Euro crisis – Act II: the consequences of an Irish default

 by Holger Zemanek

The Irish bailout shows that Greece was just the first act of the ongoing euro crisis. It is now almost certain that Ireland will accept an EU/IMF rescue package to calm down financial markets. In this second act of this euro area tragedy, however, the UK is likely to be a leading player as well. Indeed, the British government offered direct rescue funds to Ireland as British banks hold many Irish government bonds. The already troubled and largely state-owned RBS is a major lender to Ireland.

Of course, the Irish case is very different from the Greek one. Greece had accumulated huge public debt, cheated with official deficit data and had increased wages much above what was justified by productivity. While the latter is also true for Ireland, its government actually significantly reduced public debt until the financial crisis started. Yet, at the same time, Irish banks had accumulated unsustainable private receivables financed by foreign debt. During the crisis, the Irish government nationalised these “toxic” banking assets. Government debt rocketed as a result and this is the key reason for the second act of the euro area crisis.  

Now it would appear that the Irish bank assets are to be “supranationalised” at European level. Euro-area taxpayers and also British taxpayers will bear the risk and perhaps the costs. And there are at least two further problems with the quasi-bailout. Firstly, a rescue package for Ireland will potentially increase moral hazard for (not only) Irish banks but also for governments throughout Europe. Secondly, the political resolve in Ireland to undertake radical reform programmes and severe budget cuts may in practice be weakened by the rescue funds. This could weaken the necessary structural adjustment and threaten the Irish recovery.

However, there is a more important point. If Greece and Ireland are unable to repay the rescue package and guarantees become payable, public debt in the rescue-providing countries will increase. Then Irish and Greek debt will have to be paid back in the “donor” countries by spending cuts, tax increases or higher inflation. Not only will the banks and lenders to Ireland or Greece have to bear the costs but all taxpayers in the UK or Germany. A European transfer union would be established through the back-door.

The third act of the tragedy is already looming with Portugal as the next candidate for default.