Friday, January 7, 2011
Ireland: A case study in bad crisis management
For those of you who do not immediately recognize me, I'm John G from Rightosphere. Good to be here, thanks to BOSMAN for inviting me.
You may not know this, but since the fall 2009, I am living and studying in Ireland. I'm doing a Bachelor's degree in Finance and economics.
One of the absolutely best things about studying economics in Ireland is that you get to see a crisis unfolding in front of your eyes. You can read the newspapers, watch the TV news, discuss the crisis with professors and tutors during lectures and tutorials. It is a golden opportunity to learn which I am really grateful to have.
The answer I'll try to answer tonight is: What went wrong?
I am going to try and keep this short, so let's go to the top reasons why Ireland did so badly while other countries - like my home country of Sweden - have done so well:
1) Inexperienced leadership
While Ireland has several experienced politicians, they do not have any politicians with experience when it comes to dealing with financial crises. The concept of an overheated boom was largely unfamiliar to them. In most of western Europe and in America, everyone knows that a boom will be followed by a bust, which will be followed by a boom etc. Ireland didn't know this, because their economy pretty much hadn't been overheated before. Ireland in the 1980's had the nickname "The basketcase of Europe" - hardly a flattering nickname, but sadly enough a good one: That was exactly what Ireland was. The UK under Thatcher had risen from the slum, and Germany's economy had recovered long long time ago. In the US, inflation was finally under control - it was morning again in America. Ireland still struggled. Despite being a member of the EU (which means free trade with at the time about 10 countries), it hadn't been able to catch up very much.
The Irish got tired of this. They felt the world was moving while they were left in the dust. So in the early 90's, they made some radical changes: Income taxes were slashed severely, and the corporate tax was reduced to 12.5 % (less than half what it had been). It is true that the EU subsidized Ireland and contributed with earmarks to building infrastructure, but what is often forgotten is that EU did this for several countries, and of all these countries, only Ireland made any significant improvements. It is therefore clear that it was the tax cuts that did the trick; the economic aid could never in itself have created any sustainable growth.
Ireland was also lucky enough to do these economic reforms at the same time as the dotcom bubble was about to take off. Many of these dotcom companies (among them Dell) choosed to settle down in Ireland because of the favorable tax conditions. Suddenly, Irish growth was above 5 % - something I'm quite sure they had never before experienced. The dotcom bubble did burst, but the following recession was still mild and the Irish thought that "if this is the worst it gets, we're definitely on the right track".
And so, tax cuts continued. The problem was that taxes really didn't need to be cut further; the first tax cuts had been very productive and made Ireland competitive, but now when Ireland already had about the lowest taxes in Europe, this wasn't needed anymore.
Ireland's politicians were used to handling snipers, guerilla warfare, sectarian conflicts between protestants and catholics... but overheated booms? Never heard of them before!
This inexperience was costly: The first Ireland did when the market crashed in september 2008 was to raise the federal deposit insurance to unlimited. That's right - if you had money in an Irish bank it went bankrupt, you'd get all your money back. This leads us to the second problem:
2) Ireland is a small state
Yes, Ireland only has 4.5 million inhabitants. Add a very low level of taxation, and this means that Ireland cannot afford any unlimited federal deposit insurance. Or any bailouts. Unfortunately, because of the inexperienced leadership, they got both.
What was Ireland trying to do? They formed something called NAMA, a "bad bank" which would take over all the bad loans that the banks held. They actually copied what Sweden did in the early 1990's. It's just that the Swedish government (at the time a conservative government) was not dealing with a crisis of the same size, and it was also trusted by world financial markets - Sweden has never had any trouble getting loans. Ireland, on the other hand, has a government of clowns which denied that a crisis was looming even in September 2008 - yes, they actually said in mid-september 2008 that "the economy has turned a corner" and that things would now, after a few rough weeks, continue like normal.
