Paschal Donohoe (Dublin Central, Fine Gael)
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The committee has held a number of meetings on this and intends to publish a report on it. I am delighted to welcome two of the foremost economists in Ireland, Dr. Alan Ahearne and Professor John McHale, who will be familiar to all the members. I thank them for attending this meeting to give us their views on this topic.

Before inviting our guests to speak I must issue the privilege notice. While it is highly unlikely it will be invoked during the meeting, if I did not read it out, it would be the one time it would be. Members are reminded of the long-standing parliamentary practice to the effect that they should not comment on, criticise or make charges against a person outside the Houses or an official either by name or in such a way as to make him or her identifiable. By virtue of section 17(2)(l) of the Defamation Act 2009, witnesses are protected by absolute privilege in respect of the evidence they give to this committee. If they are directed by the committee to cease giving evidence in relation to a particular matter and they continue to so do, they are entitled thereafter only to a qualified privilege in respect of their evidence. They are directed that only evidence connected with the subject matter of these proceedings is to be given and they are asked to respect the parliamentary practice to the effect that, where possible, they should not criticise nor make charges against any person or entity by name or in such a way as to make him, her or it identifiable.

I invite Professor McHale to make his statement.

Professor John McHale:

I thank the committee for the opportunity to appear before it today. This statement provides some introductory reactions to the report of the four Presidents of the EU and also the European Commission's blueprint report. These documents set out an ambitious, staged project for the development of economic and monetary union, EMU. The vision is a combination of strengthened disciplines to limit adverse spillovers between member states and improved supports to improve stability and enhance convergence. The Commission's blueprint is the more ambitious document, with a greater focus on necessary crisis resolution tools. While the documents are very welcome contributions given the magnitude of the growth and employment challenges, there is a concern that they, and especially the four Presidents' report, focus too much on disciplines relative to supports and too much on supply to the neglect of demand.

On fiscal integration, significant steps have already been taken to improve structures for fiscal discipline with the six pack, fiscal compact and, most recently, the two pack. With Ireland's debt projected to peak this year at an unsafe 123% of gross domestic product, GDP, we have no choice but to reduce our deficit and debt. The new disciplines reinforce and make more credible a direction in which we have no choice but to go. However, the crisis has revealed the fragility of a country's debt sustainability and associated access to borrowing within the monetary union even at lower debt levels. The new crisis resolution tools, notably the European financial stability facility, EFSF, the European Stability Mechanism, ESM, and the European Central Bank, ECB's, outright monetary transactions, OMT, programme, have been significant steps forward. These steps have been hesitant, with the early proposals for the design of the ESM undermined by threats of a low trigger for private debt restructuring and official creditor seniority. While the announcement of OMT has had a significant impact on bond yields, the adequacy of the design has yet to be tested.

The proposals for a central fiscal capacity and associated stabilisation fund offer the potential for improved shock absorption capacity, especially if the fund has a capacity to borrow. These proposals are envisioned as a longer-term reform and not as part of the policy arsenal to resolve the current crisis. However, more and faster action may be needed. While it is understandable that there is resistance to a risk sharing debt redemption fund, DRF, and eurobills that were included in the Commission's proposals but not in the four Presidents' report, the revealed fragility of creditworthiness within the monetary union suggests the need for bolder action to prevent self-fulfilling runs on sovereign debt in vulnerable countries.

With regard to banking integration, the crisis revealed deep flaws in national level regulation and supervision of banks and also the potential for vicious feedback loops between banks and sovereigns where banks remain a national responsibility. The plan for a staged process to a European banking union is thus a welcome development. The envisioned end point is a US style, least-cost bank resolution process, with clear priority for loss absorption running in the order of equity to junior bonds, to senior bonds and finally to uninsured deposits. The recent Cyprus experience shows that elements of this model can be brought in on an accelerated basis. The envisioned system would be backed up by a European resolution fund, funded by risk based levies on banks, a capacity to borrow, possibly from the ESM, and ex post risk-based levies to repay such borrowings. Deposit insurance would remain a national responsibility, although the design of national systems would be harmonised.

This system offers an improved end point in terms of minimising moral hazard and sovereign risks. However, with parts of the European banking system still under significant capital and funding stress, care must be taken in the phasing in of the new system so as not to impair further credit availability in the heavily bank-reliant euro area economy. While strengthening the claims of insured depositors, least-cost resolution will make other creditors more wary of providing funding to banks and more prone to flee at early signs of trouble. The tougher resolution framework will need to be complemented by a stronger focus on ensuring banks are adequately capitalised, backed up by rigorous stress tests and ESM involvement in ensuring adequate capital levels where necessary.

