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Ireland's economy

Threadbare

Fears about Ireland’s public finances and banks have made a European bail-out look imminent. How deep is the country’s economic mire?

Nov 18th 2010 | DUBLIN

IRELAND, says the country’s finance minister, Brian Lenihan, does not need a bail-out from the European Union, the IMF or anyone else, and it has not asked for one. But help is at hand, however Mr Lenihan describes it. On November 18th, after many nervous days for investors and European politicians (see Charlemagne), officials from the EU, the IMF and Ireland were due to begin what all sides call a “short and focused consultation” on how much help Ireland might need, and how soon. Many expect a bail-out package to be assembled within days.

In recent weeks the bond markets have become frantic about the sorry state of Ireland’s economy, public finances and banks. Investors have rushed out of Irish government debt: ten-year bond yields rose to nearly 9% last week, six and a half percentage points more than German ones, though they have fallen a bit since. The worries have also infected the bonds of other weak economies at the periphery of the euro zone (see article). Investors have been unnerved by Germany’s insistence that plans for a sovereign-debt default should be built into any future euro-zone rescue scheme.

Ireland is in deep trouble. Its economy is yet truly to emerge from a recession that began in early 2007 (see chart 1). Since then GDP has risen in only one quarter. GNP (a better guide to Irish living standards, because it excludes the net flows of income to parents of the country’s many foreign-owned firms) has fallen for nine quarters in a row. Consumer spending has fallen even harder than income: households saved 12% of their disposable income last year, up from 3.9% two years ago. House prices, which had risen faster than in any other rich country, are 36% below their 2006 peak and still falling. Job prospects are bleak. The unemployment rate is close to 14%, up from 4% or so in the mid-2000s.

The public finances are in a dreadful mess. The government is on track to spend 12% of GDP more than it takes in taxes this year, even after spending cuts and tax rises worth ?14.5 billion ($19.6 billion). The deficit will be a staggering 32% of GDP once injections of capital into broken banks are taken into account (see chart 2). The total cost to the state could rise to ?50 billion, or 30% of GDP. Anglo Irish Bank, a reckless property lender taken over by the government in January 2009, would account for two-thirds of that.

Last month the government said that a further fiscal tightening of 10% of GDP over four years would be needed to cut the budget deficit and stop public debt from spiralling out of control. Details of a ?6 billion first instalment of this ?15 billion squeeze are due to be set out on December 7th by Mr Lenihan in his budget for 2011.

Ireland’s banks have been locked out of wholesale capital markets, and reports say that corporate deposits are shifting abroad. This has left the banks increasingly reliant on short-term loans from the European Central Bank (ECB), funding a sizeable fraction of their assets this way. For now they, like all euro-zone banks, have access to the central bank’s funds at its main interest rate (1% at present) for up to three months. But the ECB’s rate-setting council would like to tighten the terms soon. The ECB is said to have pressed Ireland to avail itself of aid from the euro zone’s rescue fund, created earlier this year, to reopen market financing for its banks. Investors fret that Ireland’s banks might need yet more support if a weak economy spurs a wave of further defaults on property loans.

As bad as things are, Ireland is not on the brink of default. The treasury has around ?20 billion of spare cash, enough to bridge the gap between spending and taxes well into next year. Until the recession hit it had borrowed very little: the public debt stood at only 25% of GDP in 2007. A chunk of the government’s notional debt has not been raised in the public markets. The capital it put into its banks is in the form of promissory notes, essentially IOUs. Much of the rest was issued recently and will not mature for a while.

So Ireland has few bonds to finance next year (?4.4 billion comes due in November 2011). Its government is hoping that bond markets will be assuaged by the publication of a four-year economic plan later this month and by the budget. Support for the budget seems likely, even though the ruling coalition’s thin parliamentary margin is likely to be even thinner after a by-election on November 25th. Fine Gael, the main opposition party, does not have an alternative plan. In a poll for the Sunday Independent this month, 69% of respondents said the opposition should back the government’s budget. Most Irish people, it appears, know that there are no easy ways out of the hole.

Broke, boom, bubble, bust

Ireland has been in trouble before. In the late 1980s the economy was sickly. Public debt was close to 120% of GDP. High tax rates choked growth yet did not produce enough revenue to finance a generous welfare state. High inflation and interest rates deterred investment. The young and educated went abroad. Ireland seemed doomed to be western Europe’s straggler: “The poorest of the rich” was the title of a 1988 survey by The Economist.

