Patrick Honohan: Currency choices in Ireland past and present
Presentation by Mr Patrick Honohan, Governor of the Central Bank of Ireland, at Queen's
University, Belfast, 31 March 2015.
* * *
Accompanying charts can be found at the end of the speech or on the Bank Ireland's website.
Introduction
A certain nostalgia has recently been evident, south of the border, for the sterling link period
before 1979, when Bank of England notes circulated alongside the Irish pound. But are those
traditionalists looking at history through rose-tinted lenses? The financial crisis has certainly
highlighted weaknesses in the European economic and monetary union, but previous currency
arrangements were not trouble-free either. Irish financial affairs suffered setbacks in the 1950s
and 1980s also, which I would like to recall to you today. With careful attention to appropriate
fiscal and financial policies, recovery from Ireland's recent difficulties within the euro area
should continue to strengthen.
Currency arrangements in Ireland over the past couple of centuries, though mercifully less
colourful than in many other countries, have been distinctive to say the least.1 Despite the Act
of Union, the Irish pound fluctuated considerably against sterling in the early decades of the
19th Century until the two currencies were unified in 1826 (Figure 1).2
Sterling link 1826-1979
Even after the Irish and British pounds were unified, the Bank of England's commanding
banking position in England did not extend to Ireland, which relied on the Bank of Ireland and
on an expanding group of its competitors, some headquartered in Belfast, some in Dublin and
some in London, to ensure the payments system, including with their own banknotes (though
the Bank of Ireland's monopoly on notes did not apply outside most of a 50-mile radius of
Dublin). A handful of spectacular, but isolated, bank failures in the 19th Century only served to
emphasise the overall stability of the banking system that emerged in those years and which
arguably inculcated a degree of complacency about banking and a disregard of its fragility
when carelessly managed or supervised.
This system worked so much to the satisfaction of the establishment that few voices were
raised against its substantive continuation into the period of the Irish Free State. North and
south of the border, the notes of the various banks continued to circulate at par alongside those
of the Bank of England and, when a national currency commission was established in Dublin in
1927 - albeit shortly after the unfortunate repegging of sterling to gold at its pre-war level - its
notes were explicitly expressed as payable in sterling. Indeed the words "sterling payable to
bearer on demand in London" were printed on these Irish notes into the 1950s. By 1979, the
one-for-one no margins peg with sterling had persisted for over 150 years. No better evidence
of the financial conservatism of the political and business elite in this period could be desired.
But was the sterling link a good system for the Republic? One political argument for retaining it
was to ensure that currency distinction would not exacerbate the economic barriers resulting
from partition in the 1920s. However, as has been well documented, the intensity of
NorthSouth commercial and economic interactions was rather modest in subsequent decades, so
this can hardly be thought a decisive consideration. Besides, the idea of "breaking the sterling
link" had an attractive political ring to it for some of those keen to sever links with Britain.
On the other hand, trading links across the Irish Sea remained remarkably strong for the early
decades of independence. As late as 1960 almost three-quarters of the Republic's exports went
to the UK and almost half of her imports came from the UK. Even after six years of EEC
membership had contributed to geographic diversification of Irish exports, the UK accounted for
about a half of both exports to and imports from Ireland. Of course gravity retained its pull. But
the lack of a need to set up foreign exchange hedging or even foreign exchange purchase and
sales procedures when exporting to (or importing from) Britain may was sometimes thought to
have been an inertial factor slowing the diversification of Irish export trade into more dynamic
parts of the European and world economy - though export diversification was certainly in
progress.
The openness of the capital account vis-à-vis Britain and the conservatism of the Irish banks,
perhaps attributable to few sound lending opportunities presented to them, resulted in a large
accumulation of liquid banking assets in the London money market in the early decades of
independence (Figure 2). Quite the opposite to what happened later, then, in this regard.
Not surprisingly, interest rates too tended to track those in London. But there were two notable
exceptions. The first was in 1932 with the formation of a Fianna Fáil government, in apparent
response to which the Irish banks, seemingly fearful of radicalism, widened their lending
spreads over the London bank rate (cf. Ó Gráda, 1994). The other notable exception was in the
mid-1950s when, in a mistaken presumption that some monetary independence could be
retained despite the exchange rate peg, Irish official and bank lending rates were held down
despite increases in London. This latter episode was marked by an outflow of funds for which
the adopted remedy was an overdose of fiscal austerity (as it would be termed now) associated
with a recession and a surge in emigration. The power of the financial markets in influencing
fiscal policy was thus displayed earlier than many may realise.
