Misjudging the Fiscal Stance: Lessons from Ireland's Boom

and Bust

Alan Ahearne

NUI Galway, Bruegel and Central Bank of Ireland

Presentation at the Workshop organised by the Norwegian Ministry of Finance’s Advisory Panel

12 November 2012

Outline

Overview of boom and bust.

Fundamentals or a bubble?

The fiscal stance. Conclusions.

House price boom and bust

Source: Ronan Lyons, July 2011

Rapid increase in household debt

Bubble in construction sector New homebuilding, share of GDP

0

2

4

6

8

10

12

14

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

%

residential investment to GDP

long run average

Ireland lost competitiveness in euro area

Source: Regling and Watson, 2010

Relative unit labour costs

Consumption and investment spending plunged after bubble burst

Surge in lending by Irish banks…

0%

5%

10%

15%

20%

25%

30%

35%

2003 2004 2005 2006 2007 2008

Source: Regling and Watson, 2010

Private sector credit growth of the Irish banking system

…funded by international capital markets

Source: Regling and Watson, 2010

Loan-to-deposit ratios

0%

50%

100%

150%

200%

250%

Ireland Portugal Spain

2004

2005

2006

2007

2008

100% loan-to-value common

Source: Regling and Watson, 2010

Large external imbalances

Fundamentals or a bubble?

How do we distinguish a bubble from a rational response to fundamentals?

Plausible fundamental arguments: Strong growth in GDP and incomes. Low interest rates and financial integration. Young population and immigration. Profitable, well-funded banking system.

Measures of overvaluation

Source: IMF

Measures of overvaluation

Source: Ronan Lyons, July 2011

Measures of overvaluation

Source: Marius Jurgilas and Kevin J. Lansing, 2012

Ratio of house price to rent

Consumer price inflation relatively low and stable…

-8

-6

-4

-2

0

2

4

6

8

jan-

99

jul-9

9

jan-

00

jul-0

0

jan-

01

jul-0

1

jan-

02

jul-0

2

jan-

03

jul-0

3

jan-

04

jul-0

4

jan-

05

jul-0

5

jan-

06

jul-0

6

jan-

07

jul-0

7

jan-

08

jul-0

8

jan-

09

Consumer price inflation (%)

…with no clear evidence that unemployment was below NAIRU

Employment Unemployment (%)

The value of anecdotes in diagnosing a bubble

Media’s role in inflating the bubble. Tax breaks. Auctioneers & Valuers. Amateur real estate investors. Vacant properties. Joe Kennedy and the shoe-shine boy.

The fiscal stance

Ireland ran headline budget surpluses during the boom.

At the time, estimates for the cyclically-adjusted balance also looked benign. Trends (H-P filter) missed bubble. Estimates of output gap (and structural

deficit) ignored financial imbalances.

Headline budget surpluses during boom

Bubble generated windfall tax revenues

0%

20%

40%

60%

80%

100%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

% o

f T

ax

Re

ve

nu

e Others*Capital Gains TaxStamp DutiesCorporation TaxIncome TaxVAT and Excise

*Customs, CAT, RPT, MVD, Ag. & Emp. Levies

Source: Regling and Watson, 2010

Benefits of hindsight 2006

Seen then Seen now 2007

Seen then Seen now

Output gap 0.4 0.2

Structural Budget

2.7 0.7

Source: Max Watson, 2012

Benefits of hindsight 2006

Seen then Seen now 2007

Seen then Seen now

Output gap 0.4 2.8 0.2 6.5

Structural Budget

2.7 -4.0 0.7 -7.2

Source: Max Watson, 2012

Conclusions

Fiscal stance was misjudged because financial imbalances were ignored.

Something like “finance-neutral” output gap (Borio et al, 2012) would have been useful.

Self-reinforcing spirals between economic activity and asset values.

Asymmetric risks.