Dr. Alan Ahearne:

One of the main purposes of banking union is to break the link between banks and the sovereign. The question asked was how that would happen in practice. That is where the single resolution mechanism comes into play. It works in two different ways. One could ask where the money would come from if the Irish banks required more capital. I do not know whether they will require more capital. There is supposed to be a stress test done on the banks. It would be better for the stress test to happen sooner rather than later. It seems to have been put off more than once. If the banks are under-capitalised, we need to know about that. That is true right across Europe. It is politically convenient to put off the stress tests because politicians do not like putting money into banks but if the banks are under-capitalised, that will weigh on the amount of credit they give out which will affect economic performance. The sooner we find out the true state of the European banking system, the better.

That is one advantage of the single supervisory mechanism. The European Central Bank has taken over the job and before it begins to supervise banks across Europe, I presume it will do the mother of all stress tests. At least if I was working for the European Central Bank I would not want to have a situation where in three years time one or more banks fail and then I realise they have failed because of problems that existed before I took on the responsibility. Let us get it all nice and clean from day one and therefore carry out a very tough stress test. The European Central Bank will probably carry out a very tough stress test. Some people fear that but I believe it is positive. One has to find out the extent of the problem and fix it.

Having done that, if more capital is needed in Irish banks, the issue is who puts it in. The place it should come from is a European fund. We are not talking about failed banks; we are talking about banks that have a future. We are not talking about plugging massive holes in the balance sheet. We are talking about giving them enough capital so that they can function as proper banks. The State has done more than enough recapitalisation of banks and the money should rightly come from Europe, for example, the single resolution mechanism or perhaps some fund linked to it.

That would be very helpful in breaking the link because when one talks to people involved who hope to lend to this country at low interest rates and to buy Irish bonds, they are not worried about the fiscal situation. The Government has huge credibility in terms of reducing the fiscal deficit. The State has it because it has been earned since 2008. Neither the previous Government nor this one have blinked in terms of doing fiscal consolidation. They have rightly got on and done the job. The people who buy Irish bonds do not worry about that. What they worry about is whether more money is needed for the Irish banks and whether that will add to the country’s debt levels. By and large the people who buy Irish bonds understand fiscal and economic issues inside out but they are less comfortable with the banking stuff. They are worried that there is a further black hole. The way to resolve the issue is to say that if more capital is needed, it will not come from the State as that breaks the link. That is very important. The big risk in terms of this country going back to the market and staying in it is coming from the banking sector. That was also true in late 2010. It was not so much the fiscal issue, it was what the recapitalisation and rescue of the banks would ultimately cost. The people who buy bonds and lend to the Government could not really get a handle on that.

A second issue, which is as important, is the legacy issue, that is, getting some fund in Europe to buy shares in the Irish banks and paying a good rate for that, which would allow the State to reduce its debt. That is also extremely important. Both of those factors are very important for the economy and the Government should push hard on them. It is well known that the previous Government did try to have burden sharing with senior bank bondholders in late 2010 and Europe stopped that, and so the State is owed something significant from Europe. The sort of banking union that is being put in place should have been put in place as the single currency was created. The Irish can justifiably ask for recapitalisation to be done retrospectively. That would be an important part in breaking the link. The other point is that at the moment a deposit guarantee system is done nationally and that then links the sovereign to the banks. If that was done at a European-wide level, again, one would help to break the link. That is the second component.

The question was raised about rules, where they are all leading and if they are all necessary. In part, the fact that there are so many fiscal rules is based on a misunderstanding of what caused the crisis. If one goes back two years, certainly in Germany and some other countries in Europe, the argument was that the reason we have this euro crisis is because governments were spending too much, that it was a fiscal policy problem. It has been shown clearly that it was not the problem. A hangover of that is the huge amount of rules we now have. It is also partly a German approach. When I talk to German economists, there seems to be a belief that there is no problem that cannot be solved by more rules. If rules do not work, they say that one should make them tighter and have more of them.