Inflation too tracked that in the UK rather closely in the sterling link decades, except during the
period of wartime price controls. The pass-through was not immediate or exact,3 but, taking
one-year with the next, it was inescapable. To that extent, the sterling link imported to the
Dublin-based authorities the credibility of the London authorities in regard to inflation, though by
the 1970s, this was nothing to write home about (Figure 3).
So, for three-quarters of a century after Independence, Ireland maintained a one-to-one peg
with sterling. At first, this was not an unusual position for a post-colonial country. But,
one-byone, each of the former countries of the sterling area abandoned such a link, typically very soon
after independence (Honohan and Lane, 1999). Some countries were motivated either by
economic nationalism or a desire to exploit the apparent pro-growth potential of an autonomous
currency. The break in other countries was driven by unsustainable expansionary
moneyfinanced fiscal policy. By 1978 only Sierra Leone and Ireland were left as members of the
sterling area.
Exchange rate mechanism of the European Monetary System 1979-1993
Ireland had begun to toy with a break in the arrangement from at least as early as 1976, when
sterling took an alarming slide against the US dollar (and against the currencies of the
European "snake" linked to the Deutsche Mark), triggering Irish inflation. The strongest
economic arguments for a break were (i) the fact that the currency link to what had been the
epitome of financial strength no longer provided financial stability, combined with (ii) a
perception that the long-period of relative economic decline for the UK would continue and
would augur poorly for an economy too closely linked with it. Yet, lacking a clear alternative
policy, and fearful of switching to too tough a regime, the Irish authorities had left any decisive
step to change currency policy on the long finger.4
Suddenly the landscape changed when, triggered by the French Government's desire to rejoin
the currency "Snake" arrangement according to which continental currencies maintained a joint
float against the US dollar (the chart of exchange rate movements thus tracing a snake-like
appearance), a movement among leading European politicians to create a 'zone of monetary
stability in Europe' forced the Irish Government to make a choice. A new type of exchange rate
regime, tying Ireland into the seemingly more vigorous, less volatile, continental economies with
their recent record of lower inflation seemed to be on the cards.
Should the Irish government join the exchange rate mechanism (ERM) of this new European
Monetary System (EMS), even at the risk of having to break the sterling link (if the UK did not
join)? Perhaps the new arrangement really would represent something different and more
acceptable that the austere Snake - tougher than the sterling link, but weaker than the latter.
After some initial hesitation, largely motivated by the fear of the regime being too strict, but
eased by some ad hoc European subsidies (also granted to entrants Italy and Denmark),
Ireland joined the ERM, while Britain stayed out.
The outcome did not correspond to expectation. The ERM proved to be a much softer or more
lax exchange rate regime for Ireland than the sterling link. Not only did sterling - still the main
trading partner currency - strengthen as a result of North Sea Oil and the anti-inflation policies
of the Thatcher Government, but the ERM itself failed to live up to its branding as a zone of
monetary stability. In particular, with its many realignments, the ERM lacked a "nominal anchor"
which would ensure price stability. This allowed less disciplined member states frequent
opportunities to offset wage competitiveness drift with adjustments to the peg. Devaluations of
the Irish pound against the DM - core currency of the ERM - were thus more frequent than had
been envisaged, occurring about once a year in the first eight years of the system. This
includes three big Ireland-specific devaluations, in 1983, 1986 and 1993. Furthermore,
fluctuations against sterling were high - much higher than during the Napoleonic suspension
(Compare Figure 4 with Figure 1).
No longer constrained by the discipline of the sterling peg Irish inflation soared at first in the
ERM (Figure 3), though it came under control by the mid-1980s. The inflation surge can be
largely attributed to the soaring budget deficit (and accompanying relaxed national pay
agreements) 1977-1981, accommodated and reinforced by the sharp weakening of the Irish
pound against sterling in the first years of the new system. This experience presaged the deep
fiscal crisis of the 1980s. That crisis, which was exacerbated by the UK recession, can hardly
be blamed on the change in exchange rate regime. The growing reliance on foreign borrowing
by the Government was already well under way in the final years of the sterling link and there is
no suggestion that access to foreign borrowing was eased or necessarily hampered by entry
into the ERM. Indeed, the decoupling of the Irish pound from sterling arguably somewhat eased
the economic pressures of adjustment by allowing Ireland to retain a degree of international
competitiveness through that difficult decade.
But the heightened uncertainty about inflation, exchange rate developments and the budget
resulted in high nominal and real interest rates. Short-term interest rates, over-compensating
for the risk of realignment, did not fall to German levels but averaged over 21⁄2 percentage
points higher in real ex post terms (Figure 5; Conroy and Honohan, 1994). Clearly markets
were not convinced about the conduct of macroeconomic policy in general, and imposed that
penalty.
