The past year and a half have been difficult for the global economy, though few OECD countries have felt the chill of crisis as much as Ireland. In just a few years the country has gone from being what many viewed as a model of fast growth and confident prosperity to an economy mired in recession and burdened by uncertainty.
How times have changed, for the economic performance of Ireland since the mid-1990s had been remarkable: GDP per capita growth averaged close to 5% from 1995 to 2007. Over a decade, living standards increased by one-third. Employment growth was spectacular and drew in large numbers of foreign-born workers. Irish people who had emigrated in earlier years came home, and there was for the first time large-scale inward migration: within the space of a few years, workers from the then EU accession countries, such as Poland, rose to 8% of the labour force.
This pace of growth is virtually unprecedented in the experience of OECD countries. Ireland looked and felt like a different place from the one economists had taken to describe as the “sick man of Europe” in the 1980s. Indeed, with the economy developing at a speed more familiar to emerging countries, Ireland was now dubbed the Celtic Tiger.
Other OECD countries inevitably looked to the Irish experience to see what could be learned to boost their growth performance. How did Ireland manage to raise living standards so fast?
There is no single explanation, though the ability to attract foreign direct investment (FDI) was a key driver. The stock of inward FDI now comes to around 80% of national income, and foreign-owned companies account for the majority of exports and a substantial share of employment. Multinationals were attracted by the open, flexible and market-oriented economy. Favourable taxation and a skilled English-speaking workforce also helped. Membership of the European Union, including monetary union and the single market, was crucial. The emergence of sectors such as information and communications technologies, pharmaceuticals and international financial services, were particularly suited to this small, open and dynamic economy. But while this was good timing, it is quite clear that Ireland’s success did not come overnight, but emerged from effort over many years by policymakers, business people and other social partners to put Ireland’s house in order and create a good framework for business, investment and job growth.
The increase in living standards was the reward for good decisions taken in those earlier years. Secondary school was only made free in Ireland in the late 1960s, leading to a belated but large increase in educational attainment. While this investment in human capital did not show returns during the period of weak macroeconomic performance in the 1980s, there was a large latent potential for higher productivity, whose benefits were reaped from the mid-1990s. In fact, foreign companies continue to appreciate Ireland’s young and well-educated workforce.
The economy had developed resilience too. While the Irish economy slowed around 2000 as the “dotcom” bubble burst, GDP never actually contracted in annual terms, unlike in several other OECD countries, and unemployment rose only marginally. A strong recovery followed, with GDP growth averaging over 5% from 2002 to 2007.
So, why did it all end? Today, Ireland is experiencing one of the most severe recessions of OECD countries. The peak-to-trough fall in gross national product is likely to be close to 13%, according to OECD forecasts. The unemployment rate has risen from just over 4% to 13% in less than two years. How did the situation deteriorate so quickly?
One clue is that the most recent years of expansion were driven much more by domestic demand than in the years running up to 2000. Exports, which had expanded at a lively rate, grew more slowly. Productivity growth slowed sharply too, while inflation, wages and labour costs increased more rapidly. In short, Ireland was losing competitiveness, and the current account deficit was growing.
The property market was at the heart of this new surge in demand: house prices at the peak were around four times higher in real terms than in 1995. While house prices had been low in the mid-1990s, and demand for housing was pushed up by rising incomes and a growing population, a decade later prices had reached unsustainable levels. What is more, those house prices were driven up by rising credit, with total borrowing soaring by an average annual rate of 20% during the most recent years. Commercial property was also surging, with retail rental values in Dublin’s Grafton Street soon being ranked among the most expensive in the world, alongside the likes of Fifth Avenue, Bond Street and the Champs Elysées.
The property boom had a major effect on the whole Irish economy. House-building reached 13% of national income, a larger share even than in Spain, and drew in vast numbers of workers. Consumption was supported by rising property wealth. Banks were lending money at a fast pace, and property-related loans became a large part of their overall exposures.
House prices peaked in 2007. Prices have since dropped by 25% and further falls are likely. As the property market turned, economic activity began to slow with sharp falls in house-building. It was always going to be difficult to rebalance the Irish economy from construction towards exports and a more sustainable level of demand. But the international financial crisis made such a correction even harder to achieve by shrinking export markets and adding further pressures on the financial system. The result has been a dramatic fall in demand, with the economy facing one of its sharpest contractions in activity in decades.
How will the Irish economy recover? There have been few policy levers available to support demand. As a small country within the euro area, cuts in interest rates and monetary support measures by the European Central Bank have helped, but can only go so far. Tackling large losses in the banking system has had to be the priority to avoid systemic financial collapse. The National Asset Management Agency (NAMA), together with other measures, is designed to clean up the wounded banking system by taking a portfolio of crisis-stricken property-related assets valued at 40% of gross national income off bank balance sheets.
While other countries have launched fiscal stimulus packages, the Irish budget balance swung from a surplus in 2007 into a deficit that will be close to 12% of GDP this year, reflecting over-reliance on property-related revenues. This level of government borrowing is already playing an important role in supporting spending, but has meant that there was no room to ease fiscal policy further. Indeed, the dire situation has forced a tightening of fiscal policy to date of around 7.5% of national income, and further budgetary consolidation measures are planned in the coming years.
This policy constraint means that much of the recovery will need to come through adjustment in the private economy, both households and business. In particular, Ireland’s high prices need to fall to restore its competitiveness in international markets. This is already happening: the harmonised index of consumer prices fell by almost 3% in the year to November 2009. Remarkably, nominal wages are being cut, with anecdotal evidence pointing to widespread reductions of 5-10%. Such wage deflation is without precedent in Ireland and in the historical experience of OECD countries. This shows how flexible the Irish labour market can be, and suggests that the economy is adjusting very rapidly. However, there are risks associated with such deflation, particularly as falling incomes will make it harder to ease the burden of outstanding debts.
But while there are signs of positive economic adjustment, the downturn is likely to continue for some time, and the OECD forecasts the recovery to be slow. One key economic and social question is whether policies can be put in place to stop the high rate of unemployment becoming permanent. With deflation, social benefit payments will need to fall in cash terms just to keep the same real value, compared with the cost of living. At the same time, for workers on low earnings, unemployment benefits are reaching temptingly high levels compared with wages. Together with weaknesses in activation programmes for people out of work, there is a real risk that unemployment could indeed become permanently high unless policies adjust to provide stronger encouragement to return to work as the economy recovers.
After the vigorous expansion of the past and the severe downturn, many are left wondering where Ireland will go next. This is particularly true for younger Irish people who had never experienced a recession until now.
Ireland should be able to sustain high living standards in the future because of its skilled labour force and open, market-friendly economy. Foreign companies have largely maintained their position in Ireland, and clusters of expertise are growing in areas such as finance and life sciences. But incomes are likely to be permanently lower than anticipated as the result of the economic contraction and necessary fiscal consolidation. While the evidence shows that the expansion in recent years could not be sustained, fostering a new period of strong and sustained growth in the coming years will be a challenge. Much will depend on learning the lessons of the past two decades.
OECD (2009), Economic Survey of Ireland, November, Paris.