Whatever happened to Ireland?

Morgan Kelly

The Celtic Tiger faces severe challenges. This column argues that the Irish government’s commitment to absorb the losses of its banking system may well lead to a Greek-style debt ratio by 2012. It is a test-in-waiting for the EU, but one that could be solved by a debt for equity swap to cover the losses of Irish banks.

From basket case to superstar and back again – or almost. One has to wonder: How did all this happen? How did an economy where employment doubled and real GNP quadrupled during the “Celtic Tiger” era from 1990 to 2007, come to have GNP contract by 17% by late-2009 (with further falls forecast for 2010), the deepest and swiftest contraction suffered by a western economy since the Great Depression? The adjustments faced by the nation are monumental (see Cotter 2009 and Honohan and Lane 2009).

Two booms

The key to understanding what happened to Ireland is to realise that while GNP grew from 5% to 15% every year from 1991 to 2006, this Celtic Tiger growth stemmed from two very different booms. First, the 1990s saw rising employment associated with increased competitiveness and a quadrupling of real exports. As Ireland converged to average levels of western European income around 2000 it might have been expected that growth would fall to normal European levels. Instead growth continued at high rates until 2007 despite falling competitiveness, driven by a second boom in construction. I analyse this second boom, the Irish bubble, in a recent CEPR Discussion Paper (Kelly 2010).

Credit bubble

Ireland went from getting about 5% of its national income from house building in the 1990s – the usual level for a developed economy – to 15% at the peak of the boom in 2006–2007, with another 6% coming from other construction. In effect, the Irish decided that competitiveness no longer mattered, and that the road to riches lay in selling houses to each other.

However, driving the construction boom was another boom, in bank lending. As Figure 1 shows, back in 1997 when Ireland’s economy really was among the world’s best performing, Irish banks lent sparingly by international standards. Lending to the non-financial private sector was only 60% of GNP, compared with 80% in Britain and most Eurozone economies. The international credit boom saw these economies experience a rapid rise in bank lending, with loans increasing to 100% of GDP on average by 2008.

These rises were dwarfed, however, by Ireland, where bank lending grew to 200% of national income by 2008. Irish banks were lending 40% more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and 75% more to house buyers.

Figure 1. Bank lending to households and non-financial firms as a percentage of GDP (GNP for Ireland), 1997 and 2008.

This tripling of credit relative to GNP distorted the Irish economy profoundly. Its most visible impact was on house prices. In 1995 the average first-time buyer took out a mortgage equal to three years’ average industrial earnings, and the average house cost 4 years’ earnings. By the bubble peak in late 2006, the average first-time buyer mortgage had risen to 8 times average earnings, and the average new house now cost 10 times average earnings, with the average Dublin second-hand house costing 17 times average earnings (see Figures 2 and 3).

As the price of new houses rose faster than the cost of building them, investment in housing rose. By 2007, Ireland was building half as many houses as Britain, which has 14 times its population.

The flow of new mortgages peaked in the third quarter of 2006, and then fell rapidly. By the middle of 2007 the Irish construction industry was in clear trouble, with unsold units beginning to accumulate. More than one-sixth of housing units are now estimated to be vacant.

Figure 2. Irish house prices relative to average industrial earnings, 1980 – 2009

Figure 3. Irish new house prices and first time buyer mortgages relative to average industrial earnings, 1990 – 2009

Banking collapse

This property slowdown was bad news for an Irish banking system which had lent, usually without collateral, an amount equal to two-thirds of GNP to property developers to finance building projects and make speculative land purchases. Share prices of Irish banks fell steadily from March 2007, with the crisis coming to a head in late September 2008 with a run in wholesale markets on the joint-second largest Irish bank, Anglo Irish. After aggressive denials that the banking system faced any difficulties, the Irish government has been forced to improvise a series of increasingly desperate and expensive responses.

