Anyone interested in getting to the root of the Irish problem rather than simply mocking our Prime Minister for not wanting to build tractor factories or something could do a lot worse than reading this World Bank report, which came to my attention via Guido Fawkes.
Although growth remained strong for most of the first decade of Ireland’s membership of the eurozone, the analysis we have presented suggests that the seeds of the crisis were sown around the time the single currency began at the beginning of 1999. But was this a causal factor or a coincidence?
Elements of eurozone membership certainly contributed to the property boom, and to the deteriorating drift in wage competitiveness. Low interest rates and the removal of exchange rate risk facilitated the boom; the insensitivity of the exchange rate and of interest rates to domestic developments removed a traditional external constraint or at least warning sign. The enlargement of the EU also meant that the boom could continue longer than otherwise, fuelled as it was by strong inward migration.Up to 2003, the property boom was financed without significant recourse to foreign borrowing, but after then the banks started to borrow heavily from abroad. This was an effortless undertaking thanks to the removal of currency risk and went essentially unnoticed by analysts, the focus of policy attention having shifted away entirely from balance of payments concerns. Unlike imbalances of the past, overborrowing did not lead to interest rate increases, again because currency risk had been altogether removed. Only when credit risk became an issue after September 2008 did the financial markets belatedly sound a warning sign.
Specifically, real interest rates 1998-2007 averaged minus 1 per cent, compared with
over 7 per cent in the ERM period (even excluding the crisis of 1992-3) and 3¾ in the floating rate period between the two. The fall in nominal interest rates was even steeper. No wonder long-lived assets like residential property, capitalized at permanently lower discount factors, seemed and were appropriately valued more highly than before. The problem was to determine just how much higher. EMU introduced that element of uncertainty. Much the same could be said of wage rates. As shown by Honohan and Leddin (2006), the former tendency for deviations in wage competitiveness to correct themselves (error correction model), detectable in previous data, was no longer evident after EMU began. The regime once again tolerated a larger movement away from equilibrium before warning signals sounded.
To be sure, all of these imbalances and misalignments could have happened outside of EMU – indeed, similar problems were experienced in other non-euro countries in the EU and the EEA. But the policy antennae had not been re-tuned in Ireland, and corrective action that could and should have been taken (fiscal policy, bank regulation, centralized wage negotiations) were neglected as a result. A costly error that will not be repeated in Ireland and should not be repeated elsewhere.