Hamish McRae: Ireland's travails may be short-lived, but the eurozone's future is not bright

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The Independent Online

Well, the game is over – or at least it will be in the next few days. Even a week ago the Irish government thought it could get by without external support. But things move very fast in financial markets and the gap between being a government being in control of events and losing control is a tiny one. It is a salutary lesson for us all.

So how can a country that does not need to borrow from the markets, has a current account surplus, is starting to grow again and certainly is seeing solid demand for its exports – find itself in this position and what are the implications for the rest of us?

The immediate reason was that Ireland was bounced into seeking support by its partners in the eurozone. Stories were leaked by officials in Brussels that it had started talks on a loan. These were furiously denied by Dublin but it didn't make any difference. Various ministers and central bankers from other countries, in faux-helpful tones, urged Ireland to do the right thing and seek support – their motives being not to help Ireland but to take pressure off other weak eurozone members such as themselves. The IMF played it straight, saying it had not been approached for help, but with Europe piling on the pressure, the country had to fall in line. It is not nice but this is what happens. We will see to what extent Ireland retains some control over its policies – and its red line is the 12.5 per cent corporate tax rate – as the negotiations proceed in the days ahead.

There is however a second reason why Ireland could not longer go it alone. Its banks, though guaranteed, indeed part-owned, by the state faced a steady loss of deposits. Investors were taking their money home. So the banks became increasingly dependent on support from the European Central Bank. This is part of the agreed system whereby the ECB will give liquidity support to all banks but there is a fine line between a bank needing liquidity and being solvent. All the banks have problems but one, Anglo Irish, is in a far more perilous position. It was/is a specialist property lender and, leaving aside issues of governance, it was inevitably and profoundly caught up in the property crash.

You can see the effect of this in the main chart. Other countries have had to support their banks in the past and not just in the emerging world. The Nordic countries, examples you might think of financial probity, took a huge hit relative to their GDP in the early 1990s. What has happened in Ireland is well within recent historical experience and had it not been a member of the eurozone it would probably have been able to avoid the most extreme elements of the boom and now be able to work its way though the crash. But the ECB, as many of us warned, had to set interest rates at the best compromise it could for the whole of Europe, resulting in too loose a policy for fringe countries such as Ireland and Spain. The one-size-fits-all interest rate did not fit Ireland.

To say this is not to excuse Irish policymakers. They could have done better with the tools they had. But euro-membership made matters far harder. Not only did Dublin have no control over interest rates; the euro created a sense of euphoria that with the best will in the world would have been hard to counter. In the short-term the euro had been good for Ireland. It cut borrowing costs and encouraged inward investment. But it proved a poisoned chalice, with a very slow-acting poison. To say all this is not to "dis" the euro. It is simply to point out that while membership brought some advantages, losing control over monetary policy had dire consequences.

Mind you, British banks did not help. You can see the outstanding loans made to Ireland and other fringe eurozone countries by our banks in the smaller graph. The Irish subsidiary of Bank of Scotland was particularly aggressive in spraying money into property and Lloyds, now custodians of that sad empire, is still sorting the mess. One of the main reasons why the UK is chipping into the Irish pot is because it is in our self-interest that it should be stable and prosperous. It is not to support the eurozone.

And the consequences? I can see at least three. The most positive is that the Irish economy will continue to recover. It would have probably recovered anyway but getting all this stuff out of the way will give a material boost to confidence both within the country and externally. It is humiliating for the government of course. When I was chatting to an Irish Cabinet minister 10 days ago I did, perhaps cheekily, ask what would happen if they had to go for the bail-out. "Well, that's not the plan," was the reply. Well it is now.

But humiliation does not in the long-run matter. If the financial and commercial community is convinced that this is the turning point, then it will indeed be the turning point. The export side of the Irish economy, the chunk that created its extraordinary growth, is doing just fine and will do better as global demand picks up. The debt burden remains huge but growth is the key to reducing it. The drivers of that growth remain intact.

The second consequence will be less agreeable. We have to wait for the detail but if the bond-holders of Irish banks don't get back their full entitlement – in the silly jargon of the markets are given a "haircut" – that will make it harder for banks in all fringe countries to raise cash. The consensus is that the bond holders should suffer, at least on some categories of debt. But think of the signal to investors. Why buy the bonds of a bank in Spain when you can buy those of a bank in Germany ... or China? This is about trust, trust that has been so hard won and can so easily be thrown away.

The third consequence will be contagion. Two down – Greece and Ireland – how many to go? The eurozone will, I am sure, be pulled together for a few more years, but there will be further political ructions against austerity, further tensions in the markets, more crisis meetings in Brussels, more bail-outs. Not good, not good at all.

The performance of gilts proves that the markets trust the UK government

Strangely enough, sterling and UK gilts are becoming something of a safe haven. The euro has suffered and investors were unnerved by the way US long-term interest rates rose after the last bout of quantitative easing by the Federal Reserve. By contrast the feeling that the UK government has got a grip on things has led to a rethink of gilts' attractions.

Some work by Citigroup Capital Markets highlights this. In the run-up to the general election and the window before the coalition was formed, UK gilts behaved rather like the bonds of euro fringe countries (Greece, Ireland, Portugal and Spain). If there was a rise in sovereign debt concerns, gilts fell along with the others. But after the coalition was formed gilts behaved much more like US treasuries or German bunds: they tended to rise in price, not fall, if there was a hint of trouble on the fringe.

Note two things. One is that this conclusion comes from daily price data, so it is not a view, but an observation. The other is that the change occurred before the emergency Budget. That suggests that the markets did not need to see the detail; they just recognised that the government would do whatever had to be done.

That is really encouraging as it means that the coalition is trusted and accordingly has gained room for manoeuvre should things turn out worse than expected, or indeed better. We get the Autumn Statement, a scaled-down version of what Gordon Brown had upgraded to the Pre-Budget Report, on 29 November, along with the Office for Budgetary Responsibility's forecasts. Citigroup ponders whether the OBR's forecasts for the deficit may turn out to be too pessimistic and that we may get some pleasant surprises. We will see. The OBR would be right to be cautious and the debt remains huge. It is just that we may be able to get things under control a bit faster than expected.

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