Greece, Italy, Portugal, and Spain have all come under fire for a varied mix of labor inflexibility, high-spending, and lost competitiveness, yet Ireland’s experience demonstrates that the Aegean flu can attack even apparently flexible, parsimonious, and competitive economies. Following a massive financial crisis, Ireland now faces the same double-edged sword wielded at the other GIIPS1: lost competitiveness and an unsustainable government debt trajectory.
The Celtic Tiger
Well before the euro’s introduction in the late 1990s, Ireland was prospering. From 1990 to 1995, GDP was growing significantly faster than in other GIIPS, and inflation and borrowing costs were not only below that of the other GIIPS, they were close to German levels.
Additionally, Ireland’s governance and business climate indicators2 were among the world’s strongest. Labor markets were flexible and the education system was one of the best in Europe.
A Path to Crisis
Whereas in other GIIPS, the euro added confidence where there previously was none, in Ireland, the euro gave an unsustainable boost to an already booming economy.
From 1995 to 2000, growth in Ireland accelerated to an average of 9.6 percent per year, and interest rates fell below German levels by 2005. Irish wages grew nearly five times faster than the Euro area average from 1997 to 2007, resulting in the real effective exchange rate (REER) increasing by 36 percent from 1999 to 2008, compared to an average increase of 13 percent in the other GIIPS.
This rapid growth and a European monetary policy which was far too loose for Ireland fueled the enormous overleveraging of the financial sector. The supply of credit exploded, surpassing 200 percent of GDP by 2008 after averaging around 40 percent from 1975 to 1994. In just 10 years, financial and monetary institutions expanded their balance sheets by approximately 750 percent of GDP, and by 2007, gross financial exposure had reached nearly 1400 percent of GDP. In the other GIIPS, balance sheets expanded by “only” 100 percent of GDP and exposure averaged close to 200 percent.
An extraordinary housing bubble emerged. From 1997 to 2006, housing completions grew by 9.6 percent a year, and by IMF calculations, Irish house prices grew by 90 percent more than fundamentals predicted, compared to 28 percent in Spain and 20 percent in the United States.
As in other GIIPS, the economy shifted away from manufacturing and toward services and housing. Financial intermediation, real estate, and business sectors sapped 10 percent of GDP away from the industrial sector from 1999 to 2006. Residential investment grew from 5 percent of GDP in the mid-1990s to over 12 percent by 2007.
Throughout the course of this boom, the Irish government appeared to behave responsibly, running an average budget surplus of 1.6 percent of GDP from 1997 to 2007, helped by surging tax revenues. Over that period, the aggregate Euro area never once recorded a surplus, and Greece averaged a deficit of 4.8 percent.
Ireland’s Massive Bust
In 2008, Ireland’s bubble burst. Over the next two years, domestic demand fell by 16 percent, investment collapsed by over 40 percent, and housing prices plunged 30 percent. By the end of 2010, Irish output will likely have contracted by 14 percent since the beginning of the crisis.
The financial sector was hit even harder. Financial equities plummeted by more than 70 percent. In June of 2009, bank losses through 2010 were estimated to be as high as 35 billion euros, or 20 percent of GDP; since that estimate, nationalized Anglo Irish Bank announced losses of 12.7 billion euros, the biggest loss in Irish history.
The government responded to the financial crisis with extraordinary measures, issuing capital injections and guarantees to depositors and creditors of major banks and purchasing troubled assets. The total assets of the guaranteed banks are now valued at 440 billion euros, or 270 percent of Irish GDP and 2700 percent of Ireland’s average yearly net debt issuance.
These measures obviously took a heavy toll on government finances. At 13.9 percent of GDP, estimated financial sector stabilization costs through 2009 are the highest of any advanced country.
In addition, the loss of output and increase in unemployment—the largest rate increase of any advanced country—drove tax revenues down by 11.6 percent in 2009, exposing the prudent budget as a mirage: the IMF estimates that the structural balance (which ignores cyclical increases in revenues or expenditures) was in deficit, at -9 percent of GDP in 2007. Real government expenditures, despite staying steady relative to GDP, had been among the fastest growing in Europe.
This, coupled with public support of the financial sector, plunged the government balance into deficit; it reached -14.8 percent of GDP in 2009. Debt—even excluding the government guarantees of the financial sector—is expected to leap from 25 percent of GDP in 2007 to nearly 90 percent in 2011.
Finding the Way Back
To escape the trap now ensnaring the GIIPS, Ireland must follow a path similar to the others—restore competitiveness and return public finances to a sustainable trajectory.
Competitiveness is already returning. Since its peak in mid-2008, the REER has fallen by 10 percent and exports are adding to growth. The wage adjustment is already underway as well, as public sector wages were reduced by 5 to 15 percent in December of 2009. This will help rebalance the economy away from services and the financial sector and—drawing on Ireland’s sound business climate and flexible labor market—towards exports.
Irish leaders have already taken bold steps—including expanding the tax base, increasing the minimum pension age, reducing social welfare benefits, and cutting public wages—to lower spending by 2.5 of GDP in 2010 and reduce the deficit below 3 percent of GDP in 2014. Achieving these goals will be difficult: as increasing unemployment and still-retreating domestic demand continues to cut into tax revenues, deficits are still expected to exceed 10 percent of GDP through 2011. Both steady, tenacious leadership in Ireland and the “ruthless truth telling” of the IMF—now a major player in resolving the European crisis—are critical in ensuring that these much-needed reforms persist, especially if public support wanes.
The financial sector still presents a difficult-to-evaluate risk to Ireland’s budget reform. If events in Ireland or Europe shake banks, the government will be forced to make good on its guarantees and debt could balloon even higher. To reduce this risk, flexibility is needed in how financial support programs respond to continuing trouble and, when appropriate, unwind these guarantees.
The case of Ireland underscores the fact that flexibility and dynamism do not make a country immune to the disease now afflicting southern Europe. A financial bust can overwhelm public budgets in a matter of months, even after many years of rapid growth and budget surpluses.
During the boom, the Irish state could have moderated the economic misalignment toward services and real estate through taxes: for example, a large VAT hike on services and home construction. This would have both reduced the tidal wave of capital that flooded real estate markets and the financial industry and cushioned the fiscal adjustment when the boom ended. As Ireland discovered, reducing spending during lean years is much more difficult than withholding expenditures during a boom.