The increase in secondary-market spreads on Irish government debt in the past five months is symptomatic of the sudden emergence of a twin crisis in the banking sector and in the public finances.
Ireland’s exposure: Blessing in the 1990s, curse in the global crisis
It was always to be expected that Ireland would be particularly exposure to a global downturn, considering the exceptionally large contribution of exports to GDP and the vertical integration of much of Ireland’s manufacturing sector into the global production chains of major multinational firms. These characteristics contributed to a sustained output boom during the 1990s but now act to amplify the downturn. Moreover, the Irish export sector must cope with a trend loss in wage competitiveness since 2000 and the sharp slide in sterling over the last six months.
Two other domestic factors have compounded the misery.
- In the new millennium, the sources of growth shifted, and the continued economic boom was characterised by an over-expansion in the construction sector, with excessive levels of building of residential and commercial property and large bets being placed on the value of development sites.
This property bubble was funded by the Irish banking system, which in turn relied heavily on the international inter-bank market and accumulated substantial net external liabilities. Accordingly, the collapse in the property sector has been centrally important in the deterioration in the financial health of the Irish banking system.
- A second home-grown contributory factor has been the brittle state of the Irish public finances.
Although the Irish government ran annual budget surpluses until 2006, an increasing share of the revenue that supported these surpluses was coming from taxes whose yield is sensitive to high and increasing asset prices and asset transactions (capital gains taxes, capital acquisition taxes and stamp duties) and on corporation profits tax – much of it coming from multinational firms. Once the asset markets turned, the volume of transactions dried up and profits collapsed, the level of tax revenues plunged during 2008 exposing a structural deficit – exacerbated by a strong upturn in public expenditure in the last few years.
Together with the operation of automatic stabilizers, this turnaround resulted in a general government budget deficit of 6.8% of GDP in 2008. In January 2009, the government projected budget deficits (under a no-change scenario) of 11% of GDP for 2009 and 13% of GDP in 2010. Moreover, even these numbers are subject to downside risk, in view of the continuing deterioration in the economy.
Favourable starting point, but urgent action is needed
Fortunately, the Irish government entered the crisis period with a healthy balance sheet – the gross government debt stood at only 24.8% of GDP at the end of 2007 and Ireland has a sizeable sovereign wealth fund in the form of the National Pension Reserve Fund. But the sudden emergence of such a large deficit, and the prospect of some additional borrowing needed to deal with the banks, mean there is no time to lose in adopting corrective measures.
The problem of the banks has received greatest international attention, yet is likely to be the smaller of the two sources of additional borrowing requirements.
These banks steered clear of the asset-backed securities that have caused problems elsewhere, but their heavy exposure to property-related lending at home, and in the UK have raised questions in the market about their ability to weather the inevitable growth in loan losses.
Traditionally conservative institutions, the two big banks’ lending decisions appear to have been destabilized in the mid-2000s by the reckless expansion of the third one, Anglo-Irish Bank. The latter bank was allowed to grow at an average real rate of 36% per annum, bringing its market share from 3% to 18% of Irish-controlled banks in 10 years. The other banks responded by relaxing their lending conditions even as the property market was obviously reaching its peak. Loans were made to final residential borrowers, property management companies (shopping malls, etc.) and property developers.
Irish property prices have now been falling steadily for over two years, and seem clearly far from the bottom. With rising unemployment and sharply falling retail sales, the recoverable value of the property-related loan book is essentially unknowable. The banks entered the downturn with substantial book capital, but although they have announced much increased loan loss provisions and suspended dividend payments to conserve capital, their share prices have collapsed to about 2-3% of their peak value. At such prices, the market is evidently discounting very substantial loan losses well in excess of those envisaged by the banks in their worst case scenarios.
The government deposit guarantees and tail risk
At the end of September 2008, apparently faced with the inability of Anglo-Irish Bank to rollover its debt and fearing a contagious reaction onto the other banks, the government announced a blanket guarantee of the liabilities of the main Irish-controlled banks. Subsequent revelations of some balance sheet window-dressing at Anglo and some dubious transactions related to share purchases, contributed to the government’s decision to take full ownership control of that bank in January.
Since the gross bank liabilities guaranteed by the government amount to well over twice GDP, the open-ended nature of the possible bank losses that might fall on the budget seems to have contributed a lot to market concerns about the public finances.
The biggest one day increases in the secondary market spreads were on days dominated by bank-related news. Heightened regulatory oversight and the appointment by the government of new directors to the boards of all the guaranteed banks should help stem any additional accumulation of tail risks. Indeed the indications now are of banks that have reverted to their traditional pre-bubble conservatism.
