The Irish economy: Why did it all go wrong so quickly and what needs to be done?

Patrick Honohan 26 July 2008

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Irish equities are trading this week more than 56% below their peak of eighteen months ago. Aggregate output is falling. The government has announced emergency spending cuts to forestall the danger of breaching the magic 3% borrowing ceiling. Clearly something has gone badly wrong with the “Celtic Tiger” economy, but what?

In fact, there is no mystery here for any close observer of the Irish economy. The key to understanding what has happened lies in recognising that Ireland’s recent run of rapid growth falls into two quite distinct parts. Up to 2000, we saw the genuine “Celtic Tiger” period. This was a delayed – and hence very fast – convergence to the frontier as the economy finally achieved full employment (and an end to underemployment in the farm sector) with rising participation rates and a reversal in the traditional direction of migration flows. The hallmark of this period was wage moderation – having risen by almost 2% per annum in the previous decade, exchange-rate-adjusted wage rates relative to trading partners were flat from 1986-2000.

The equilibrium reached in 2000 would have been a good place to stop.

The Irish boom

But before we could catch our breath,1 the demand momentum generated by the process of economic convergence was ratcheted up by the sharp decline in nominal and real interest rates resulting from Euro membership. Thus, convergence to a sustainable level of prosperity was succeeded by an unsustainable property boom, which was accompanied by deterioration in competitiveness and a relaxation of fiscal discipline.

In the 1980s, the ERM had delivered average real interest rates of 7%; even the floating rate period from 1993-1998 had real interest rates averaging almost 4%. In contrast, since joining the EMU, Ireland has had real interest rates averaging negative 1%. Capitalisation effects from these low interest rates compounded by optimism generated by the new prosperity and supported by net immigration resulted in a surge of residential property prices and construction activity. Lifting real house prices to four times their traditional level, and increasing the employment in construction from its traditional 6-7% up to almost 14%, this property boom spilled over into the rest of the economy. Wage rate developments were no longer moderate. They rose by over 2.5% per annum from 2000. Even fiscal performance deteriorated, as too much of the tax receipts – temporarily bloated by the construction boom – was spent on public sector pay rate increases.

Housing market participants’ extrapolative expectations were reinforced by the demonstration effect of similar but more modest property bubbles in the United States and the United Kingdom. Although credit may not have been an important driver in the early part of the bubble, new banking entrants ensured that it was not a constraint. To finance the construction boom, banks turned to the international market and imported funds equivalent to an astonishing 50% of GDP in just four years. By 2005 banks – increasingly dependent on this market segment for revenue growth – were relaxing their credit standards as the growth in demand slowed. Speculative house buyers exited the market as soon as house prices peaked in January 2007; prices have been falling steadily ever since. Standard econometric models suggest that equilibrium real house prices are still easily 25% below current levels.

This reversal in the fortunes of the economy may seem to have come very suddenly. But this slowdown had long been forecast by those who had diagnosed the marked change in the character of Irish growth after 2000. What is sudden is only the realisation that those shouting “wolf” were right all along. Spooked by the global credit crisis, banks have raised their credit standards and spreads from March 2008, but the fall-off in credit demand had come much earlier. Employment in construction has been falling since house prices started to turn.

The decline of the construction sector has had gradually accumulating knock-on effects throughout the economy. Equity prices have been falling faster than house prices since February 2007. A lot of attention has focused on the consequences for the banks, which is not surprising given the degree to which they have concentrated on lending for construction and home ownership over the past decade, borrowing those huge sums from abroad to finance the lending. Even though they do not appear to have indulged in the radically unsound practices of US mortgage lenders exposed in the sub-prime crisis, the share prices of Irish banks have been marked down very sharply, reflecting market expectations of a much reduced stream of profits in the years ahead, evidently sharpened also by association with the worldwide banking difficulties.

Of course, other international developments have not helped either. The surge in the price of oil, the marked slowdown of the US economy (a major export destination), and the soaring international value of the euro have all added to the gloom.
Although it was the interest rate shock coming from Euro-membership that triggered the bubble, and although the easy old path of devaluation is no longer available, the authorities are probably relieved that they do not also have to deal with an exchange rate crisis.

Back to reality

If the economy is to be brought back to the equilibrium that prevailed around 2000, more than house prices will have to fall. The two-thirds fallback in equity prices has already brought them back in real terms to levels not seen since early 1997. The three other key areas for adjustment are evidently wages, taxation and public expenditure. The artificial construction boom lulled decision-makers into a false sense of security on all three fronts.

First, wages. The social partnership model has long stopped delivering wage moderation assuring competitiveness. As mentioned, this was the case between 1986 and 2000 – by which stage Irish labour was super-competitive – but since 2000, during the construction boom phase wage rates have resumed the path of steady deterioration which proved so damaging in the 1970s and early 1980s. This was fuelled by the demand spillover from construction, and in turn contributed to the opening up of what is now a sizable current account deficit. This loss of competitiveness must be arrested – if not reversed – if the growth in unemployment is to be halted. The current national pay negotiations are timely and crucial in this regard.

The second area is taxation. Stamp duty and other revenues from the construction boom were so great that governments could reduce other tax rates and boost allowances; arguably, tax reductions have overshot what was sustainable. A gradual and modest upward adjustment will be needed for the medium run if needed public services are to be financed.

The third area is public expenditure. Revenue from the unsustainable construction boom made governments complacent about spending growth. This manifested itself in an upward drift in public sector pay rates – above what would be needed to retain and attract the needed staff – and in the adoption of some hugely costly initiatives such as decentralisation. As Philip Lane recently noted on Vox, sudden and drastic action here is not what is called for. Correcting these excesses, rather than cutting back on core public service provision, is what is needed in the adjustment as the economy edges its way back to 2000, where it belongs.


1 The Irish economy behaves more like the hare in Aesop’s fable than a tiger, as Brendan Walsh and I suggested in “Catching Up With the Leaders: The Irish Hare” Brookings Papers on Economic Activity 2002(1):1-77:

 

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Topics:  Europe's nations and regions

Tags:  Ireland, Celtic Tiger economy

Professor, Trinity College Dublin; Nonresident Senior Fellow; Peterson Institute for International Economics; CEPR Research Fellow

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