1. Designing a Strategy for Recovery
Economics Seminars
Graduate Centre of Business
Kemmy Business School
University of Limerick
Ireland
Friday , February 27th, 2‐3pm

2. Designing a Strategy for Recovery
The Irish Economy Between a Rock and Hard
Place
Brendan Walsh
Professor Emeritus
Department of Economics
University College, Dublin

3. Outline
• The International Financial and
Economic Crisis
• The Irish Case
• What is the Way Forward?
My presentation is journalistic rather than
scholarly!

4. The global crisis took somewhat
complacent policy makers and
economists by surprise

5. The Golden Decade (1997‐2008)
of Steady Growth and Low
Inflation had made us
complacent
Things were NICE,
especially for the global
banking industry
Non‐Inflationary Consistently Expanding

7. Contrite central bankers
“Shocked disbelief”
Former Federal Reserve Chairman Alan
Greenspan testifies during a House Oversight
and Government Reform Committee hearing
on Capitol Hill October 23, 2008, in
Washington, DC.

8. Disputatious economists
Still no agreement about the Great Depression
quot;The prevention and cure of depressions is a
central mission of macroeconomics, and if we
can't understand what happened in the
1930s, how can we be sure it won't happen
again?“
Robert E. Lucas Jr.,
1995 Nobel Laureate in economics
John Dewey Distinguished Service Professor of Economics
University of Chicago.

9. Did the New Deal help?
Referring to the National Industrial Recovery
Act of 1933, two UCLA economists recently
claimed:
“The economy was poised for a beautiful
recovery, but that recovery was stalled by
these misguided policies.”
[Cole and Ohanian, JPE, August 2004)

10. “I think the stability of monetary aggregates and
nominal spending in the post‐war United States
is a major reason for the stability of aggregate
production and consumption during these years,
relative to the experience of the interwar period
and the contemporary experience of other
economies. If so, this stability must be seen in
part as an achievement of the economists,
Keynesian and monetarist, who guided
economic policy over these years.”
Robert Lucas, Nobel prize winner in economics
1995

11. “The question I have addressed in this lecture is
whether stabilization policies that go beyond
the general stabilization of spending that
characterizes the last 50 years, whatever form
they might take, promise important increases in
welfare. The answer to this question is No: The
potential gains from improved stabilization
policies are on the order of hundredths of a
percent of consumption, perhaps two orders of
magnitude smaller than the potential benefits
of available “supply‐side” fiscal reforms..”
Lucas, Presidential address to American
Economic Association, January 2003

12. The global background
For years, in macroeconomics courses, we
lectured students on the unsustainable
global imbalances, principally
the large US “twin deficits”
‐ fiscal and balance of payments ‐
And the corresponding surpluses in the
emerging giants, especially China

13. The financial industry – which attracts the
bright, if not necessarily the best,
through its extravagant reward
structure ‐ responded enthusiastically
and developed numerous dazzling new
products that made it impossible – until
it was too late – to measure and locate
the risks to which it was exposed

14. The global background
Allen Greenspan applauded the creativity of
these innovations
The Federal Reserve (and the European Central
Bank) argued that asset price bubbles were
not a concern so long as consumer price
inflation remained low

15. The expansion of credit allowed consumer in the US
and some European countries to finance an
amazing , seemingly endless consumption and
housing boom/bubble
Ben Bernanke argued that the global saving surplus
was finding a natural home
Despite some forebodings, the system was believed
to be stable

16. According to a leading international economics
textbook published in 2006 major banking
crises belonged in the history books
“Today, bank runs are not a major problem for
the banking systems of advanced economies.”
Students would only see them depicted in films
like Mary Poppins and It’s a Wonderful Life

17. But, the world remained
uncertain

18. Knightian uncertainty
The sense in which I am using the term is that
in which the prospect of a European war is
uncertain, or the price of copper and the rate
of interest twenty years hence . . . About
these matters there is no scientific basis on
which to form any calculable probability
whatever. We simply do not know.
(J.M. Keynes, 1937)

19. 2008 was the year of the Black Swan
But so was 1998 ‐ LTCM

20. As Donald Rumsfeld would have said:
“What we have to fear are the unknown
unknowns”
Combinations of events that “should” only
occur once in a billion years.
No‐one can predict these, although bankers are
paid as if they could.

21. A perfect storm
The subprime mortgage crisis that spread in the US during 2007
was initially believed to be contained to a small part of the
US financial system
But it spread throughout the US and then world‐wide
The crises of September 2008 and in particular the collapse of
Lehman Brothers on the 15th convinced people that the
existing financial structure was in danger of collapse
No sign of new equilibrium

22. Meanwhile in Ireland
The Irish economy became fully integrated into
the global economy with the adoption of the
euro in 1999. As the currency risk associated
with the Irish pound was removed, Irish
interest rates quickly converged with the
lower German rates.
From 1999 to 2008 real interest rates were
negative in Ireland.

