Outsiders Advocate Economic Suicide

August 6, 2010
Channel 4’s ‘Big Brother’ is soon to leave our television screens for good, and not before
time. Unfortunately, the reality show’s legacy is likely to prove long-lasting. Indeed, its
enduring contribution to society is the creation of a sub-culture that rewards non-
celebrities of limited talent from various walks of life. Perhaps the most dangerous of
this new species however, is the pop-star economists, who champion solutions to our
current economic woes that would prove catastrophic to the nation’s financial health.
The nuclear option of a euro exit combined with sovereign default may make for good
theatre, but it’s an awfully dumb solution.
A decision to leave the euro and introduce a new currency would pose serious technical
challenges and could not be done overnight. ATMs, cash registers and vending machines
would all require reprogramming, which means that the impending changeover would be
in the public domain. Businesses and households with domestic deposits would attempt
to secure the value of their funds and move them offshore in anticipation of devaluation.
The capital outflows could not be blocked by decree, since there is unrestricted capital
movement in the EU. Thus, only an exorbitant rise in interest rates could prevent a
banking system collapse.
The pressure on the banking system would result in a sizable reduction in the availability
of credit and economic recession would prove inevitable. The shortage of credit would
be aggravated by foreign creditors, who are likely to curtail lending to a probable
defaulter ahead of a euro exit. Additionally, both stocks and bonds would suffer a
substantial decline in value, as investors adjusted their allocations ahead of the impending
devaluation. The reduction in capital market liquidity means that the corporate sector
would be unable to secure either debt or equity financing at a reasonable rate. The
economy would simply come to a standstill and an already-dire employment situation
would rapidly deteriorate.
A euro exit could see the new national currency depreciate by as much as 50 per cent, and
the increase in the outstanding stock of euro-denominated debt would prove unbearable.
The government would have little option but to introduce a new law that provided for the
conversion of former euro debts into the new currency. The redenomination of
outstanding euro liabilities into the new currency would need to apply not just to
government debt, but also to the borrowings of the banking, non-financial corporate, and
household sectors if a catastrophic decline in consumption and investment was to be
avoided.
The redenomination of euro debts would undoubtedly, be subjected to legal challenges,
which could prove successful, while the de facto public and private sector default would
shut the nation out of international financial markets. The pop-star economists argue that
capital markets have no memory, and consequently, that access to external borrowing
would resume quickly. It is true that those countries that defaulted during the 1990s took
an average of just 3 ½ months to regain market access after defaulting. However, the
current external economic climate is hardly comparable to the 1990s. Perhaps the 1980s
average of 4 ½ years would prove to be a more appropriate benchmark.
It is also conceivable that once market access had been regained, new debt issues would
be priced at a punitive rate, as investors demanded a sizeable inflation and liquidity risk
premium. History confirms that international financial markets do indeed have a
memory, and defaulters are typically awarded a lower credit rating and charged higher
borrowing costs than non-defaulters of similar financial strength. The effect tends to be
particularly pronounced for surprise defaults and small economies. Both characteristics
would seem to apply to Ireland.
It is also unclear whether the competitive devaluation would provide sufficient impetus to
the economy to even consider a euro exit. First, a unilateral withdrawal from the single
currency is a breach of the Maastricht Treaty, and it is thus improbable that Ireland could
continue as a fully-functioning member of the EU. Foreign-owned businesses account
for roughly 90 per cent of Irish exports, and absent euro and EU membership, a
substantial share of this business is likely to relocate elsewhere.
Second, the import content of Irish exports is the third highest in the OECD, behind
Luxembourg and Hungary, such that a sharp fall in the purchasing power of the new
currency and increase in import costs would limit the improvement in competitiveness.
Finally, the examples used to support the case for devaluation including the relatively
recent defaults in Argentina, Russia and Uruguay provide little, if any merit to the nuclear
option. Each country benefitted from high rates of import substitution, buoyant external
demand and rising prices for commodity exports, not to mention exuberant debt markets
as investors sought out attractive yields. None of these factors apply to the Irish case.
There are no easy solutions to Ireland’s economic predicament, but the nuclear option is
simply unthinkable and akin to economic suicide. Thank God the pop-star economists
are outsiders.

www.charliefell.com

The views expressed are expressions of opinion only and should not be construed as
investment advice.
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