Thank you, Chairman. I am glad to have the opportunity to speak to the committee today and to take questions about the role of the euro in what went on. Since the mid-1990s this has been one of my main research areas. The idea of monetary union was in the air since the early 1990s and there was a lot of discussion about what might happen once the euro was formed. Of course, now we have seen all that has gone on in the first 15 years.
I will make four points in this opening statement, so it will be an overview of the more detailed written statement I have provided. The first point is to talk about the global context. Europe, in the end, is a relatively small part of the world economy. We have to remember that the euro area lives in a global economic and financial system.
Second, I will talk about the impact of the euro in its first decade until the crisis. My third point is about the role of national macro and financial policies under the euro. My fourth point will be about how the euro has affected crisis management since 2007-2008.
In terms of the global context, since the late 1990s the creation of the euro was not the only major event in the world economy. In the background, for example, the rise of China had a big effect. China was growing so quickly that it was important in the late 1990s, but by the mid-2000s it was very important. That had trading effects, although maybe less so here. For example, the economies of Portugal, Greece, Italy and so on were quite affected by the rise of cheap imports from China. Financially, the surpluses coming out of China were essentially flowing into the US financial system. Low interest rates in the US prompted, for example, the rise of securitisation in US financial markets and European banks were active in the US system. Therefore, there was a deep connection between what was going on in the US in the mid-2000s and what was going on in Europe. A lot of that was being intermediated through banks. European banks were important in linking the US financial system to the European financial system.
That meant that by the mid-2000s we had this global liquidity situation where interest rates were quite low globally, while capital was flowing and trying to find extra yield. There was a lot of interest in innovative products like asset-backed securities. There was a lot of availability of non-deposit funding. What we saw were lots of countries starting to run much larger imbalances. That was true in the euro area but also outside it. We saw the Baltic economies and Iceland running large deficits. Within the euro area, Ireland was running a current account deficit, but it looked smaller than what was happening in Spain, Portugal and Greece for example.
Let me now turn to the direct effect of the euro itself, which was interacting with those global factors. It is important to split the time period into sub-parts. First of all, from 1997 to 2001, there is an entry phase. The fact that EMU was going to happen already led to a decline in interest rates in the periphery of Europe. It led to a lot of optimism that now interest rates and inflation would be lower. It created a situation where there was more temptation to invest, consume more and save less.
I would emphasise, however, that period really came to an end with the recession in 2001. The US recession and the European recession in 2001, even though relatively brief, did break that initial phase. If one went back and asked people in 2002 and early 2003 what happened next, they would say essentially that the exciting phase was over. Essentially, one might think at that time that the world would settle down to more normal behaviour. At that point, however, from 2003 to 2007, the import from the US of low interest rates, innovative financial products - and global banking corporations looking to invest through the interbank market and bond market in national banking systems across Europe - all of these credit events were happening then.
I would emphasise that at that time the fundamentals in Europe were looking less good. The interaction of credit supply was becoming more available, but in fact the story in Europe was becoming less positive. In a number of economies demographic factors were turning more negative. Oil prices were going up, which was a negative for importing countries in Europe. The dollar depreciated quite a bit. From 1999 to 2001 the dollar appreciated a lot, which has boosted Ireland in particular. From a low in late 2000, when €1 bought only $0.82 cents, by 2008, €1 bought $1.57. That was a pretty massive dollar depreciation against the euro.
In countries like Ireland and Spain, one saw that the business model of building export markets was replaced by an emphasis on local activity, especially construction. The quality of economic activity from a long-term sustainability point of view declined in that period. Essentially, there was a credit supply shock with all of this global liquidity being available, but in fact there were fewer productive opportunities in Europe at that time.
I will come back to the crisis period after 2007. Let me turn to my third point about what the role of national policies inside a monetary union is, especially in the context of this kind of credit shock. I will come back to interest rate policy in a minute. The other levers of policy include credit policies, thus using financial regulation to ensure that banks do not over lend. Today, we are talking in Ireland about loan-to-value ratios and loan-to-income ratios. The Central Bank of Ireland could have used those tools in the mid-2000s. Other countries did use them to a much larger extent than here.
This morning, Mr. Regling talked about the fact that these were out of fashion a little bit at that time. I think one can find examples where they were used more extensively than here. That is the first line of defence. When the source of the instability is global credit, the more direct way to deal with that is through regulation of credit politics here in Ireland.
The second line of defence is fiscal. At a micro level concerning the role of taxes and subsidies that might have encouraged investment in housing, those policies could have been changed. At a macro level, the narrative is that under monetary union the scale of fiscal surpluses one needs to run when one is in an all out boom situation, is much larger than was achieved.