On economic integration, in its response to weak growth and high unemployment, the plan envisions efforts to further the development of the Single Market and structural reforms to improve supply-side performance. There are plans for greater co-ordination of structural reforms where the policy changes have potential spillover effects on other members. One promising element is the convergence and competitiveness instrument,CCI, whereby member states enter into contractual arrangements for well-defined structural reforms in return for financial support. Sometimes it appears that European policymakers see the solution to Europe's weak growth as being only on the supply side. While well-designed structural reforms can bring significant benefits, the process can be difficult and slow, with the impact effects sometimes being negative. In the case of labour market reforms, a recent review by the International Monetary Fund, IMF, of its policy advice in this area noted: "An important branch of research has focused on the cross-country evidence regarding the effects of specific labor market institutions on the unemployment rate. .. This research has reached two broad conclusions: The devil is in the details (and the details are hard to capture in the rough measures of institutions used in regressions); and the combination of institutions matters very much."

With the ECB's single mandate for price stability and the rules of the Stability and Growth Pact, SGP, focused on national level policies, tools are lacking for aggregate demand management in the euro area as a whole, even if the flexibility present in the SGP is sometimes under-appreciated. The co-ordination potential of the European Semester process could be better used to ensure an appropriate aggregate stance of euro area fiscal policy. This should be focused in particular on stronger countries that retain the so-called fiscal space for more stimulative policies. Given the depth and nature of the recession, Europe may be poorly served by what at times appears as a single minded supply side focus. In sum, the proposals in the reports set out an ambitious and necessary agenda for the effective functioning of EMU. Care must be taken, however, that understandable concerns about moral hazard and structural impediments to growth do not overwhelm the emerging design.

Dr. Alan Ahearne:

I thank the Chairman for the invitation to appear before the committee today. In my opening remarks, I will make some brief comments about recent developments in economic governance in the EU and about some of the proposals for the future of economic and monetary union set out in the so-called four Presidents' report and in the Commission's communication on the issue published late last year. In addition, I will talk about the implications for Ireland of these developments and proposals. I will also mention some proposals for fiscal and monetary policy actions at the European level that could boost employment and growth.

It is well known that the original Stability and Growth Pact failed to prevent a major ongoing crisis in the euro area. The SGP rules were disregarded by larger member states, and in any event they wrongly focused almost exclusively on budgetary issues while ignoring excessive private capital flows which were the root cause of the crisis. European leaders have responded to past failures with a new regime of obligations and surveillance. This regime is built on a dizzying number of new rules and regulations. We now have six packs and two packs, economic partnership programmes and post-programme surveillance programmes, European Semesters, macroeconomic imbalance procedures and macroeconomic scoreboards. Highly intrusive oversight of draft national budgets in the euro area by the European Commission will be in place by the end of the year. Where is all this enhanced oversight leading us?

This new regime, in and of itself, will not make for a better functioning monetary union.

We will benefit, however, from these recent developments if they pave the way for genuine fiscal union in Europe or, as the four presidents' report put it, "a fiscal capacity for the EMU". This capacity should include risk sharing, such as an insurance type scheme between member states, and should ultimately lead to some form of eurobonds or euro indemption fund.

As an aside, I hear a lot of discussion about Ireland regaining its economic sovereignty. The phrase is used a lot in the political system and in commentary. It is usually associated with Ireland being able to borrow again from financial markets. Anybody who thinks that when Ireland can borrow again from financial markets it will mean we have regained full economic independence, should have another look at the treaty and the six pack. They should look at the two pack also.

A more urgent priority is the establishment of a banking union in Europe. A speedy resolution of problems in the banking sector is a precondition for growth. The single supervisory mechanism constitutes a first step and its establishment may help to speed up the restoration of a properly functioning banking system in Europe. However, it is the single resolution mechanism that will potentially yield greater benefits. In that context, Ireland must ensure that European leaders deliver on their 29 June commitment to break the vicious circle between banks and sovereigns.

In addition, although in principle the so-called bailing in of uninsured creditors and failed banks - which will likely be part of the final bank resolution and recovery directive - has much to recommend it, in practice it is not clear that policy makers will choose such actions in the absence of a genuine lender of last resort in the banking system. The experience of Cyprus is informative in that regard.

As I have said at this committee previously, bolder monetary and fiscal policy actions are needed at European level to end the economic crisis. The ECB could cut interest rates further and expand its credit programmes to support lending to SMEs. A European-wide programme of investment in green-tech infrastructure, for example, could boost aggregate demand and employment.

The pace of fiscal consolidation in some EU countries needs to be readjusted to support economic recovery. This is especially true of Germany.

Paschal Donohoe (Dublin Central, Fine Gael)
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Thank you Dr. Ahearne. I now turn to colleagues' questions and Senator Reilly was the first to signal.

