|Figure 1. Bank lending to households and non-financial firms as a percentage of GDP (GNP for Ireland), 1997 and 2008
Morgan Kelly, professor of economics at UCD (University College Dublin) says in a recent paper, Whatever happened to Ireland?, that adding Irish bank losses to its national debt will leave Ireland in 2012 with a debt-GDP ratio of 115%. But if looking at the ratio in terms of GNP, which gives a more realistic picture of the Ireland’s discretionary tax base, this is a debt-GNP ratio of 140% - - above the ratio that is currently sinking Greece. He says that even if bank losses are only half as large as expected, Ireland is still facing a debt-GNP ratio of 125%.
Both Ireland and Denmark were outliers in Europe by guaranteeing existing unsecured bank bond debt in September and October 2008. Ireland extended coverage to interbank deposits and existing and new senior unsecured debt. It also guaranteed covered bonds and even subordinated debt. The ECB explicitly recommended on October 20, 2008 that government guarantees on interbank deposits should not be provided.
On the night of September 29, 2008, when it was agreed to issue the blanket guarantee for the Irish banks, the issue of State protection for unsecured debt narrowed the options available when the extent of the banks' problems finally dawned on reckless/negligent and incompetent policymakers.
Gross National Product (GNP) is a better measure than GDP (gross domestic product) of the value added accruing to residents of the country. In Ireland, GNP is now considerably lower than GDP because of income flows to non-residents, especially profits and dividends of foreign direct investment enterprises. GNP is about 82% of the value of GDP. In 1970, the reverse was the case with GNP higher, because of income flows to Irish residents from abroad. As a result of this turnaround, GNP growth has been somewhat slower than GDP growth.
In December 2009, GDP was valued at €170.9bn and GNP at €139.0bn.
SEE: Finfacts article, Mar 30, 2010; State funding of Irish banks may amount to €32bn - - 1 year's tax receipts; Banks accused of "reckless" lending and "shoddy practices"
The Obama administration hasn't been shy about spreading the pain.
The new General Motors (GM), 61% owned by Uncle Sam, reported net income of $865m in the first quarter on Monday, compared with a $6bn loss by the old GM, in the same period last year.
While global sales grew by 24%, interest expenses dropped by $863m as a result of the shedding of debt.
The Obama task force pushed GM into bankruptcy last June, wiping out common stockholders and squeezing the holders of $27bn in GM bond debt into accepting a 10% share of the new GM. Bondholders also got warrants to buy more stock in a New GM if its future value exceeds $15bn, and again if it exceeds $30bn.
That old bond debt, along with old lawsuits, contracts and other trash, was dumped into Old GM, or Motors Liquidation as it is called.
All this happened in “the land of the free.”
Could Ireland be the home of the brave?
Maybe it's too much to expect!
The following is a republication of an article by Prof. Kelly which was first published on the VOXeu website.
Whatever happened to Ireland?
The Celtic Tiger faces severe challenges. This column argues that the Irish government’s commitment to absorb the losses of its banking system may well lead to a Greek-style debt ratio by 2012. It is a test-in-waiting for the EU, but one that could be solved by a debt for equity swap to cover the losses of Irish banks.
From basket case to superstar and back again – or almost. One has to wonder: How did all this happen? How did an economy where employment doubled and real GNP quadrupled during the “Celtic Tiger” era from 1990 to 2007, come to have GNP contract by 17% by late-2009 (with further falls forecast for 2010), the deepest and swiftest contraction suffered by a western economy since the Great Depression? The adjustments faced by the nation are monumental (see Cotter 2009 and Honohan and Lane 2009).
The key to understanding what happened to Ireland is to realise that while GNP grew from 5% to 15% every year from 1991 to 2006, this Celtic Tiger growth stemmed from two very different booms. First, the 1990s saw rising employment associated with increased competitiveness and a quadrupling of real exports. As Ireland converged to average levels of western European income around 2000 it might have been expected that growth would fall to normal European levels. Instead growth continued at high rates until 2007 despite falling competitiveness, driven by a second boom in construction. I analyse this second boom, the Irish bubble, in a recent CEPR Discussion Paper (Kelly 2010).
|Figure 2. Irish house prices relative to average industrial earnings, 1980 – 2009
Ireland went from getting about 5% of its national income from house building in the 1990s – the usual level for a developed economy – to 15% at the peak of the boom in 2006–2007, with another 6% coming from other construction. In effect, the Irish decided that competitiveness no longer mattered, and that the road to riches lay in selling houses to each other.
However, driving the construction boom was another boom, in bank lending. As Figure 1 shows, back in 1997 when Ireland’s economy really was among the world’s best performing, Irish banks lent sparingly by international standards. Lending to the non-financial private sector was only 60% of GNP, compared with 80% in Britain and most Eurozone economies. The international credit boom saw these economies experience a rapid rise in bank lending, with loans increasing to 100% of GDP on average by 2008.
These rises were dwarfed, however, by Ireland, where bank lending grew to 200% of national income by 2008. Irish banks were lending 40% more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and 75% more to house buyers.
