THE IRISH ECONOMY THE EMU EFFECT

Cormac Lucey

THE IRISH ECONOMY

1. What happened?
2. Where are we now? 3. Where are we going?

4. Afterword.

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WHAT HAPPENED?
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1. WHAT HAPPENED?
A. EMU - Cheap credit.
B. Credit bubble. C. Debt bubble.

D. Property bubble.
E. Activity bubble. F. Cost bubble. G. Public sector bubble. H. The largest bubble.

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1. WHAT HAPPENED? A. EMU CHEAP CREDIT

Rossa White, Davys Stockbrokers, January 2005
The simplest way to estimate the appropriate policy rate for Ireland is to use the Taylor Rule. It specifies that the real policy rate reacts to two crucial variables: deviations of inflation from its targeted level; and deviations of real GDP from its long-run potential.

The rule sets the nominal policy rate equal to the rate of inflation plus an equilibrium real interest rate and the weighted average of the aforementioned deviations. John Taylor found that it neatly described the US Federal Reserve's decision-making process and it is now widely used by forecasters to estimate the desired level for policy rates.

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1. WHAT HAPPENED? A. EMU CHEAP CREDIT

Rossa White, Davys Stockbrokers, January 2005
Putting all of this together, we reckon that an appropriate policy rate for Ireland is around 6%, fully four percentage points above its actual level. There is no doubt that an inappropriate policy rate for Ireland is fuelling the booming residential construction sector. One way to think about it is to imagine the mayhem that would ensue were interest rates to rise to 6%. Our worry is that an elongated boom could lead to a more severe correction in the housing market when rates finally begin their ascent (to 3% rather than 6%) or when sentiment changes.

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1. WHAT HAPPENED? A. EMU CHEAP CREDIT

John Taylor The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, November 2008

The bigger the gap between what national interest rates should have been and EMU interest rates were, the bigger the increase in housing investment.

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1. WHAT HAPPENED? A. EMU CHEAP CREDIT

John Taylor The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, November 2008

Is it pure coincidence that the biggest outliers are those EMU members now suffering the greatest distress?

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1. WHAT HAPPENED? B. CREDIT BUBBLE

As a result of under-priced credit, private sector debt levels grew sevenfold in the decade following Irelands EMU entry.

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1. WHAT HAPPENED? C. DEBT BUBBLE

By the end of 2008, private sector debt had mushroomed to 257% of GNP in Ireland leaving us well ahead of the supposed bold boys.

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1. WHAT HAPPENED? D. PROPERTY BUBBLE

450,000
400,000

350,000

300,000

Dublin house prices. Pre-EMU and Post-EMU. Two distinct trajectories.

250,000

200,000

150,000

100,000

50,000

0 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

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1. WHAT HAPPENED? D. PROPERTY BUBBLE

Engulfed by low interest rates and a wave of credit, Irish property prices soared to the moon.
By 2006, Rossa White was reporting that properties in some Dublin suburbs were selling for over 100 times the rental income that could be earned from them.

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1. WHAT HAPPENED? E. ACTIVITY BUBBLE

2,200 2,000

Irish employment numbers (000). Pre-EMU and Post-EMU. Two distinct trajectories.

1,800

1,600

1,400

1,200

1,000 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

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1. WHAT HAPPENED? E. ACTIVITY BUBBLE

All of the jobs growth in the boom years was concentrated in services and construction.

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1. WHAT HAPPENED? E. ACTIVITY BUBBLE

Within services and construction, jobs growth was concentrated in the interest-rate sensitive sectors of construction and financial services.

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1. WHAT HAPPENED? F. COST BUBBLE

Drowning in a torrent of cheap money, wage levels took off and international competiveness weakened. See OECD unit labour costs indexed at 100% in 1993.

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1. WHAT HAPPENED? F. COST BUBBLE

Wage levels across the economy took off.
And it wasnt just wage levels for our public representatives and civil servants.

The most basic rate of welfare payment for the long-term unemployed amounts to 188 weekly in Ireland. That is equivalent to 819 monthly. The most basic rate of welfare payment for the long-term unemployed in Germany amounts to 359 monthly, less than 45% the Irish rate.

