reflections

Nov 19, 2010 | 12:05 GMT

6 mins read

The Eurozone and the Irish Problem

It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.
The financial storm clouds continued to swirl around Ireland on Thursday. Early in the day, the country's Central Bank chief said that a "very substantial loan," likely worth "tens of billions" of euros, would be needed to right the Irish ship, which was confirmed later in the day by Finance Minister Brian Lenihan. These comments come as EU powers — Germany and France — demand that Ireland raise its corporate tax rate as a necessary condition of any bailout package. This confirms STRATFOR's assessment from the beginning of the week that the issue of the corporate tax rate would come to the fore of the Irish banking (and thus sovereign) bailout debate. One did not have to be present in the conference rooms of the European Council's Justus Lipsius building to realize that Dublin would be pressured over its corporate tax rate. France has been eying the Irish tax rate — the lowest among the Western European Union member states — with annoyance for at least two years, and made the idea of an EU-wide corporate tax rate one of the projects of its 2008 EU presidency. The issue again surfaced as recently as an October EU finance ministers' meeting. The low corporate tax has allowed Ireland to attract foreign investors — of the Anglo-Saxon variety that Paris and Berlin find particularly irksome — giving Dublin a degree of economic independence from the continental powers. Dublin has used this independence to repeatedly ignore Franco-German dictate — with popular referenda defeating both the Nice and Lisbon treaties. A continent of supposed EU allies is becoming less and less confident in each other. The Irish, not surprisingly, refuse to budge on the issue. Lenihan said the corporate tax rate was "an absolute red line" and Deputy Prime Minister Mary Coughlan said it was "non-negotiable." The rhetoric from Dublin, therefore, is that Ireland will stick to its corporate tax rate over getting a bailout. The Irish society is so committed to preserving the low corporate tax rate that all sectors of the society — from low income to its billionaires — favor raising their income taxes instead, therefore preserving the policy that led to the emergence of the Celtic Tiger economic miracle. The corporate tax rate is to the Irish what gun rights are to Texans. Under "normal" circumstances, however, when a country goes to the International Monetary Fund or the European Union hat-in-hand for a bailout, it has no ability to resist the attached conditions of the aid and essentially comes prepared to part even with its hat. However, in the case of Ireland — and Greece before it — the two countries actually have leverage — their collapse would hurt EU heavyweights Germany and France as much, if not more, than Athens and Dublin. According to the Bank of International Settlement data, Irish banks owe German investors $138 billion and France $50 billion. But the threat of collapse goes further than just direct debt owed to French and German investors. Markets are still skittish from the 2008 financial sector crash and the fear is that a collapse in a peripheral Eurozone economy would ultimately find its way to a far more important, and bigger, country such as Spain or Italy. At that point, all bets would be off because there is no way anybody, not even Germany, would have the arsenal to bail out the entire Club Med and the resultant panic would most likely lead to the collapse of the eurozone and potentially another global recession. In the Irish case, their ability to hold out from getting a bailout is enhanced because the government is fully funded until mid-2011. Dublin only has to raise around 23 billion euros for the entire year, a far cry from Athens' need to raise 25 billion euros in May and April. But the idea of Berlin and France on one end and Dublin on another angling for better terms of the bailout for the next six months is not one that instills confidence. While Dublin continued to hold out, investors could decide to dump Portuguese and Spanish investments, causing a continent-wide panic regardless of how the Irish crisis progressed. We do not foresee this happening. There are in fact four scenarios that we see, none of which we believe will lead to the doomsday scenario of a eurozone collapse. First, Germany folds: Berlin decides to give Ireland a bailout without changes to the corporate tax rate. In the interest of eurozone stability — and German influence on the Continent — Berlin lets Ireland keep its golden egg-laying goose — at least for now. Berlin can always deal with pesky Ireland at a later stage when the fate of the entire eurozone is not at hand. Second, Berlin either forces the tax rate to be phased in at a later stage, thus letting Dublin have a quasi-victory, or conditions corporate tax increases as potential punishment for Irish inability to stick to the terms of the bailout. A third scenario is that Berlin retracts or softens comments that from 2013 onward, investors will have to shoulder costs of eurozone bailouts via losses on investments, comments that in part started the current panic. There is already evidence that Germany's financial institutions are pushing back on these comments — they already helped rescue Greece at Berlin's request. The problem with this scenario is that German Chancellor Angela Merkel faces three key state elections in four months and anti-investor rhetoric plays well among European populations, since they usually conflate the word "investor" with the idea of "American hedge-funds" rather than "our own banks." The fourth scenario is that Ireland folds. Germany forces the European Central Bank to stop buying Irish bank bonds on the secondary market, forcing Dublin to come to the negotiating table. This is as close to the nuclear scenario as there is, but ultimately Ireland folds because defaulting on debts — its banks do owe $69 billion to American investors, who have flocked with gusto to Ireland — would do as much harm for its image as a business-friendly island as raising the corporate tax rate. One way or another, the eurozone survives the Irish crisis to live another day. But the Irish case of a country at least theoretically contemplating financial suicide over accepting German aid illustrates that under the crisis caused by investor lack of confidence lies a more fundamental problem — a continent of supposed EU allies becoming less and less confident in each other.

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