Sunday, November 28, 2010

Ireland versus Greece: A High-Level Comparison

Greece and Ireland in the same economic sentence - in normal times, this would be unthinkable, Europe’s economic darling and the black sheep. And yet Ireland is country number two in the Eurozone to seek an aid package. The story of the two countries could not be more different.

Unlike Greece, Ireland experienced both strong economic growth as well as improving public finances in the last twenty years. While Greece ran persistent budget deficits, Ireland made a concentrated effort to curb its debt. In 1987, public debt reached an all time high of 112% of GDP; by 2007, debt was just under 25%. During the boom years, from 1997 to 2007, the Irish government ran budget surpluses averaging 1.6% of GDP.

Also unlike Greece, Ireland experienced a sustained and material improvement in living standards. In the 1980s, the Irish had a per capita national income that was 60% of the European (EU 15) average. From 1990 to 2007, the Irish economy grew at an astonishing 6.4% a year - by 2007, Ireland had a per capita income that was 26% higher than the European average, trailing just Luxembourg, Denmark and Sweden.

So what went wrong in Ireland? Broadly speaking three things:

First, the economy was over-heating: the IMF believes that in 2007, Ireland grew at 7.1% above potential. Several distortions emerged as a result. Inflation was 70% above the Euro area average, producing negative interest rates from 2000 to 2007 and leading to a gradual erosion in competitiveness. Manufacturing wages grew much faster than in Ireland's trading partners: between 2000 and 2009, Ireland's manufacturing wages grew by 30% more relative to its trading partners. What is more, the Irish economy is deeply weeded to Europe and United States – a slowdown there had a disproportionate impact in Ireland.

Second, cheap credit produced a housing bubble. From 1975 to 1994, Ireland built ~23,500 homes a year; this number began to rise and in 2006, Ireland built more than 93,000 homes. While much of that growth replenished and upgraded the housing stock, it created at least three distortions. First, there was a rise in housing prices, which rose fourfold from 1995 to 2007. Second, construction made up 13% of national employment in 2007, up from 6-7% in the 1990s. And third, the banking sector became increasingly intertwined with real estate: in June 2010, more than 50% of credit outstanding was either to real estate and construction businesses or to residential mortgages.

The housing bubble was only the most extreme form of a rise in private debt. Irish households had a gross debt-to-income ratio of 108% in 2002; by 2009, this had grown to 200%. For non-financial companies, the debt-to-income ratio was just over 4; by 2009, it had grown to 10. To make this kind of lending possible, Irish banks relied increasingly on (short-term) loans. Irish banks had a gross external debt of $284 billion in Q1 2003, but that number grew to a high of $1 trillion in Q3 2009. At the end of Q2 2010, Irish banks had short-term liabilities of $610 billion, far above the $100 billion or so of government debt. As the Financial Times put it, “The trigger for Ireland’s bail-out was not the sovereign’s inability to borrow (it is funded well into 2011), it was the inability of Irish banks to refinance their borrowing in the wholesale markets.”

The third big problem was that fiscal policy was highly pro-cyclical. When the economy shrank, revenues plummeted while social spending took off. From relative balance in 2007, government spending rose by 12% between 2009 and 2007 while revenues collapsed by 20% in the same period. This demonstrated the country’s fiscal weaknesses: while Ireland had managed to run budget surpluses, the structure of revenues and expenditures changed in at least three ways.

First, there was a steady erosion in the tax base: in 2010, an estimated 45% of tax units were exempt from the income tax, up from 34% in 2004. According to the political economy narrative, this erosion was part of a grand bargain forged in the late 1980s and early 1990s whereby unions traded slower wage growth in return for lower taxes. Second, the tax system became increasingly dependent on "pro-cyclical" revenues such as corporate taxes, capital gains taxes and stamp duties. In 1987, according to the Honohan Report, these made up 8% of tax revenues; by 2006, they were 30% of the tax base. When the economy shank, therefore, tax revenues were hit hard. Third, the size of the public sector grew by 30% between 2008 and 2000 and public sector wages rose faster than private sector ones. Hence, there was more rigid expenditure in place when revenues dropped.

Putting all this together paints a very different picture. Where Greece faced chronic deficits and a high debt to start with, Ireland had been running surpluses and had paid down its debt. Both countries experienced higher inflation than the Euro average; this produced increased indebtedness in both countries, though the property bubble in Ireland was much more pronounced. While Greece’s main challenge is to infuse a stagnant economy with some dynamism and competition, Ireland just needs to regain some of its vibrancy. And lastly, while Greece’s challenge is mostly around government debt, Ireland’s challenge is to recapitalize its ailing banks.

Sources
IMF, Article IVs
Central Statistics Office 

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