Euro crisis casts a pall of gloom

These are years in which economic history is being made. In 2007, Ireland’s long property boom ended and the first tremors were felt in the western financial system.

In 2008 Ireland descended rapidly into recession and the world changed with the collapse of Lehman Brothers. The following year, Ireland and the global economy suffered the largest declines in output since the first half of the 20th century. In 2010 the implosion of Greece triggered the euro sovereign debt crisis, culminating – for Ireland – in an international bailout.

The year just ending has been no less momentous. While the Irish economy and banking system showed some signs of stabilisation, domestic conditions remain grim in most respects, and a new Government, though limited in what it can do, has rarely been radical in its policy decisions (see panel).

Worse still, as the year ends, the real economies of Ireland and Europe appear to be stagnating – if they are not already in recession – and the euro crisis has become so severe that the currency’s very existence is in question.

Here at home, 2011 has been a mixed bag economically, but the “feel-bad” effect has dominated, owing to high unemployment, heavy public and private indebtedness, continued austerity and huge uncertainty surrounding the euro.

About the most encouraging sign in 2011 came from gross domestic product – the widest measure of economic activity. In the first three quarters of the year, the economy expanded, even if a surprisingly strong first half was partially reversed by a contraction in the third quarter.

Much of the solid performance was accounted for by the vaunted export sector, which continued to do well in 2011, even if – again – some slowdown was to be seen into the second half as the world economy weakened.

Auguring well for the future of exports were patterns of foreign direct investment during the year (foreign-owned companies account for 90 per cent of Irish exports). Early indications point to an increase on 2010 in the numbers of jobs created by IDA-assisted companies.

If being bailed out by the international community damaged Ireland’s reputation as a place to do business, the effects on FDI at this juncture appear to have been limited at most.

Another encouraging development, and one which differentiates Ireland from the Club Med countries, was the continued improvement in the economy’s international balance of payments position. A surplus on the current account of the balance of payments means that an economy is earning more from abroad than it is paying out to foreigners for their goods and services.

In the final years of the Celtic Tiger, Ireland ran large deficits (although much smaller than Greece and Portugal, the two other bailed-out euro-zone countries). But, by 2010, the deficit had turned to surplus, and another surplus may be notched up in 2011.

But if there were reasons for optimism in 2011, there are more reasons to show that the Irish economy did not begin a wide-ranging recovery.

Most depressing was the labour market. The rate of joblessness – the percentage of the workforce without a job – is one of the highest in the developed world, even if it remained broadly stable throughout the year, at just under 15 per cent.

But in a labour market as open as Ireland’s, where many people move in and out of the workforce, often owing to migration, the jobs picture is best illustrated by the total numbers at work, rather than rate of unemployment. And by this measure, 2011 was another grim year. In the first nine months of the year, the number at work in the Irish economy declined by 33,000 to stand at just under 1.8 million in the third quarter.

Though this was less bad than the same period in 2010, when employment fell by 52,000, it suggests that the labour market is still some distance from stabilising.

The decline in the number of pay packets, combined with stagnating real wage rates and a high rate of savings, caused consumer spending to continue to fall in 2011.

Indeed, by the widest measure, it fell by more in the first nine months of the year than it did in the same period in 2010.

One reason for the elevated rate of saving is the weakened state of household balance sheets. With high levels of debt on the liabilities side, falling property prices on the asset side means that “net” wealth is being eroded for many people, and wiped out altogether in some cases.

According to the Central Statistics Office’s newly launched index, the decline in residential property prices accelerated in 2011 on the previous year. By October, nationally prices were 45 per cent below their peak in 2007. With so much downward momentum, it appears only a matter of time before they break through the 50 per cent threshold. That has already occurred in the capital in mid-2011.

Continued over-supply and weak demand are both driving down prices. Contributing to the weakness in demand is the banking system. Although the hugely costly and controversial restructuring of the banking system decided by the EU-IMF troika does appear to have brought some stability, it is likely to be many years before the banking system is self-supporting and performing its credit provision function properly, as evidenced by its lending to homebuyers.

According to figures from the Irish Bankers’ Federation, the number of new mortgages issued continued to plummet in 2011, with just 10,000 being extended across the State in the first nine months of the year.

