Thursday, 1 December 2011

A new deal is required

Tom McDonnell: On Monday and Tuesday we will be treated to the latest instalments of the austerity show. While the structural deficit does need to be closed there are good and bad ways to do this. What we almost certainly wont get next week is a credible growth strategy.

It is clear the current pro cyclical fiscal stance is embedding the depression. Long-term unemployment is now at crisis levels and there is a huge risk that high levels of cyclical unemployment will transform into high levels of structural unemployment with disastrous long-term social impacts. Out debt burden (public and private) is consistent with years of future stagnation. If we cannot reduce the debt burden or spark nominal GDP growth then the next few years will be very grim.

We have a Euro zone wide failure of policy. The institutional architecture of the currency union has failed. This is not a cause for shame. Prototypes and innovations fail all of the time. But we have now put the Euro through its paces and it has burst into flames at the first sign of adversity. We must learn the lessons and causes of failure if we are to improve the model. We know the reasons for its failure. A common currency without a fiscal union is incoherent. There are a number of design flaws including:

1. Imposing a single interest rate over a non-optimal currency area amplifies booms and busts
2. The absence of a lender of last resort magnifies the likelihood of sovereign debt crises
3. There are no mechanisms, protocols or conditions for writing down debt
4. There is no EU-wide special resolution regime for banks
5. There are no centralised fiscal mechanisms to provide counter cyclical support for depressed regions
6. There is no transfer mechanism to compensate countries blighted with an overvalued currency
7. There is no centralised financial regulation
and yes
8. There is insufficient budgetary coordination and integration - although this demands greater democratic accountability

All of these mistakes need to be rectified. It seems reasonable to ask whether the Euro is worth saving. Yet the consequences of a Euro break up are likely to be catastrophic.

It is evident the Greek write-down does not go far enough. Write downs or restructurings are probably required for other countries including Ireland. We could start with the promissory notes. But reducing the debt is just one side of the equation. The other side is growth.

We need a new deal for Europe and for Ireland. A new Marshall plan. A deal that would allow the continent to recover. A sister organisation to the ECB responsible for fiscal policy and economic growth should be established. A beefed up European Investment Bank is one candidate to occupy this role.

The greatest challenge for the Irish Government and for Europe is to get its people back to work. Austerity will not achieve this. In Ireland we need programmes to transform the skill sets of the unemployed and other workers to match the needs of the economy. The G.I. bill in the United States is one model we could pursue. The G.I. Bill was a law that provided vocational or college education for returning World War II veterans. The simple fact is the skill base of the unemployed segment of Ireland's labour force is likely to be far out of step with the future needs of the economy. This is particularly the case for the 100,000+ former construction workers that have lost their jobs. For many of these workers there is little prospect of future employment in Ireland. Yes this will cost money, but we still have €5 billion in the National Pension Reserve Fund.

As the weeks pass into years hope for the long term unemployed fades farther into the distance. The Government has an opportunity to start turning the tide next week. It is time for a new deal.


Tom McDermott said...

Excellent analysis of the problems with the Euro and the myopia of austerity, but do you really think the "catastrophic" scenario resulting from the break up of the Euro is credible given the source (UBS bank!)? Would be nice to see some analysis from academia - as opposed to self-interested banks - of what might happen in the event of the euro breaking up.

Tom McDonnell said...

@ Tom

The effects of a breakup would depend on the type of breakup.

What about Ireland leaving the Euro? It's hard to be sure.

On the plus side we would probably immediately default thereby reducing our debt burden. We would also regain control of monetary policy. Expect large scale printing of money. The value of the currency would fall making exports cheaper and improving competitiveness.

Against this if the currency does devalue against the Euro our debt burden (denominated in Euros) would increase - possibly offset by one or more of those defaults.

To maintain the value of their savings and investments people and businesses would try to take all their money out of Irish financial institutions. Capital controls would have to be instantly imposed to prevent the banking system from collapsing. Capital controls are illegal under EU law. Of course the ECB would no longer feel obliged to continue providing Emergency Lending Assistance to our banks so they might collapse anyway. The exchequer deficit would have to be balanced overnight as no one will lend to us. Much of this adjustment would probably be achieved through seigniorage.

Longer term is harder to predict. Multinational companies would factor in the additional cost of exchange rate fluctuations when deciding to come here. The hoped for competitiveness gains for exports would have to be weighed against more expensive import costs.

This is just one scenario and I agree with you that we should not trust the estimates of special interests.