Yet from this adversity sprang the Celtic tiger, Europe’s unlikely answer to the fast-growing economies of Asia. A new government, led by Charles Haughey, had started to cut public spending to tackle the deficit. Unions and employers agreed to a three-year period of wage restraint as part of a programme for national recovery. Inflation and interest rates fell.

Better still, Ireland looked attractive to American firms seeking a foothold in the EU ahead of the removal of barriers to trade in goods in 1992. It offered an educated, English-speaking, cheap workforce (some of whom were lured back from abroad), as well as state grants and a low corporate-tax rate. Intel, a giant maker of semiconductors, arrived in 1989 and started production near Dublin the following year. That landmark investment encouraged other firms in.

The economy grew by an annual average rate of 6.5% between 1990 and 2007. However, this long expansion had two phases: a healthy boom and an unhealthy bubble. The first phase was largely export-led and powered by productivity gains, as Ireland caught up with the level of know-how in the rest of the rich world. Foreign firms provided the technology and capital; Ireland supplied the skilled workers.

The switch between the two phases was hard to spot at the time, but probably happened in 2001-02. In the bubble years the main engine of Ireland’s economy was a housing boom that eventually ran out of control. With GDP growing by around 5% in most years, everything seemed fine to most people. But the economy was now on a narrower footing.

The number employed in construction reached 272,000, around one-eighth of the workforce, in 2007. That has since fallen by more than half (see chart 3). Add in employment in related trades, such as estate agencies, mortgage brokers and banks, and the housing boom was supporting perhaps one-fifth of Irish jobs.

It seemed easier to make money speculating in second homes or commercial property than in sounder ventures. Wages and prices rose at a faster rate than those of Ireland’s trading partners, harming competitiveness. A current-account surplus turned into a deficit as import!s flooded in. Visitors to Dublin were shocked by how expensive it had become.

What had once been strengths became weaknesses. Start with Ireland’s place in the EU. The effort to qualify for membership of the euro when it was created in 1999 had kept inflation in check. But once in the single currency Irish borrowers were faced with irresistibly low interest rates, which pushed up the prices of goods and assets alike. Anglo Irish and other banks started to borrow heavily in the euro interbank market to fund property loans. Ireland’s openness to foreign capital had brought in high-tech factories and modern business services; this gave way to hot money that could disappear in a trice.

The partnership with the unions had helped lay the foundations for the tiger economy. But in 2002 it produced a big pay rise for public-sector workers, who grumbled that they had not shared fully in Ireland’s new-found riches. Income tax was cut, sometimes to bridge the gap between what firms wanted to pay and what unions asked for. This left the exchequer ever more dependent on taxes on new homes, housing turnover and earnings from finance. When the bubble burst, these receipts evaporated.

Even migration turned from boon to drawback. In the 1990s skilled Irish people returned home to sustain the expansion. As the 2000s went on new migrants, many from eastern Europe, fed the demand for yet more houses. A lot of them were there to work in the construction industry or in the bars and clubs where builders relaxed after work. This Ponzi-like spiral could not go on for ever but was enough to keep the bubble inflated for a while longer.

Small is beautiful, but ugly too

It’s still wet and windy

Ireland’s small size has also been both a help and a hindrance. The helpful side was mentioned often at a conference of 400 business chiefs hosted in Dublin earlier this month by IBEC, an employers’ group. “The agility of a small economy means you can push changes through quickly,” said Christoph Mueller, the German chief executive of Aer Lingus, an Irish airline.

Smallness also makes austerity a bit easier to stomach: everyone knows someone, or knows of someone, who has lost a job or taken a pay cut to keep one. Yet the very cosiness has contributed to the trouble. “There is a culture of ‘I can’t slam people, because I know them’,” says a business leader. This may explain why Ireland’s bank regulators were so complacent about the scarily rapid growth of Anglo Irish, its concentration of lending risk in a single sector and its heavy exposure to a few dozen property developers.

In a report on the banking crisis this year Patrick Honohan, head of Ireland’s central bank since 2009, wrote of an “unduly deferential” approach to banks by regulators. The tight-knit world of Dublin’s political and financial elite does not encourage challenges to consensual thinking. Perhaps this groupthink lay behind the government’s pledge to guarantee the debts of Anglo Irish and five other banks in September 2008. That has limited the state’s ability to force losses on the banks’ bondholders and left the public finances in ruins. Mr Honohan’s report says that some sort of guarantee was necessary to stem a run on deposits and to prevent a collapse in the banking system and the economy. Nobody seemed to think that Anglo Irish might be insolvent. Even so, the guarantee need not have been quite so broad.