Kathryn Reilly (Sinn Fein)
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I would like to thank Professor McHale and Dr. Ahearne for their presentations and especially for providing the information beforehand. There is so much information to digest that it is nice to be able to examine it beforehand and then structure questions accordingly. Given their expertise, I have a few questions to ask both witnesses. Knowing the Irish domestic and political terrain as well as both witnesses do, do they think the levels of economic, fiscal and monetary integration proposed by the Commission are likely to secure political support?

The President of the European Commission, José Manuel Barroso, has said that for a policy to be successful, it not only has to be properly designed but it also has to have a minimum of political and social support. How do the witnesses think that smaller member states, such as ourselves, will fare in this genuine Union?

In the years leading up to the creation of the single currency, many economists warned that political compromises at the heart of the euro were going to create real economic problems further down the road. Do either of the witnesses see any potential economic problems that may arise from the political compromises that will inevitably emerge as the Commission's proposals make their way through the European Council?

Given the witnesses' expertise, it would be remiss of me not to mention the topic of austerity. There have been a number of recent interventions from Ashoka Mody, the Minister for Social Protection, Deputy Joan Burton and, indeed, President Barroso yesterday. In his commentary, Professor McHale said that the new disciplines reinforce and make more credible a direction that we have no choice but to go in, in any case. Yesterday, President Barroso said that while he thought the austerity policy was fundamentally right, it has reached its limits. I would like to get the witnesses' comments on that.

In advance of the budget, do both witnesses think it would be in the public interest to shift the policy away from such austerity? Do they think that policy has reached its limits and that we now need to begin making greater investment?

In his comments, Dr. Ahearne said that Ireland must ensure that European leaders deliver on their 29 June commitment to break the toxic link between banks and the sovereign. Does he think that they can actually do this and, if so, under what conditions will we see this happening? It has been under consideration for nearly a year, so under what conditions does he think we will finally see the breaking of that link?

Bernard Durkan (Kildare North, Fine Gael)
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I thank our guests for appearing before the committee today and congratulate them for their submissions. First, as ordinary citizens of the EU, we can now see the degree to which the EU was unprepared for the crisis that emerged. This was referred to earlier by Professor McHale. Second, a number of remedies proposed to address the emerging issues did not work, or if they did work, they had the opposite effect.

I have a question concerning the ongoing discussion on austerity versus economic growth. What is the best way forward for our economy and, similarly, for all European economies in the current European context? Given the degree of debt already accumulated in a number of eurozone countries and a number outside the eurozone, what is the best way forward? The so-called policy of austerity is of course a necessity, not a policy. It is a question of using resources that are available, or not available as the case may be, so where do we go from here?

Bernard Durkan (Kildare North, Fine Gael)
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I would draw attention to remarks by a former member of the troika who appeared to revisit his previous position on these matters. A lot of action has taken place since then but information currently being fed into the public arena can have a destabilising effect on European countries across the entire eurozone and beyond it. That issue must be dealt with sooner rather than later. From my experience as a public representative, I see signs that are not helpful at present. There are distinct signs of unrest across Europe.

To what extent have European institutions - and national institutions both within and outside the eurozone - addressed the issue of portraying to their respective communities the extent to which resources are available to deal with the situation presenting itself? In other words, is it feasible to say to the public at large that there is no alternative? Or is there an alternative? If there is such an alternative through the hard times we see emerging at present, how do we go about pursuing it?

A multiplicity of currencies within the EU will never work. As long at that remains there will always be scope for predatory activity in the financial markets, thus enabling people to make a lot of money rapidly with consequences ultimately for the economies concerned. I have held that view for a long time, although not everybody agrees with me. They may disagree but I still strongly hold that view. I believe that it will not work without a single currency that has the full support of all EU member states, including those who aspire to accession.

Seán Kyne (Galway West, Fine Gael)
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I would like to welcome Dr. Ahearne and Professor McHale to the committee and thank them for their contributions. Dr. Ahearne mentioned highly intrusive oversight of draft national budgets. Considering all that has happened in the EU and within our system, do both witnesses think this is necessary? Dr. Ahearne also referred to eurobonds. Given the German concerns regarding this, how realistic is the notion of eurobonds? Perhaps both witnesses could answer that question.

As regards the four presidents' report, there is a discussion on the European deposit insurance scheme, which it says would strengthen the credibility of existing arrangements and serve as an important assurance that eligible deposits of all credit institutions are sufficiently insured. I would like to hear the witnesses comment on that point and how important something like that would be.

Dominic Hannigan (Meath East, Labour)
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I thank Deputy Kyne. Would Professor McHale like to respond first?

Professor John McHale:

I thank the Chairman and all members for the really excellent questions. There is quite a lot here. One theme that came up in a number of members' questions related to the intrusive level of disciplines that have been put in place under the six-pack, the two-pack and so on. One concern I share with Dr. Ahearne relates to the sheer complexity of the rules that are being put in place. Even for supposed experts in this area, going through the rules for the implementation of the Stability and Growth Pact is quite a mindnumbing exercise and, sometimes, trying to figure out how the rules combine together can be extremely difficult. This goes to the point made by Senator Reilly in terms of political support.