23. There were benefits from adopting the euro
but also costs
Especially in the overheating of the economy
after 2002
The one‐size‐fits all policy of the ECB was not
appropriate for Ireland and our Central Bank
and Financial Services regulator failed to
exercise their residual powers

24. We spent too long sharing the credit for the
Celtic Tiger or Irish Hare
Forebodings and warnings about the looming
storm were too muted
And many in official Ireland choose to ignore or
even ridicule policy critiques
Preferring instead to don the Green Jersey

25. While the economy went into recession briefly
in 2002, rapid growth quickly resumed
fuelled by
The ECB’s easing of monetary policy and
The inflow of labour from the New Accession
States

26. May 1997
26

27. Oct 2004
27

28. The Centre for the Study of Small States,
The Source of Wealth in Small States
University of Reykjavik, Iceland
Small States as Financial Centres
Ireland as a Case Study
Brendan Walsh
University College Dublin
14th September 2007
http://bobbiblogger.files.wordpress.com/20
08/11/iceland-11.jpg

29. Fallout from US sub‐prime mortgage market
• On 15th August 2007 Sachsen LB Europe plc
confirmed that its Dublin subsidiary in Dublin,
the Ormond Quay conduit, had to be rescued by
a loan of €17.3 billion.
• This episode highlights the need to have a single
financial regulator across the Eurozone and drew
some unwelcome attention to the nature of
some of the firms in Irish International Financial
Services Industry.
29

30. Another Lap for the Irish Hare?
Patrick Honohan
and Brendan
Walsh,
Dublin Economics
Workshop,
Kenmare October
2007

31. Our forebodings were mild:
“Some financial vulnerability is evident”

32. In 2008, all changed, changed utterly

35. 11 February 2009

36. Warning signs
Whereas the earlier boom had been led by
inflows of FDI and rapid export growth, the
second wave was increasingly led by a boom
in the non‐traded construction sector (which
masked the contraction in industrial
employment) and financed by ballooning
borrowing from abroad (which allowed the
Irish banks’ balance sheets to explode).

37. Warning signs
Dependence on construction
both employment and taxes
Dependence on foreign capital inflows

38. % of total
employment
08

40. We were warned!
Many commentators drew attention to the
looming crisis facing Ireland,
Notably the IMF after its official visits.
Here, for example, is a quote from their 1999
Country Report:

41. “In light of the rapid growth in credit and strong
housing price increases, a number of Directors
expressed concern about the risks of an asset
price bubble and the potential vulnerability of
the banking system. Directors stressed the need
to enhance the forward‐looking aspects of
regulatory policy and, in this regard, welcomed
the supervisory authorities’ recent initiative to
assess the financial system’s vulnerability to
specified macroeconomic shocks. They felt that
a peer review, particularly by supervisors from
a country that had undergone a real estate
boom, might be helpful”

42. Apportioning the blame
How much of Ireland’s meltdown has been due
to
• Home‐grown, domestic policy errors and
how much to
The global crisis (+ a bit of Paddy bashing in the
UK press)?

43. Domestic policy issues
The housing bubble was more extreme here
than in any other EU country
including Spain
Failure of Central Bank to exercise its residual
authority over lending to moderate this
The dependence of the banks on foreign
borrowing was also greater than in other
countries
Iceland excepted

44. Domestic policy issues
The growth of the banks’ balance sheets ‐
based on foreign borrowing – should also
have been restrained
The financial stability assessment was a useless
exercise

45. Regulatory issues

46. “The central expectation, based on an
assessment of the risks facing both the
household and non‐financial corporate
sectors, the health of the banking sector and
the results of recent in‐house stress testing is
that, notwithstanding the international
financial market turbulence, the Irish banking
system continues to be well placed to
withstand adverse economic and sectoral
developments in the short to medium term.”
CBFSAI, Financial Stability Report 2007

47. “But risk management models have during
this crisis proved themselves wrong in a
more fundamental sense. They failed
Keynes’ test – that it is better to be roughly
right than precisely wrong. With hindsight,
these models were both very precise and
very wrong. . . . Stress-testing was not
being meaningfully used to manage risk.
Rather, it was being used to manage
regulation. Stress-testing was not so much
regulatory arbitrage as regulatory
camouflage. ”
Andrew Haldene, Bank of Eng, February 2009

48. Loss of competitiveness
Due to strength of euro and failure of social
partnership to deliver wage moderation

49. Index
Fe
b-
75.00
80.00
85.00
90.00
95.00
100.00
105.00
110.00
115.00
7
Fe 5
b-
7
Fe 6
b-
7
Fe 7
b-
7
Fe 8
Sterling Link
b-
7
Fe 9
b-
8
Fe 0
b-
8
Fe 1
b-
8
Fe 2
b-
8
Fe 3
b-
8
Fe 4
b-
8
Fe 5
b-
8
Fe 6
b-
8
Fe 7
EMS Period
b-
8
Fe 8
b-
8
Fe 9
b-
9
Fe 0
b-
9
Fe 1
b-
9
Fe 2
b-
9
Ireland 1975-2009
Fe 3
b-
9
Fe 4
b-
9
Real Effective Exchange Rate
Fe 5
b-
9
Fe 6
b-
9
Floating Period
Fe 7
b-
9
Fe 8
b-
9
Fe 9
b-
0
Fe 0
b-
0
Fe 1
b-
0
Fe 2
b-
0
Fe 3
b-
0
Fe 4
EMU Period
b-
0
Fe 5
b-
0
Fe 6
b-
07