It is the case that the fiscal balance was in surplus for a long time but fiscal surpluses of 1% or 2% of GDP were basically not enough. There are counter examples. I wrote in the report that in 2007 countries like Finland and Sweden had surpluses of more like 5% of GDP. Again if we roll back the clock, would that have been something that was seen as politically viable in the Irish situation - running surpluses in the mid-single digits? In the report I describe also the possible role of a rainy day fund. Essentially, given how difficult it is to manage surplus situations, it might have been a way to communicate to the population that some of this tax revenue was a windfall, so the capital gains taxes, the stamp duties and so on might be seen as ring-fenced. They were not going to be long-term revenues at the level that they were and those revenues could have been diverted into a secure fund, which then could have been released when the downturn came. I wrote about this in the late 1990s before the EMU pointing to this perhaps being one of the innovations we need. Regarding going into the euro, there was enough evidence that one needs to run fiscal policy on a more prudential basis than was achieved. It is important to say that it is not the case that the Irish system failed to deliver surpluses. There were surpluses and public debt came down to a relatively low level but this was of a different order - the scale of it that was needed to stabilise the system was much greater than was politically discussed at the time.
I will turn to interest rate policy, the one that we do not have under the euro but could have had outside the euro. One thing we could have taken before joining the euro was to revalue the Irish pound, so in terms of the lock-in exchange rates, we could have done more. There was a small revaluation in early 2008 - it was around 3%. The Irish economy was rocketing in 1998 and 1999. It could have been anticipated that a much bigger revaluation could have been a good way to start in the move to the euro because that would have relieved inflationary pressures that built up. In terms of interest rate policy, in the period 1999 to 2002 it is clear that we would have chosen much higher interest rates if we had been outside the euro. The economy was really strong, inflation was quite high and way above the European average. We would have seen much higher interest rates here. It is not super clear after that. From 2003 to 2005 inflation here has come down and in 2004 and 2005 we were pretty close to the European average. It is not clear to me that the Irish Central Bank at that time would necessarily have picked much higher interest rates. In 2006 and 2007 we were back to a situation where the economy started to overheat again and we would have picked higher interest rates. I think the interest rate sequence we would have seen would have been different but I also would emphasise that carries its own problems.
When a country has a small economy with its own currency and it raises interest rates in the heated situation we were in, there will be offsets. One is that it will look very attractive to global investors. If one is offering a 5% interest rate when France is offering 3%, one will have a lot of capital flowing in. It could have brought in foreign capital to look for gains here. The currency would have appreciated. The interest rates we would have needed to cool down the housing market might have been the interest rates that would have had severe consequences for the export sector. Switzerland is seeing that now. There is a trade-off between the currency position and the interest rate position we want for financial stability versus what is desirable for the real economy. That is the conundrum, there is no way around it, which is why, essentially, there is the current debate. Interest rates cannot do everything. We need the credit policies - the macro-prudential policies - as well.
Iceland had a floating currency. If one mixes a floating currency with poor regulation, one can get perverse outcomes because the krona in the mid-2000s was quite strong. What that meant was that an Icelandic risk-taker could say to an international bank that in euro terms he or she was worth €1 billion because of this currency appreciation effect and therefore he or she could offer it better collateral and could borrow more. Again, with a well-regulated banking system that effect goes away but one has to think about the interaction of interest rate policy, regulatory policy and fiscal policy together.
My final point is about the crisis. In the first period of the crisis from August 2007 onwards, there was a fairly positive view of European Union membership because it must be remembered that with the euro we had access to European Central Bank, ECB, liquidity whereas if countries outside Europe like Iceland, Latvia and so on had foreign debts and if they did not have liquidity to help service those debts, the scale of the problem was going to get bigger. One could say there is a little bit of inoculation but there is a down side to inoculation which means resolution is postponed. It must be remembered that a big part of liquidity provision is allowing foreign investors to escape, that the foreign depositors could leave the Irish banking system and be replaced by ECB liquidity. It is important to emphasise again that a major beneficiary of liquidity is not necessarily local but the fact that foreign bondholders can get out of their positions in a smooth and easy way. ECB liquidity is a double edged sword. It is a big benefit of being part of the euro system but there are some down sides in that some crisis resolution options are avoided through that mechanism. I would say that the ECB delayed too long in coming up with an outright monetary transactions, OMT, type structure. In 2011 and 2012 there was unnecessary prolongation and a deepening of the crisis through the debate about whether the ECB has a role in eliminating redemonination risk.
If we had not been in the euro we can imagine the scenario where we had borrowed a lot but were outside the euro. That scenario would have been a much deeper crisis but maybe faster recovery. The crisis would have been deeper because if we owed dollars or other foreign currencies, there would have been a lot of bankruptcies. On the other hand, the foreign creditors might have come up with deals. They might have shown forbearance. They might have offered debt restructuring and so on. On the alternative of being outside the euro, the initial crisis would have been deeper because we would have had to face up very quickly to many bankruptcy situations. Living standards would have dropped a lot because one of the consequences of devaluation is that imports become very expensive and since so much of what we consume here are imports, we would have seen a very sharp decline in living standards. That is what happened in Iceland. When the krona devalued in Iceland it helped recovery because Icelandic firms have become more competitive over time but the impact effect is a lot of financial distress and a big decline in consumption. I do not think there is one answer to the question of which is better - a very devastating shock crisis but quicker recovery or having a more stable, gradual approach, which is what we have had.
