Government of any stripe will face explosive political challenge of cutting public spending
Our current economic woes were caused mainly by low interest rates fuelling inflation, writes CORMAC LUCEY
DIFFERENT PEOPLE have offered different explanations for our current economic crisis. The excesses of the American banking system “triggered the crisis”. Reckless lending and weak financial regulation are to blame. Some say that the Government “blew the boom”.
Garret FitzGerald blames Charlie McCreevy’s performance as finance minister. Others blame Brian Cowen’s record as finance minister.
Meanwhile, aficionados of motivational theories assert that we have “talked ourselves into recession”.
In my opinion, there is a more convincing, economic explanation for what went wrong.
An immediate benefit of joining European Economic and Monetary Union (EMU) was a fall in our interest rates. To evaluate just the interest rates boost we got, economists use the Taylor rule. This is an economic rule of thumb that predicts what central bank interest rates should be. It states that the lower actual inflation rates are, the lower interest rates should be. It also states that the more unused capacity there is in an economy, the lower interest rates should be.
In January 2005, Rossa White of Davy Stockbrokers used the Taylor rule to estimate that European Central Bank interest rates were appropriate for Ireland. A similar story applied across the decade 1997-2007. Ultra-low interest rates encouraged increased borrowing. Increased borrowing drove up property prices. A simple look at a graph of average house prices shows a clear shift in the upward trajectory of Irish house prices at the time we joined EMU: they went, in 1997, from an average of €100,000 to almost €400,000.
Not only did ultra-cheap interest rates stimulate house prices, they stimulated the wider economy too. This can be seen from the numbers employed in the Irish economy – a clear shift upward around the time that we joined EMU, from 1.3 million to around 2.1 million.
It wasn’t just Ireland that experienced a boom from low interest rates. Other members of the EMU such as Spain and Greece experienced the same effect. Is it a coincidence that average unit labour costs rose more steeply in Ireland, Spain and Greece than in the euro zone as a whole, and much more steeply than in Germany? Is it a coincidence that Ireland, Greece and Spain are the EMU members now experiencing the greatest financial distress?
There are many competing explanations for what happened to the Irish economy over the last decade. But to me, none has the persuasive power of inappropriately low interest rates spawning a debt bubble and a housing bubble, which boosted economic activity and supported both tax cuts and generous government spending increases.
If credit was the key influence of the last decade, we need to consider credit as we look forward to the next decade . Using forecast data set out in the recent supplementary budget generates an implied interest rate for Ireland of -5.5 per cent. That is fully 6.5 per cent below the current ECB rate of 1.0 per cent. This suggests that Ireland now needs a heavy dose of quantitative easing, ie monetary stimulus that goes beyond interest rate cuts.
But there is a wider and more worrying point than the appropriateness of the current EMU interest rate for Ireland. The situation where the EMU interest rate is much too high for Ireland’s circumstances is likely to persist for some time. This is because our output gap is likely to remain large as the collapse of the property sector spills over into other sectors and as public spending is curtailed and tax revenues increased: that will keep our output gap larger than in the rest of the euro zone.
That in turn will put a dampener on Irish inflation and will keep our inflation lower than in the rest of the euro zone. These two factors mean that EMU interest rates may, for some considerable time, remain significantly too high relative to Ireland’s needs. The downward swing in the Irish economy may have transformed a situation where EMU interest rates were structurally too low for a long time to one where they will be structurally too high for a long time.
In establishing Nama, the Government is attempting to stabilise the Irish banking system. The Government is right to do so. But it risks paying well over the odds for a project that may repair the banking system and restore the supply of credit only to find that demand for credit has dried up.
The recent Mazars report on bank finance for small and medium-sized enterprises (SMEs) confirmed this. While it found that total credit to SMEs had remained relatively static over the nine months covered by its review, it also found that “the value of new applications for credit decreased by an average of 42 per cent”.
The implication is that we face into a prolonged period of deflationary pressures as credit supply remains constrained while credit demand falls off sharply as people and businesses repair damaged balance sheets.
The best-case scenario for Ireland over the coming decade is to copy Germany over the last decade. Germany restored its cost competitiveness through cost-cutting and wage restraint.
Markets here are already forcing deflation in property prices, private sector pay and retail prices (eg restaurants and hotels).
With economic growth elusive, taxation revenue approaching its limits and with one-third of Government spending being borrowed, the economic case for a sharp reduction in public spending is unavoidable. That is the explosive political challenge facing our government – whether it comprises Fianna Fáil and the Green Party or Fine Gael and Labour.
Earlier this summer as he left social partnership talks, Irish Congress of Trade Unions general secretary David Begg criticised the Government for a “failure of ambition”. The situation is considerably worse than that. Too many prefer hackneyed analysis and comforting conclusions to a rigorous approach that might lead to difficult conclusions. We may be suffering from a failure of comprehension.
Cormac Lucey is a fellow of the Institute of Chartered Accountants in Ireland and an associate of the Irish Management Institute. He is a former vice-president of Rabobank International and was special adviser to Tánaiste Michael McDowell during the last government. Garret FitzGerald is on leave