This tripling of credit relative to GNP distorted the Irish economy profoundly. Its most visible impact was on house prices. In 1995 the average first-time buyer took out a mortgage equal to three years’ average industrial earnings, and the average house cost 4 years’ earnings. By the bubble peak in late 2006, the average first-time buyer mortgage had risen to 8 times average earnings, and the average new house now cost 10 times average earnings, with the average Dublin second-hand house costing 17 times average earnings (see Figures 2 and 3).
|Figure 3. Irish new house prices and first time buyer mortgages relative to average industrial earnings, 1990 – 2009
As the price of new houses rose faster than the cost of building them, investment in housing rose. By 2007, Ireland was building half as many houses as Britain, which has 14 times its population.
The flow of new mortgages peaked in the third quarter of 2006, and then fell rapidly. By the middle of 2007 the Irish construction industry was in clear trouble, with unsold units beginning to accumulate. More than one-sixth of housing units are now estimated to be vacant.
This property slowdown was bad news for an Irish banking system which had lent, usually without collateral, an amount equal to two-thirds of GNP to property developers to finance building projects and make speculative land purchases. Share prices of Irish banks fell steadily from March 2007, with the crisis coming to a head in late September 2008 with a run in wholesale markets on the joint-second largest Irish bank, Anglo Irish. After aggressive denials that the banking system faced any difficulties, the Irish government has been forced to improvise a series of increasingly desperate and expensive responses.
As well as guaranteeing the deposits and most bonds of Irish banks, the Irish government has currently spent, or committed itself to spend, around €40 billion on a National Asset Management Agency to buy non-performing development loans from banks, and to invest around €30 billion in Irish banks. Despite this large injection (equivalent to half of GNP), Irish banks remain moribund.
While the Irish government bailout deals with bank losses on loans to property developers, it does nothing about their two other problems: a heavy reliance on wholesale funding; and the prospect of further large losses on mortgages and business loans.
Half of Irish bank funding comes from international wholesale markets. Without continued government guarantees of their borrowing and, more problematically, continued access to ECB emergency funding, the operations of the Irish banks do not appear viable. Borrowing in bond markets at 6% to fund mortgages yielding 3% is not a sustainable activity, and Irish banks face no choice but to shrink their balance sheets. Should Irish bank lending return to normal international levels, our results indicate that property prices will return to an equilibrium two thirds below peak levels, with larger falls possible in the medium term as the flow of new lending is curtailed sharply.
The third problem facing Irish banks is their mortgages. With house prices down by around 40%, renewed emigration, and unemployment tripled to above 13%, Irish banks face substantial mortgage defaults. For comparison, in Florida and Arizona, whose investor fuelled housing bubbles closely resembled the Irish one, 25% of mortgages are non-performing.
On top of the continued disintegration of its banking system, Ireland faces two other problems: unemployment and government deficits. Private sector employment has fallen by 16%, while the number of males aged 20-24 in work has halved. The collapse in Irish competitiveness (wages have risen over 40% relative to its main trading partners since 2000) which cannot be solved by a devaluation, will frustrate efforts to reverse this decline.
Fifteen fat years allowed the Irish government to cut income taxes, increase spending and still run a budget surplus. Between 2007 and 2009 however, tax revenue fell by 20%, while expenditure rose by 9%, moving the state from a balanced budget to a deficit of 12% of GDP. In contrast to its inept handling of the banking crisis, the Irish government has moved decisively to reduce expenditure and increase tax rates, and appears on target to reduce its deficit to 3% of GDP by 2012.
Ireland’s government debt is still moderate. At the end of 2009 gross debt was 65% of GDP and, after subtracting the state pension reserve and pre-funded borrowing, net debt was 40% of GDP. Assuming that deficit targets are not missed too badly, gross debt should still be under 85% of GDP by the end of 2012.
This debt would probably be manageable, had the Irish government not casually committed itself to absorb all the gambling losses of its banking system. If we assume – optimistically, I believe – that Irish banks eventually lose one third of what they lent to property developers, and one tenth of business loans and mortgages, the net cost to the Irish taxpayer will be nearly one third of GDP.
Adding these bank losses to its national debt will leave Ireland in 2012 with a debt-GDP ratio of 115%. But if we look at the ratio in terms of GNP, which gives a more realistic picture of the Ireland’s discretionary tax base, this is a debt-GNP ratio of 140% – above the ratio that is currently sinking Greece. Even if bank losses are only half as large as we expect, Ireland is still facing a debt-GNP ratio of 125%.
Ireland is like a patient bleeding from two gunshot wounds. The Irish government has moved quickly to stanch the smaller, fiscal hole, while insisting that the litres of blood pouring unchecked through the banking hole are “manageable”. Capital markets may not continue to agree for long, triggering a borrowing crisis which will start, most probably, with a run on Irish banks in inter-bank markets.
Ireland may therefore present an early test of the EU bailout fund. However, in contrast to Greece, Ireland’s woes stem almost entirely from its banking system, and could be swiftly and permanently cured by a resolution which shares the losses of Irish banks with the holders of their €115bn of bonds through a partial debt for equity swap.
Cotter, John (2009), “Crises in the banking sector and attempts to refinance”, VoxEU.org, 19 May.
Honohan, Patrick and Philip Lane (2009), “Ireland in crisis”, VoxEU.org, 28 February.
Kelly, Morgan (2010), “Whatever Happened to Ireland?” CEPR Discussion Paper 7811.