Thus far, the process of putting in place these various rules has gone reasonably smoothly, including the success of the fiscal treaty in the referendum. However, many people are simply switched off and have come to the conclusion they cannot really understand the workings of many of these rules. This creates a lot of risk in respect of the legitimacy of the process. One issue with which members probably are very concerned is that of democratic accountability, but legitimacy very much depends on public understanding of what is happening and there has been too much unnecessary complexity built in. A lot more could be done and while I acknowledge this joint committee plays an important role in this process, at European level a great deal more also could be done to explain to people the workings of these various rules and the reason they are so necessary.

Another theme running through the questions related to political compromises and this goes back to a theme in my statement about this balance between these disciplines, which are necessary, and supports. In some senses, one could think of supports as being the quid pro quo for the disciplines. This was clearly visible in the context of the fiscal treaty debate, where it was made explicit that access to the European Stability Mechanism, ESM, depended on having this fiscal compact. However, I worry that we will get the disciplines, which in many ways are necessary, but that in the process of political compromise, we may not get the supports which really are required for the successful functioning of economic and monetary union, EMU. I also noted this in my statement but this is evident in respect of the things that fell out on the way from the Commission's blueprint to the four presidents' report. There is no mention that I can recall in the aforementioned report of the debt redemption fund or the eurobills, for instance.

Another theme in the questions pertained to the need for austerity. What we have seen in this crisis is that in the case of a country within the monetary union with a high level of debt, which in particular is heavily dependent on foreign funding of that debt or on foreign investors to invest in that debt, access to borrowing and basic creditworthiness is incredibly fragile. This is the reason I stated we really have no choice but to get down to safer levels of debt and deficits. However, the crisis has shown that we also need effective lenders of last resort within the eurozone or these crises will recur. This is where the elements that already have been put in place, such as the ESM and the ECB's outright monetary transactions, OMTs, are so important but we must go further. First, the OMTs must really be shown to be effective and to be really accessible to countries and this is yet to be proven. However, in the longer term, we probably need to take bolder steps towards moving to something like a debt redemption fund or more in the short term to the eurobill proposals. This is supposed to be the return for the disciplines and, consequently, we must keep our eye on the process in order that we do not just get the disciplines, and the supports get lost along the way.

I will close by responding to another theme in the questions which related to the debate on austerity. It certainly has exploded in the last while as a result of the comments of Professor Mody, the debate about the Reinhart and Rogoff empirical findings, the comments of President Barroso, the Minister for Social Protection, Deputy Burton, as well as those of President Higgins and so on. There has been much discussion and it certainly appears as though austerity is being questioned in this trade-off Deputy Durkan mentioned between austerity and economic growth. However, it is very important to distinguish between two things from the point of view of what it is that we are criticising. I refer to a national, domestic view in which we must decide what to do in the context of the arrangements that exist, that is, in the context of the Stability and Growth Pact as it is designed, the context of the supports that are there and the conditionality that exists within the programme Ireland is in. The judgment of the Irish Fiscal Advisory Council has been that because of the vulnerability of our access to borrowing, it is very important that we meet the conditions of the programme. In a highly uncertain environment, it is important we recognise that because of uncertainties in respect of growth, we may need to have a little bit of a buffer or a margin of safety to ensure we can meet these key targets. If we hit these targets, we then will be in good standing with official funders and even were we to need another programme, the likelihood is that we would be able to get access to a programme without a restructuring being imposed on Irish debt. Effectively, the latter would be a default, which I believe would be highly disruptive.

The fear of such a default could make the whole thing self-fulfilling, because this is what private investors are looking at most. They are asking whether, if this country needs another programme, it will be forced to default and to the extent we remain in good standing with official funders, it becomes much less likely that such restructuring would be imposed and our chances of getting back into the markets are significantly greater. Moreover, as the threat of default recedes, it helps confidence to return and interest rates tend to fall right across the economy, including in the banking system, and that supports this process of a restoration of growth. Consequently, from a national perspective, it is highly important that we stick with the plan to get the deficit down, to meet the targets and to remain in good standing with official funders. The process we now are seeing unfold with dramatic falls in interest rates is likely to continue and we have a very good chance of being able to return to market funding.

While this pertains to the domestic side, we can distinguish it from what is happening at the European level and I now am talking about the design of the system itself. One point I made in the statement, which I believe Dr. Ahearne also underlined, is there is a contractionary bias in European policy.

