Address by Director of Economics and Chief Economist Lars Frisell to the Bank of Finland in Helsinki, Finland

21 March 2013 Speech

Ireland’s crisis and recovery – breaking the vicious circles 1

As you know, the Irish economy has undergone an extreme boom-bust cycle during the last decade. The Irish crisis shares many features of the banking crises in Sweden and Finland in the early 1990s – only that it is of a much greater magnitude. Whether measured in terms of prices, credit, construction activity – or cost to the taxpayer - it is unfortunately one of the worst property bubbles on record.

Like many other asset bubbles, it started from strong growth, which in Ireland’s case began around 1990 and largely resulted from greater economic integration with Europe. During the 1990s, growth was underpinned by fundamentals, as exceptional export performance was accompanied by moderate wage and price inflation and healthy public finances. In the early 2000s, however, the nature of the “Celtic Tiger” changed from one that reflected strong fundamentals to one that was fuelled by excessive credit expansion. Easy access to funding led to a dramatic increase in property investment and prices soared. In the decade between 1997 and 2007 residential and commercial property prices rose almost four-fold. At the same time, domestic banks’ exposure to the property sector rose from 45 per cent of their balance sheet in 2000 to almost 70 per cent in 2007. Property prices have fallen by about 50 per cent since the peak six years ago, and have left many households in deep negative equity, and banks with large unrealized losses.

The boom was not just a price bubble, but involved a huge expansion in construction – much more so than in Sweden and Finland in the 1980s . Overpriced assets are in themselves not necessarily a matter of great concern. Many asset bubbles, including the IT-crash in the early 2000s, had relatively small consequences for society at large. Certainly, when asset prices rise and fall over a short time period there will be winners and losers (and the almost arbitrary redistribution of wealth may be objectionable on its own) but it doesn’t mean there is a net loss for the taxpayer. At the peak of the Irish bubble almost 90,000 housing units were produced, which is more than at the peak of the Swedish construction boom in 1990 (Sweden has about twice the population of Ireland) and about three times the annual housing production in Finland (which is also a larger country than Ireland). Many of these houses and apartments will never be lived in. An even larger number will significantly deteriorate before they find a buyer. This is the real cost to society, a huge waste of productive resources.

Another problematic feature of the Irish property bubble, which was virtually absent in the Swedish and Finnish crises, is the large amount of retail mortgages that were taken on for investment purposes. Small companies, family businesses and ordinary households would acquire one or even two apartments or houses to sublet, with the expectation to profit both from the stream of rents and from a price increase. These buy-to-let mortgages now add to the perhaps largest remaining problem facing the Irish economy, the number of mortgage arrears. Currently some 95 thousand private residential mortgage accounts for principal dwelling houses (PDH) are in arrears of over 90 days, and some 28 thousand buy-to-let mortgages.

Turning to the sovereign, the bursting of the bubble had devastating effects on public finances, for three reasons. First, Irish tax revenues had become dependent on the property sector to an extraordinary and unhealthy extent. At the peak, property-related revenue constituted some 18% of total tax revenue, or 4.5% of GDP. Naturally, this income collapsed along with the bust.

Second, the Irish government had allowed expenses to grow gradually over the 2000s, with a primary budget deficit emerging already in the years preceding the crisis. Given Ireland’s strong performance and low official debt, this did not seem to pose a problem at the time. But when unemployment in the construction sector exploded the cost of natural stabilisers added to an already weak position. Thirdly, and most disastrously of course, the bank rescue proved prohibitively costly. I have read that the Swedish bank rescue ultimately cost the taxpayer about 2 per cent of GDP, and the Finnish one about 8 per cent. The Irish sovereign has injected 64 billion euro into its banks – equalling almost 40 per cent of GDP. The result has been Irish public debt exploding from below 25 per cent of GDP in 2007 to 117 per cent only five years later. All this money is not lost of course, about two thirds constitute equity in banks. However, it may take a long time before Ireland can recoup the value of these assets.

I will say a few more words about the Irish bank bailout. Irish banks became heavily reliant on wholesale funding during the 2000s as their balance sheets expanded. The creditors were mainly other European commercial banks. From 2002 to the peak of the bubble, the overall loan-to-deposit ratio in Irish banks increased from 130% to almost 220%. When interbank markets threatened to shut down after the default of Lehman Brothers in September 2008, the Irish government issued a general guarantee of the liabilities of the banking system, lasting two years. The initial guarantee covered a broad range of liabilities including some existing subordinated debt and covered bonds, and was introduced in the belief that the problem facing the banks was largely a liquidity problem.

