating a credit/property boom in the US particularly, they created the inevitable crash in the financial and banking system, with global affects.

Impact on Ireland

The first question in 2008 was whether our banks faced a liquidity crisis or were insolvent.  Initially, the assumption was the former.  At any rate, a banking collapse in Ireland would have a contagious effect on their creditors, mainly banks in France and Germany that had funnelled cheap Euros to Ireland.  The Government decided in September 2008 to guarantee bank debts, converting private debt into public debt held by the Government on the basis that the problem was illiquidity.

However, the collapse in the property market – and with the value of assets held against liabilities – meant in effect that the banks were insolvent and needed recapitalisation.  A converse measure of the property boom is the fall is house prices; from the peak of 2006 to today by around 50%.  So far, Ireland has injected or committed €62bn into Irish banking, equivalent to about 40% of GDP

With the onset of the 2008 crisis, bond markets decided to disaggregate Eurozone risk.  Bond yields for Ireland, Greece and Portugal went over 7%, beyond national sustainability.  By 2010, Ireland could no longer afford the yields demanded in the sovereign bond market.  Ireland needed and received a four-year programme of support from the ECB, European Commission and IMF amounting to over €60bn.

Response

In response to this crisis, the Government took dramatic action: the establishment of the National Assets Management Agency to assume under-performing loans from the banking sector; a fundamental reform of the banking sector, reducing it to two pillars, both reduced to sizes appropriate to our GDP; reduction of between 15% and 20% in the public sector wage bill; reduction in public expenditure of €15bn; creation of an Irish Fiscal Advisory Council; aggressive action to achieve a deficit target of 3% of GDP by 2015.

Recovery

70% of the consolidation necessary to reduce the deficit to below 3% of GDP has already been implemented.  Reduction in the underlying deficit to 9.4% of GDP last year – a level well within the limit set under the terms of the EU/IMF Programme.  The Government is committed to reducing the deficit further – the deficit limit set for this year is 8.6% of GDP and the latest data shows we are on track to achieve this target.  Consolidation implemented this year amounts to €3.8 billion (circa. 2½% of GDP), with roughly 60% of this is on the expenditure side.

Stabilising the debt-to-GDP ratio is crucial: we estimate that the debt ratio will peak at 120% in 2013.  We have achieved six of the quarterly targets set by the EU/IMF Programme in a row since the Programme began in late 2010. The economy returned to growth last year. GDP increased by 0.7% in 2011 – the first year of growth since 2007, with the exporting sectors are leading the recovery.  Exports increased by 4.1% in 2011 and are now above pre-crisis levels.

The export-led recovery means the balance of payments remains in (a small) surplus. We won a record number of new inward investments in 2011.There has been a substantial improvement in relative labour costs. Our inflation rate remains low, just over 2%. In short, we are trading our way to recovery.  Domestic demand remains subdued; households are running down high debts accumulated during the boom and precautionary savings remain high in a very uncertain environment. The outlook is for a second successive year of positive growth. GDP growth of 0.7% is forecast for this year and jumping to 2.2% next year as domestic demand expands and a stabilized banking sector resumes credit.  Unemployment will stabilize at 14.3% this year and begin to fall thereafter.

Medium Term Prospects

Medium-term growth potential is strong, with a flexible, adaptable economy (e.g. wage reductions), pro-enterprise environment (e.g. ease of doing business amongst best in world), high levels of education, very favourable demographics (the highest fertility rate in the EU) and further structural reforms to boost growth potential.  Medium-term forecast is for GDP growth of 3% per annum.

We will achieve our deficit of 3% by 2015. We will retain our exceptionally low 12.5% tax on all trading profits. We have a strong RnD base, encouraged by a 25% tax rebate and strong intellectual property regime. We have grants/facilities assistance for new investors, with a highly education, low cost and flexible workforce.We are highly open, globalised and business friendly, featuring in the top ranks of global indicators.  Intel, Facebook, Google, Coca-cola, IBM, Microsoft, Pfizer, Boston Scientific, Merck all have operations in Ireland.

In Ireland we have inpharmaceuticals 8 out of top 10 global companies; in technology – 8 of top 10; software – we are the largest global exporter; services – half of top financial services companies; medical devices – 15 of top 25 companies.

Context is Key

Given Ireland’s export orientation and open highly globalised economy, the international economic and financial context is a key factor. The policy of austerity required in Ireland to get us back on track is now accepted policy in the Eurozone.  Stable public finances and restoration of the banking sector are essential conditions for sustainable economic growth. The Fiscal Compact, an agreement on national budgets by all signatories, will underpin Eurozone stability.  The Irish public gave their assent to its ratification last week.

Fiscal Compact

The Fiscal Compact is formally titled the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union. The aim of the Treaty is to ensure that euro stability and better governance and coordination. The  key elements of the Stability Treaty are: balanced budget rule in national law; 3% of GDP with 0.5% structural; national debt to 60% of GDP; any gap to be close by 1/20th per anum; stricter excessive deficit procedure for breaches of the revised Stability and Growth Pact; new elements of Eurozone governance, primarily mandated Eurozone Summits and a Eurozone President; and restricted access to the European Stability Mechanism (ESM) to those countries which have ratified the Treaty.

