When Irish Eyes Are(n't) Smiling

I have been following the currency markets quite heavily in the past few weeks trying to gage the effects of the much discussed QE2 that the U.S. Federal Reserve implemented. Personally, I was expecting that to lead to more inflation in the U.S. dollar and depreciate its value relative to other currencies, including the Euro. Imagine my surprise when I found that I was correct in inflation being expected by the market (due to high treasury yields) but that the Euro was actually the one depreciating versus the dollar! How could this be?

The answer lies in Ireland. Ireland has been prompting a huge wave of currency speculation in the past few days because of the fiscal deficit the government has run up and a supposed housing bubble that is supposed to be imminent. In order to salvage the value of the Euro, and to help Ireland recover from this debt crisis, the European Union (EU), the International Monetary Fund (IMF), and the United Kingdom have all pledged funds to bail Ireland and its banking system out. They all have great reasons to pledge this large sum of money (estimated to be upwards of $140 billion). Ireland is the U.K.’s largest export partner and if Ireland goes down, so does a significant chunk of the United Kingdom’s economy. The IMF was created with the explicit intention of stabilizing the global economy, which would require an Irish bailout. However, the European Union has the strongest incentive to help out Ireland because if Ireland’s economy collapses, as a member of the EU, it has the potential to take down the rest of the EU (or at least the Euro) with it.

Basically, what’s happening is that the funds for the bailout have been raised already; everything is almost essentially in place to bail Ireland out. Once Ireland’s economy has been saved, the Euro should return back to its normal exchange rate and life will move on for the rest of the world (Ireland would still likely face financial regulations and hardships for a while).

So why hasn’t this happened yet? Simple answer: Ireland refuses to accept the money. The Irish government is worried that some of the restrictions they would have would include eliminating their ultralow corporate tax rate, which has long been a staple of the Irish economy. Ireland is playing a wait-and-see bluffing game to try to make the deal on their terms and, with how their capital and debt are structured, this game could last for months. It’ll be an interesting storyline that I, for one, will certainly be watching.