Sunday, November 21, 2010

European Union will bail out Irish mistake

Published in The Tennessean, Sunday, November 21, 2010

European Union will bail out Irish mistake

by Richard J. Grant

Four years ago, the government of Ireland was running a healthy budget surplus. During the previous 20 years Ireland had transformed its economy into the envy of Europe.

Until the early 1980s Ireland had been a big-government, high-tax, high-inflation, high-unemployment land of economic stagnation. Its main export was people. Government spending consumed more than 50 percent of its economy. The corporate income tax rate was 50 percent and the top personal rate was close to 60 percent. The inflation rate had been in double digits for much of the previous 10 years. Ireland had been phasing out its protectionist tariffs, but in the mid-1980s its unemployment rate reached 17 percent and its economic growth rate was still only about 2.3 percent.

By 2006, Ireland's corporate tax rate was 12.5 percent, the lowest in Europe. Its top personal income tax rate had dropped almost to 40 percent. Government spending was less than 35 percent of gross domestic product (GDP). Tighter control over the money supply kept the rate of price inflation down around 3 percent.

During the previous 10 years, Ireland's growth rate had averaged 7.4 percent and Irish income per person grew to be 10 percent higher than that of the United Kingdom and 20 percent greater than in France and Germany. Irish expatriates had good reason to return to their homeland, and many did. Foreign investment flooded in as well.

As Irish wealth grew, many people bought property. There was big demand for housing and office development. And with the European Central Bank holding interest rates low, credit was easy for construction loans and mortgages. It seemed natural for property prices to keep rising. The banks grew more promiscuous in their lending while regulators grew more complacent.

The Irish property bubble was not the only one in the world to pop in 2008. As was the case in many other countries, the magnitude of the bad debt problem was not immediately recognized. The banks were in serious trouble, but the regulators mistook the signs of insolvency for a mere lack of liquidity. They believed that the stronger banks could absorb some of the bad loans of the weaker banks, and that the Central Bank of Ireland (which cannot create money) could supply sufficient reserves.

Depositors began to pull their funds out of the banks, so bank reserves kept shrinking. Existing government deposit insurance seemed no longer able to ensure depositor complacency. That was when the Irish government made an innocent, but big, mistake.

The government decided to end the crisis by guaranteeing every deposit as well as most of the debt issued by Irish banks. The finance minister believed that this would restore confidence in the banking system thereby solving the liquidity crisis with very little more cash.

The finance minister would soon learn just how expensive a credit guarantee can be. He had, in effect, issued a credit default swap to the banking industry free of charge. He nationalized the losses of the banking industry. Taxpayers now carry the burden.

The surpluses and balanced budgets of the “Irish miracle” have given way to increasing deficits. The budget deficit is expected to rise this year to 32 percent of GDP.

The Irish government has bravely insisted that it can carry the burden. But it will soon accept a bailout from the European Union.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2007-2010

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