Irish Budget: Key Questions on the Economic Collapse
By Peter McColl and Alasdair Thompson
What has happened in Ireland?
Ireland this week passed an emergency budget that has both cut public services and increased taxes. It comes after a 2 year period of austerity following the collapse of Irish banks in 2007. So how did this happen?
It started when the level of bad debt in major banks like Anglo-Irish has becoming so substantial that it means they are unlikely to be able to go on trading. These banks have massive deposits that will be lost if they go insolvent. This is because the banks have made huge losses on loans that cannot be repaid by debtors. The assets that the loans were secured against have lost their value. The debt can now be said to be toxic. The deposits include large sums invested by individuals (life savings included) and by larger institutions.
But wasn’t Ireland’s economy lauded as a miracle?
Ireland enjoyed a long economic boom from 1995-2007. At first this “Celtic Tiger” economy was based on export led growth. The country exploited its young, highly skilled, English speaking workforce and very low rates of corporation tax to attract multinational companies seeking access to the European Union.
After Ireland entered the Euro in 1999, interest rates were halved overnight from 6% to 3%. High interest rates could have helped to avoid an asset bubble developing. When interest rates are low it becomes easier to borrow, and the prices of things like houses rise at a rate beyond that at which the economy can support. Interest rates are inextricably linked to currencies. You can only have one interest rate per currency. Because demand was low in France and Germany the interest rate for the Euro had to be low.
So how did this create the conditions for an economic collapse?
Low interest rates produced a massive bubble in the Irish property market. In 2006 construction was 23% of Irish GDP. Nearly a fifth of the workforce was employed in building. Between 2000 and 2007 Irish house prices doubled. This is because lower interest rates make borrowing much easier.
This was a classic asset bubble. Rising borrowing on property created more jobs in construction. The economy became more dependent on construction and people began speculating on houses through buy-to-let and home improvements. This increased the price of houses even further. The problem was that the wealth didn’t exist to support these increases.
It should be noted, though, that although the Euro removed one tool to avoid an asset bubble, other, fiscal, as opposed to monetary, tools did exist. Ireland had, and still has, no regular property tax; a land value tax could have steadied demand, encouraged more efficient development and captured some of the excessive profits generated then for public use or to build reserves which could now be drawn upon.
Then in 2007 there was a ‘credit crunch’. This happened because a property asset bubble in the USA had just burst. Too many Americans defaulted on mortgages. These mortgages were based partly on speculative values. Once the speculative value vanished thousands of mortgage holders could neither keep up repayments nor sell their houses.
That many of these liabilities slipped into negative equity, where the value of the asset is less than the debt owned against it, and due to the unknown risks associated with many of the complex financial instruments being traded by the banks, banks around the world stopped lending to each other and to house-buyers. If no one knew which assets had real value how could anyone know who was worth lending to? Without the vital lubricant of easy mortgages the speculative element of house prices in Ireland also evaporated.
Suddenly there was no money to finish thousands of houses that were under construction around Ireland, leaving widespread ‘ghost estates’ of unfinished or unoccupied houses.
How did a collapse in the housing market lead to a collapse of the banks?
The Irish banks were, of course, the main lenders to the Irish housing market. When house prices crashed the banks were left with massive levels of bad debt. So the government had to bail out Allied Irish Bank and the Bank of Ireland for €7bn in February 2009. Worse, the Irish government agreed to underwrite all deposits in Irish banks. In the event of a collapse Irish taxpayers, and not the banks’ creditors who had made bad bets and caused the crises, would cover all the costs.
How did the Irish Government respond?
This bail out was accompanied by a massive austerity package that proposed removing the right to free medical care for the over-70s, reinstating University fees, stopping a planned programme of vaccination against cervical cancer and a range of other measures. The people were expected to pay for the banks failings.
The government argued that this austerity package would not only help to pay for the bailout, but would help the economy to grow and allow a way back to wealth. That has proved to be an ill-founded assertion. Ireland’s economic performance is substantially worse than that of Spain which used a stimulus package instead of austerity when faced with a similar situation.
The Irish Government then created a ‘bad debt bank’ called the National Assets Management Agency (NAMA). This stripped bad loans out of Allied Irish, Bank of Ireland and other Irish banks and put them together in one bank owned by the state in return for government bonds.
The creation of NAMA was intended to allow the banks to start lending again by removing toxic assets. However, in late 2010 it became clear that there was a very large amount of toxic debt remaining in most of the Irish banks, requiring a further bail out. The bail out will prioritise the repayment of investors, many of whom are wealthy speculators first.