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1. WHAT HAPPENED? G. PUBLIC SECTOR BUBBLE

With buoyant tax revenue and explosive growth in propertybased taxes, Ireland, like Cosmo Girl, could have it all: high levels of government spending and low taxes.
Gross Government Spending (bn)
50.0 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1997 2007

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1. WHAT HAPPENED? H. THE LARGEST BUBBLE

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WHERE ARE WE NOW?

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2. WHERE ARE WE NOW?

A. Property bust.
B. Wealth bust. C. Banks bust.

D. Spending bust.
E. Employment bust. F. Public finances bust. G. Interest rate bust. H. FX bust. I. Intellectual bust.

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2. WHERE ARE WE NOW? A. PROPERTY BUST

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2. WHERE ARE WE NOW? A. PROPERTY BUST

Residential property values down 30% 60%

Site values down 80 100% According to NCB Stockbrokers, if house prices continued to drop in 2010 at the same rate as in 2009 then over 50% of all mortgage holders would have been in negative equity by year-end.

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2. WHERE ARE WE NOW? B. WEALTH BUST

According to Central Bank analysis (page 46, CB Q1 2010 report), Irish private sector wealth levels have taken a substantial hit as a result of property devaluation.

b Housing Financial Total Debt Net

Q4 2006 Q2 2010 520 290 810 -175 635 380 270 650 -190 460 -27% -7% -20% 9% -175

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2. WHERE ARE WE NOW? B. WEALTH BUST

I think that the hit has been much greater. In my view it is this wealth hit (and the resulting threat of a pauperised old age which many face) that has led to the sharp rise in Ireland's savings rate rather than any uncertainty.
b Q4 2006 Q2 2010

Housing
Financial Total Debt Net

520
290 810 -175 635

260
270 530 -190

-50%

340 -295

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2. WHERE ARE WE NOW? C. BANK BUST

Shares of Bank of Ireland, the good bank, are worth just 1% of their peak value.

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2. WHERE ARE WE NOW? C. BANK BUST

Discounts paid on face value of loans acquired by NAMA (haircuts) from:
AIB 54%

Bank of Ireland
Anglo Irish Bank Irish Nationwide

42%
62% 64%

EBS

60%

The modest enough difference between the sinners at Anglo and the saints at Bank indicates that the problem is much deeper than misbehaviour by a few pantomime villains.

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As Irish banks reduce core lending, Anglo, INBS & Halifax wind down their loan books.

2. WHERE ARE WE NOW? D. SPENDING BUST

Retail Sales Index (Value)
120

115

110

105

100

95

90 2006 2007 2008 2009 2010 Dec-10

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2. WHERE ARE WE NOW? E. EMPLOYMENT BUST

2,200 2,000

1,800

1,600

1,400

1,200

1,000

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2. WHERE ARE WE NOW? F. PUBLIC FINANCES BUST

With sharply reduced economic activity, government tax revenues have collapsed. Governments estimate of tax receipts for 2009: Budget 2007 Budget 2008 56b 52b

Budget 2009
2009 update, 01/09

43b
37b

Ulster Bank estimate, 03/09 34b

2009 update, 12/09

32b (-45% from original est.)

Had the government not introduced a number of revenue-raising measures (vat increase, income levy etc) in the budgets of 2008, the eventual outcome would have been even worse.

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2. WHERE ARE WE NOW? F. PUBLIC FINANCES BUST

-32%

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2. WHERE ARE WE NOW? G. INTEREST RATE BUST

For the decade 1997 2007, ECB interest rates appropriate for the Eurozone as a whole were too low for Ireland. Credit stimulus was the result. But in 2008 that was reversed as: a) Irish inflation went from being above the average EZ to being below it; and b) Spare capacity in the Irish economy (using unemployment as the measure of this) went from being below the EZ average to being above it. With neither of these factors likely to reverse quickly, we now face a prolonged period where interest rates appropriate for the EZ as a whole, will be too tight for Irelands circumstances. Demand for credit will therefore be weak for the foreseeable future.

