Should Ireland default and devalue?

November 19, 2010
Mohamed El-Erian weighs in on Ireland today, and is blunt.

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Mohamed El-Erian weighs in on Ireland today, and is blunt:

What is most desirable is not feasible given the path Europe is embarked on; and, to make things even more complicated, what appears feasible to Europe is not necessarily desirable. As a result, Ireland finds itself stuck in an unstable muddled-middle.

What seems probable in Ireland is a Greece-style bailout. It’s a debt-go-round, basically: the sovereign takes on the bad debts of its banks, becoming less creditworthy itself in the process; and then the EU takes on the debts of the sovereign. Writes El-Erian:

While seemingly exceptional to many, this approach constitutes the path of least resistance. In fact, it is the most feasible. But we should not confuse feasibility with desirability.

At its roots, the approach addresses liquidity but not solvency. It adds to the debt overhang rather than reducing it. And it uses the socially-painful method of income and growth compression as the principal way to promote international competitiveness over time.

This approach hasn’t worked in Greece, which still has sky-high borrowing costs and which is no more internationally competitive now than it was during the bailout. And it’s unlikely to work in Ireland, either.

So what might work? Default and devaluation, basically:

In a wider policy debate, debt restructuring would be considered as a possible pre-emptive option rather than a disorderly inevitability; thought would be given to the possibility of the weakest Euro-zone members taking a type of sabbatical from the club and rejoining on a stronger and more sustainable basis.

These options are still unthinkable politically. But as El-Erian says, the longer they’re put off, the worse the consequences for European growth in general, and the higher the likelihood that the crisis will engulf the entire eurozone. Right now, says, El-Erian, “given the undeniable strength of core Euro-zone countries, anchored by a fiscally sound and economically robust Germany,” it’s possible to structure a default and devaluation in such a way that the country concerned emerges in a strong fiscal position and with a healthy growth outlook. But the longer we wait, the harder that becomes.

I do think that it would be grossly unfair should the lenders to Ireland’s insolvent banks find themselves getting bailed out by Irish and EU taxpayers at 100 cents on the dollar. Is a sovereign debt restructuring the only way to avoid that? I’m not sure. And it’s also politically all but impossible to build a mechanism into the eurozone allowing countries to exit and re-enter again at a more competitive level, now that the currency union has been deliberately designed without that possibility in place.

Essentially, what El-Erian is calling for requires a level of political unity within the eurozone which has rarely existed historically and which certainly doesn’t exit now. Which is why, as he says, “the region as a whole will lose out in terms of both what is desirable and what is feasible.”


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