Saturday, 4 July 2015

A cautionary tale

I've just finished reading The Fall of the Celtic Tiger (Oxford University Press, hardback 2013, paperback 2014), a fine book cowritten by my old classmate at Trinity College Dublin, Donal Donovan, and our former monetary economics lecturer, Antoin Murphy. Well worth reading from many perspectives: the story of how the best performing economy in Europe became a financial basket case is gripping, and it's got many lessons for countries elsewhere, including for us.

One is the importance of keeping a very close eye on the structural fiscal balance - the true shape of the government's books, shorn of cyclical influences. The Irish government of the first half of the 2000s spent up large on the back of a cyclical and unsustainable boom in revenue, a lot of it emanating one way or another from the massively overheated Irish property sector. In reality, its spending (and the future commitments it also entered into) left it hugely exposed, financially, when its revenues plunged.

At the time, as the book explains, watching the structural balance wasn't much in vogue, and it didn't help that when the first estimates were eventually made of the true Irish position, they didn't correctly pick up the sheer awfulness of the fiscal books. These days we're more on the ball - though the media attention at Budget time is still disproportionately on the government's headline fiscal numbers and not enough on what's really happening under the bonnet - and I was pleased to see that Treasury continues to beaver away at improved ways of calculating where we really are.

I was also struck by how quickly the Irish fiscal situation deteriorated when the balloon finally burst, and there's a lesson there too. Here is what the level of Irish government debt looked like before things went to hell in a handbasket (based on the data in Table 6.1 of The Fall of the Celtic Tiger).

That looks good, doesn't it? Despite the big spendup, revenues were so large that the government could scatter cash to the four winds and still have enough left over to work government debt down to what looks like a conservative level of just under 25% of GDP. You'd think that debt at that level was low enough to be able to cope with anything the domestic or global economy might throw at you, wouldn't you?

But it wasn't.

So when our Fiscal Strategy Report says,
The Government has five fiscal priorities:
2 Reducing net government debt to 20 per cent of GDP by 2020, including repaying debt in dollar terms in 2017/18
5 Using any further fiscal headroom – including from positive revenue surprises – to get debt down to 20 per cent of GDP sooner than 2020 
I say, right on.

And finally there is the whole issue of overheated property markets: as you read the book, you find yourself asking, are we on the same slippery slope to a property bust as the Irish were?

On balance I'm inclined to think not. We do have some of the same characteristics as the Irish did: a surge in property demand from growth in incomes, strong net immigration, and a monetary policy imported from elsewhere that doesn't suit our circumstances (in Ireland's case it was the common eurozone monetary policy, in ours the Fed's which has, for example, helped drive our fixed rate mortgage rates to low levels). But we don't have others, notably the reckless lending of the Irish banks in general and their huge lending to property development companies in particular.

But sorting out what's happening in real time is as hard here as it was in Ireland. You can easily miscategorise things: what looks to you like a 'genuine' increase in housing demand meeting a near-fixed short-term supply curve could as easily be the early to mid stages of a speculative bubble. And often enough there may be elements of both stories happening at the same time.

Which is why I thought this chart was so interesting. It's by Ronan Lyons, an assistant professor at Trinity, and it appeared a few days ago in this article on the Irish economy blog. It's his estimate of the strength of the different factors that were driving the Irish housing boom/bubble.

As you can see, different things mattered at different times. As the boom started (1995-2001), you had decent sized contributions from a variety of sources - people's incomes (blue), demographics (green), bank lending (red), and those too-low eurozone interest rates (yellow) all played a part. The bubble period of 2001-2007, however, was driven overwhelmingly by loose lending.

Wouldn't it be useful to see the same analysis done here?


  1. I'm going to go above my pay grade in replying to this post, Donal, and disagree with even specifying a debt/GDP target.

    What's most important, surely, is firstly, servicing costs, and secondly, if servicing costs are perfectly acceptable (eg only 1.5% of GDP currently and likely to fall further even if the stock of debt is constant) then the opportunity costs of not borrowing to fund worthwhile projects, especially at a record low interest rate, will continue to mount. When (if) interest rates 'normalise' we may well (will) rue that missed opportunity.

    For example, Auckland is crying out for more central government funding, and there are so many schools so dilapidated that kids and teachers health is adversely affected, that borrowing to fix them (if taxing the richest a little more is so out of the question) can, according to the standard growth theory models, reap rich rewards.

    Of course, my 'political economy' interpretation of why such targets as the debt/GDP ratio are pursued so enthusiastically by our politicians would be an essay in itself, so I won't go into that today!

    In the case of Ireland, when the GFC hit it lacked the single most important adjustment mechanism available to fiat currencies, a floating exchange rate able to respond to country-specific shocks. In New Zealand, for example, the exchange rate has adjusted rapidly to the fall in dairy prices, so, all things being equal, the effect on income is muted, imports will fall, domestic import-substitution activity will pick up, and the country should survive, if not nicely, then maybe with just a hiccup. That Ireland's current account has now climbed into substantial surplus surely has more to do with depressed consumer spending than export innovation.

