Bertie's legacy

By: Alan Ahearne, Bruegel and NUI Galway

Bertie Ahern’s ten-year tenure as Ireland’s prime minister coincided with the country’s extraordinary economic boom. But as so often happens during prolonged booms, large imbalances eventually emerged, especially in the housing market.

 

As Ahern gets ready to depart following his resignation last week, these imbalances have begun to unwind—and things are beginning to look ugly. Though many observers are rightly concerned about Spain, it may be Ireland that becomes the next serious test of EMU’s one-size-fits-all monetary policy.

 

Fuelled by excessive credit growth and misguided tax breaks for property, Ireland’s housing boom became a bubble. Interest rates that were inappropriately low for a fast growing economy were also a major factor. Calculations using Taylor rules suggest that policy interest rates of around 10 percent were called for in Ireland over the period 2003-2006 to contain overheating.

 

In the latter stages of the boom, the pace of new homebuilding far exceeded sustainable demand, resulting in an enormous overhang of unsold properties when the bubble bust in 2007. Builders have responded to the glut in housing by shelving new projects. In response to the global credit squeeze, lenders in Ireland have tightened standards for both developer and mortgage loans.        

 

Most analysts expect that house completions will drop at least 40 per cent this year, a figure that is consistent with recent readings from forward-looking indicators of building activity.

 

It follows from some simple arithmetic that the Irish economy is likely to fall into recession this year. Since new homebuilding accounts for roughly 10 per cent of GDP, the slump in completions will subtract 4 percentage points from growth this year. Unless the remaining 90 per cent of the economy grows at least 4½ per cent, GDP growth will turn negative.

 

Over the past five years, GDP (excluding new homebuilding) rose about 5 per cent per year on average. A repeat performance this year looks increasingly improbable. Consider the two largest categories of spending: personal consumption and exports.

 

Consumer spending has been buoyant over recent years, boosted by strong growth in employment and after-tax incomes. But we almost certainly at a turning point.    

 

In a study of dozens of property cycles across 18 industrial countries since 1970, my former colleagues at the US Federal Reserve and I found that consumption typically weakens markedly during housing downturns, as unemployment rises and households tighten their belts.

 

Sure enough, the growth of retail sales has slowed dramatically and consumer confidence has tanked. Some economists expect employment growth to come to a searching halt this year. February saw the largest jump in unemployment on record. This rise pushed the unemployment rate to 5.5 percent, a figure not seen since June 1999.

 

The outlook for exports is also worrying. Between them, the United Kingdom and United States account for 36 percent of Ireland’s exports. The depressing effect on exports of slower growth abroad will be compounded by the rise in the value of the euro against both sterling and the dollar.  Ireland’s competitiveness vis-à-vis other countries in the euro area has also deteriorated because Irish inflation has exceeded the euro-area average.

 

Worryingly, the weakness in economic activity will likely feed back into the housing market. The expected sharp slowdown in immigration from Eastern Europe will further depress demand for housing.

 

Worse still, what has happened in the housing market may be repeated to various degrees across other sectors in the economy. Commercial property (such as offices and shopping centres) looks especially vulnerable.

 

Ireland’s main strength is that the country remains attractive as a destination for inward FDI from the United States. In addition, Ireland’s low net public debt to GDP of around 10 percent gives policymakers plenty of room to maintain heavy spending to improve the country’s substandard infrastructure. However, with the public deficit this year almost certain to overshoot the budgeted deficit of 1 percent of GDP, Ireland looks on course to come up against the SGP threshold of 3 percent in 2009.

 

Membership of EMU has arguably saved Ireland from a fate similar to Iceland, but faced with a perfect storm of a housing bust, tightening credit conditions, and a rising currency, it is becoming increasingly difficult to see how the Irish economy avoids a major recession.

 

 

Reference: Ahearne, Alan, John Ammer, Brian Doyle, Linda Kole, and Robert Martin, (2005) “Monetary Policy and House Prices: A Cross-Country Study”, International Finance Discussion Papers 841.  Washington: Board of Governors of the Federal Reserve System (September).  Found at: http://www.federalreserve.gov/pubs/ifdp/2005/841

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