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2. WHERE ARE WE NOW? G. INTEREST RATE BUST

Since 2008, this situation has reversed. Interest rates that are appropriate for the Eurozone as a whole are now too high for Ireland and too low for Germany. This can be seen in the chart below where Credit Suisse suggest that an appropriate policy (Central Bank) interest rate for Germany is 4.5% compared to minus 4.6% for Spain, Ireland, Greece and Portugal. The simplest way to think about the Eurozone is to imagine the proverbial man with the upper half of his body in the over and the lower half in the deep freeze. On average his temperature is OK but different parts of his body are put under intolerable strain.

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2. WHERE ARE WE NOW? G. INTEREST RATE BUST

6.0% 4.0%

2.0%

0.0% 2005 -2.0% 2006 2007 2008 2009 2010

EZ Taylor Rule Int Rate

Ireland Taylor Rule Int Rate

-4.0%

-6.0%

-8.0%

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2. WHERE ARE WE NOW? G. INTEREST RATE BUST

4.0% 2.0%

0.0% 2005 2006 2007 2008 2009 2010

-2.0%

Int Rate Boost / (Penalty) Implied for Ireland by Taylor Rule

-4.0%

-6.0%

-8.0%

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2. WHERE ARE WE NOW? G. INTEREST RATE BUST

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2. WHERE ARE WE NOW? H. FX BUST

With a depressed economy, a currency devaluation would suit Ireland. Instead, since the financial crisis broke, the Euro has appreciated 25% against Sterling.

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2. WHERE ARE WE NOW? H. FX BUST

IF AND

1.00 = 1.13 IRP1.00 = 1.27

(= 1.00 / .887)

THEN

IRP 1.00 = 1.12

(= 1.27 / 1.13)

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2. WHERE ARE WE NOW? I. INTELLECTUAL BUST

Unlike in the 1980s, today there is broad intellectual confusion in the diagnosis of our problems. We have a veritable Tower of Babel of conflicting intellectual explanations for our crisis. Some such as our president, Mary McAleese, and the Glen Dimplex CEO, Sean ODriscoll suggest that things would be better if only we were more positive about things. The political establishment (including Fianna Fil, Fine Gael, Labour and the Greens) would all like us to be more positive and to aid the retail and hospitality sectors by spending more. Left unanswered by these people is the question of just how this crisis then started in 2008, at a time when the public mood was pretty positive? The Establishment takes the view that our crisis is largely homemade, to use the phrase of Central Bank Governor, Patrick Honohan. In this view (supported by Regling and Nyberg), greedy bankers and lax regulation caused a credit bubble which triggered unsustainable levels of construction activity and unsustainable public finances. Left unanswered is the question of why similar crises unfolded at the same time in Greece, Portugal and Spain?

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2. WHERE ARE WE NOW? I. INTELLECTUAL BUST

And there are countless other explanations of our crisis, many embarrassingly sectional and credulous in nature. Those working in training suggest that we need to upskill our workforce they ignore massive unemployment levels even among the highly skilled. Trade unionists suggest that we need to craft our solution to favour their members they ignore the massive loss of cost competitiveness over the last decade which suggests pay restraint and reduction among their members. Political scientists suggest that we need to reform our structures of government they ignore the fact that our political system worked pretty well up until this last decade.

Some economists suggest the need for a fiscal oversight council (no doubt populated by economists like them) they ignore the fact that establishment economists failed, in the middle of the last decade, to warn of the crisis then brewing.

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WHERE ARE WE GOING?

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3. WHERE ARE WE GOING?

A. Key facts.
B. The polar choices. C. The official response.

D. Implications.

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3. WHERE ARE WE GOING? A. KEY FACTS

With the government guarantee of the banks main liabilities, the finances of the banks and the finances of the State are joined at the hip.
The eventual losses at the Irish banks may total 100b (= my personal hunch). Irelands public sector debt (headed towards 200b by 2014) and its private sector debt (325b as of April 2011, according to the Central Bank) totals circa 500b (if we allow for some double-counting). Public sector debt does not include NAMAs debt. With 1.5m full-time employees, 500b is equivalent to 333k per full-time employee. Or put another way, our gross (public + private) debts amount to four times national income (GNP). I do not think that will not be able to pay these debts in full. More importantly, markets agree.
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3. WHERE ARE WE GOING? A. KEY FACTS