On whether the rules are useful, they are in the sense that one could not possibly have a fiscal union or eurobonds, which would be a good idea, without such fiscal rules. One could not possibly have a case where Italy, for example, could issue eurobonds that would be backed by the German Government but yet it could do whatever it wanted on the fiscal policy side. Germany is not going to tolerate that nor should it or any other country. If one is going to have guarantees from all the states, which is what would be entailed with eurobonds, from countries borrowing, then one would have to have very tight rules. They are not a means in themselves but they are a stepping stone to something else that would be valuable. What would be valuable in terms of making monetary union work is much closer fiscal integration in terms of eurobonds and shared risk.

Professor McHale mentioned the United States as a functioning country with monetary union. If one has a bad shock in the state of Pennsylvania all the unemployment and social welfare benefit is paid by the federal government, so it is a real shock absorber for Pennsylvania that the money is not coming out of the local state finances. That is the type of shock absorber one needs at European level for the currency to function properly.

A number of questions were asked about austerity. The stance at European level is wrong in the sense that the recession is going on for so long and the numbers coming out, in particular from southern Europe, are so bleak in terms of unemployment and growth.

If we think about support for closer integration, that support will only be there if the social fabric can hold together. I do not think we can have another few years of recession in the EU area without the social fabric breaking apart. Typically a recession lasts just a few quarters but this one has been going on for years. There is too much social stress so there needs to be a policy change at the European level and, as I mentioned, both monetary and fiscal stimulus. The ECB can do more - it can cut interest rates. It can come from 75 basic points all the way down to zero as has been done in the United States, which would help a bit. It would be particularly positive if those lower interest rates can be made to feed through to where they are needed, namely, in southern Europe. That would also be helpful in Ireland. It costs firms in Spain and Italy a lot of money to borrow. The ECB interest rates are very low but they are not the transition channel that goes from the ECB to the firms and households that borrow. That has broken down. Banking union is in itself a way of fixing that transmission mechanism.

There is another thing the ECB can do. I used to work for a think tank in Brussels called Bruegel and some of my colleagues there recommended that the ECB buy more SME-type loans from banks and not discount them in terms of collateral. That would help and would make lending by banks to SMEs more attractive. It is a good suggestion.

On the fiscal side I mentioned Germany. I do not think it is appropriate that Germany is being fiscally so tight. I have spoken to many German economists and policy makers and they will mention two things. They say we are competing against China and must therefore be very competitive and that is why they are not willing to spend so much or give big pay increases. They also talk about demographics, saying we have an ageing population and must save for our old age. From their narrow perspective there may be something to that but the fact that the Germans are being fiscally very conservative when they do not need to be is very negative for the rest of the EU area.

We can look at the recent numbers and the terms of the next two budgets where a €3 billion adjustment is planned for next June, with a €2 billion adjustment to follow, or €5 billion in total. These were written down in order to get the budget deficit below 3% before 2015. For a couple of reasons, two in the main, it now looks as if the Government could hit that 3% target with less than €5 billion in the coming two years. We will know more in the coming two weeks when the Department of Finance produces its projections for growth. It might well be that the Government could do €4 billion or €3.5 billion, let us say, over the next two years and still hit that 3% target. One could argue that the Government should stick to the €5 billion of adjustment, starting with the €3 billion in the next budget and the deficit will then come down to 2% of GDP by 2015, or one could say we can still hit our 3% target without having to do quite as much. There are arguments for and against on both sides and economists will argue about it.

For two main reasons I can see things are working out a bit better. One is the promissory note restructuring, which helped. The other is that when the programme was initially designed it was quite conservative - it built in a bit of leeway. It is hard to work out exactly how much tax revenue there will be from growth. There is no scientific formula so one makes an estimate. It turns out that quite a bit of leeway was built in because the makers were quite conservative. What has happened is that while growth has underperformed tax revenues have not - because of that built-in leeway. All that has helped. For my part, I believe there is certainly a case for sticking with the 3%, or its like, and doing somewhat less over the next two years in terms of budgetary adjustment. I would not have said that a few years ago when interest rates were high and there was still a lot of work to be done but interest rates have come right down and a lot of the restructuring and broadening of the tax system has already been done, which opens up some leeway.

One question might be what would the money be used for if the Government did €1 billion less fiscal adjustment over the next two years. Who will benefit from that €1 billion - would it be high-paid public sector workers? What could it be usefully used to do?