But even if loan losses come out at the high end of the range of estimates currently being entertained by analysts, the overall losses would not in themselves entail unaffordable additional government borrowing. (This is regardless of whether the Government has to go beyond the currently envisaged recapitalization of the main banks in order to put them back on a self-supporting basis.)
Tax sources must be reoriented
Given how much the shift in the structure of tax revenue has contributed to the fiscal problem, it seems evident that there must be a return to more stable sources such as personal income tax, VAT and excise taxes. And the late pre-crisis surge in government spending must be reversed.
Government actions to date
In Summer 2008, the government signalled its intention to take decisive corrective action to deal with the emerging problem by bringing forward the annual budget from December to October. That budget introduced a progressive income levy, although some of the expenditure cuts that were announced were very poorly received and were not put into effect. Further steps were announced in February 2009, cancelling future instalments of public sector pay increases that were agreed in September 2008 and imposing, from March 2009, a levy on public servants whose average net effect is to lower take home pay by 7.5% of gross income. This levy (rationalized as a quid-pro-quo for the liberality and security of public sector pensions) represents a de facto pay cut for public sector workers, which is a substantial shock after a decade of rapid growth in absolute and relative public sector pay.
However, even with some additional measures that have been announced, the current scale of the fiscal adjustment amounts to only 1.5% of GDP. Moreover, the government’s popularity has plummeted, such that there is uncertainty about the capacity of the government to implement further fiscal reforms.
The government’s stated strategy (as laid out in its submission to the European Commission in the middle of January 2009) has been to undertake fiscal adjustment in a gradualist fashion, with the goal of returning the general government deficit to below the 3% limit by 2013. But the sceptical market perception is increasing the cost of borrowing beyond what was projected (as is the case for several other sovereigns), and it has become evident that the gradualist path leaves the government vulnerable to funding risk.
Frontload the fiscal adjustment
Accordingly, the most prudent strategy at this point is to front load the fiscal adjustment. Along one dimension, it is now time for the government to increase tax rates and eliminate a host of tax breaks, rather than deferring such moves to next year’s budget. In relation to public spending, more needs to be done in terms of controlling current spending. It also makes sense to introduce a substantial pause in the public capital programme. While the Government has been planning a high level of public investment (at around 4.5% of GDP), a deferral of some major schemes would greatly ease the funding situation.
Upward adjustments in tax rates and the deferral of public spending may not seem the ideal tools for dealing with a recession. However, even with a substantial further correction that is plausible in terms of scale, the government would still be running a 2009 deficit that is substantially above any other euro area economy.
Consumer confidence and government finances
Moreover, the restoration of confidence in the public finances would also improve consumer confidence. As in the late 1980s, when a debt-to-GDP ratio of the order of 130% was quickly reduced by the implementation of a credible fiscal plan, the mitigation of uncertainty would provide a boost to confidence, potentially offsetting some of the impact of a higher tax burden on consumer spending. (The household savings rate in Ireland is relatively high compared to the US or UK, such that tax increases could be financed by a decline in savings rather than a reduction in consumption for many households.)
The future can be bright
If the required fiscal adjustment is implemented, the future can be bright for the Irish economy. While the construction and property price bubble that sustained growth in the 2003-2007 period skewed the structure of the economy and its balance sheet in a damaging way, many of the factors that drove the original and extraordinary Irish Hare expansion during the late 1990s remain in place (Honohan and Walsh 2002).
In addition, while unemployment is growing, the current crisis has underlined the adaptable nature of the private-sector labour force, with employers and workers negotiating an impressive array of firm-level deals to maintain employment, including measures such as substantial nominal pay cuts, adjustments in working hours and sabbatical schemes. Accordingly, its attractiveness as a globalised economy with a highly-open labour market means that there is no reason why Ireland cannot emerge from this crisis as a mature, high-productivity contributor to the wider European economy.
Social partnership model
Finally, in relation to the political economy of fiscal adjustment, there remains considerable potential in the social partnership model that has dominated the Irish policy formation system over the last two decades. There is quite a degree of convergence across the unions, employer federations and the government in terms of a common understanding of the scale of the problem and the required general framework for an economic recovery programme. While the unions did not agree with the public sector pension levy and are currently protesting against the government’s actions, there is widespread agreement that tax increases are inevitable and must be widely applied. The current crisis represents an important test of the consensus-based approach to policy formation.
Subject to the imperative of quickly restoring confidence in the public finances, the path of fiscal adjustment will be much smoother if a political formula is found that can allow all parties to claim ownership of the programme.
Patrick Honohan and Brendan Walsh (2002). “Catching Up With the Leaders: The Irish Hare,” Brookings Papers on Economic Activity, 2002(1):1-77.
Originally published at Vox and reproduced here with the author’s permission.