I did not talk about it at the monetary policy level but Dr. Ahearne did and one can certainly see it with the single price stability mandate of the ECB. One also sees it in fiscal policy which is a very national focus on each country reaching its targets under various excessive deficit procedures. I do not think there is enough attention to the overall aggregate stance of a European fiscal policy, to extend to it what President Barroso was getting at in terms of the overall fiscal policy that gets produced by the process for Europe as a whole. We must pay more attention to that aggregate fiscal stance, to demand in the European economy in general, and more attention to developing lender-of-last-resort supports to reduce the fragility of individual countries. They are all reforms that need to take place. I do not believe it is inconsistent to believe that there is too much of a focus on austerity in the overall design of economic and monetary union while recognising that given the system as it exists, the right course is to continue with the fiscal adjustment policies that are currently being pursued.

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?

Dominic Hannigan (Meath East, Labour)
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I presume Dr. Ahearne does not wish to declare an interest in that regard. For the information of members, I will be meeting my German counterpart, Mr. Gunther Krichbaum, later in the week in the Bundestag and no doubt we will share with him some of those comments about Germany's current economic situation. Dr. Ahearne mentioned the think tank, Bruegel. We sent an invitation asking a delegation from Bruegel to attend the committee. This has been accepted and will happen in late May or early June when we will be able to ask delegates for their views on how Europe is developing.

I call Senator Fidelma Healy Eames.

Fidelma Healy Eames (Fine Gael)
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I welcome Professor McHale and Dr. Ahearne. It would be remiss of me not to given they are both from NUIG. It is great to have both of them at the committee.

I have a number of questions for both guests. Dr. Ahearne has described the "dizzy" number of schemes we have which is what many people feel about the language used about Europe and how we interact with it. They believe that interface is dizzy and that its rules and schemes are changing. One thing is invented and does not work and then something else comes along. This may be an over-simplistic question. If we did not have the euro would we have the problems we now have, and at such a scale? That question is for Dr. Ahearne. This time last year when we were looking at the fiscal compact treaty he spoke in advance of others about the need for a banking union. How close does he believe we are to that?

There is much talk about our having reached the limits of austerity. The feedback I get from constituents would certainly be that we have. Do the delegates believe that to be the case? Dr. Ahearne mentioned that we might not need as big a budgetary adjustment but I wonder how we can even push for the adjustment we still must make. Is there a case for renegotiation with the troika? When the troika gives money it comes with so many conditions, oversight and intrusion. Some of these conditions are very good in terms of structural reforms given that certain matters had gone completely out of kilter. However, some of it is not so good. We see Mr. Ashoka, one of the architects of the entire plan, saying that perhaps they got it wrong. Why did we not impose similar conditions on our banks when we gave them money? Have we been too lax with our banks? How have other countries done this? We have given money to banks for recapitalisation, mortgage debt, etc. but we are not sure if the money went where it was meant to go. For example, we know some of it was spent on very large pension payouts to failed bankers. Those questions are for Dr. Ahearne.

In his paper Professor McHale stated the problem is not only on the supply side. Perhaps he would explain exactly what he means in that regard. Why is the European area not growing at present? We have some growth in this country but it seems to be negligible because the euro area is not growing. How would a debt redemption fund work and what would be its benefits to Ireland?

Eric Byrne (Dublin South Central, Labour)
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I thank both witnesses for their very detailed and learned contributions to the debate. I do not know whether, being a politician, I see the world through a politician's eyes while they, being economists, see it through the eyes of an economist. I presume we are mutually dependent, one on the other.

If I am correctly interpreting what has happened yesterday and today with regard to the President, Michael D. Higgins, the Minister, Deputy Joan Burton, and the Tánaiste, Deputy Eamon Gilmore, President Hollande of France was elected because of the recognition that austerity on its own cannot turn around the community. We recognise Europe has an important role to play in assisting countries such as Ireland to overcome the austerity trap into which we were locked after the previous Government did its deal with the troika. I reinforce what Dr. Ahearne stated on the importance for Ireland of holding the European leaders to the commitment they gave us on 29 June to break the link between sovereign debt and banking debt. The problem is the previous Government locked us into the circumstances in which we find ourselves today.

I agree absolutely with Dr. Ahearne that it is frightening to consider the possibility of social alienation in Europe. We see the huge numbers of youth unemployment in Spain. It is incredible the Italians seem to think comedians are better in parliament than real politicians. As an Irish citizen I am concerned about growing anti-European feeling. It is interpreted in various countries in various ways, with some going ultra-right and others going ultra-left. We have a substantial ultra-leftist simplistic political band of politicians here. Perhaps the witnesses can explain in further detail European dependence on the German economy and German politicians doing the right thing. Is this something they also feel or am I paranoid that we are so dependent on the decision-making process in Germany that it can make or break the Union?

Will Dr. Ahearne explore in greater detail his warning note on whether the Government really believes its suggestion that we could be out of the programme by the end of this year and whether it is conscious of its ramifications? What are his thoughts on this issue? As he quite rightly stated, a fundamental tenet of the Government is that we want to break out and regain our economic independence, hence the desire to leave the programme by the end of this year.

