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Dublin now,keep your eye on Madrid and Rome

Andrew Neil | 11:44 UK time, Monday, 22 November 2010

So Ireland has been forced to accept a bail out after all.

Last week this blog predicted it could be as much as E100 billion -- and it doesn't look as if it will be far short of that. The money from two EU funds, the IMF and Britain (which will also chip in a bilateral loan) will be used first to rescue Ireland's bust banks and then clean up Dublin's stretched public finances.

Britain's contribution -- around £7 billion -- will be controversial in the country even if there's a consensus behind it across the parties in Westminster. But the http://www.bankofengland.co.uk/reckons British banks hold £83 billion in Irish bank debt, £50 billion of it with RBS alone. That's quite an exposure and gives Britain quite an incentive to keep Ireland's banks afloat.

I had a bit of a spat with Ken Clarke on Radio 5 live last night. He denied that Ireland's membership of the euro had anything to do with its current predicament (he also insisted he'd never said Britain should join the euro, which was news to me). I suspect most economists will think he's in denial.

The euro did not cause Ireland's woes but it sure exacerbated them because the ability to borrow very cheaply in a strong currency allowed Irish banks to go on a much bigger borrowing binge than if its currency had still been the punt.

Moreover, the fact that Dublin no longer controls its own currency, interest rates or money supply means all the pain of readjustment has to fall on fiscal policy, which is very painful indeed.

So I doubt many people would agree with Mr Clarke that the euro was irrelevant. But Tory Eurosceptics who think the Irish crisis another nail in the euro coffin are likely to be disappointed. Though euro-membership almost certainly makes readjustment more painful for countries like Ireland and Greece, leaving monetary union is not a realistic escape route.

Just consider what would happen if Ireland returned to the punt. The punt would inevitably slide dramatically against the euro and other major currencies. But all its debt -- which it already can't pay -- would remain denominated in the euro. So it would need to convert punts into euros to repay those debts -- and a weak punt would make that euro-debt an even greater burden than it already is -- and it's already unbearable. The same would be true if the Greeks went back to the drachma.

For these reasons the euro is likely to survive, albeit covered in copious amounts of sticking plaster. But I'd add one caveat: if the bond markets now turn not just on Portugal but on Spain and (whisper it) Italy too ... then the EU stability funds could not cope and the Eurozone really would be in an existential crisis -- and all bets would be off.

The markets already have Portugal in their sights and I expect a bail out will have to be arranged for Lisbon too. But the real tests are Spain and Italy, because of their size. Last week Spain issued a big chunk of public debt with no problem and the markets are not yet focused on Italy.

But both could easily become the story this winter. Keep your eye on Madrid and Rome.

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