Hamish McRae: Sovereign defaults in the eurozone are inevitable

It is about Ireland of course. But it is not just about Ireland - indeed it is mostly not about Ireland but about the rest of the eurozone and about taxation in Europe. To see why, consider the sequence of stories of the past few days.

First there were last week a series of rumours that the country would seek an emergency loan from the European Financial Stability Facility. These were denied by Dublin. Then at the weekend there were leaks from unnamed officials in Brussels that informal talks had already begun. These were again denied by the Irish, who pointed out that the country was fully funded until July next year.

Then there was a string of comments by European officials, by the Portuguese finance minister, by the governor of the Bank of Spain, all designed to bump Ireland into accepting European money. The comment to the Wall Street Journal by the Portuguese finance minister, Fernando Teixeira dos Santos, is a classic in smarminess.

"I would not want to lecture the Irish government on that," he said. "I want to believe they will decide to do what is most appropriate for Ireland and the euro. I want to believe they have the vision to take the right decision." Translated, that means: "We desperately need you to accept a European bailout because we hope that will take pressure off us, as insurance on our debt is almost as high as yours and we can't get through to next July before we have to go back to the markets."

All this is a sharp distinction in tone from the other potential source of official funds for Ireland, the International Monetary Fund. Its managing director, Dominique Strauss-Kahn, played it straight. Talking to reporters in Japan at the weekend, he said: "Everybody knows that the situation with Ireland, it's a difficult situation.

"So far I haven't received any kind of request. I think they can manage well. If at one point in time, tomorrow, in two months or two years, the Irish want support from the IMF, we will be ready."

Ireland is learning the harsh lesson that it is only when your back is to the wall that you know who is on your side and who isn't. Now, it may well turn out the country does seek help from Europe in the next few days. It has had huge subsidies from its membership of the EU and resisting pressure from what has been for many years its paymaster is tough, particularly since, separately from this possible bailout, Irish banks have been receiving massive liquidity support for the European Central Bank.

But loans come at a price and one of the suggestions has been that were Ireland to go to the EFSF part of that price would be for Ireland to increase its corporate tax rate from the present 12.5 per cent, the lowest in the EU. That rate certainly irks other EU members, including the UK, but has been one of the chief lures that the country has dangled in front of would-be foreign investors.

Would the EU have the right to demand a change? That is not clear but it could argue, reasonably enough, that a country in severe fiscal straits should consider increasing revenue from any source. If the price for doing "what is most appropriate for Ireland and the euro" is the loss of fiscal autonomy in a such a key area, you can see why Ireland is desperate to avoid having to pay it.

In any case I am not sure it will make much difference in the end to the euro. There will be sovereign defaults in the eurozone, with a default by Greece now inevitable. Ultimately the thing that underpins any country's debts is its ability to raise enough tax to service and eventually repay them. Greece cannot hope to do that. Ireland will be pushed to do so but probably can. I would, however, worry about the long-term credit-worthiness of Portugal, Spain and Italy.

So then you have to ask whether a default of a eurozone state breaks up the eurozone. I don't think we know the answer to that yet. We do know that the Germans, who hold the cards, will do absolutely everything they can to stop such a default, even if they have to grit their teeth as they do so. My instinct is that a country defaulting would not of itself lead to that country leaving the euro, but if its costs and prices were totally out of line, that probably would be the least painful way of extracting itself. If that is right in the short-term, things will be patched up and the euro will come through this downturn intact. But the next downturn, in five or 10 years' time? Surely not.

A failure of the Bank of England

So the Governor of the Bank of England has to write another letter to the Chancellor explaining why consumer price inflation, at 3.2 per cent, is above the top band of its range. That is the ninth one that he and his predecessor have had to write since the system was founded. So how many letters have they had to write explaining why inflation was below the bottom of the range? None, zero, zilch.

You might think, given this, that there has been a bias in policy towards inflation. It is true that policy is not just about the inflation mandate; it also has to take into account the state of the economy, so you could justify some acceptance of above-average inflation right now when demand is slack. But the years since the Bank took over the setting of interest rates have had two strong growth phases as well as two dips, the first not very serious. So over time you would expect there to be as many undershoots as overshoots.

Conclusion? It is surely that the Bank has failed to fulfil its mandate, a disagreeable conclusion to be sure, but at least we know where we stand.

[Source: The Independent, London, 17Nov10]

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