The Irish Crisis. Philip R. Lane Trinity College Dublin. New Zealand Treasury, 8th December 2010 / 22

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1 Philip R. Lane Trinity College Dublin

2 Introduction Economic Crisis: GDP decline of 15 percent between Fiscal Crisis: Surplus in 2007; core GGB of percent in 2009 and 2010 Banking Crisis: Heavy losses of Irish banking system

3 Ireland: Some Basic Facts 2010 GDP: e157 billion 2010 GNI: e125 billion Employment: 1.86 million Population: 4.45 million

4 The Celtic Tiger Years: Rapid productivity-driven output growth Long-delayed Catch Up Process Major expansion in inward FDI: European integration; the weightless hi-tech sectors Little in ation: large over-hang of surplus labour Start of housing boom: entry to EMU : very weak euro against $/ rising incomes, lower interest rate under : big tax cuts, growth in public spending : pause (global hi-tech recession; euro appreciation;..)

5 The Bubble Period Rapid credit growth: housing; commercial real estate; households; Funded by explosion in net foreign liabilities of Irish banking system Rapid growth in property prices Major expansion in construction activity: large proportion of male workforce Tax breaks for property investment Substantial inward migration (New Member States etc) Associated revenue windfall and rapid growth in public spending Expansion in current account de cit Real exchange rate appreciation Relative contraction of tradables sector 2008: Bursting of the bubble, compounded by the global crisis : Crisis Management

6 GDP Growth Rate GDP Growth GDP Growth Year

7 2 Ratio of Private Credit to GDP 1.75 (Private Credit / GDP) Year

8 6 Current Account Balance (Ratio to GDP) 4 2 CA/GDP Year

9 Net Foreign Liabilities of Main Irish Banks NFL/GNP

10 The Economic Crisis Shuddering Halt in Construction Sector Approx 50% decline in housing prices; 90% for some development land Collapse in Investment Hike in household savings rate (2% in 2007; 12% in 2010) Jump in unemployment but also signi cant exit (participation, emigration) Fiscal tightening adding to demand slump Tightening of credit conditions Negative in ation (in part, terms of trade gain from Sterling decline) Aggregate exports doing well but driven by FDI-dominated sectors (2009 GDP -7%; GNP -10.5%) Some level of downward pay exibility in private sector

11 The Banking Crisis I Traditional property-driven crisis. Slowdown since late 2006 but hope for soft landing liquidity pressure on Irish banks International nancial crisis - trigger for hard landing Extensive guarantee of existing liabilities: September 2008-September 2010 (Plus ongoing guarantees of new debt issuance) Heavy reliance on ECB liquidity Initial State capital injections into banks National Asset Management Agency (NAMA): announced April 2009 NAMA acquiring property development loan books Transfer values at a steep discount to face value of loans Post-transfer: recapitalisation of banks

12 The Banking Crisis II Prospect of other bad debts (mortgages, HH, SMEs). Central Bank PCAR exercise: March 2010, update September percent core Tier 1 ratio target. Large government ownership stakes in the main banks; nationalisations of extreme o enders (Anglo-Irish Bank, Irish Nationwide) projected losses e70 billion-e80 billion for domestically-owned banks (about 16% of peak loans) Shareholder equity at start of crisis about e23 billion Subordinated bonds at start of crisis about e20 billion Senior bonds about e85 billion Fiscal outlay: e35-e40 billion in capital transfers; e10-e20 billion in nancial investments

13 The Fiscal Crisis 2007: budget surplus; gross public debt 25% of GDP (net debt 14% of GDP) 2008 budget (announced December 2007): rapid spending increases Summer 2008: brake applied (e1 billion in spending cuts) October 2008: early announcement of 2009 budget (e2 billion in tax increases for 2009) February 2009: expenditure adjustments (e2.1 billion) April 2009 emergency budget (e5.4 billion) December 2009: Adjustment of e4.1 billion for 2010 Cumulative total so far: e14.6 billion scal plan: e15 billion of discretionary tightening (e6 billion in 2011). (2/3 spending; 1/3 taxes) Goal: Debt stabilisation; 3% GGB in 2014/2015/?