Both witnesses touched on the Cypriot experience, and I ask them to make general comments on the notion, heretofore unheard of, that savers or small investors would have to pay for governmental or banking indiscipline. Professor McHale reminds us Ireland has a projected debt of 120% of GDP this year, which is a frightening figure. In various ways we have touched on the re-negotiation of the promissory note and the €20 billion which could be accessed. Dr. Ahearne suggests we could dip into this to ease the burden of austerity. Will both witnesses comment on current thinking on the possible extraction of €1 billion from the €20 billion to ease the budgetary situation? Union leader Jack O'Connor stated we are at breaking point and there are other ways to balance the books other than taking €300 million more this year from public pay.

Paschal Donohoe (Dublin Central, Fine Gael)
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I welcome the witnesses and thank them for their contribution. To continue the theme regarding the causes and limitations of austerity, if financial markets will not lend to a country, or will only lend at a rate which is too expensive for the country, what are the choices open to it? We need to distinguish between countries which have access to financial markets and countries which do not. The policy choices available to both types of country are fundamentally and gigantically different. In the discussion we have on austerity as a policy choice, will the witnesses comment on the choices open to a country which cannot afford to borrow from the financial markets?

To dwell on the Cypriot experience, it appears to indicate a euro in Cyprus is not worth the same as a euro in Ireland, France or other countries because of the various events that have occurred since. Do the witnesses agree with this assessment? If so, and they, as I do, believe it is a problem, how do we fix it?

What do the witnesses see as being the obstacles to generating the common fiscal space we have discussed? The big development of recent months has been the extension of the recession to countries which thought they were immune. There is clearly a need for a demand stimulus. To this point some have believed fiscal policy co-ordination must mean austerity for everybody. What needs to happen to generate the common fiscal capacity mentioned by the witnesses?

Professor John McHale:

Many questions have been asked so I will be selective and answer those focused on me. Senator Healy Eames asked about the focus on the supply side. A narrative has developed that Europe's problems are supply-side problems because labour, product and capital markets are not growing quickly enough and require structural reforms, which often mean measures such as reducing employment protection and changing unemployment benefit systems. Certainly, important reforms need to take place in labour and product markets, including completion of the Single Market. When one examines the economics it is harder to bring about the structural reforms which lead to better performance in terms of growth and employment than much of the rhetoric seems to suggest. It takes a long time and often the immediate effects are damaging to growth and employment rather than helpful. Measures need to be taken, but the existence of a magic recipe to turn around European growth is exaggerated. Examining the recent history of European growth, one sees a big drop during the crisis, and recovery when countries were generally pursuing more stimulative policies.

With the sharp turn to austerity, which was common right across Europe, one sees quite a significant fall off in growth. This year, within the eurozone, the projection is that the zone will contract by 0.3% of GDP, coming back slowly next year. It is hard not to believe that there is a significant demand side element to this and that the co-ordinated austerity that is taking place is a significant component of the European growth problem.

Added to that is the less than helpful stance of the European Central Bank or, more accurately, the stance of the ECB that is not as helpful as it could be. While the ECB has certainly brought interest rates down to a low level and provided huge support for banking systems, its stance compares less favourably with that of the US Federal Reserve, which has done things like signalling strongly that it will keep interest rates low for a long period of time and clearly focusing on what is happening not just to inflation, but also to employment. The single mandate of the ECB has led it to pursue a less stimulative monetary policy than would otherwise be the case.

There is a need to challenge the narrative that Europe's growth problems are all on the supply side. There is also a need, in this revamp of economic and monetary union, to make sure it is capable of counter-cyclical action so that the focus is not just at a national level. We must also look at what the sum total of these national policies amount to in terms of the overall fiscal stance of the eurozone, although I certainly do not see enough evidence of that happening at present.

Members also asked about the debt redemption fund and there are different proposals being examined in that regard. One of the core proposals, which is contained in the European Commission's blueprint, envisions debt above 60% of GDP effectively becoming mutualised. In Ireland's case at the moment, that excess amounts to about 60% of GDP itself because, as Deputy Byrne pointed out, we will be at 123% of GDP this year. The proposal essentially means that as debt becomes due to be rolled over or used to finance new deficits, we could finance about 63% of GDP in the Irish case, through this fund. The funds would be raised collectively, with joint and several guarantees. Effectively this would give us guaranteed access to low-cost funding up to that amount. This is combined with disciplines that force countries to bring their debt to GDP ratio down over time. In the original proposal from the German Council of Economic Advisers, the fund was set up so that at the end of the process, countries would have debt to GDP ratios below 60%. It was a combination of disciplines and supports, essentially giving countries access to low-cost funding and for that reason, I believe it would be a very effective crisis resolution tool. The concerns that Ireland has about raising funding over the next few years, which are forcing it to pursue very a tough austerity programme in order to regain access to market funding, would be eased by such a fund.

