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Wheels fall off Ireland's austerity bandwagon

With the cost of Ireland's debt rising, some people are suggesting the answer to our problems may be a break-up of the euro, writes Stephen King

European Central Bank president Jean-Claude Trichet has praised Ireland's austerity measures: 'Greece has a role model and that is Ireland,' he said earlier this year

"It was only when Argentina broke its currency peg with the dollar that it started to grow and its deficit came down," argues Nobel prize-winning economist Joseph Stiglitz [above], adding for good measure that the only way the euro would be able to survive would be for Germany to leave altogether."

More options: Fed chairman Ben Bernanke

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At the beginning of the year, Ireland was the poster child for the merchants of austerity. While the people of Greece seemed unable or unwilling to accept massive cuts in public spending, the Irish stoically accepted their fate, resigned to a prolonged period of self-flagellation.

Ensconced within the euro, the Irish recognised rightly that they could not continue living beyond their means following the deepest global economic crisis since the 1930s. True, Ireland had, for many years, benefited from its reputation as the Celtic Tiger but, as its economic expansion matured, it became increasingly dependent not on productivity gains and low-tax advantages but, instead, on easy credit and an unsustainable property boom.

In recent days, however, the wheels have begun to come off Ireland's austerity bandwagon. The most obvious symptom has been a persistent rise in the cost of borrowing for the government. Its 10-year bond yields threatened to head through 7% at one point, leaving them dramatically higher than the eurozone's 'best in class'. Germany's bond yields, for example, stand at just 2.3%.

This rise in Irish bond yields was not supposed to happen. Earlier in the year, Jean-Claude Trichet, president of the European Central Bank, heaped praise on Ireland's willingness to swallow the bitter pills of austerity. Presenting to lawmakers in the European Parliament, he said: "I don't want to elaborate more on Greece... Let me only say that Greece has a role model, and that is Ireland... Ireland took very seriously its problems".

Doubtless Trichet believed Ireland would be rewarded for its devotion to belt-tightening. Governments that deliver austerity are supposed to benefit from much lower bond yields. Lower bond yields, in turn, reduce the cost of servicing existing government debt, thereby reducing the burden on taxpayers. So, although austerity is a painful process, a credible austerity plan can alleviate the pain.

In Ireland's case, the aim has been to reduce the budget deficit from around 14% in 2009 to just 3% of GDP by 2014. And by adopting a "scorched earth" approach to deficit reduction at the beginning of the process, the hope was that Ireland would benefit more or less immediately from a lower cost of borrowing.

Yet it has hardly been plain sailing. Current spending – on things such as public sector wage costs – fell only 1% in the first half of this year, a decline that still leaves a yawning gap between expenditure and revenues. And with the costs of the Anglo Irish Bank support operation, the overall budget deficit will rise to a whopping 32% this year.

Admittedly, the government can argue that this is a "one-off" effect which will drop out of the numbers in 2011, but investors are now wondering whether all the dead bodies in the banking system have really been exhumed. And as they wonder, bond yields rise further, leaving the Irish nation without the expected rewards for being the austerity poster child. Instead, Ireland finds itself in a vicious fiscal circle: as interest rates rise, so the cost of servicing existing government debt goes up, forcing the government to contemplate even bigger cuts.

For some, the answer to Ireland's problems is a break-up of the euro. For example, Joseph Stiglitz, the Nobel prize-winning economist, has claimed that Spain, which has also struggled to put its fiscal house in order, would eventually go the same way as Argentina.

"As its economy slows, the improvement in its fiscal position may be minimal. Spain may be entering the kind of death spiral that afflicted Argentina just a decade ago. It was only when Argentina broke its currency peg with the dollar that it started to grow and its deficit came down," he said, adding for good measure that the only way the euro would be able to survive would be for Germany to leave altogether.

Then again, Stiglitz has a book to sell. Such controversial views will do no harm to his sales figures. His comparisons with Argentina, however, completely miss the point. At the end of the 1990s, Argentina operated a currency board. The peso was tied to the US dollar, supposedly for all time, and international investors lent heavily to Argentina, believing their money was safe. Having borrowed too much, however, the peso eventually collapsed. The peso value of dollar-denominated foreign debt went through the roof, leaving Argentina with no choice but to default.

The euro is a different kettle of fish altogether. There are no longer any pesetas, drachmas or punts. Unlike Argentina's pesos, they don't exist any more. There is no currency peg to be broken because the euro, by definition, is a single currency. There may be problems aplenty, but citing Argentina's currency collapse is, at best, mischievous.

Could old currencies be reintroduced? Yes, but only with great difficulty and with little benefit. Imagine, for example, that Ireland announced it was leaving the euro, hoping that Irish citizens would now be happy to own newly-issued Irish punts. Surely, given the certainty of immediate and substantial devaluation, the Irish would take their existing euros out of the Irish banking system and put them into German and French banks as fast as possible, generating an even bigger financial failure than we've seen so far.

Alternatively, they might simply refuse to accept the newly-issued punts, leaving the economy euro-ised (in the same way that Panama is dollarised: the official currency there is the balboa but the only currency circulating on the streets is the US dollar). The Irish Central Bank would then have lost its seat in the European Central Bank for no beneficial reason whatsoever.

Stephen King is managing director of economics at HSBC

What are the euro's alternatives?

Defaults and restructurings cannot completely be ruled out: in all debt crises, there's always a tension between the interests of the debtors (in this case, the Irish and the Mediterranean countries) and the creditors (German and French financial institutions which bought bucketloads of Mediterranean debt at stupidly low yields earlier in the decade).

But the most obvious solution is to do what all good monetary unions do: allow for fiscal transfers from one part of the monetary union to another.

Courtesy of the federal government in Washington, that's what happens between US states. It is also, of course, what happens between England and Scotland.

This is not going to be easy. At least, however, the introduction of fiscal transfers would reveal that all nations within the euro – both debtors and creditors – have a responsibility for sorting out this crisis.

Admittedly, we've so far seen only tentative steps in this direction with the creation of the European Financial Stability Facility, the operation of which remains unhelpfully opaque. Ultimately, however, monetary unions work only if there is also a shared sense of fiscal responsibility.

Rather than triggering the euro's demise, this crisis may instead prove to be the catalyst for even more political integration than we've seen so far.