Wednesday, November 17, 2010

Irish Economic Crisis

Ireland is a tragic case for a few reasons.

Boom and Bust. After joining the EU, Ireland appeared to have an economic miracle - rising investment, growth and rising living standards. At the start, much of this was based on a solid foundation. Investment helped lift Irish living standards. But, unfortunately, the positive growth led to an unsustainable boom. Banks got carried away at the prospect of continued growth. Banks relaxed their lending criteria and reduced their liquidity ratios. This led to a boom in construction and housing. When the economy turned, many investment projects looked too ambitious. Firms lost money and this led to record bank losses. The boom had turned to a bust, and the government was forced to bailout the Irish banks.

The combination of bank bailouts and economic downturn led to a dramatic collapse in tax revenues and need for more welfare payments. The Irish budget deficit shot up from 3% of GDP to over 12% of GDP (35% if you include bank bailouts)

Faced with a recession and large budget deficit. The Irish government felt they had no choice but to tackle the deficit through higher taxes and spending cuts. Remarkably the Irish electorate largely accepted these stern measures such as public sector wage cuts of 5%. Yet, these emergency measures exacerbated the loss in confidence and led to lower spending and investment. The consequence of the austerity measures was that the Irish economy suffered a double dip downturn.

Ironically, the harsh austerity measures failed to reassure nervous European bond investors. Bond yields on Irish bonds have continued to grow to crippling levels. The result is that Ireland is facing the need for a bailout and more austerity measures. This is the last thing the economy wants, but, given constraints of being a Euro member there is little alternative.

Lack of Alternatives

The Irish largely see EU membership as an unqualified success and by implication, membership of the Euro a good thing. Unfortunately, this crisis has shown the limitations of being a member of a single currency and common monetary policy.

Usually, a country in the situation of Ireland which needed to cut budget deficit in times of recession, would at least have monetary policy to offset some of the decline in spending and investment. For example, they could have followed UK and pursued quantitative easing. This would have increased demand and lowered their exchange rate. This depreciation would have helped domestic firms exporting.

But, Ireland doesn't have this option. Membership of the Euro means you have to follow the unpalatable options but, there isn't much else you can do to help.

The situation looks grim. There may be some crumbs of comfort. Recent figures on investment spending looked promising. The Irish crisis is ironically going to weaken the Euro. But, it may not be enough to pull the Irish economy back to growth without much economic pain.

There is also a sense of unfairness. The banks which created a large part of problem through irresponsible lending have been rescued unconditionally by government. But, it is ordinary people who are experiencing pain of wage freezes, job losses and spending cuts.

If it was as simple as leaving the Euro, I would tell them to do it tomorrow. But, leaving the Euro is not that simple. (why difficult to leave Euro)

The Irish economy shows

  • The dangers of allowing a boom and bust in bank lending
  • the difficult of cutting budget deficit in recession. - Measures tend to be self-defeating unless you have some very powerful antidote.
  • The difficulty of adopting a common monetary policy for an area as diverse as the Eurozone.
The Irish is crisis is particularly tragic because it didn't need to be like this. With better regulation and monitoring of the boom, lending could have been curtailed in boom. If they weren't in the Euro, they would have had more room for manoeuvre to deal with the situation they currently face.


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