25 July 2019

Currency, Credit and Crisis:

Central Banking in Ireland and Europe

392 pages,
ISBN 9781108741583

Reviewer: William A Allen, NIESR

Patrick Honohan is an Honorary Professor of Economics at Trinity College Dublin, and he was Governor of the Central Bank of Ireland from 2009 – 2015. His book contains an interesting account of Irish monetary history, but it is mainly an account of his activities and experiences at the central bank. He became Governor in the midst of the financial crisis, when the Irish financial system and public finances were in a truly dire condition, mainly as a result of a real estate and building boom financed by the banks which had resulted in massive bad debts. Professor Honohan played a large part in sorting the problems out and restoring Irish finances to a respectable condition.

It is not easy for small countries like Ireland to decide how to manage their monetary policies. If they fix their exchange rates to another currency, they have to put up with a monetary policy chosen by another country, which might not suit them; if they float, they have to bear the fixed costs of managing a monetary policy of their own, and they have to find a way of dealing with international capital flows which sometimes aggravate their problems (e.g. New Zealand had to put up with unwanted exchange rate appreciation in the years before the financial crisis). For a long time Ireland had a currency board based on sterling; in 1942 it set up its own central bank, but the Irish pound was fixed to sterling; in 1979, Ireland joined the European Exchange Rate Mechanism when the UK didn’t, thus breaking the link with sterling; in 1993 it followed the UK out of the ERM; and in 1999, it became a founder member of the euro area. In summary, Ireland has made a long transition from sterling to the euro.

Some people think that the boom and bust that Ireland experienced in 2008 was in some part the result of its joining the euro area in 1999. Its rate of inflation (excluding mortgage interest) was 2.5% in 1998. Joining the euro meant a radical reduction in short-term interest rates from just over 6% in summer 1998, pre-euro, to just over 2½% in spring 1999, post-euro. Not very surprisingly, inflation rose in 2000, to 4.7%. Post-euro monetary policy in Ireland is a prime suspect in the real estate boom which ensued.

Professor Honohan will have none of that. He describes the decision to join the euro as ‘largely political.’ He is surely right. If Ireland had carried out the same tests as the UK did in considering whether to join, it would have stayed out. That implies that the decision carried some costs. But in diagnosing the causes of the crisis, Professor Honohan points his finger at inadequate and excessively deferential supervision of the banks, which failed to stop them from lending recklessly and ultimately disastrously.

It is quite obvious, with the benefit of hindsight, that bank supervision was inadequate; but it is also quite obvious that the monetary policy to which Ireland subjected itself when it joined the euro area was completely unsuitable. If the ill effects of monetary policy were to be suppressed, then some kind of countervailing, and unprecedented, restraint would have had to be exerted by macro-prudential policy; in practice that would have amounted to the same thing as imposing severe prudential restrictions on all the banks, and on a range of other financial companies. I suppose that in some sense, Professor Honohan is right in saying that it could have been done, but it would have required a degree of foresight and courage not given to many mere mortals, and it would have raised serious questions about the legitimacy of the central bank.

Professor Honohan’s account of what happened during the crisis has many interesting aspects. I will comment on just three.

First, the central institutions of the euro area consistently refused to contemplate collective equity support for banks in distress. The most they were willing to do was to lend to the national governments of the banks, so that those governments could provide equity support. This seems to me to represent an appalling failure of solidarity within the euro area. No one was asking for a transfer or a bail out, but they were asking for some risk sharing at a fair price. Professor Honohan attributes the refusal to provide it to pervasive mistrust, and that is the only possible explanation. Yet the sustainability of a multi-national currency surely requires some minimum degree of trust among the participating countries.

Second, the financial crisis forced Ireland into a very severe fiscal contraction – not so much because of the need to make good the banks’ losses, their liabilities having been guaranteed by the government, but mainly because the loss of taxes received on the banks’ pre-crisis profits left a big gap. The fact that Ireland managed to achieve the contraction, not without damage but at any rate peacefully and on schedule, seems to me remarkable. Professor Honohan has no particular explanation for it, except to point out the importance of the interest rate reductions that Ireland rather fortuitously received on its official loans in 2011, when similar interest rate reductions were granted to Greece.

Third, Professor Honohan asserts that central banks ‘cannot and should not aspire to micromanagement of financial institutions’ (p 168). The word ‘micromanagement’ has no precise definition, but some of the interventions that he describes, such as telling banks how to treat their customers, could easily be interpreted as micromanagement, even if in a good cause. Irish regulators are not, I think, outliers in this respect. There has been a general trend towards micromanagement by regulators. It entails the consequence that regulators will be held responsible for financial institutions’ conduct, certainly by public opinion and perhaps in law, if the regulators are deemed to be ‘shadow directors’.

Ireland has overcome its financial crisis with exemplary success, and Professor Honohan’s account is readable, clear and fascinating. He clearly believes that the euro area’s troubles are not yet over, and it is impossible not to agree.