Is Ireland At Risk of a Financial Crisis?
An AEA conference paper “Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison” by Carmen Reinhart and Ken Rogoff has received considerable media attention in recent days (Martin Wolf in the FT; The Economist). In it, Reinhart and Rogoff compare the current US situation to previous financial crises and find some striking parallels. These authors present five graphs that shows the evolution of key indicators for the US and the average values for previous major crises.
In this note, I show these graphs for the Irish case, since there has been considerable domestic and international debate about whether Ireland is a candidate for a financial crisis. I follow the Reinhart-Rogoff event study method which focuses on the four years in the run up to a crisis (plus the subsequent three years for those crises that have already played out).
Figures 1 and 2 show the evolution of housing and equity prices in Ireland over 2003-2007. Both show a sharp drop in values during 2007, following a considerable run up during 2003-2006. The deterioration in the current account over 2003-2007 is also quite striking, from a balanced position in 2003 to a deficit close to 5 percent of GDP in 2007. As is displayed in Figure 4, output growth has also shown a reversal during 2007 – but at close to 3 percent, it remains very high relative to European norms. However, Figure 5 shows that public debt is less than half its value from 1997 (for public debt, the Reinhart-Rogoff method sets a t-10 baseline of 100). Although the 2007 and 2008 budgets have permitted a significant decline in the general government budget balance, the Irish fiscal position is very healthy.
In summary, the Irish data show some clear warning signs. However, output growth remains significantly positive and the healthy state of the public finances provide some comfort. Against that, membership of the euro area constrains macroeconomic policy in the event of a sharper downturn, with no option to cut domestic interest rates and fiscal policy potentially constrained by the Growth and Stability Pact (even in spite of Ireland’s low public debt).
Figure 1. Real Housing Prices (2003=100).
Figure 2. Real Equity Prices (2003=100).
Figure 3. Current Account Balance.
Figure 4. Output Growth
Figure 5. Public Debt (t-10= 100)