I wish to return to something Dr. Ahearne said and which was also raised in a number of questions regarding the particular fiscal policy that is being followed. Dr. Ahearne mentioned that there might be scope to ease the planned fiscal adjustments of €5.1 billion up to 2015. I will give a brief recap on the Fiscal Advisory Council's thinking on this issue. First, the original projections to get our deficit down to 3% of GDP by 2015 are a central forecast. We know there is huge uncertainty around growth so, in that context, we looked at past forecast errors and built confidence intervals around those projections. Even now, with the central forecast dropping to closer to 2% of GDP, there is about a one in three chance, based on historic forecast errors, and even with the assumption that the €5.1 billion of adjustment will actually take place, that the 3% target will still be missed. There is a one in four chance that our debt to GDP ratio, which is now 123%, will not have stabilised by 2015. The reason for the margin of safety and for aiming at something below the 3% target is to give some insurance that the actual target will be met, which we believe is critical to ensuring we retain access to borrowing.

Deputy Donohoe asked why we are engaging in this austerity programme and about the implications of a situation where the financial markets will not lend to us. The real rationale for doing these very difficult things and engaging in this austerity is to retain access to borrowing. It is somewhat paradoxical in the sense that we are pursuing this austerity programme because we fear there will be much greater austerity if we lose access to borrowing, given that we still have a very large deficit. In essence, we are trying to pursue a plan that allows us to phase out that austerity to the maximum extent possible, given the negative effects that those fiscal adjustments have on growth. We want to be able to retain access to borrowing so that we can maintain the welfare state we value, in terms of social protection, social services and so on. It comes back to the importance of access to borrowing. If we lose that access and the financial markets do not lend to us, we would have much more accelerated austerity and would probably be forced to default. My reading of the evidence leads me to disagree somewhat with Professor Mooney's thesis, which tends to play down the negative effects of defaults on countries. That is what seemed to lead him to believe in a different strategy, involving more debt restructuring or default and less austerity. What we see from episodes of default is that although countries can often regain market access surprisingly quickly after defaults, the outward costs, particularly coming through mechanisms of the banking system, but also confidence effects and so on, can be significantly negative. The likelihood is that the crisis would go into another vicious phase if we ended up in default.

Therefore, in order to be able to phase out this austerity without a highly disruptive default taking place, we need to be able to borrow. Of course, we have not been able to borrow from the financial markets until quite recently. We have, instead, relied on official lenders but, of course, to retain access to official funds, we had to meet the conditions of the loans, which require that we meet the targets. The most important element for secure future market access is that investors believe we will have access to official funding, should we need it. The world is an uncertain place and shocks that occur in other countries could spill over to us and uncertainties remain about future growth prospects. Investors are uncertain what the future will bring.

They are considering whether we will be in good standing with official funders and particularly that we would get that funding without them forcing us to restructure our debt as, for instance, occurred in Greece. If a country's debt is not on a sustainable path, they will not lend to it without a restructuring, which is likely to have quite negative effects on the economy in the short to medium term. Any programme is likely to have much tougher conditionality as we have seen in Greece if a country is not in good standing because it has not met targets in the past. This is why the fiscal council has emphasised the importance of meeting those targets in this highly uncertain growth environment just to give some sort of cushion. We previously thought that cushion would only come by making adjustments of more than €5.1 billion.

Coming to Deputy Eric Byrne's question, the good news is that because of a number of developments, particularly the promissory note development, we can now have that margin of safety without doing any more than the Government is already planning. The fiscal council's strategy has remained the same but we can now have that margin of safety without having to impose even more difficult and damaging austerity on the economy.

Dominic Hannigan (Meath East, Labour)
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We have five minutes for Dr. Ahearne to answer as many questions as he can. If either of the witnesses feel they have not answered everything, after reviewing the transcript they can send in further information in writing and we will ensure it is circulated to members.

Dr. Alan Ahearne:

Deputy Donohoe asked what would happen if markets would not lend. That is just arithmetic. The country then has to close its budget deficit instantly because nobody would lend. In the case of Ireland, with a big budget deficit, it would be simply catastrophic and would mean considerably more austerity. For that reason it is very important to be able to borrow either from financial markets or from a programme.

We probably have some leeway in the budgetary adjustment in coming years if one thinks about access to financial markets. The Government might confirm it was going to hit its target of 3% of GDP target by 2015 but from that it would back out the adjustments it needs in the next two years. If that number was four rather than five, then it would do four and thereby reach the target. How would financial markets respond? I do not believe they would respond badly. Provided that the financial markets view the debt as sustainable and would start to reduce, I believe they might well be relaxed. In order to ensure they feel relaxed about it, we could give them certainty about the next few years.