50. Loss of fiscal control
The loss of control of the public finances has
also been very rapid here, fuelled by the
dependence of property‐transactions‐related
taxes loss of control of expenditure over the
electoral cycle

51. The booming property market created fiscal
complacency, with expenditure expanding on
the assumption of continued revenue
buoyancy

52. Tax bonanza from property boom
to continue?

53. Tax receipts crash
Budget 2009

54. Still in Denial?
Mr Cowen took issue with “commentators in
the public debate” who blamed the current
crisis entirely on an overreliance on revenues
from the construction industry. He described
that analysis as “futile and facile”.
Irish Times 12 Feb 2009

55. The world credit markets have
taken a dim view of our
predicament

56. Eurozone 10 year Government bond
spreads over Germany (in bps)
300
250
200
150
100
50
0
Germany France Belgium Italy Spain Portugal Austria Ireland Greece
NL

57. What is to be done?
I tell you naught for your comfort
Yea, naught for your desire
Save that the sky grows darker yet
And the sea rises higher.
G. K. Chesterton, 1911

58. What must be done?
• Repair the banking system
• Restore balance to the public finances
• Regain lost competitiveness

59. No one seems to know the
magnitude of the government’s
guarantee to the banks

60. Fixing the banking system
• There is no off‐the‐shelf recipe for success
here
• The best financial minds in the world are
grappling with the problem in the US, Britain,
and Europe
– So far without a winning model emerging

61. are all Swedes Now”. So said oft-quoted finance
“We
professor Nouriel Roubini last week, calling for large-scale
nationalisation of the US banking system. With agreement
on that point even from thinkers on the right of the political
spectrum, Roubini’s Swedish comparison is looking less
exaggerated by the day.
Alan Greenspan stunned many when he said this week it
might be necessary to “temporarily nationalise some
banks” to engineer a “swift and orderly restructuring” of
the broken sector. “Once in a hundred years this is what
you do.”

62. Elements of the solution
• Overcome the denial of the extent of the
losses arising from the reckless lending of the
past few years and clearing the way for an
adequate recapitalisation of the main banks
• Restore international confidence in our
banking supervisory and regulatory system

63. Fixing the banks
• Overcome the denial of the extent of
the losses arising from the reckless
lending of the past few years
• Should the toxic assets be “marked to
market” even when no market for them
exists?
• Should they be hived off into a “bad
bank” or asset management company?

64. “Even as the solutions to the financial
crisis are debated in Congress and among
economists, the F.D.I.C., one of the
agencies that deals most closely with the
nation’s banks, has already been
transformed.
The rising tide of foreclosed real estate is
so overwhelming that the agency, which
had shrunk to a relatively tiny 4,800
employees from as many as 15,000 in the
last period of bank meltdowns in the
1990s, is in the midst of a military-scale
build-up as it undertakes one of the
greatest fire sales of all time. “
New York Times, 13 February 2009

65. blitz by the F.D.I.C. may offer
“The
lessons for the Treasury
Department, which is separately
struggling with an even more
monumental challenge: how to
help still-operating banks move
giant loads of toxic debt off their
balance sheets, in the hope that
the banks will begin taking risks
again and stimulate the economy.”

66. Restoring balance to the public
finances
• The collapse of tax revenue has been so
dramatic that here is no alternative to a
major downsizing of the public sector
• The burden of taxation will also have to rise,
but in a way that minimises disincentives
– taxing the stock of real property will have to be
part of this

67. Restoring competitiveness
• A fall in our costs relative to those of our
trading partners is required
• As members of a currency union, a
devaluation is ruled out
• The effects of a devaluation have to be
mimicked

68. Mimicking a devaluation
• This requires reducing the domestic
components of our cost base
– Wages and salaries
– Fees
– Rents
– Regulatory hindrances
• Think back to the 1920s and Britain’s attempt
to achieve these outcomes

69. • So far deflation has been confined to
imported effects
– Interest rates
– Energy
– Exchange rate effects

70. Restoring competitiveness
• Rebuilding international confidence in
Ireland as a suitable place in which to do
business
• Cementing our commitment to the single
currency
– Sorting out our hang‐ups over Lisbon
• Boosting the productivity of our labour force
and the contribution of our educational
system to our children’s economic prospects

71. Do we tackle the problem
ourselves or do we have to ask for
outside assistance?