How the Irish Learned to Stop Worrying and Love the Treaty (Sort of)

These days, people mostly refer to the “law of unintended consequences” when pointing out something bad and blaming it on a naïve but well-intentioned regulator. The lesson to be learned, typically, has to do with hubris. It is a favorite hobbyhorse of libertarians, who oppose regulation for philosophical reasons, but like to think of themselves as pragmatists. Who wouldn’t oppose regulation, if it’s bound to fail anyway?

Photo by William Murphy

There’s a bit of reductio ad absurdum at work here: since humans are error prone, goes the logic, putting them in charge of complex systems driven by human behavior is folly. Never mind that this rests on the rather shaky claim that there’s no middle ground between bad regulation and no regulation, as if we don’t regulate complex systems all the time: how did we ever manage to get to the moon, or get across Manhattan in a taxicab? No, far better to allow “the market” to “regulate itself.” Because the market never get things wrong. Ahem.

Certainly no one foresaw that the global financial crisis would turn euro-skeptic Irish voters into reluctant “euro-yes” voters. Europhiles everywhere are holding their breath until Friday, when the Irish will vote on the Lisbon treaty. Lisbon is a stripped down version of the grand and extremely wordy European Constitution, which the French and Dutch quite cantankerously rejected a few years back. The slimmer Lisbon has allowed most European legislatures (except for Ireland) to bypass the popular vote altogether and ratify it straightaway, thus avoiding all the nail biting.

Now it looks like maybe, just maybe, the Irish will approve it, too. If so, it would allow the treaty to come into force, since all that would remain is for the Polish and Czech presidents to add their signatures to it (which… sigh… isn’t totally guaranteed.) The Irish already voted on the Lisbon treaty once, when they voted against it, soundly. But that was a year ago, before the financial crisis popped the Irish property bubble, crippled the banks, and called the solvency of the Irish government into question. It’s not that Irish voters have suddenly fallen in love with the EU. It’s that the crisis has thrown the benefits of the EU into stark relief. Indeed, the economic shelter of the single currency zone may end up, unexpectedly, binding small countries like Ireland closer to the union than ever before.

Photo by William Murphy

The irony is that the dire condition of the Irish economy also owes something to the Euro; it is a consequence of the “one-size-fits-all” monetary policy set by the European Central Bank. This happens to be something the naysayers did predict would happen, when the single currency was adopted a decade ago. The countries of Europe are just too economically diverse—with differing rates of growth and employment. There is no single interest rate that works for everyone. During the expansion, the accommodative interest rates appropriate for rigid, slow growing Germany, were like gasoline on the smoking hot economies of Spain and Ireland.

It’s not impossible to set monetary policy for a large and diverse economy; the Federal Reserve does it. At the low end, unemployment in the Netherlands and North Dakota are both hovering just above four percent, and at the high end, Spain and Michigan have 15% and 17% unemployment, respectively. These aren’t so different in absolute terms. Except, in America, what economists call the “factors of production” can shift more easily from one region to another, which helps iron out the differences. A software engineer in Raleigh North Carolina, for example, is far more likely to drive 3000 miles for a job in San José, if the pay is good, than a German engineer in Stuttgart is to drive 750 miles to Barcelona. Europe lacks a single market for labor and services; so economic imbalances tend to persist.

Perversely, the single currency may even exacerbate regional inflation. Here’s how the Economist put it last June:

The ECB’s one-size-fits-all monetary policy can never be perfectly tailored for any individual member country. In principle, higher inflation should act as a coolant to overheating economies by reducing real household incomes and by making firms less competitive, reducing the incentive to invest. In practice, strong real growth and high inflation are a draw to foreign capital, adding more fuel to the fire. For the same exchange-rate risk, a euro put to work in Spain might earn a better return than in slower-growing parts of the euro zone.

In the past, foreign investors worried that property booms in Spain or Ireland would fuel high inflation and ultimately lead to a depreciating currency. This fear of currency devaluation kept a damper on investment demand. But the Euro has mitigated the risk: higher rates of return in the Spanish and Irish property markets are no longer weighed down by currency worries. Accordingly, foreign capital has flooded in, fueling a debt-driven boom that went bust. And the downturn has pushed the Irish banking system to the brink.

Photo by William Murphy

The last time the Irish went to polls over Lisbon, it was June 2008, back in the days before Lehman. Voters were more receptive to the well organized “no” campaign, which stoked voter concerns over tax issues and worries that defense provisions in the Lisbon treaty would undermine Ireland’s neutrality. This time round, however, the “yes” campaign has been better organized, with celebrities and business lobbies united behind the effort. But the biggest change has been the economy. Unemployment has more than doubled in the last year, property prices have fallen by more than 25%.  Taxpayers face the even more daunting prospect of an Irish bank bailout that makes the U.S. Treasury’s unpopular Troubled Asset Relief Program seem quaint.

The Irish government has formed the mother of all bailout funds, called the National Asset Management Agency (NAMA). The plan is for it to buy distressed real estate assets from five Irish banks. All told, the fund is on the hook for €77 billion ($112 billion) in bad real estate investments. That number might seem small compared to American bailouts, yet it represents 46% of Irish GDP. To put that in perspective—if TARP were that big, instead of $750 billion, it would run six trillion dollars.

Irish Finance Minister Brian Lenihan described the situation bluntly:

The turmoil in the international markets has been very damaging to us because Irish banks borrow heavily from abroad to fund lending. As foreign banks withdrew funding from our banks, the ECB filled the gap. It is absolutely the case that without the steadfast support of the European Central Bank, our financial system would have collapsed.

Membership in the Eurozone has facilitated Irish banks’ irresponsible lending. By the same token, it has offered the Irish government a way out of its current mess. Almost certainly, Ireland, on its own, would be hard-pressed to borrow the funds it needs for NAMA, without paying bondholders ruinous rates of interest. As recently as last winter, the very solvency of the Irish government was in doubt. Ireland sovereign credit default spreads widened to over three and a half percent—the highest in the eurozone. CDS spreads reflect the likelihood of a government defaulting on its debts. They have since narrowed, due to the backing provided by the ECB. The ECB has also agreed to indirectly finance NAMA, by accepting Irish “NAMA bonds” as collateral. So, in lieu issuing debt in a hostile environment, NAMA will be able to buy troubled real estate from Irish banks with bonds of its own issue, and then the Irish banks will able to exchange those bonds for cash at the ECB.

Photo by William Murphy

Given the scale of the problem, it’s difficult to see how Ireland could restart its banking system without its European partners. This is, in essence, the argument the Irish government has put to voters as the day of the vote nears: a “no” vote for Lisbon will hurt the Irish economy. It is an undeniable scare tactic. Yet so far, voters seem to be listening.

As for the “law of unintended consequences”, it’s worth pointing out that it’s not really a law at all. It’s more like an adage. Robert K. Merton, the sociologist who explored the idea in 1936, didn’t argue that every social or political reform was bound to fail. He was just trying to understand why they failed. Unfortunately, like Murphy’s Law, his idea has come to express a kind of pessimism about human affairs. Not every unintended consequence is bad; we just tend to call the good ones “innovation”. The Euro may very have made the European monetary system too rigid for its own good. Still, the single currency system may prove flexible enough to help small countries like Ireland out of trouble.