Is the difference between Iceland and Ireland not R but €?

I have been reading Paul Krugman’s “The Return of Depression Economics”. It was originally written to cover problems in the Asian economies in the late nineties, but has been updated to cover the strikingly similar things that have occured everywhere in the past year. He spends a good deal of time on how small economies come under pressure. It’s interesting to note how this works, and interesting to note that Ireland has largely escaped.

As I best understand it, the mechanism behind a currency collapse in an economy runs as follows (I’ll update this if more knowledgeable people wish to correct me):

1. A country enters a growth period.
2. Investors see the potential for big gains investing in the country; a lot of foreign money flows into the country.
3. A bubble develops in the economy; either the government or a significant segment of private enterprise racks up a lot of debt denominated in foreign currency.
4. The economy begins to slow, investors get nervous, rumours of a devaluation start.
5. Hedge funds or other investors see the opportunity to make money from a devaluation in the currency. The country comes under speculative attack. Regardless of justification, a self fulfilling prophecy (or feedback mechanism) is created.

At this point the country has a Hobson’s choice. It can attempt to shore up its currency. To do so it must make it an attractive place to invest. In order to do this, it must raise its interest rates to punitive levels. This will cause the economy to contract severely, trigger fresh discussion on whether the country should devalue the currency. Eventually it finds it must devalue. Alternatively it can devalue the currency; now it will find that the foreign debts it holds are now relatively much larger when measured in its own currency. This in itself becomes a problem. There is fresh discussion on the solvency of the country. Eventually the country must call in the IMF and it ends up with massive interest rates and other punitive measures. Measures, it should be added, that the larger countries that are ultimately behind the IMF would never agree to during a recession under more or less any circumstances.

This is almost precisely what happened to Iceland; interest rates there are 17% at the moment, down from a high of 18%. It is estimated that this might ultimately cost the country something like 85% of its GDP.

I am trying to imagine an Ireland that didn’t join the Euro. It is true that a large portion of Ireland’s bank problems is down to huge loans to property developers. Presumably these loans would have been denominated in Punts in this scenario. However I fail to see how an Ireland whose economy had been running hot for the best part of two decades, well positioned between the US and Europe and running extremely free market policies avoids taking in a serious amount of hot foreign money. I also fail to see how an economy the size of Ireland could possibly have defended its currency even in a moderately healthy state, much less with the type of budget problems we are now seeing. Is the only thing standing between Ireland and Iceland the Euro? And for those on the fringes floating the suggestion Ireland leave the Euro, how would a new Punt avoid that fate?

The Euro seems completely unassailable, backed as it is by the major European economies, most notably Germany. But as a complete layman I also wonder is a similar attack — and resultant damage to the economy — possible through other means? We’ve heard a lot about credit spreads recently. Can a speculative attack be mounted through this mechanism?

Further reading:

The Return of Depression Economics
Paul Krugman blog
Report on the Icelandic collpase
Telegraph speculation on Ireland leaving the Euro
ECB on Ireland’s credit rating