There is little evidence of the downward trend in the UK's share of Irish exports being either
accelerated or slowed by ERM membership (Figure 6a), though the share of imports coming
from the UK did finally begin to decline (Figure 6b)5. The long-hoped for participation of the UK
in the system finally occurred in October 1990, only for sterling to exit again within two years as
the system fell apart in the crisis of 1992-1993.
Managed float 1993-1998
The kind of adjustable peg currency regime at the heart of the EMS subsequently became
largely discredited (Fischer, 2001). With the ERM fluctuation margins widened after the
1992-1993 crisis to an undemanding 15 per cent, there followed a curious interval during which
a seemingly rather under-defined policy actually resulted in considerable exchange rate and
inflation stability.
The policy regime was described as a managed float (within the wide ERM bands6) with a
general objective of price stability. That objective was not quantified, however. Achievement of
the objective was said to be "predicated on maintaining a firm exchange rate vis-à-vis other low
inflation countries" (Central Bank Annual Report 1996) - so there was an exchange rate
objective, though again unquantified. Forex intervention was undertaken to smooth the
exchange rate, and the exchange rate objective was "supported by changes in interest rates as
required".
Despite the seeming vagueness and ad hoc nature of this policy regime, the five-and-a-half
years that it covered enjoyed more inflation stability than the subsequent era, with the
fourquarter moving average staying almost wholly within a 1-3 per cent band. The ex post real
interest rate differentials also narrowed significantly in this period. Furthermore, helped by the
maintenance of international wage and price competitiveness, the mid-1990s was (as we must
remember) a period of rapid employment and output growth and of substantial budgetary
consolidation with an international balance of payments surplus. To an extent, this favourable
experience is likely to have been facilitated by the determination to adhere to the convergence
criteria established for entry to the single currency.
Nevertheless, the chequered history of exchange rate volatility since the end of the sterling link
meant that, when EMU finally got under way in 1999, it was ironically with some sense of relief
that, less than 20 years after breaking the link between the Irish pound and sterling, Ireland
abandoned currency autonomy in favour of the euro.
The euro since 1999
It is fashionable now to decry the initial design of the euro as if its travails were easily
foreseeable or indeed inevitable. Certainly important improvements in euro area institutional
structures have been launched post-crisis, especially the creation of bailout funds and a
centralised bank supervision mechanism. But it is equally true that sufficient existing national
policy tools were available to have enabled the regime to survive its first 16 years without the
trauma that has been experienced. All that was needed was disciplined national economic
policy, supplemented where necessary by sufficient common surveillance of participating
countries' policies.
True, when countries like Greece, Ireland, Italy, Spain and Portugal got into trouble, the
traditional safety valve of devaluation was no longer available. But, one needs to recall that it
was the systematic tendency to over-use that lever that had resulted in the inflationary stop-go
of the 1970s and 1980s which was the major backdrop to the determination of many countries
to "import the credibility of the Bundesbank" by signing up for the euro. The absence of a
devaluation lever must be considered as a feature, not a bug, in the system.
The fault, I am thus arguing, lies not so much in the system's design as in the inadequacy of
national economic and financial policies to take account of the risks that were still associated
with the euro. There is another dimension worth mentioning. And that is the complacency of
financial markets, which assumed that policies would in the end prove adequate (or, if not, that
failing policies would be compensated by bail-outs) and accordingly did not provide to national
authorities until it was too late the uncomfortable warning signals for which bond markets are
notorious. Indeed, as had been foreseen, for the entire decade before the crisis broke, the
single currency removed the risk premium in wholesale Irish interest rates, an achievement
which was hailed at the time.
With the Irish economy booming already from 1994 and continuing to grow rapidly after the
start of the euro, low interest rates were not exactly what was needed to restrain what was
obviously a somewhat overheated economy. But fiscal policy could have taken the strain - as
could macroprudential policies.
The creation of a sovereign wealth fund (the National Pension Reserve Fund) can be thought of
as a step in this direction, though the annual 1 per cent of GDP contribution to it did not take
enough spending power out of the economy. Personal savings were also incentivised by a
remarkably generous special savings scheme introduced in 2001, but this scheme disgorged
the savings five years later, with the economy still in its boom phase. And fiscal incentives for
the already over-dimensioned construction sector continued for far too long. While the overall
headline figures for the Government's finances showed a comfortable position, and the debt
ratio fell to 25 per cent of GDP, stable sources of revenue had been displaced by volatile ones,
and large expenditure commitments were undertaken making the future evolution of the public
finances over-dependent on a continuation of the housing boom.
