I gave a presentation today on the outlook for the Irish economy at the annual conference of the Regional Science Association International (British and Irish Section). The presentation was considerably more upbeat than many I have done in recent years but still discusses a number of important medium-term risks to the economy. Slides are here in PowerPoint form and here in PDF.
Probably the biggest economic story in Europe this week has been the release of recorded phone calls from 2008 between executives of the now-notorious Anglo Irish Bank. Anglo was a recklessly aggressively property development bank with, as the euphemism goes, serious corporate governance issues. When the bank got into trouble, its liabilities were guaranteed by the Irish government.
Paying off Anglo’s creditors ended up costing the Irish government over €30 billion, the equivalent of about 20 percent of GDP or about €6500 (or $8500) per person in the country. The newly-released recordings (from the weeks prior the guarantee decision) show Anglo executives were aware that the bank was undergoing a severe crisis and needed more state financing than they were willing to admit to the public officials. They also show a fairly contemptuous attitude to these same officials.
The Anglo tapes raise many questions and I’ll return to these questions later. However, for now I want to make a few points about the guarantee decision and the role that it played in Ireland’s economic crisis.
The reaction to the tapes in Ireland has, justifiably, been one of outrage. However, there is also a growing public perception that the fiscal austerity of recent years has largely been the responsibility of a few rogue bankers. I think this perception is incorrect and it would be a mistake for the public to ignore the crucial roles played by a far wider set of economic policy mistakes made by governments they elected.
Here is a new paper I have written titled “Ireland’s Economic Crisis: The Good, the Bad and the Ugly”. One of the points the paper makes is that Ireland would be undergoing a severe fiscal crisis even the state hadn’t spent a cent on its banks. The public debt-GDP ratio went from 25 percent in 2007 to about 120 percent today while a sovereign wealth fund worth about 20 percent of GDP has largely been wiped out.
Bank-related costs have been about 40 percent of GDP, with about half of that due to Anglo. This means that large fiscal deficits, rather than bank-related costs, have accounted for the majority of the build-up in net debt over the past few years. Even without spending a cent on Anglo, Ireland would have a debt ratio of 100 percent of GDP and a large fiscal deficit.
The additional debt due to bailing out bank creditors certainly played a crucial role in Ireland having to enter an EU-IMF program in 2010. However, while it is easy to blame external bodies for the pain associated with austerity, Ireland’s policy makers have had little choice over the past few years in relation to tax increases and spending cuts.
As I discuss in the paper, Ireland’s fiscal crisis is largely the consequence of the extreme over-concentration of the economy in the years prior to the crisis on the construction sector. Lax banking regulation allowed an excess supply of credit to fuel a huge housing bubble, construction activity was off the charts and the government relied heavily on revenues from this sector to finance tax cuts and spending increases. Once the bubble popped and the construction sector collapsed, the government was left with a massive loss of revenues and a substantial increase in welfare spending.
Without budget cuts, Ireland was heading for deficits of over 20 percent of GDP in 2009 and even this year, after years of spending cuts and tax increases, the deficit is still over 7 percent of GDP. Deficits on this scale were not sustainable for a euro area member state, so Ireland would be undergoing austerity today even if the EU and the IMF had never arrived to provide funding.
This point is important because it makes it all the more difficult get the public to accept tax increases or spending cuts when they view these cuts as simply the fault of a group of rogue bankers. This viewpoint also distracts from the rogue economic policy making of elected politicians and senior civil servants.
Worth noting is that this is the second Irish economic crisis of my lifetime. Sometimes, the current era feels like a repeat of my teenage years with fiscal crises and high unemployment blighting the country. To avoid another future crisis, debate in Ireland needs to move beyond blaming Anglo’s bad eggs towards asking wider questions about how to run their economy on a sustainable basis.
Having made these points, I want to emphasize that I do not at all agree that the bank guarantee was a correct or unavoidable decision, even given what Irish policy makers knew at the time. This is the position put forward by Irish economists, Donal Donovan and Antoin Murphy in an extensive chapter on the guarantee in their new book. (In fact, Donovan and Murphy argue that the guarantee would have been the correct policy even if the authorities knew the true state of the banks so that it would cost 40 percent of GDP!)
This book makes a number of points I disagree with but, since it’s not available for people on the internet to read, there is perhaps little point in going into too much detail here. I will quickly make two observations.
First, the strength of the arguments made by Donovan and Murphy is well summarized by their argument for why it may have been reasonable to include subordinated bank debt in the guarantee. They argue that
It has been suggested that, given the high degree of uncertainty, if not panic, prevailing, attempts to fine-tune the coverage of the guarantee might not have been well understood by markets the following morning and could have derailed the overriding objective of restoring confidence in the Irish banks.
This is a bizarre argument. For starters, the guarantee was fine-tuned because undated subordinated debt was excluded. However, the idea that financial market participants would have been “confused” that the government failed to guarantee debt that is explicitly contractually required to take losses in the event of a liquidation simply defies belief. I spoke with many financial market professionals in the years after the guarantee and their only reaction to the guaranteeing of subordinated debt was confusion as to why it was included.
More importantly, Donovan and Murphy’s extensive chapter does not consider the most obvious alternative to the type of guarantee offered by the Irish government. This alternative was to guarantee deposits for some period of time as well as specified new bond issues but to leave previous bond issues uncovered.
This ECB paper from 2009 details the emergency measures taken by all EU countries and shows that guaranteeing new bond issues only was the approach taken by almost all countries. Such a guarantee would have had the exact same impact in providing a (temporary) improvement in the funding situation for Irish banks without unnecessarily guaranteeing the bonds owned by investors who had unwisely given money to a recklessly-run bank.
Anyone who thinks there was no way to tell in “real time” that the guarantee was a bad decision is advised to watch this video of my colleague Morgan Kelly’s instant reaction to the decision. The arguments of the other participants in the debate also give you an idea how weak the case was for making this decision.
So the guarantee decision was a bad one and exacerbated the losses associated with Ireland’s banking crisis. But the austerity being suffered in Ireland has wider causes than the behavior of a few bad apples at Anglo Irish Bank and debate on future policies needs to focus on a wider set of issues than how to deal with rogue bankers.