Is Ireland At Risk of a Financial Crisis?

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).

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Figure 2. Real Equity Prices (2003=100).

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Figure 3. Current Account Balance.

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Figure 4. Output Growth

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Figure 5. Public Debt (t-10= 100)

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7 Responses to "Is Ireland At Risk of a Financial Crisis?"

  1. Mary Stokes
    Mary Stokes   January 14, 2008 at 5:46 am

    Thanks for your post.Your graphs of these select indicators give a good overview of Ireland’s recent economic performance and highlight the country’s rising external imbalances.I’d be interested to hear your opinion on where you think the Irish economy is headed.Although “output growth remains significantly positive” and the public debt/GDP is low, I’m still not all that comforted based on a few recent articles and pieces of research I’ve read. The Irish economy seems extremely dependent on the housing industry. According to data attributed to Allied Irish Bank printed in a recent article (link below), house building accounts for 14% of the Irish economy. And for every 10,000 fewer homes that are built, almost 1% is shaved off the economy’s growth rate. As AIB forecasts only 50,000 homes will be built in 2008 – a 28,000 drop from 2007 – Ireland’s output growth will not likely remain as ‘significantly positive’ going forward.http://www.moneyweek.com/file/40440/the-irish-stock-market-is-cheap-but-its-no-bargain.htmlMoreover, the slowdown in the property market could impact Ireland’s healthy fiscal situation by reducing tax revenues. So based on this information, it’s hard to be upbeat about Ireland’s economic prospects.Recent IMF research (link below) also seems to give little reason to remain upbeat. According to Daniel Kanda, shocks to U.S. GDP have a larger impact on Irish GDP than shocks to the euro area or the U.K.http://www.imf.org/external/pubs/cat/longres.cfm?sk=21497.0Again, I’d love to hear your opinion on where you think the Irish economy is heading. Thanks again for your post!

  2. Ulrich Fritsche
    Ulrich Fritsche   January 18, 2008 at 6:13 am

    Interesting figures!Some thoughts why the Irish economy might be already trapped in a low growth scenario for a while (please correct if I am not right):1) The Irish “Wirtschaftswunder” of the last decade (even longer) was based on (i) the fact that the currency was undervalued when entering the currency union, (ii) the fact that there was a low-wage/ tax-based stimulus package which attracted enormous investment by foreign firms (mainly FDI), (iii) a certain degree of decoupling from continental Europe since the trading relations with the US are so important.2) The Irish “Wirtschaftswunder” became more and more “internal demand driven” as the currency appreciated and the housing boom/ wealth effect nexus was strong (as in the US?). The negative side effects are: a real appreciation or even “overvaluation” (I was in Ireland over the summer, compared to continental Europe, Ireland is expensive now…), external balances increase … but for a while everybody hoped we will land softly (scenario: US, end 90s). 3) The US depriciation against the Euro is a trigger, this in turn affects Ireland more heavily. Cheap labour from Eastern Eirope helps for a while but at the end, Irish products are more difficult to sell.4) The Irish economy is in a double trouble: High value of the currency which you can only get rid off by falling prices (a disinflation is probably not enough) or by dramatically increasing productivity (without spillovers to nominal wages). Fiscal stimulus can only help for a while, the imbalances have to be corrected by shifting the (real) exchange rate. The US depriciation worsens the situation since Ireland is more affected than other European countries.Conclusions: Ireland faces a hard time (like Portugal). The German “Rosskur” (no increase in unit labor costs for about a decade) is a hard way to go. I know what I am talking about.