Companies are also affected by the impaired banking system, with limited credit provision being at least one factor in the shrinking of the domestic enterprise sector – by the third quarter of the year there were 5,000 fewer people registered as self-employed than in the final three months of 2010.

Given all this, where is the evidence of more solid foundations under the banking system? The massive flight of mostly foreign deposits from banks based in Ireland, which began in September 2010, continued into the new year, but then started to stabilise.

By August, a very limited reversal began, although the October figures suggest that it may not last as the euro crisis deepened.

The stabilising deposit base also allowed a lessening of the dependence on central bank funding. At the end of 2010, Ireland-based banks owed €183 billion to the central banking system (mostly to the European Central Bank, but €50 billion of that was owed to the Irish Central Bank). By the end of last month, the total had fallen to €149 billion, a still massive figure, but progress nonetheless.

A further sign of progress, however limited, came in the summer when US private investors bought a stake in Bank of Ireland. That acquisition in turn reflected a wider improvement of international confidence in the Irish economy, something demonstrated most clearly by sharp falls in yields on Irish Government bonds in late summer and into the autumn.

This marked a clear decoupling from Portugal, whose government bond yields had closely tracked those of Ireland’s for a protracted period. But the decline in yields ended in early October, before rising again, almost certainly the result of wider euro zone uncertainty.

And it was the euro crisis that overshadowed all else economically in 2011. Although the crisis had been ongoing since early 2010, resulting in bailouts for Greece and Ireland in its first year and a rescue of Portugal in the spring of 2011, the crisis moved into endgame in July 2011 when the too-big-to-bail economies contracted contagion.

What triggered the loss of confidence in Italy and Spain – and whether it was inevitable all along – will long be debated, but it is difficult to avoid the conclusion that the decision to allow Greece to default was the game changer. With no developed economy having defaulted on its sovereign obligations in living memory, OECD government bonds had been seen as the safest way to store wealth.

In order to ensure that this remained the case, “No default” had been the official mantra from the beginning of the crisis. But by mid-year – and largely at German insistence – a de facto default was agreed, with a 20 per cent haircut on Greek sovereign debt initially mooted. By October that had risen to 50 per cent, and the final figure may well be larger still once agreed in 2012.

Whether or not the decision to write down Greek debt was the correct one, the failure to put in place a policy response to deal with the contagion effects was utterly disastrous. But that merely reflected EU leaders’ repeated failures over the course of the year to take measures proportionate to the scale of the crisis. Summits in July, October and December all failed to address the crisis, gravely undermining the credibility of euro-zone policy makers and putting the future of the currency at risk.

If there was anything that surprised in 2010 and well into 2011, it was how limited was the impact of the uncertainty on the real economy in Europe. But in recent months that too has changed as clear signs of a credit crunch in Europe emerged. All indicators point to stagnation or worse in the final quarter of the year. Ireland, Europe and the wider world economy face a new year in which risks and uncertainties could hardly be greater.

Has a change of government made a difference for the economy?

The extent of government influence over economic affairs is often overstated. For any government in the predicament of the current Irish administration, the scope for boosting economic activity in the short run is limited in the extreme.

With so much budgetary consolidation to introduce, the Government can only boost growth prospects in the medium and long term, by changing structures and institutions to make them more efficient. But if the economic gain of implementing such reforms is back-loaded, the political gain is immediate – affected interest groups don’t take unsettling reforms lying down.

The Fine Gael-Labour coalition, in office since March, has not shown a great appetite for taking on vested interests, although there have been exceptions.

The taxing of pensions to fund the summertime Jobs Initiative was certainly brave.

At individual minister level, Alan Shatter could never be accused of backing away from taking on one of Irish society’s most powerful interest groups – the legal profession.

And if the public sector reform plan set out by Brendan Howlin in November is ruthlessly implemented, it would herald real change in the public sector.

But on most of the radical changes that the coalition could have taken on, its has been timid. A minimalist approach to the sale of State assets was favoured over the recommendations of the McCarthy report.

A Comprehensive Review of Expenditure did not result in the axing of big-spending programmes, such as a community employment scheme that has been shown to be ineffective in getting people back to work, and reallocating the monies to more effective programmes.

Perhaps more than anything else, the fact that the Croke Park agreement has survived intact shows the coalition’s unwillingness to bring about rupture with the past.