As well as guaranteeing the deposits and most bonds of Irish banks, the Irish government has currently spent, or committed itself to spend, around €40 billion on a National Asset Management Agency to buy non-performing development loans from banks, and to invest around €30 billion in Irish banks. Despite this large injection (equivalent to half of GNP), Irish banks remain moribund.

While the Irish government bailout deals with bank losses on loans to property developers, it does nothing about their two other problems: a heavy reliance on wholesale funding; and the prospect of further large losses on mortgages and business loans.

Half of Irish bank funding comes from international wholesale markets. Without continued government guarantees of their borrowing and, more problematically, continued access to ECB emergency funding, the operations of the Irish banks do not appear viable. Borrowing in bond markets at 6% to fund mortgages yielding 3% is not a sustainable activity, and Irish banks face no choice but to shrink their balance sheets. Should Irish bank lending return to normal international levels, our results indicate that property prices will return to an equilibrium two thirds below peak levels, with larger falls possible in the medium term as the flow of new lending is curtailed sharply.

The third problem facing Irish banks is their mortgages. With house prices down by around 40%, renewed emigration, and unemployment tripled to above 13%, Irish banks face substantial mortgage defaults. For comparison, in Florida and Arizona, whose investor fuelled housing bubbles closely resembled the Irish one, 25% of mortgages are non-performing.

On top of the continued disintegration of its banking system, Ireland faces two other problems: unemployment and government deficits. Private sector employment has fallen by 16%, while the number of males aged 20-24 in work has halved. The collapse in Irish competitiveness (wages have risen over 40% relative to its main trading partners since 2000) which cannot be solved by a devaluation, will frustrate efforts to reverse this decline.

Debt crisis

Fifteen fat years allowed the Irish government to cut income taxes, increase spending and still run a budget surplus. Between 2007 and 2009 however, tax revenue fell by 20%, while expenditure rose by 9%, moving the state from a balanced budget to a deficit of 12% of GDP. In contrast to its inept handling of the banking crisis, the Irish government has moved decisively to reduce expenditure and increase tax rates, and appears on target to reduce its deficit to 3% of GDP by 2012.

Ireland’s government debt is still moderate. At the end of 2009 gross debt was 65% of GDP and, after subtracting the state pension reserve and pre-funded borrowing, net debt was 40% of GDP. Assuming that deficit targets are not missed too badly, gross debt should still be under 85% of GDP by the end of 2012.

Conclusions

This debt would probably be manageable, had the Irish government not casually committed itself to absorb all the gambling losses of its banking system. If we assume – optimistically, I believe – that Irish banks eventually lose one third of what they lent to property developers, and one tenth of business loans and mortgages, the net cost to the Irish taxpayer will be nearly one third of GDP.

Adding these bank losses to its national debt will leave Ireland in 2012 with a debt-GDP ratio of 115%. But if we look at the ratio in terms of GNP, which gives a more realistic picture of the Ireland’s discretionary tax base, this is a debt-GNP ratio of 140% – above the ratio that is currently sinking Greece. Even if bank losses are only half as large as we expect, Ireland is still facing a debt-GNP ratio of 125%.

Ireland is like a patient bleeding from two gunshot wounds. The Irish government has moved quickly to stanch the smaller, fiscal hole, while insisting that the litres of blood pouring unchecked through the banking hole are “manageable”. Capital markets may not continue to agree for long, triggering a borrowing crisis which will start, most probably, with a run on Irish banks in inter-bank markets.

Ireland may therefore present an early test of the EU bailout fund. However, in contrast to Greece, Ireland’s woes stem almost entirely from its banking system, and could be swiftly and permanently cured by a resolution which shares the losses of Irish banks with the holders of their €115 billion of bonds through a partial debt for equity swap.

References

Cotter, John (2009), “Crises in the banking sector and attempts to refinance”, VoxEU.org, 19 May.

Honohan, Patrick and Philip Lane (2009), “Ireland in crisis”, VoxEU.org, 28 February.

Kelly, Morgan (2010), “Whatever Happened to Ireland?” CEPR Discussion Paper 7811.