    In addition, the immutable fact is that with an external deficit, a continuous government surplus inevitably results in higher household debt in order to maintain current spending levels. Both New Zealand and Irish households reacted in precisely this manner when their governments were running surpluses in the 2000s.

    I would add that most of the advanced economies had debt/GDP ratios higher than 20% when the GFC hit, and the ones with their own currencies, and who borrow in their own currencies, were able to carry on quite happily. Germany, for example, touted as Europe's strongest economy, currently sits at 85% gross debt/GDP, primarily because it does not stint on cutting edge investment eg in green energy, and seems to not only suffer no harm, but positively benefit from its 'high' debt level.

    As regards your plea for more research on our prospects of a housing collapse, Michael Reddell has some interesting analysis you may have missed, and I tend to agree with most of what he writes, which, for me, is great. Interestingly, a 1999 presentation by him is on my reading list for 300 Macro this semester, and I've been looking forward to that paper for a long time!


  2. Thanks for those thoughtful comments. Good ideas recognise no pay grades.

    Don't know that I've covered everything you've said - actually, that's a fib, I know I haven't - but here are some responses.

    I think you're right about not pursuing a constant debt/GDP ratio, and that there should be room for cyclical movements in it, otherwise you'd be abandoning the option of discretionary fiscal policy, which would not be a good idea (you'll have seen the fuss in the UK over the Chancellor's cunning plan for 'no deficits'). And taking advantage of cyclically low interest rates to spend on infrastructure would be an excellent example of when you might want to (provided, as you say, you lock it in at fixed interest rates). So what you should probably aim for is some low target level of debt/GDP but allow cyclical variation around it, as we did in practice (not that we had much choice) when the GFC/earthquakes hit.

    Where parts of Europe have gone wrong (in my view) is running fiscal deficits year in year out, irrespective of cyclical needs/opportunities, resulting in a long-term rise in the debt/GDP ratio. I don't know Germany well enough to comment on whether this was OK because they put the debt to good use, but I do know France, and I know that they didn't: they haven't run a fiscal surplus since the early '80s, and the spending largely went on transfer payments rather than investment. And Greece speaks for itself.

    On Ireland, sure, they gave up the exchange rate option, and eurozone monetary policy was therefore a nuisance both in creating the bubble and reducing the options to deal with the crash. As you'll know there's a big debate about whether the euro was a good idea in the 1st place, or, if it was, who should have been in it (almost certainly, not Greece, for one). Ireland probably met the traditional requirements for being part of a currency union (eg in terms of high intra-zone factor mobility).

    That said, Ireland did pull the only levers you have left to pull, if devaluation is out, to restore competitiveness (cuts in incomes and other costs and asset prices), which is more than can be said for some of the other PIIGS. It wasn't pleasant at all, sure: I was back there last year and found that the ongoing bitterness is immense, esp about the bank rescues. As the Donovan/Murphy book says, though, and I agree, when the crisis hit, the government had few options left other than the ones they had to take.

    Whether the current BOP surplus is more down to depressed C than high X is somewhat in the eye of the beholder, but for the record in the latest year (2014), C was +1.1% and X was +12.6%.

    I like Mike's blog and I've had it running here in 'The latest from these interesting blogs' pretty much from day 1. Well worth following.

  3. Michael Reddell8 July 2015 at 15:33


    (Thanks for the nice comments)

    I found your post really interesting, and must get round to reading the book.

    I just had two observations:
    - the first is that (wrongly as it turns out) it was widely assumed that Ireland was running a structural surplus before the crisis. I just checked, as one example, the IMF's OCt 07 WEO numbers, and they thought the surplus averaged more than 1% pa in each of the years 2004-07. I think structural balance ideas should guide fiscal policy, but I would now be very wary of anything too specific. That said, Ronan Lyons's tax chart is pretty persuasive.
    - that breakdown of factors driving the housing market is fascinating. When I saw it, the story looked very plausible. But it appears that his credit conditions variable is credit relative to deposits - which isn't quite the same thing as a measure of lending standards. In the UK and NZ that variable would have shown up as a key influence over 2002 to 2007 and yet our banks came thru unscathed, and UK banks mostly lost money on their offshore exposures (3/4ths of all losses were on offshore assets, and without those losses there would have been systemic crisis)

    btw, Luc has me a little worried if a 1999 presentation of mine is on a macro reading list. I don't promise to stand by anything I said back then!

  4. Thanks for the comments: I'm deep in big piece of work so just quick response for now.
    Structural balance mismeasurement - absolutely. I've seen some crazy examples out of the EU, for example, which bear no relation to reality. But hopefully people are getting better at it even if it's still iffy.
    Variable definition - agree again (I've only seen the potted summary for his research so I'm not too clear on variable specs). Suspect, even if that's the wrong one, and there are better/other ones re credit standards/excess credit, the answer would come out the same for Ireland for 2002-07