Impact of Austerity

All that accepted, the limitations on austerity are recognised.  Eurozone unemployment is at record levels at almost 11%, the highest it has been since the Euro’s creation.  This means some 17.4 million out of work: France – 9.3%;

Spain a whopping 24% or, if you are under 25, it is 50%; Greece – 21%; Italy and Poland – 10%. Even in Germany, unemployment rose to 2.88 million or 5.6%.

The fear is that you may have a cascade effect within the EU; unemployment suppressing growth, jeopardising private credit and mortgage viability with know-on effects on property values and banking, leading to restricted credit, further crimping of growth and more unemployment.

The global trading environment currently operates in a context of uncertainty, faltering demand and sluggish growth.  This will hamper the EU’s recovery and have a knock-on effect on the economic performance of both the US and Asia. The equation is simple; growth in excess of interest rates reduces the debt burden. Growth depends on demand that in turn depends on confidence.

So the emerging consensus in Europe is that while we need to get our fiscal books in order, we need too a strategy to promote growth, or what is termed a “growth compact”.    It needs to be targeted at what is likely to drive growth – a focus on education, research and development, the commercialisation of innovation, labour market supply, key infrastructural needs (including green growth) and adaptability and competitiveness.

Key Issue

As you are aware, the key issue facing the Eurozone today is confidence in the banking sector.  The focus has moved from Greece to Spain.  The underlying issue in Spain is the same that affected Ireland: namely bank lending practices, fuelled by the Euro, that now jeopardise bank solvency.   We in Ireland are painfully aware that there are limits to the capacity of the State to recapitalise systemic banks.  How can the Eurozone agree a solution to this problem; how, in other words, to create instruments to stabilize banks that do not jeopardize State solvency.  We have arrived at the nub of the issue.

Where to from here?

The question is where to from here for the Eurozone?  A number of features have been suggested as vital.  Continued ECB liquidity; the injection of €1trillion between December and January/February had an immediate effect in stabilizing both banks and sovereign bond markets.  That needs to be continued, including for short-term liquidity. Continued low interest rates; Eurozone inflation is 2.8%, lower than the EU at 3%.  The ECB has just announced that it will stick with 1%, with a future cut possible.  Some form of joint approach to the debt/banking issue: it will not be US-style fiscal federation but I suspect a little will go a long way in resurrecting confidence in the Euro as a shared currency that is here to stay.  A shared currency means also fiscal consolidation – the Fiscal Compact is a start in the long process of the Eurozone members converging toward fiscal probity.

What does this mean for Asia?

The EU has been good for Asia.  Last year the EU exported €330bn work of goods and services to Asia.  It imported €532bn worth from Asia.  The Asian share of EU imports is today almost 32%.  The Asian share of EU exports is almost 22%.  The EU has been good for Korea too.  The EU now ranks as Korea’s third most important trading partner, after China and Japan and ahead of the US.

The EU is Korea’s fourth most important import partner and its second most important export partner, after China. This is not just a strong trading relationship for Asia and Korea.  It is a now a vital economic one.  Indeed, we can see movements in the KOSPI directly affected by assessments about the Euro crisis and its resolution. The Korea-EU FTA has greatly strengthened that relationship.  There has been a high high utilization rate with 66% of Korean exporters 48% of EU exporters availing of the FTA provisions.  Businesses have been prompt on both sides to seize the market opportunities created by the FTA, which is very positive.

The FTA ensures that our trading relationship will continue to prosper over time.  Already we have seen it positively affect the overall EU export performance here and significantly improve the export performance of several Korean sectors. The recovery of the EU as an economy, therefore, is critically important to the prospects for growth in Asia and in Korea.

Conclusion

Since the C9th, the relationship between France and Germany has determined European destiny.  This has proven to be catastrophic when pursued solely as a contest between competing national interests.  When pursued cooperative as in the European project, it has been enormously beneficial.

The European project has been extraordinarily successful.  Under it, across a wide spectrum of issues, French and German leaders found an extraordinary degree of policy convergence – on market integration, common standards, institutional develoopment, law, the Common Agricultural Policy, Cohesion Funds and monetary union. Because of the European project, since WWII Europe has enjoyed peace, stability, prosperity, integration, regional cohesion, food security, internal capital and labour mobility, and enhanced status internationally.

The Euro itself was and remains the key manifestation of the European project and the European ideal.  As a shared currency, it has hugely facilitated the free movement of people, goods and capital that lies at the heart of the European project.  It yielded an unprecedented period in European prosperity.  And it quickly became a major global currency, heavily invested in by both private and public capital.  Whatever stresses and strains it may suffer, it is underpinned by the commitment of all EU members to ensure that it survives and prospers, that the current Euro crisis is a transitionary phase that will be superseded by enhanced coherence, mutual support and improved governance within the Eurozone. The Euro and the European ideal are as inseparable as the joint and several recoveries of the EU economies.

Thank you.

Advertisements

Leave a comment

Filed under Ireland

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s