Wednesday, April 15, 2009

Ireland Takes One for Germany

Here's Ambrose Evans-Pritchard at his gloomy, apocalyptic best describing the danger of Ireland falling into a debt deflation cycle not seen since the 1930s. As Evans-Pritchard notes, the most tragic part of this slow-motion trainwreck is that it does not have to happen: if the ECB aggressively cut rates, and Ireland had monetary sovereignty to devalue its currency, then they could perhaps settle for a lost decade instead of an outright depression. Unfortunately for the Celts, the Germans exert de facto control over the ECB, and the Germans are far too worried about the potential inflationary pressures of quantitative easing to pursue such heterodox monetary policies. Apparently memories of needing a wheelbarrow of cash to pay for a loaf of bread scar a nation's collective psyche for generations. From the Telegraph:
If Ireland still controlled the levers of economic policy, it would have slashed interest rates to near zero to prevent a property collapse from destroying the banking system.

The Irish central bank would be a founder member of the "money printing" club, leading the way towards quantitative easing a l'outrance.

Irish bond yields would not be soaring into the stratosphere. The central bank would be crushing the yields with a sledge-hammer, just as the Fed and the Bank of England are crushing yields on US Treasuries and gilts.

Dublin would be smiling quietly as the Irish exchange rate fell a third to reflect the reality of trade ties to Sterling and the dollar zone....

Brian Lenihan, Ireland's finance minister, said the economy would contract 8pc this year on top of the terrifying 7.1pc drop in the final quarter of last year.

But what caught my ear was his throw-away comment that prices would fall 4pc, which is to admit that Ireland is spiralling into the most extreme deflation in any country since the early 1930s. Or put another way, "real" interest rates are rocketing.

This is torture for a debtors' economy. You can survive deflation; you can survive debt; but Irving Fisher taught us in his 1933 treatise "Debt Deflation causes of Great Depressions" that the two together will eat you alive.

Don't blame the victim. Ireland has been betrayed twice in this saga. Once by New Labour, which led Dublin to believe that Britain would join EMU at the same time – covering Ireland's dangerously exposed flank of Sterling trade.

It was betrayed again by the European Central Bank, which opened the monetary floodgates early this decade to nurse Germany through a slump, holding rates at 2pc until late 2005, despite flagrant breach of the ECB's own M3 money targets. Fast-growing Ireland and the Club Med over-heaters were sacrificed to help Germany. They were left to cope with credit bubbles as best they could.

Ireland struggled. Construction reached 21pc of GDP – a world record? – compared with 11pc in the US at the peak. Mr Lenihan hopes to shield banks from the calamitous consequences by creating a buffer agency. It will soak up €80bn to €90bn in toxic debt – or 50pc of GDP.
He borrowed the plan from Sweden's bank rescues in the early 1990s, but overlooks the key point – it was not the bail-out that saved Sweden's financial system, the country recovered only by ditching its exchange peg and regaining its freedom of action.

Without that sort of liberation, Ireland's property slump will grind on for years and more multinationals will join Dell in decamping to cheaper plants in Poland. Ireland risks a deflationary slide into bankruptcy.

Of course, it is not the job of the ECB to set policy for Dublin's needs. But it would at least help if Frankfurt began to set policy for Europe's needs. Has the ECB noticed the collapse of industrial output in Spain (-24pc), Germany (-23pc), Italy (-21pc), France (-14pc)?
If Europe fell into depression, would the ECB notice? Don't answer.

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