The party is over

Ireland's economy

The party is definitely over
Mar 19th 2009 DUBLIN

From The Economist print edition

How wage cuts and tax rises might preserve the gains of Ireland’s Celtic Tiger years
AFP

DUBLIN is full of shiny new office buildings and retail outlets. But many are unoccupied, monuments to a construction boom that went bust. At one site, the football ground at Landsdowne Road, the cranes are not idle. The stadium is being renovated and will reopen in 2010. “At least someone is drawing a decent wage,” says one watching Dubliner.
This year’s St Patrick Day’s parties were glum, even in Washington, where Brian Cowen, the Irish taoiseach, gave Barack Obama the usual bunch of shamrock (see above). Ireland is having a deeper recession than any other euro area country. The economy probably shrank by 2.5% in 2008 and may contract by another 6.5% this year. Unemployment has jumped from 5% to 10.4%, a faster rise even than in America. Irish banks may be free of the toxic securities that have poisoned rivals’ balance sheets, but they are blighted by souring property loans. And a crisis in public finances has forced the government to bring in an emergency budget on April 7th.
To envious observers, Ireland’s fall from grace is an overdue payback for its previous swift rise. Between 1990 and 2007 the economy grew by an annual average of 6.5% (see chart 1). It is easy now to dismiss the rise in living standards in the “Celtic Tiger” years as illusory, particularly as Ireland enjoyed house-price and credit booms that were big even by British standards. But to focus on the bursting of the housing bubble would be to miss the lasting gains that were made.
Ireland’s expansion went through two phases. The first, led by exports and powered by foreign direct investment, ended roughly in 2002. Foreign companies, mainly American, provided bags of capital and know-how. Ireland offered in return a young, educated, English-speaking, low-cost workforce. State grants, a low corporate-tax rate and access to the EU’s single market made things sweeter.
That gave way to a period of growth on weaker foundations. Low interest rates, a consequence of euro membership, lit a fire under property prices and spurred a building and retailing boom. The boom got a fillip in 2004 as migrants from the EU’s new members flooded in. Continued growth gave the impression that all was well. But as one Irish economist notes, the Celtic Tiger had already vanished.
When the bubble burst, it left a legacy beyond the pile of unsold houses and bad debts. The housing boom had chipped away one pillar of Ireland’s appeal: its low costs. Inflation had picked up and unit labour costs (ie, pay adjusted for productivity) rose sharply relative to Ireland’s main trading partners. A recent study by the European Central Bank found that Irish unit labour costs had risen by a third between 1999 and 2007, the biggest jump in the euro area. A healthy current-account surplus in the mid-1990s had turned into a big deficit a decade later, a sign that Ireland had become too pricey.
One contributory factor was a big rise in public-sector wages after a 2002 review. State workers grumbled that they had been left behind by the private sector. The review led to a hefty increase in pay, a symptom also of a generally lax approach to public finances. Charlie McCreevy, finance minister between 1997 and 2004, scorned the notion that fiscal policy should lean against the business cycle. “When I have the money, I spend it. When I don’t, I don’t,” he once said. Cuts in income tax left public finances too dependent on windfall revenues from VAT on new homes, capital-gains tax and stamp duty. Those revenues dried up swiftly once house prices and sales slumped, pushing the budget into deep deficit.
The fragile economy and a continuing loss of competitiveness have made bond markets nervous about Ireland’s ability to dig itself out of its fiscal hole. The yield on Ireland’s ten-year government bonds, at 6%, is way above those of Germany, at 3.2%. Both countries borrow in euros, so the gap is a rough guide to how creditworthy investors consider Ireland to be.
One big concern is the cost of the state’s guarantee of bank debts, hurriedly given last September. The assets covered are worth 2-3 times annual GDP, not the 7-8 times quoted by some, says Patrick Honohan, at Trinity College, Dublin. The banking system looks big on paper but it is swollen by foreign banks with offices in Dublin and loans abroad. These are not key to Ireland’s economy, so the government does not have to stand behind them.
Even so some of the guaranteed banks’ assets are sure to turn bad. Kevin Daly at Goldman Sachs reckons total losses could be €20 billion ($27 billion), or 10% of GDP—mostly from bad loans to property companies. Even on gloomier assessments, the cost ought to be manageable, as Ireland’s public debt was low to start with.
Yet the pressing task remains to rein in the budget deficit. The mini-budget in April will be the fourth fiscal package in a year. In February, in the teeth of union opposition, the government introduced a levy on public-sector pensions that cut take-home pay by an average of 7.5%. The pain will intensify in April. Income-tax rates seem certain to rise, some capital projects may be put on ice and more current spending will be cut. The Irish insist on keeping their 12.5% corporate-tax rate. Still, once the economy bottoms out and new measures take their full effect, the 2010 deficit ought to be less scary to the markets.
Some economists would like an agreement that cuts public and private pay in tandem. As a euro member, Ireland cannot devalue to restore competitiveness. So wages must fall. Karl Whelan at University College, Dublin is sceptical that a co-ordinated pay cut is likely or even necessary. “This is a flexible market economy: with a 10% unemployment rate, wages will fall.” Indeed, they already are. A Dublin Chamber of Commerce survey found that nine out of ten firms were reducing or freezing pay; almost a third of respondents were cutting executive salaries by 10% or more.
Ireland’s response to austerity goes against the grain. In America and Britain, policy is geared to avoiding deflation, which raises the real cost of debt. But Ireland seeks salvation in lower wages, even though its households are also heavily indebted. Whereas many countries want to lift their economies by fiscal expansion, Ireland is tightening its budget. Few other countries face such big deficits. The Irish hope for a payoff in improved confidence among foreign investors and at home. Consumers are aware of the gap in the budget and know tax rises are coming, says Alan Barrett at ESRI, a research institute. Spending may even pick up if the uncertainty over taxes is ended.
There may be regrets about the excesses of the housing bubble, but not about Ireland’s globalised growth model.“The key is to turn the model back to export-led growth,” says Brian Lenihan, the finance minister. “So we have to attend to competitiveness.” For all its ills, Ireland has form when it comes to retrenchment: it cut debt sharply in the late 1980s. If adjustment within the euro means wage cuts, that is a price Ireland seems ready to pay.

Courtesy of "The Bagman" who enjoyed living off the fat of the Celtic Tiger