The Irish economy is well removed from a full-blown financial crisis. (I take it that the outstanding feature of such a crisis is the inability roll over liabilities.) Even so, it is useful to review, with the Irish situation in mind, the list of crisis-prevention actions that received broad assent after the Asian crisis. A reasonable overall assessment is that Ireland is still in a relatively strong position, but it is worthwhile to concentrate on minimising the remaining tail risk. Here is a partial list:
Exchange rate regime: Avoid soft pegs. This became known as the “bipolar view” – completely fixed or freely floating exchange rate regimes are the least crisis prone for countries with open capital accounts. (See here for a recent thoughtful account.) Being part of the euro zone is an unmitigated blessing in this regard.
National balance sheet: Avoid serious currency and maturity mismatches. Here again the ability to borrow in one’s own currency is a huge advantage. It also appears that the NTMA is doing a good job managing the maturity structure of the national debt. The existence of the NPRF is also fortuitous – even if initially put in place for another purpose. It should be viewed as a critical liquid reserve and not tapped as an easy source of funding. Although no one likes to hear about IMF intervention or bailouts from our EU partners, I see nothing wrong with careful contingent planning and agreements. I think it is highly unlikely that Ireland will need such funding. But I think it is even less likely if arrangements are in place to smoothly access funding under extreme circumstances. This would be a clear signal that the government will do everything possible to pay its debts, and would limit the risk of falling into the bad equilibrium that Philip Lane discussed in yesterday’s comments.
Macroeconomic management: Avoid destabilising fiscal policies. Although Irish fiscal policy comes in for much deserved criticism, the dramatic reduction in the net debt put the country in a strong initial position. Unfortunately, the running of a structural budget deficit during the property boom and the reliance on asset-based taxes left the country vulnerable. The key question now is what deficit can safely be run. One plausible view is that significant short-term consolidation is required to protect creditworthiness. The danger is that this will deepen the recession and potentially even deepen the fiscal hole. An alternative approach is to make the minimum adjustment necessary to show that the public finances are under control – clearly not a risk-free strategy either. This debate will continue.
Transparency: The combination of non-transparent financial-sector balance sheets and implicit or explicit government guarantees is lethal. It is indefensible that analysts are still trying to figure out how bad the bank balance sheets really are. An open, Obama-style stress test is urgently needed to reduce uncertainty.
Regulation: Err on the side of prudential regulation. Evidently, the emphasis on prudential regulation lost out in the ever-present tradeoff between encouraging innovation and minimising systemic risk. We have now had further confirmation of the tendency of financial markets to produce bubbles and the incredible damage that ensues when those bubbles burst. There needs to be root and branch reform of the regulatory system to restore confidence in the system and ensure that balance sheets are never allowed to accumulate such vulnerabilities again.