Debt and Austerity: Post-Crisis Lessons from Ireland

Department of Economics and Centre for Macroeconomics public lecture Debt and austerity: post-crisis lessons from Ireland London School of Economics and Political Science Tuesday 17 November 2015 Patrick Honohan, Governor of the Central Bank of Ireland Check against delivery I am delighted to have been invited back to the LSE over forty years since I embarked on my PhD studies under Michio Morishima and Cliff Wymer, having first taken the M.Sc. in Econometrics and Mathematical Economics anchored then by Terence Gorman and Denis Sargan, ably supported by up-and-coming stars such as Partha Dasgupta, David Hendry, Steve Nickell and Amartya Sen. My topic then was “Uncertainty, Portfolio Choice and Economic Fluctuations”, a theme which has not proved irrelevant to someone involved in macroeconomic and financial sector policy in subsequent years! I still draw on the framework taught at the LSE in the 1970s, with its emphasis on solid data analysis and time series econometrics as well as attention to distributional issues and welfare economics. Certainly all of this and more is needed to understand and respond to the required economic adjustments that emerge following a financial crisis. The challenge From late 2008 the inevitability of a devastating economic downturn in Ireland, entailing massive job losses and acute indebtedness difficulties, became increasingly clear. The task for the Irish authorities from then on was to minimise the aggregate damage and navigate through the coming years in such a way as to maximise the chances of a strong recovery of employment and incomes. In parallel this would entail choices that would influence the allocation of the heightened risks that had become evident as well as how the looming burden would be distributed. And recovery is under way. Having jumped from about 4 to 15 per cent, unemployment is back in single digits. The decline is partly attributable to migration, but job growth has also returned. The Irish downturn hit bottom in mid- 2012, and the recovery since then has been solid: employment grew by a cumulative 7 per cent in the following three years. [Three Charts: unemployment and employment.] Origins of the Irish crisis The origins of the Irish financial and economic crisis of 2008-12 are well understood. The strong economic performance of Ireland in the years running up to euro area membership (a performance which had been based on a sustainable expansion of competitiveness-driven exports) combined with the sharp lowering of interest rates at the time of entry created the preconditions for a property bubble, not least a subversive overconfidence in the continuity of growth and a complacent market-trusting regulatory and policy environment. From 2004-7, easily financed by the plentiful supply of international liquidity, Irish and foreign-owned banks advanced vast sums to Irish property developers and final purchasers of residential and commercial real estate at home and abroad. By 2007, 13 per cent of Irish workers were engaged in the country’s construction industry –twice as many as normal – and, as the boom fed other domestic sectors, the Government’s tax revenue soared with swollen inflows from capital gains tax and corporation profits tax as well as property transaction-related receipts. The additional revenue allowed the Government to lower the income tax schedule substantially over the years (as well as offering many property- investment related tax concessions) and to increase social benefits and public spending generally. Overall real GDP growth rates – previously flattered significantly by the activities of multinational corporations – were in the early 2000s being recorded at around 5 per cent per annum, levels which, by this stage, were now attained largely because of the construction boom.[1] Role of bank credit Qualitatively similar features to the Irish boom were also in evidence in other countries in those years. What made Ireland distinctive was the scale of credit expansion, and the fact that a bank credit-fuelled property-price bubble was accompanied—yet not noticeably moderated by—a construction boom, exacerbating the scale of losses. As far as the local banks are concerned,[2] it is worth recalling that their growth and their losses were entirely conventional and traditional in nature. For example, in contrast to the US case, Irish banks did not rely extensively on an “originate, package and sell” model for their lending; almost all of what they lent was kept on their balance sheets. And the Irish banks did not invest much in the notorious US-based securitisations.[3] After a record-breaking run-up to the point where Dublin residential property prices deflated by the CPI were about 3½ times the level of a decade before, property prices in Ireland peaked around the turn of 2006-7 and started falling quite sharply soon thereafter. [2 Charts House prices] By the Autumn of 2008, it was clear that a major economic correction was under way. Employment in construction was falling, with knock-on effects throughout the economy. The fiscal position was suddenly deteriorating. While there had been on average a general government surplus for the previous decade, with gross government debt shrinking to below 25 per cent of GDP by 2007, reliance on the boom-time revenue sources that were now evaporating had been so large that a sizable deficit was now emerging, augmented by the increased cost of social protection spending. The deficit was growing both in absolute terms and especially as a percentage of GDP, which was already shrinking alarmingly. Total Government spending jumped from 39 per cent of GDP in 2007 to 58 per cent two years later as measured at the time.[4] Tax revenue fell by 30 per cent in the same period. While the tax and spending movements had the merit of being a strong automatic stabiliser – the general government position moved from balance to a deficit of about 14 per cent of GDP in the same period (and would have been 11½% in the absence of bank rescue spending), this would not be sustainable for long. Initial policy response Although a deficit of 14 or even 11 per cent of GDP can hardly be considered austere, Government had already begun a programme of fiscal adjustment in 2008, without which the deficit would have been even wider. The taxation of income in particular was increased, and a four-year plan of tax and expenditure changes designed to restore stability to the public finances was under way. Additional fiscal pressure was emerging from the banking system. Initially interpreted as merely part of the global liquidity tightening that emanated from the US subprime problems, the Irish banks were encountering increasing difficulties in rolling over their international borrowings: maturities were shortening and the geographical spread of the providers of funds narrowing (Lane 2015). Eventually, at the end of September 2008, just after the bankruptcy of Lehman, the third largest bank (Anglo) was on the eve of being unable to meet its obligations when the Government stepped-in with a blanket guarantee for the liabilities of the locally controlled banks. At first it was not expected by the national financial authorities that the guarantee (which was copper-fastened in legislation) would entail a significant budgetary outlay, but they had not built in any safety-first mechanism to limit the State’s exposure to the pig-in-poke they had acquired. It soon transpired that supervisory awareness of the vulnerability of the banks to the property turn-down had been very limited. The sudden stop The combination of the loss of tax revenue and increased spending on social transfers with the emergence of a large contingent liability on foot of the bank guarantee was what created the vulnerability of the Irish sovereign to a sudden stop in its access to international funding. With market attention focused on Greece in the Autumn and Winter of 2009-10, and in the absence of clarity on the likely loan losses of the Irish banks, the sudden stop was somehow deferred. However, these conditions changed. The scale of the embedded bank losses began to crystallise as the larger property-related loans were purchased at a market-related “long-term economic value” by the Government-created asset management agency NAMA. That the Government would have to meet either a large recapitalisation bill or an even larger cash call on the guarantee became clearer in the third quarter of 2010. With the ECB reluctant to envisage a long- term substitution of central bank funding for the private bank funding that was not now being renewed (despite the Government guarantee[5]) the scene was set for an international rescue, engineered with the IMF and a new European lending mechanism. Worried that funding costs were moving higher than the cost of borrowing at the IMF, the Government’s borrowing arm (the National Treasury Management Agency) withdrew from the market at the end of September 2010, hoping that conditions would improve before its sizable cash balances would run out in the middle of the following year. But the banks were no longer able to fund themselves and did not even have sufficient eligible collateral to refinance at the ECB’s normal operations: one-by-one they had to fall back on emergency liquidity assistance from the Central Bank of Ireland, a facility tolerated by the ECB only for the short-term. Had the ECB convinced the market that the Irish banks would be provided with sufficient liquidity for as long as needed, the Government might perhaps have been able to formulate and implement a renewed and deepened budgetary adjustment without the need for recourse to official financing. Absent such statements of support, it was clear that an IMF programme could not be avoided and this was negotiated in November 2010.

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