Getting the public finances back on track after the collapse of the property boom would have
been painful enough, but the added borrowing resulting from the bank failures (and from the
assumption by Government of banking debts) was the straw that broke the camel's back,
triggering a loss of access to international financial markets as awareness grew of the scale of
the losses. Quick action to negotiate a programme of financial assistance from the IMF, and
from official EU lenders, stabilised the situation and eventually enabled the Government to
finance much of the additional borrowing on favourable terms.
The very fact that the most significant banking failures outside of Ireland in this crisis occurred
in non-euro area countries (Iceland, Latvia, the UK, the US) does help to emphasise that the
Irish crisis was not a creation of the euro area. True, there were major banking failures in euro
area countries too, Spain, Netherlands, Belgium, Germany, France and so on. Banking
excesses were essentially a global phenomenon in the first decade of the 2000s. Yes, Irish
banks probably found it that bit easier to access foreign funds when no account needed to be
taken of exchange rate risk. But Iceland's banks also sourced international funds without much
difficulty.
In the past, exchange rate regimes did not come complete with specific external supervision of
domestic policies. To be sure, the International Monetary Fund (IMF) has conducted
surveillance of its members' fiscal policies for decades, regardless of their exchange rate
regime. Ireland's peg to sterling was of course not accompanied by banking supervision
conducted by the Bank of England. Nor did the European Monetary System have a banking
supervision arm. And that was the decision also when the euro area was established: creation
of something like what has now been established as the Single Supervisory Mechanism (SSM)
would have been seen as a step too far by anti-federalists. Still, in its enthusiasm for forging an
understanding of the euro area as the most relevant policy unit for its actions, the ECB may
have gone too far in the other direction of failing to appreciate the dangers posed by intra-euro
area capital flows, especially through the banking system.
The IMF did not foresee the Irish banking meltdown, and this realisation may induce some
scepticism about the ability of external surveillance to prevent such problems. However, the
SSM's analysis and engagement is much more intense, and it has the full powers of a modern
banking regulator.
Fluctuations in sterling also contributed to overall economic performance in Ireland during the
financial crisis. Sterling weakened sharply in 2007-2008 pushing the bilateral nominal
exchange rate for Ireland vis-à-vis the UK to all-time record levels (Figure 7). This surge was
largely maintained during the worst of the crisis, though it has since fallen back - though not yet
(March 2015) to the levels of mid-2007.
Concluding remarks
Each of Ireland's three currency regimes has seen periods of relative prosperity and of crisis
and recession. This should not surprise us. The textbooks have struggled to determine
unambiguously what type of exchange rate regime works best in all environments for different
types of country. Poor economic policies and bad luck are more reliable determinants of
episodes of poor economic performance than choice of exchange rate regime.
During the 1970s the sterling link in practice tended to export Britain's relatively lack-lustre
economic performance to Ireland in a way which was only partially offset by domestic policies.
The greater flexibility of the ERM could not insulate the economy from the consequences of
fiscal collapse and fiscal correction in the 1980s. And policy inattention to the heightened
vulnerabilities of the single currency meant that Ireland was one of the worst performing euro
area countries in the downturn of 2008-2012.
Should we not conclude that the choice of exchange rate regime for a country like Ireland is of
second order importance for national welfare relative to the quality of domestic policy choices
and implementation? If so, focussing on these domestic policy issues is what is needed to
ensure that Ireland can reach its full potential in the euro area.
References
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European Countries: A Gravity Study." The Economic and Social Review 30(2): 159-174.
Fischer, Stanley. 2001. "Exchange Rate Regimes: Is the Bipolar View Correct?" Journal of
Economic Perspectives 15(2):3-24.
Gerlach, Stefan and Rebecca Stuart. 2014. "Money, Interest and Prices in Ireland, 1933-2012."
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Honohan, Patrick. 1997. "Currency Board or Central Bank? Lessons from the Irish Pound's Link
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Honohan, Patrick and Charles Conroy. 1994. Irish Interest Rate Fluctuations in the European
Monetary System. (Dublin: Economic and Social Research Institute).
Honohan, Patrick and Gavin Murphy. 2010. "Breaking the Sterling Link: Ireland's Decision to
Enter the EMS." IIIS Discussion Paper No. 317, Trinity College Dublin.
Ó Gráda, Cormac. 1994. Ireland: A New Economic History 1780-1939. (Oxford University
Press).
Thom, R. and B. Walsh. 2002. "The Effect of a Currency Union on Trade: Lessons from the
Irish Experience," European Economic Review 46, 1111-1123.
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