14 Some Features of the Fiscal Adjustment De facto average 7.5 percent pay cut [ pension levy ] in public sector in January 2009 Further 5%-12% cuts in public sector pay in 2010 budget - but no further nominal cuts (Pay levels still very high) Recruitment freeze; cuts in capital spending (from a high level; also tender prices down) Major increase in top marginal tax rate: 45% to 52% (kicks in at low level) Cuts in welfare payments (but pensions not touched) - roll back after very rapid growth Narrow tax base: much scope for raising taxes A scal hangover

15 The Fiscal Multiplier Open Economy: fall in domestic demand implies fall in imports (improvement in trade balance) - working assumption is that multiplier is only 0.5 But nancially-stretched households: fall in disposable income raises bank losses? 2010: (some) GDP growth despite major scal austerity package

16 The EU/IMF Deal I Trigger: Funding of banking system (exit of private wholesale funding in September 2010; excessive reliance on ECB and Irish central bank for funding) Also: revision to 2009 GDP, lower GDP de ator, less optimism about future GDP growth Banks need protection against tail risk - extra capital; extra asset transfers to NAMA; asset sales Sovereign needs assured funding - on its own account but also to comfort bank funders Deal: if banks de-risked, ECB will maintain large-scale long-term liquidity provision

17 The EU/IMF Deal II Sources of e85 billion e17.5 billion domestic (NPRF; cash balances) e22.5 billion EFSM (European Commission) e22.5 billion EFSF e22.5 billion IMF Allocation of e85 billion e10 billion now for banks e8 billion extra capital (target 12 percent core tier 1 ratios) e2 billion for credit enhancements of asset sales e25 billion contingency fund for banks e50 billion to fund sovereign

18 Some Issues Treatment of bank bondholders e12 billion of subordinated bonds - exchanges (already e7 billion in face value recovered) e20 billion of senior unguaranteed bonds (issued before September 2008) guaranteed bonds national versus European solutions Cross-border risk transfer Uncertainty about growth prospects Limited scope for structural reforms - minimum wage cut by 12 percent; more deregulation of professions

19 Regrets Failure of macro-prudential banking regulation Excellent new CB governor and bank regulator now appointed Failure to run large scal surpluses during good times Exception: National Pension Reserve Fund (operational since 2001) Counterexamples: Sweden/Finland; Chile Rainy Day Fund Rethink appropriate de nition of prudence De cient Tax System Over-reliance on asset-driven revenues Unsustainable cuts in income taxes Inappropriate tax incentives for property investment Excessively narrow tax base

20 Ireland and the Euro Bubble period: not exclusive to euro area; limited role for interest rate mechanism Independent currency can be destabilising during boom-bust cycles High euro-denominated foreign debt: in e ect, foreign-currency debt but with access to liquidity provider (ECB) Adjustment process: universal nominal exibility playing a role but not

21 Lessons for Members of the Euro Area Costs of banking crises inside a monetary union: need for beter regulation Costs of real over-valuation (limits to wage exibility) Importance of long-term scal anchor (SGP inadequate): framework required Hypothetical alternative: no euro membership? new scal

22 Future Prospects for the Irish Economy Shift in composition of economic activity: more tradables activity, less construction Return to core principles of Celtic Tiger era Internal devaluation: slow adjustment process but faster in Ireland than in some other locations Overhang of high debt levels: tepid recovery in domestic spending Institutional reforms required: never again Stay informed:

The Irish Crisis. Philip R. Lane IIIS, Trinity College Dublin and CEPR. Oslo, January 12th 2010

The Irish Crisis. Philip R. Lane IIIS, Trinity College Dublin and CEPR. Oslo, January 12th 2010 The Irish Crisis Philip R. Lane IIIS, Trinity College Dublin and CEPR Oslo, January 12th 2010 Lane () The Irish Crisis Oslo, January 12th 2010 1 / 17 Introduction Economic Crisis: GDP decline of 15 percent