The Swedish government in the early 90's knew that they were going to have a rough time; the reason that they had been able to beat the Socialists was because they recognized that the economy was in a crisis and something had to be done. In his first speech as Prime minister, Carl Bildt declared that "The era of collectivism is over" - something that certainly made entrepreneurs believe in the future, even if the economy was bad at the moment. Ireland on the other hand seems to have its best days behind them. Long-term confidence in the Irish economy is much lower than it ever was for Sweden.
When you're small, you can't just save banks like the US can. The US can always borrow money (at a higher and higher interest rate, but still). For Ireland - and Sweden - there is a very practical limit to have much can be borrowed. If we need money but can't borrow anymore, we'll have to give up our independence and go hat in hand to the IMF.
If a bank in a small country fails, the small country won't be able to do much. The Irish government may have prolonged the lives of their banks, but in the long run, reality catches up: The unlimited federal deposit insurance wasn't worth the paper it was written on since Ireland never had that kind of money that would be needed to pay back all the savings if the banks did fail - and they did.
3) A government which depended on the trade unions.
Fianna Fail is a party with a long history of electoral success - they have ruled Ireland about 90 % of the time since it became independent. This is largely so because of their great network: They are viewed favorable both by the financial sector, the Catholic church and the trade unions.
Their desire to gain support from the unions proved to be fatal. Ireland's public sector salaries are the highest in Europe - even higher than in France and Sweden! The government expanded greatly during the boom, providing among other things high unemployment benefits and pensions that they cannot afford to pay today.
As if it wasn't bad enough, the government promised not to cut any salaries before 2014 (Croke Park agreement, later broken when the boys from the IMF came to town). Investors around the world watched as Ireland got itself into deeper and deeper trouble and the government seemed to care more about winning the next election than actually solving any problems.
Depending on special interest groups is never a good thing, but trying to woo the trade unions in the midst of a recession is among the most stupid things a government can do.
This recession was mainly caused by the unsustainable boom that preceded it. However, when we are trying to understand why Ireland is so much worst off than most other countries, I believe that the tree factors mentioned above explains it. More factors could be added, but that would only complicate things.
So what does the future hold for Ireland? They will now have to spend 1 out of every 5 euros to pay back the debt. The budget cuts have been severe, with about $9 billion being cut just this year - a lot for a country with just 4.5 million inhabitants. Tuition fees will increase, but I do not personally have to worry since my expenses are covered by an extremely generous grant and an equally generous study loan from the Swedish authorities. If expenses go up, the amount i get from the authorities go up. One of the positive side-effects of the welfare state: It makes it a lot easier to emigrate away from the welfare state.
I believe that Ireland needs to reform its political system to regain investor's trust - Fianna Fail and Fine Gael are very close to each other in policy, but they won't merge because of some old conflicts that stem from the civil war in the early 1920's (and this is just of many issues the Irish system has). They will also have to cut public sector salaries severely to show the world that they are serious about reforming their system.
Will they do this? Now that the IMF is in charge, chances are the public sector will take a beating now and in the following years. But the political reform will be a lot harder, since it takes a significant political courage to suggest that the Seanad should be shut down and the parliament be unicameral to save time and money. And that's just an example.
No-one will ever trust an Irish government again. This government will be voted out of office in March, when the next election is held. However, right now (based on the polls), the next government will be a coalition between Labour and Fine Gael (a right-winged party). They have governed before but never been re-elected, simply because they are too different to join in a stable coalition. Another option would be Labor + Sinn Fein, which would mean a leftist government with former terrorists - hardly what Ireland needs right now.
One last thing to note is that the US have a lot in common with Ireland: An unprepared and inexperienced leader and a government which depends on trade unions. The US is bigger and so has more options when dealing with a crisis, but the fact of the matter is that the US is quickly running out of them. And no-one can bail the United States out.
Bailouts can buy you time. Real growth requires political stability and an overall favorable business environment. That is the lesson we should learn from Ireland.