A narrower guarantee, of only short-term debt, would have cut the bill for bank bail-outs and kept the bond markets off the state’s back for a bit longer while it tackled its budget deficit. But it would still have left the state bearing a large slice of the bail-out costs if it wanted to shield depositors. Anglo Irish’s losses were probably twice as big as the sum of its equity, subordinated debt and senior long-term debt. There was too little capacity to absorb losses.

It has hurt Ireland that the bank bail-out has been so drawn-out. It took an age to set up the National Asset Management Agency (NAMA), to house the bad assets of the country’s banks, and to devise a process for pricing them without transgressing EU state-aid rules. This in turn delayed until September the Irish central bank’s estimate of how much capital banks would need to make up for the losses on NAMA assets, and how much the state would have to stump up. The discount to face value that NAMA paid for dud loans was steep—67% for the final ?19 billion of Anglo Irish’s assets. This further depleted banks’ capital, placing an additional burden on the state. Some of the cost of recapitalising the least sickly banks has been borne by the National Pension Reserve Fund, a pot of money set aside to fund future welfare costs. The taxpayer will have to bear the ?34 billion poured this year into Anglo Irish and into Irish Nationwide Building Society, a smaller but equally troubled state-owned lender.

Even if Ireland’s EU friends were to write a cheque to cover the costs of bailing out the banks, putting the public finances right would still be a huge task. Tax revenues plunged from ?47 billion in 2007 to ?33 billion (about 20% of GDP) in 2009 and will not return to their old levels when the economy eventually recovers because the money once raised from housing and finance will no longer be there. The share of public spending in GDP is high for a country with a tiny defence budget, a young (and thus healthy) population and jobless benefits that are scanty by the standards of rich countries in continental Europe.

Some observers of Ireland’s troubles reckon the attempt to tackle the deficit with austerity measures is self-defeating. In this view cutting public spending and raising tax serve only to push the economy deeper into recession and depress tax revenues still more. But this would require spending cuts to have a large effect on domestic output—which is less likely in a highly open economy such as Ireland’s, where a lot of spending goes on import!s. Moreover, Ireland’s precarious fiscal position weighs on confidence. Because much of its budget deficit is structural rather than merely cyclical, leaving it untackled is unlikely to spur consumers to spend and firms to invest. And public-sector pay cuts are part of a broader strategy to regain cost competitiveness. As a member of the euro, Ireland cannot deval‎!ue its currency. So wages have to come down.

No rainbows yet, nor crocks of gold

There are some shafts of light amid the gloom. Lower short-term interest rates have eased the pressure on indebted households: interest costs are low by historical standards despite the high level of debt (see chart 4). And Ireland is regaining competitiveness. Unit-wage costs have improved by 6% in the past year compared with Ireland’s trading partners, according to the ECB. These average gains understate the marginal changes that matter most. The wages of newly hired people have fallen—the skilled unemployed are willing to work for less than they earned in the go-go years. The talk at the IBEC conference was that job openings at big firms were oversubscribed by well-educated applicants.

Foreign direct investment, on which the first, healthy boom was based, has held up well. Ireland is attracting a new generation of foreign firms, such as Activision Blizzard, a computer-games company, which has hired 800 people to carry out technical support. “This year is likely to be our best for seven years,” says Barry O’Leary, head of IDA Ireland, the state agency that targets mobile foreign investment.

Many of Ireland’s strengths remain unaffected. Its workforce is still young, skilled and adaptable. The government is adamant that its low corporate-tax rate of 12.5% will not be raised, although some of its EU partners may want to make this a condition of a bail-out. Rents are falling fast and constructing purpose-built factories and offices is far less costly. A surfeit of hotels has made it cheaper to put up visiting executives from parent firms. The resilience of the foreign-owned sector is one reason why industrial output rose by 11.5% in the year to the third quarter.

Big firms are now doing quite well from exports; the small firms that have lasted this long will probably survive. “There is lots of money on the sidelines in terms of high consumer saving and stalled investments,” says Philip Lane, an economist at Trinity College Dublin.

It would be foolish to understate Ireland’s difficulties. Depressed wages and higher taxes mean there will be little improvement in average living standards for a while. The fiscal crisis will take time to resolve, even with help from other European countries to ease the burden of the banks. But painful decisions now will lay the groundwork for an eventual return to growth—with luck, at a sprightly pace rather than a giddy one.

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