By then loans (bond yields) had become so expensive that the Irish state could no longer afford it alone. The EU and the IMF were brought in to bail out the country. This bailout, though, consisted simply of new loans. Loans at a preferential rate in comparison to the market but still far more expensive than in the UK, for example, and at interest rates which are likely to be higher than Ireland’s future rate of growth. In real terms Ireland’s debt will likely increase further. The new loans give Ireland more time to recover but change none of the underlying problems. In treating the crisis as one of liquidity, access to money, and not solvency, ability to repay that money, they risk confusing a problem of confidence with a real failure in Ireland’s economy. This is why many economists think the bailout is doomed to fail.
The left have jumped on the failure of the austerity package that followed the first bailout to explain the failure of Ireland. The right have argued that the failure of the Irish economy is due to the country’s membership of the Euro. In truth they’re both right. The Euro contributed to the housing asset bubble, and the austerity package has hampered a recovery.
It is true, however, that the UK, despite wisely staying out of the Euro also had a huge housing bubble. So we can conclude that the Euro added to the asset bubble, but cultural factors are also important. Irish people have long been obsessed with property in a way that is alien in most of Europe (outside the British Isles).
What is to be done?
Iceland was faced with a similar situation in 2008. It chose to allow the banks to default. The result has been a much better recovery for Iceland. While it was unfortunate that some savers lost their money, most losses were made by wealthy speculators. This will also be the case in Ireland.
Allowing the banks to go to the wall will have significant repercussions. It will result in the economic reputation of Ireland being damaged and may prevent companies from investing in Ireland. Given that the Celtic Tiger was based on investment by multinationals that could be a serious problem.
But the bailout is going to be very painful in the short term, and there is no medium to long term guarantee of success. It could be that allowing the banks to default is the best thing that could happen for Ireland. It’s certainly been that way for Iceland, which is now emerging from recession.
What about Ireland’s Corporation Tax?
A lot has been said about the Irish republic’s low rate of corporation tax. Eurozone countries were reported to have threatened not to bailout the country out if its ‘predatory’ rate of tax was not increased. There have been similar calls in the UK, while our own rate is due to be cut. The Irish government have declared the tax rate to be non-negotiable and a vital element to Ireland’s future recovery.
So is the low rate of corporation tax really that important?
In reality it’s not at all clear that it is. Low rates of corporation tax may have played a role in enticing multinational corporations into Ireland initially but that doesn’t mean that an increase now would lead to them pulling out. Companies in Ireland have experienced and highly skilled workers there and managers with families and lives settled in the country. The costs, both social and economic, to relocation are not inconsiderable. Further, since EU enlargement there are now countries which already have both lower rates of taxation and lower wage costs within the same economic zone as Ireland. Yet companies have been reluctant to move.
Ireland’s success was built more on a highly skilled and employable workforce than on low levels of taxation. Raising that taxation to cover the costs of the education and investment that made Ireland attractive would spread the pain more fairly and do far more to promote long term growth.
Appendix: Glossary of Financial Products
Sub Prime Mortagage – Mortgages sold to people most at risk of default, often to people who could not afford to pay the full interest costs of the loan. Based on an assumption that the prices of property would continue, inexorably, to rise the bank would make money by capturing this excess value. These highly risky loans were often packaged into other products and sold on to other investors.
Mortgage backed security – to shift liabilities off their books, banks packaged mortgages together and sold them off through shares, earning a commission in the process and reducing their liability.
CDOs – Collateralized Debt Obligations – mortgage backed securities, and other asset backed securities, were then bundled together and assessed for risk of defaults. The highest rated were supposed to be most secure whilst the least secure would be offered at lower cost or at preferential interest rates. Again banks made commission at this stage. CDOs were then bundled together in CDO2s, each time making assessment harder and risks more opaque.
CDS – Credit Default Swaps – a contract to for the buyer of the CDS to pay the seller a regular payment to protect an investment. If a default on the credit occurs, the seller pays out to the buyer. Often compared to insurance but unlike insurance the buyer does not have to own the underlying security. It is therefore more like a bet on the possibility of a default. CDSs are also far less regulated than insurance.
All these products became so complex that no one could keep track of where the risks existed and how much they were liable for. Banks all thought if there was a problem someone else would take the fall, instead they all did, then passed the cost onto taxpayers.