Ireland's economy was widely seen as one of the most successful in the world, yet it has been among the hardest hit by the global financial crisis. From the mid-1990s to 2007, Ireland enjoyed strong economic growth, but this reflects two different growth stories. The first lasted from the mid-1990s until the early 2000s, and can be described as one of ‘catching-up growth’: after years of lagging behind, there was a rapid convergence of Irish living standards towards those of the world’s most successful economies.

There were two main factors behind this. Firstly, favourable demographics gave rise to an increase in the number of workers entering the labour market. Secondly, an improvement in the educational level of the labour force meant that these new workers had higher productivity than their predecessors.

Other factors also contributed to this story. In particular, the arrival of the EU single market made Ireland an attractive location for inward investment, especially from the US, and helped boost Irish exports.

Other factors also contributed to this story. In particular, the arrival of the EU single market made Ireland an attractive location for inward investment, especially from the US, and helped boost Irish exports.

From roughly 2002 until 2007, however, this growth dynamic changed in fundamental ways. The economy continued to experience high growth rates, but this was increasingly based on the rapid expansion of credit and an accompanying build-up of personal indebtedness by Irish households. This was fuelled, above all else, by rising property prices. During this period, construction activity grew very strongly, accounting for a much larger share of the economy and employment than was previously the case. 

Rapid expansion of credit

The speculative bubble in property was supported by a surge in bank lending, and the balance sheets of Irish banks grew disproportionately large relative to the size of the economy. The banks had traditionally relied on their deposit base to fund their lending activity. However, greater financial integration, spurred in part by the birth of the euro, allowed them to turn more and more to short-term borrowing from abroad, from so-called wholesale money markets. This period also saw a global increase in risk appetite by financial markets, and Irish banks were caught up in this.

Rising property prices

This was reflected in both a concentration of lending in property, and increasingly risky lending practices, both of which would prove highly damaging when the bubble burst. In addition, so-called ‘light touch’ oversight of banks meant that there were failures by supervisors and regulators to identify and act on risks that were emerging in the financial system. And even though the Irish government was running a budget surplus in this period, many commentators have argued that fiscal policy played a part in exacerbating the imbalances that were building up.

Tax revenue was increasingly derived from cyclical sources – capital gains tax and stamp duty – that would prove highly fragile once the bubble burst, while public spending grew more rapidly than would have been the case under a more neutral policy stance. Finally, this period also saw rapid increases in prices and wages, which led to an erosion in Ireland’s international competitiveness.

Falling property prices

When the international financial crisis erupted in August 2007, Irish banks were left vulnerable and exposed. With falling property prices, banks began to suffer huge losses on their loans. At the same time, short term inter-bank lending, on which Irish banks had become heavily reliant for their funding, became difficult to access.

From a global perspective, a key event was the collapse of Lehman Brothers, a US investment bank, in September 2008. This gave rise to severe tensions in global financial markets.

Confidence evaporating

With confidence evaporating, Irish banks began to experience deposit outflows, and there were mounting fears about their ability to access funding from the wholesale money markets.

The crisis erupts

Responding to these pressures, the government decided to issue a blanket guarantee of the banks’ liabilities and to recapitalize them using public funds. The large costs of these measures led to an acute deterioration in the government’s fiscal position.

Although the government began to implement austerity measures designed to restore sustainability to its public finances, it was facing an uphill struggle. International investors became worried about the impact of escalating bank losses on the government’s balance sheet, and risk spreads surged on Irish sovereign debt.

In November 2010 yields on Irish government debt reached an unsustainable 9%, which meant that the government was effectively locked out of international bond markets.