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GUEST,KP BS: Ireland-What happened? (251* d) RE: BS: Ireland-What happened? 29 Nov 10

Duke, Art
I teach basic business finance (among other things) at a local University here in Scotland and some students asked me the same question. I'm more into micro (company level) economics than macro (country level but let's see if I can summarise what seems to have happened.

Two things happen in most market economies
1. Economies are cyclical
2. Governments spend more than they receive in taxes

Explain point 1: The economy has low periods when business doesn't look so good. Companies don't invest because it doesn't look like their investment will be recouped. How do they do this calculation? They use a technique called discounted cash flow or net present value analysis. The arithmetic of these calculations depends on interest rates. If they are high the investment is likely to look less profitable, but if they are low the investment is likely to look more profitable.

So what can the government/central bank do when business is bad? It can reduce interest rates, which has the effect of 'turning on' investment projects. And one company's investment project (say a new office) is another company's day to day business (think of architects, builders, electrical/IT installers etc). So reducing interest rates normally has the effect of increasing economic output.

As output grows more individuals and companies start to look at the economic prospects and think 'I'd like to spend/invest'. Because rates are cheap, it looks feasible for them to do this by borrowing money - on credit schemes for individuals, or bank loans for companies. So as the economy expands there is an increased demand for this cheap money. This demand should be self-limiting - if the demand for money goes up the cost of borrowing the money (interest rates) should go up as well. So you'd expect interest rates to be cyclic - low when the economy is doing badly and high when it is doing well.

What happened in Ireland was that their economy had got to the natural peak of the cycle in 1999 and interest rates on the old Irish Punt were increasing to about 6-7%. But it joined the Euro at a time when Euro interest rates were only 3-4%. Result: lots of cheap capital.

And that's not necessarily a good thing. In a thriving economy you'll find an eventual shortage of good investment projects. You've built the factories, got the machinery, labour is fully employed, its hard to get extra materials/workers, so what do you spend the money on? More consumer goods? That, and the thing that everyone thinks can only ever increase in price - property.

So the banks had access to cheap money which they lent out to entrepreneurs (probably good), individuals building houses (possibly good unless they were speculating) property speculators (generally bad). And these were the same banks where members of the general public kept most of their savings. Over the 'boom years' the quality of the developments that the banks lent into got lower and lower (this wasn't just in Ireland - the same thing happened in the US, Iceland, etc). In addition, when you lend money on property you tend to make long term loans (15 years+), but as the banks lent more and more (and of course borrowers demanded more and more), they financed that lending by borrowing money from other banks - often quite short-term loans. In the UK Northern Rock did a lot of this but so did the Irish banks.

In 2008 it all unwound - it became clear that that some of the loans (first in America and then elsewhere) were of low quality and never going to be repaid. That caused all the banks to panic, to stop lending to each other, and to retain as much cash as they could for themselves. That meant that the banks who borrowed short to lend long suffered a 'liquidity crisis' (banker speak for running out of cash). Some countries, including Ireland, had banks that had been (by all accounts) particularly 'adventurous' in their lending. So the first problem for Ireland has been a banking crisis. Can the Government (i.e. the taxpayer) support the banks to stop them going out of business? Bearing in mind that if they don't, all those citizens who've put their life savings into the those banks will lose their money.

2. That brings in the second problem. What can the government do in a banking crisis? Traditionally, the response to a 'liquidity crisis' is to cut interest rates so that its easier for the banks to get money and to lend it each other. The trouble was interest rates were already too low - that had caused the crisis. Lowering them had no effect on interbank transactions - even in the UK, when the Bank of England cut the base rate to 0.5%, banks still wouldn't/couldn't loan to each other.

So what else could the Government(s) do? Spend money themselves to support the banks. In the UK the Government made it clear that it could put as much as 850 billion into the banks to do this - in fact the amount turned out to be about 100 billion and it looks they'll get their money back. In Ireland the money needed has been much bigger in relation to the size of the Irish economy. The Government probably couldn't get this money from taxpayers so would they have to borrow it?

Most governments borrow money by issuing a special type of debt government bonds ('gilts' in the UK). There is a continuous process of auctioning these bonds where governments effectively are saying 'who'd like to lend us money for x years at y% interest rates?' The investors may be banks, individuals, or other countries (the Chinese have a lot of American debt for example). There is also a thriving secondary market in this debt. As this secondary market trades it tells you what the interest rate needs to be for any new debt. If 100 worth of 5% interest debt (yielding 5 per year) is sold for 90 its implied interest rate is now 5/90 or 5.55%. The average yield on UK government debt is about 3.8%. By contrast, the yield on Irish bonds has reached 9% (that means 100 of 5% debt is only valued at 55).

The yield got so high because investors don't believe that the Irish government can repay their debts in full. They already owed a lot of money before the crisis, and this has made it really bad. What governments should do is to reduce their borrowing during the 'boom years' so they've got room for manoeuvre during the bad years. Successive governments in Ireland didn't really do this (neither did the Greeks, Portuguese etc, but also neither did the UK - see The Financial Deficit Explained).

So lending money to Ireland looks risky, and investors are basically asking for 9% to loan Euros to them (rather than 3% to loan to Germany). How do you convince investors that you could repay the loans? By showing how you are cutting costs and increasing revenues.

To finish, the Irish government is facing a number of very unpleasant choices. It could:

1. Let the banks go bust and its citizens lose their money.
2. Default (not repay) on its international 'sovereign debts' - but then 'never' be able to borrow from anyone ever again. It would then have to balance its budget and make massive cuts as it would be in danger of literally running out of money
3. Come out of the Euro and devalue its currency (it would probably have to do this if it did number 2), to reduce the value of its debt. That's what the Weimar Republic in Germany did in the 1920's and we know how that ended
4. Cut its spending hugely, and raise taxes, and hope that potential investors will be convinced - this is what they have been trying to do, and what Governments everywhere did in the 1930's. The danger is that you could get into a lasting depression just like then.
5. Accept a rescue package, at lower interest rates than otherwise, which together with some cuts, will stabilise both the banks and the country's economy. The question is what terms the EU will impose on the rescue package - in particular will it want Ireland to increase its low corporation tax which has been instrumental in attracting inward (esp US) investment into Ireland?

Its not all gloom, as there are some examples of countries getting into this kind of mess and then getting out again;
Can Ireland Bounce Back - How 5 other Nations Fared

Anyway I hope that helps and I'd be interested to receive comments from readers in general - is this clear, and would my students understand it?

Cheers from a very snowy Scotland!

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