  3. Ulrich Fritsche
    Ulrich Fritsche   January 18, 2008 at 6:13 am

    Interesting figures!Some thoughts why the Irish economy might be already trapped in a low growth scenario for a while (please correct if I am not right):1) The Irish “Wirtschaftswunder” of the last decade (even longer) was based on (i) the fact that the currency was undervalued when entering the currency union, (ii) the fact that there was a low-wage/ tax-based stimulus package which attracted enormous investment by foreign firms (mainly FDI), (iii) a certain degree of decoupling from continental Europe since the trading relations with the US are so important.2) The Irish “Wirtschaftswunder” became more and more “internal demand driven” as the currency appreciated and the housing boom/ wealth effect nexus was strong (as in the US?). The negative side effects are: a real appreciation or even “overvaluation” (I was in Ireland over the summer, compared to continental Europe, Ireland is expensive now…), external balances increase … but for a while everybody hoped we will land softly (scenario: US, end 90s). 3) The US depriciation against the Euro is a trigger, this in turn affects Ireland more heavily. Cheap labour from Eastern Eirope helps for a while but at the end, Irish products are more difficult to sell.4) The Irish economy is in a double trouble: High value of the currency which you can only get rid off by falling prices (a disinflation is probably not enough) or by dramatically increasing productivity (without spillovers to nominal wages). Fiscal stimulus can only help for a while, the imbalances have to be corrected by shifting the (real) exchange rate. The US depriciation worsens the situation since Ireland is more affected than other European countries.Conclusions: Ireland faces a hard time (like Portugal). The German “Rosskur” (no increase in unit labor costs for about a decade) is a hard way to go. I know what I am talking about.

  4. interested reader   January 21, 2008 at 7:33 pm

    Ireland differs from Portugal (and Spain) in that Irleand’s TFP and labor productivity increased a lot through-out boom phase, holding unit labor costs, competitiveness, and current account issues in check. Now that the U.S. driven service offshoring phenomenon and global demand seems to fade away, Ireland’s economy looks rather exposed but from a better starting point than Spain, I would say.http://www.cesifo-group.de/pls/guestci/download/EEAG%20Report%202007/eeag_report_chap2_2007.pdf

  5. Ulrich Fritsche   January 25, 2008 at 3:44 am

    @ interested reader: Thank you for that link. The arguments are quite reasonable but still some doubts remain.a) The main argument in the report relates to the fact that Ireland’s growth is mainly “catching-up”. In such a process a real appreciation is normal and regarded to be “healthy” as long as it mirrors productivity growth. The Irish productivity figures are high when calculated as GDP per worker’s hour (or head), the figures are much lower when calculated as GNP per worker’s hour since Ireland has a large gap between GDP and GNP.b) In my understanding (just looking on Ireland as an interested “outsider”) this looks like an “extended workbench” phenomenon, where heavy FDI inflows boost GDP (and calculated productivity) but this production is very much dependent from advantages in unit labour cost levels. When looking at the figure in your mentioned EEAG report, Ireland heavily lost competitiveness on a macro level against other European countries but — due to nominal appreciation of the Euro — overproportionally against the US.c) The higher value of the Euro will be permanent for several years, that’s for sure. This in turn makes adjustment in Ireland probably harder than in Netherlands for imstance (not to speak about Germany, where competitiveness improved over a decade or Austria which is quite similar to Germany in that respect). The negative wealth effects via consumption will dampen further.The interesting question for me is: How to accomodate the adjustment process with an adequate economic policy?

    • Guest C. Flower   October 11, 2008 at 7:34 am

      “How to accommodate the adjustment process with an adequate economic policy.” This is what we are all wondering in Ireland, Ulrich Fritsche. Even eight months on this discussion is interesting to read. Our group has been discussing this for some time at machinenation.forumakers.com.and any suggestions you or anyone else might make would be read with great interest.The GDP GNP trap has been significant factor in allowing the politicians and financiers benefiting from increased personal borrowing to fudge the realities. Another factor overlooked is the extent of Irelands external indebtedness, which is the highest in Europe. Our economists have by and large called this correctly over the last few years, with the exception of the ESRI that has predicted “soft landing”.

    • Guest C. Flower   October 11, 2008 at 7:34 am

      “How to accommodate the adjustment process with an adequate economic policy.” This is what we are all wondering in Ireland, Ulrich Fritsche. Even eight months on this discussion is interesting to read. Our group has been discussing this for some time at machinenation.forumakers.com.and any suggestions you or anyone else might make would be read with great interest.The GDP GNP trap has been significant factor in allowing the politicians and financiers benefiting from increased personal borrowing to fudge the realities. Another factor overlooked is the extent of Irelands external indebtedness, which is the highest in Europe. Our economists have by and large called this correctly over the last few years, with the exception of the ESRI that has predicted “soft landing”.