Swift action can prevent bubbles from reoccurring

Dan O'Brien

Economics Editor

ECONOMICS: Benefits for Ireland of being in euro have been greater than benefits for Iceland of having its own currency

LAST WEEK this column looked at the economic catastrophes suffered by Ireland and its north Atlantic island neighbour, Iceland. Comparing the peak-to-trough changes across a range of metrics, it found Iceland has suffered more seriously than Ireland by every major measure other than employment. Of the many conclusions to be drawn and observations made from these findings, two stand out. The first relates to pre-crash developments; the second to the post-crash period.

The first conclusion is that the size of the bubbles in the two economies – rather than anything that happened when or after they burst – was the main determinant in explaining the magnitude of the two calamities.

The one area where Ireland has suffered more than Iceland is jobs – from peak to trough total employment declined by 14 per cent in Ireland, compared to 10 per cent in Iceland. Our employment shock has been worse than Iceland’s because this economy’s construction bubble was so much bigger.

One in eight people working in the Irish economy were in construction at the height of the boom. More than half of those construction jobs have since disappeared as the sector imploded. There was no sectoral bubble of the kind in Iceland, hence its less severe employment shock.

But Iceland’s banking bubble was much larger than Ireland’s, and given the centrality of the financial system to all economic activity, its implosion was the cause of the greater overall shock suffered by Iceland compared to Ireland. While Irish on-shore banks’ aggregate balance sheet grew to more than three times GDP, Iceland’s banking system reached almost 10 times GDP. When the international financial system seized up after the collapse of Lehman Brothers in September 2008, the entire edifice came down and there was nothing the government of that country could have done to prevent it, even if it wanted to.

The fallout was immediate and massive: the currency collapsed and capital controls imposed to prevent it falling further, interest rates soared to achieve the same end and a brutal credit crunch ensued as the long and very difficult process of rebuilding the banking system began almost from scratch. Even now, this process is being hindered by the huge uncertainty that remains about the losses on banks’ assets.

This will sound grimly familiar to readers of these pages when hardly a day passes without more problems and issues arising in relation to the Irish banking system. It should also offer some perspective, particularly to those who have become fixated on September 29th, 2008, in the belief that things could have turned out very differently if there had been no liability guarantee.

The authorities in both countries allowed massive bubbles to inflate. By September 2008 there was no magic wand available to wish away those bubbles. Citizens in both countries will pay dearly for a long time to come, as developments in public debt attest, despite the very different responses taken. In both countries, public debt rose from around one-quarter of GDP in 2007 to just under 100 per cent, according to IMF estimates.

And it could be even worse. Both economies face many big risks. In a report* published last month, the IMF put the following as the first of many risks: “a low-growth, high emigration trap induced by the debt overhang”. The IMF’s staffers were writing about Iceland, but they could just as easily have been writing about Ireland.

The second stand-out fact from a comprehensive comparison between the two economies – in this case since the bursting of the bubbles – has been the role of exports in contributing to recovery. The chart illustrates relative export performance since the quarter in which the financial earthquake struck, up until the third quarter of last year (the latest available data in both cases). It shows that there has not been a significant difference in export performance between Ireland and Iceland.

This is not at all what one would have expected. While being part of the euro protected Ireland from even greater instability during the worst of the crisis, the downside of being locked in to a single currency is that devaluation is unavailable as an option to rapidly regain competitiveness and make adjustment to the shock easier to deal with.

Iceland suffered all the downside of having its own currency, but far less of the upside. Iceland’s export performance has been nowhere near as strong as one would have expected following a 50 per cent devaluation, while Ireland’s has been better than could even have been hoped for.

And the absence of an export boost from exchange rate depreciation has not been confined to Iceland alone. Another neighbour has been similarly disappointed, as the chart illustrates. Despite the weakening of sterling, British exports remain below pre-crisis levels.

No currency regime is perfect and all have positives and negatives. Although things may very well change, at this juncture the benefits for Ireland of being part of a much larger single currency have been considerably greater than the benefits to Iceland of having its own currency.

But the most important policy lesson from all this, it would seem, is that policy actors must be far more willing to make calls on whether bubbles exist and to take measures to deflate them if they conclude that they exist. Of course, this is not easy as there is no way of knowing for sure whether growth is sustainable or mere froth. But given all that has happened, the case for pre-emptive pricking of suspected bubbles appears incontestable.

*www.imf.org/external/pubs/ft/scr/2011/cr1116.pdf