The coming years saw a series of capital injections into the Irish banks, as loss estimates were revised. By late 2010, yield spreads for Ireland had deteriorated to the point where debt sustainability could no longer be assured and the Irish Government sought the assistance of the IMF and the new European Financial Stability Facility. Because of financial stability concerns the assistance programme did not envisage any loss sharing with senior bank creditors so the government had to use a sizable slice of the resources of the programme to continue the process of strengthening bank capital. The result was a very delicate balance established in 2011 between ensuring adequate bank capital and retaining government debt sustainability. Though the narrative is different, and the scale is much smaller, Europe now face similarly difficult trade-offs in Cyprus. Despite major deleveraging over the past years, Irish banks have still some way to go before they can rid themselves of public funding.

Ireland’s extreme boom-bust cycle has translated into two simultaneous vicious circles, working on both the demand and supply side of the economy. Construction, which during the boom had grown to over one-fifth of the Irish economy, more or less collapsed overnight which significantly weakened aggregate demand. The sharp falls in house prices, of more than 50% since the peak, have resulted in many households facing significant negative equity. Similar to the experiences in Sweden and Finland in the 1990s, the fall in house prices and the economic malaise has prompted high precautionary savings – Irish household saving rates jumped to 18 per cent and are still above 10 per cent - at a time where public spending has to be cut. The reduced domestic spending adds to the initial unemployment shock, which further feeds the downward house price and mortgage arrears spiral. Between 2007 and 2011 real GDP fell by 11 per cent, while domestic spending fell by almost 25 per cent.

Turning to the supply of credit, despite the large capital injections by the state, the economic slump and the huge number of unresolved arrears created uncertainty over banks’ solvency and long-term viability. This triggered a deposit flight and multiplied banks’ funding costs, something that only recently have begun to reverse. In turn, high funding costs and pressure to deleverage have led to punitive costs of credit for the real economy, and probably credit rationing as well. This has constituted a significant drag on the economy and helps sustain the high unemployment and stagnant house prices.

After five years of crisis, Ireland is finally beginning to break these vicious circles. GDP has grown the last years, uniquely driven by strong export performance. Ireland managed to quickly turn around a large negative current account balance without, unlike Sweden and Finland in the 1990s, the help of a depreciating currency.

As mentioned above, the banks have been massively recapitalized by the state and the domestic banks have core capital ratios of about 15 per cent – a buffer they now can and should use to write off losses where such are inevitable. House prices are flattening out and have started increasing in Dublin.

Most welcome is that unemployment shrank, and employment grew, last year, for the first time since the crisis erupted. The changes are small, but in the right direction. Unemployment now stands at 14.5 per cent, which is high but not too dramatic, where emigration clearly helps to keep the rate down. However, like the rest of Europe, Ireland faces the problem of growing long-term unemployment.

The Irish Government has taken a large number of measures to restore competitiveness and strengthen public finances. The fiscal consolidation program adopted by the Irish Government has been front loaded and, between 2008 and 2013, has entailed measures equal to almost 18 per cent of GDP. The size of this adjustment is second only to that of Greece. Among the measures taken to increase revenues are an income levy, changes to social insurance, the introduction of a health levy, changes to tax credits and bands, increase in excise duties, a two percentage point increase in the VAT and the introduction of a property tax. On the spending side, current savings achieved to date include pay bill reductions, covering pay rates and headcount, a public sector pension levy, and reductions in social welfare rates. Another round of public sector pay cuts and other measures has recently been proposed.

The Irish commitment to the Troika program, and to exiting it in 2013, has been recognised by financial markets. Long-term yields on Irish sovereign debt are now back at a sustainable level – with a 10-year yield at around 4 per cent and with significantly lower spreads than for example Spain and Italy. On the back of this we have recently witnessed successful issues of senior bank debt.

Despite these significant adjustments, however, the budget deficit remains large, amounting to some eight per cent of GDP in 2012. Although this was well below the Troika target of 8.6 per cent, the Irish situation is of course still very vulnerable. Debt to GDP is expected to peak at 122 per cent in two years and then start to decline gradually. With the ending of the program later this year, the Irish government will be relying again on funding from private debt markets. The safety margin is therefore small.

Ireland in particular, with an export-to-GDP ratio of over 100 per cent, is vulnerable to the development of global and European demand. Finally, Ireland and Ireland’s banks depend crucially on the financial stability in Europe. This I would describe as the third vicious circle – the bank-sovereign link in the Euro zone. Ireland is currently enjoying high confidence, low interest rates and a sustainable debt trajectory. International deposits have started coming back. You may say that Ireland has deserved it. But with Cyprus currently facing difficult decisions with regard to burden sharing, it is important to make unambiguous progress towards completion of important aspects of the Banking Union, so that re-emergence of market instability can be permanently avoided.


1 Address at the Swedish Centre for Business and Policy Studies and at the Bank of Finland, March 21, 2013.