I am somewhat surprised there has not been an update to the National Recovery Plan 2011-2014. That plan set out what the Government was going to do and was helpful for financial markets. It shows not just what the debt will be but also the measures the Government will introduce to achieve that. If that was updated to go out to 2017 at the same time as announcing that we would stick to the 3% target, I do not believe the markets would react negatively.

Professor McHale is right that there are big risks involved in the coming years. I am not sure those risks would reduce significantly by, for instance, another €1 billion in budgetary adjustments that are not necessary to reach the 3% target. There are two big risks. One is from a possible recapitalisation of the banks which would require more money. That goes back to what we were discussing today, namely, Europe. If there is, it is not possible to do ever-increasing amounts of fiscal consolidation to put aside yet more money - that money would need to come from Europe. That is a risk, but one that cannot really be solved through fiscal consolidation here. The solution to that must come from Europe.

It is also true of the other big risk, which is that the euro area will not grow but stay in recession. That is a big risk for the Irish economy. I am pretty sure that if the euro area economy was growing robustly now, the Irish economy would be growing robustly. The euro area staying in recession would be a big problem for the Irish economy and for Ireland's fiscal outturn. Again, is that something the Irish can do something about? That seems to be a problem that needs to be solved in Europe through the measures I discussed earlier. If it is not solved how do we get around that one? The State now owes more than €40 billion to the EU and presumably there is leeway in terms of concessions. This is what has been happening. In recent years interest rates have been reduced and the loans have been pushed out. These are official concessions that are helping to keep things sustainable. If they had stuck to the initial rate and not pushed things out, Irish debt might well have been unsustainable by now. My guess is that if things do not pick up in Europe, they will just do more of that.

Things have turned 180° since the Deauville agreement, which insisted that private sector lenders to an economy should be subordinate to official lenders. This meant that if something went wrong with an economy, official lenders should get all the money back, but the private sector - people holding the bonds - would get a haircut. Since then, that has completely flipped and essentially the private sector lenders are senior to official lenders. If something is going wrong and the economy is not picking up, the EU - the official sector - is giving the concessions, which makes the private sector position better. If a troubled borrower has two creditors and one creditor is given concessions, that is good for the other creditor. That is a major part of the reason for our interest rates having come down. There is more leeway - in theory €42 billion worth of leeway. If we do not get a recovery and things in Europe remain bad, I would not be surprised to see even more concessions on that. If it is a problem in the euro area - in Europe - it has to be solved at a European level.

There was a question about Cyprus. The initial plan for Cyprus was very problematic in that it was going to hit depositors with more than €100,000. The real problem with the second plan is that they have had to put in capital controls. I mentioned that in my statement. Two countries have bailed in private creditors in the crisis - Iceland and Cyprus - and in both cases they had to impose capital controls. That is what it means going into this brave new world with new bank resolution involving bailing in private creditors. If that is done on a large scale - as may be necessary with some country in the future - it is also necessary to impose capital controls, which are terrible for economic growth. If banks are recapitalised, the ECB should be willing to lend to them. It looks like they were not prepared to do that in this case. Now the lesson seems to be while we will have this resolution involving bailing in, it must be accompanied by capital controls. In the Irish case the banks' creditors were bailed out, which was very expensive and bad for the sovereign. In Cyprus they were all bailed in which is also very bad and destructive to the economy. The lesson from Cyprus is that a country with many bad investments on banks' balance sheets will have a bad outcome.

There was a question on the troika programme. The country has been in a programme since 2008 and will be in a programme for some time. The programme from 2008 was a programme imposed by Government and funded by markets until 2011. Then it was a programme funded by the official sector. The country will probably be able to borrow from markets again but will still be in some sort of programme, by which I mean reducing the budget deficits, and restructuring our tax system and economy. That is all part of our programme. The reason for fiscal consolidation is not that there is a troika. It is because we had a very large budget deficit that has to be reduced. I believe there will be a programme regardless of what happens.

I was asked how close we are to banking union and the answer is not close enough. I believe it needs to happen much faster. It is very difficult to see how the euro area economy will grow unless credit is flowing properly and that will not happen until the banking systems are sorted out at a European level. The member is absolutely right to point out that the banks have been very slow to deal with the impaired loans. The Government and the Central Bank have set them targets for the mortgage arrears, which hopefully will force them to up the pace. They have undoubtedly not acted as fast as they should have to reduce that problem.

Dominic Hannigan (Meath East, Labour)
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I thank Dr. Ahearne and Professor McHale for their presentations. It is always a pleasure to have you before the committee. You have been before the committee in the recent past and we look forward to seeing you back here in the future.

We will hear a presentation from Professor Patrick Honohan, Governor of the Central Bank, about the same issue at next Tuesday’s meeting.