GERMAN 10-YEAR BOND Year 0 1 2 3 4 5 6 7 8 9 10 Interest 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 Principal -108.72 Cash flows -108.72 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 104.00 2.979% Discount 1.0000 0.9711 0.9430 0.9157 0.8892 0.8635 0.8385 0.8142 0.7907 0.7678 0.7456 NPV DCF -108.7 3.9 3.8 3.7 3.6 3.5 3.4 3.3 3.2 3.1 77.5 0.0

100.00 IRR

The 8% difference in government bond yields (11% - 3%) implies that an Irish government bond promising the same cash flows as a German one can be bought for just 53% (57.15 / 108.72) of the price.

Year 0 1 2 3 4 5 6 7 8 9 10

Interest 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00

IRISH 10-YEAR BOND Principal Cash flows -57.15 -57.15 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 100.00 104.00 IRR 11.399%

Discount 1.0000 0.8977 0.8058 0.7234 0.6493 0.5829 0.5233 0.4697 0.4217 0.3785 0.3398 NPV

-57.1 3.6 3.2 2.9 2.6 2.3 2.1 1.9 1.7 1.5 35.3 0.0

Markets expect to get only 53% of the cash flows promised by Irish government bonds (or 36% from Greek bonds, 82% from Spanish).

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3. WHERE ARE WE GOING? A. KEY FACTS

Publication of second set of bank stress tests.

Finance minister Michael Noonan welcomes positive market reaction to bank stress tests.

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3. WHERE ARE WE GOING? B. THE POLAR CHOICES

The Problem, The Polar Choices & More Problems
Economically feasible?
Solution 1 increase savings so as to restore solvency.

Political difficulties in Peripherals. Manageable?

Peripherals face solvency problem rather than liquidity problem.

Solution 2 share solvency problem on EU basis: fiscal burden sharing + money printing.

Political difficulties in Core. Manageable?

Legally prohibited under Art 125 Lisbon Treaty?

Economic difficulties in Core? Solution 3 permit default by Peripherals. Global contagion effects?
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3. WHERE ARE WE GOING? B. THE POLAR CHOICES

Kicking the Can Down the Road
Solution 1 continued austerity at PIGs. Economic difficulties in periphery.

Political difficulties in peripherals.

Muddle through scenario.

Solution 2 continued ECB assistance for PIGs.

Political difficulties in core.

Stresses within ECB. Weakening ?

Economic difficulties in core? Solution 3 permit default by PIGS. Global contagion effects?
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3. WHERE ARE WE GOING? B. THE POLAR CHOICES

Kicking the Can Down the Road
Solution 1 continued austerity at Peripherals. Economic difficulties in Peripherals. Continued weak growth makes insolvency clear. Markets riot. Political breakdown in Peripheral.

Political difficulties in Peripherals. Muddle through scenario. Solution 2 increased Core assistance for Peripherals

Political difficulties in Core.

Core country refuses to prop up Peripherals.

Stresses within ECB. Weakening ?

ECB splits over continued aid.

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3. WHERE ARE WE GOING? B. THE POLAR CHOICES

Markets have already anticipated looser Eurozone policies.

Drop of nearly 30%

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3. WHERE ARE WE GOING? Accidents B. THE POLAR CHOICES waiting to

happen. But Eventually the Road Will Give Way
Economic difficulties in Peripherals. Continued weak growth makes insolvency clear. Markets riot. Political breakdown in Peripheral.

Solution 1 continued austerity at Peripherals.

Political difficulties in Peripherals. Muddle through scenario. Solution 2 increased Core assistance for Peripherals

Political difficulties in Core.

Core country refuses to prop up Peripherals.

Stresses within ECB. Weakening ?

ECB splits over continued aid.

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3. WHERE ARE WE GOING? B. THE POLAR CHOICES

But Eventually the Road Will Give Way
Solution 1 continued austerity at PIGs. Economic difficulties in periphery. Continued negative growth makes insolvency clear. Markets riot. Political breakdown in peripheral. Political difficulties in peripherals.

Political difficulties in core. Muddle through scenario. Solution 2 continued ECB assistance for PIGs.

Core country refuses to prop up peripherals.

Stresses within ECB. Weakening ?

ECB splits over continued aid.

Economic difficulties in core?

Solution 3 DEFAULT
Global contagion effects?

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3. WHERE ARE WE GOING? B. THE POLAR CHOICES

The Cost of Default

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3. WHERE ARE WE GOING? B. THE POLAR CHOICES

The Cost of Default

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3. WHERE ARE WE GOING? B. THE POLAR CHOICES

But Eventually the Road Will Give Way
Solution 1 continued austerity at PIGs. Economic difficulties in periphery. Continued negative growth makes insolvency clear. Markets riot. Political breakdown in peripheral. Political difficulties in peripherals.

Political difficulties in core. Muddle through scenario. Solution 2 continued ECB assistance for PIGs.

Core country refuses to prop up peripherals.

Stresses within ECB. Weakening ?

ECB splits over continued aid.

Economic difficulties in core?

Solution 3 DEFAULT
Global contagion effects?

Can a defaulter remain within the EZ? Would they want to?

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3. WHERE ARE WE GOING? B. THE POLAR CHOICES

Having decided on or succumbed to default, the additional costs of Eurozone exit would be low, compared to the economic benefits.

Cost
Reputational damage? Banks insolvent? Government unable to borrow?

Default Yes. Yes. Yes.

Exit Yes. Yes. Yes.

Concerns over defending currency?

No.
Default Yes. No. No.

Yes.
Exit Yes. Yes. Yes.

Benefit
Reduced debt burden? Immediate devaluation / cost cuts? Scope for appropriate monetary policy?
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3. WHERE ARE WE GOING? C. THE OFFICIAL RESPONSE

Political unwillingness to face up to problems

Technical failure to comprehend problems

Misdiagnosis of nature and extent of problems

Piecemeal and inadequate policy measures

Continuing economic weakness & financial fragility: the Zombie Economy.

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3. WHERE ARE WE GOING? C. THE OFFICIAL RESPONSE

The economic situation is more serious that we have been admitting officially. We have deliberately not been too pessimistic in public for fear of undermining confidence and also in the hope that as the months went by things would show a sufficient turn for the better. This hope is not being realised indeed, it was not soundly based and we now have to increase the corrective measures. We should also, without being alarmist, be more forthright about the nature and extent of our problems. We would be deluding ourselves if we continued to make reassuring comments on their temporary nature There is a basic difficulty of a more lasting character and it is time we did something more effective about it.
- TK Whitaker, October 1965, quoted in Dermot Keoghs Jack Lynch.
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3. WHERE ARE WE GOING? C. THE OFFICIAL RESPONSE

Stirrings of official recognition:
A Wall Street Journal investigation, based on dozens of interviews with officials from around the EU, reveals that the divisions that bedevilled the task force pushed the currency union perilously close to collapse. In early May 2010, just hours before Germany and France broke their stalemate and agreed to endorse a trillion-dollar fund to rescue troubled euro-zone members, French Finance Minister Christine Lagarde told her delegation the euro zone was on the verge of breaking apart, according to people familiar with the matter. May 25th 2011. The EU's Fisheries Commissioner, Greece's Maria Damanaki warned that "the scenario of removing Greece from the euro is now on the table.

June 20th, 2011. Former British foreign secretary, Jack Straw MP What the Government should do instead of sheltering behind the complacent language, weasel words that it is not appropriate, we should not speculate is recognise that this eurozone cannot last.

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SUDDENLY AND UNEXPECTEDLY

Obituary for a common currency

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3. WHERE ARE WE GOING? D. IMPLICATIONS

Things fall apart; the centre cannot hold, Mere anarchy is loosed upon the world WB Yeats, The Second Coming.

You never want a serious crisis to go to waste. And what I mean by that is an opportunity to do things you think you could not do before. - Rahm Emanuel, President Obamas former White House chief of staff.

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THE IRISH ECONOMY

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