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Ireland's economic crisis: how did it happen and what is being done about it?

Ireland's path to growth

For much of the post-war period, the Irish economy significantly underperformed compared to its European neighbours. This situation began to change in the mid-1990s, when economic growth picked up and outpaced other European countries. A number of factors (including favourable demographics, a well-educated workforce, high productivity and a business-friendly environment, with low corporate tax rates) enabled Ireland to position itself well as a gateway to EU markets, particularly for US  foreign direct investment (FDI).

From about 1995 to 2002, productivity was increasing, the fiscal position of the Irish state was very strong and the unemployment rate fell to around 4%, a level economists consider is around "full employment".

Figure 1 – Unemployment rates in Ireland and 12 euro area countries 1993 – 2011 (Source: Eurostat)

Table showing unemployment rates in Ireland and 12 other euro area countries from 1993 to 2011 


The boom becomes a bubble

However, from 2002 onwards, the nature of the boom began to change. Labour productivity was no longer increasing, inflation was high and growth in GDP increasingly became related to the housing market. Across the economy, wage increases threatened competitiveness. By 2006, although the public finances still appeared strong, this was deceptive, because much of the revenue the State took in was related to the property market. The property related revenues included not only stamp duty and capital gains tax, but just as importantly, a large amount of VAT paid by developers, as well as income tax paid by workers in the very large construction sector. The tax base was effectively very narrow, and dependent to a large extent on the housing boom.

Figure 2 – The collapse in property related tax revenue which caused the fiscal crisis in Ireland

Graph showing Tax Revenues from Housing

Despite this risk, Ireland continued to increase its public expenditure, funding expensive capital projects, but also allowing some categories of current spending to rise very rapidly.

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.

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. The growth in public spending also contributed to the exuberance in the property market.


The crisis erupts

By 2007, the housing market had reached its peak. That year, tax revenues began to decline markedly, new home completions fell for the first time since 1988, and in 2008, Ireland experienced its first significant increase in unemployment in 15 years. Irish banks began to report arrears on their loan books, and with confidence evaporating, were faced with the prospect of deposit outflows. At the same time, short term inter-bank lending, on which Irish banks had become heavily reliant for their funding, became difficult to access, due to the international financial crisis.

Responding to these pressures, the government decided to issue a blanket guarantee of the banks’ liabilities and to recapitalise them using public funds. The large costs of these measures further exacerbated the structural budget deficit which the housing market collapse had revealed.

This bank debt was added to an already significant budget deficit, causing international investors to question the sustainability of 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. Unable to borrow to fund the deficit, Ireland would have faced a devastating and abrupt adjustment to public services, as spending would have had to be brought in line with revenue immediately.


The EU/IMF economic adjustment programme for Ireland

To avoid this prospect, On November 29 2010, the government negotiated a financial assistance package with the EU and the IMF totalling €85 billion (including a contribution of €17.5 billion from Ireland’s own resources). The financing provided by the programme partners is helping to cushion the very large shock which Ireland’s economy and public finances have suffered as a result of the bursting of the bubble. It is helping to keep vital public services running. In July 2011, EU leaders agreed to reduce the interest rate and to extend the maturity on the EU loans provided to Ireland under the programme. This decision brought about a significant saving to Irish taxpayers and has helped to improve the country’s debt sustainability.

Three main elements

The programme contains three main elements. First, a financial sector strategy is helping Ireland to have a smaller, better capitalised banking sector. Second, fiscal consolidation will put the country’s public finances on a sustainable path over the medium term. Third, an ambitious structural reform agenda will restore competitiveness and strengthen the economy's growth potential.  Although broad policy targets in these three areas are agreed between the programme partners (the Irish authorities, the EU, the IMF and the ECB), implementation is a matter for the Irish government, which has a democratic mandate from the Irish people.

Figure 3 – Breakdown of EU-IMF financial assistance programme

Graph: EU-IMF Financial Assistance Programme to Ireland - breakdown

Progress has been made in each of these areas, thanks to strong ownership and decisive implementation of the programme by the government:

  • Banking sector reforms – the recapitalisation of the domestic banks has been completed, at a significantly lower cost than originally anticipated. Deleveraging of bank balance sheets is on-going, despite difficult market conditions. In addition, bank mergers have been completed ahead of schedule, and bank boards are being renewed.
  • Fiscal consolidation – the government is taking steps to restore the long-term sustainability of public finances. The budget deficit target for 2012 was met and for 2013 is forecast to be within the programme ceiling (of 7.5% of GDP). The government is committed to reducing it to below 3 % by 2015.
  • Structural reforms – the government has reformed sectoral labour market agreements, and is undertaking measures to improve labour market activation for the unemployed. Efforts are also on-going to encourage more competition in sheltered sectors, such as the legal professions, thus bringing down costs and making Ireland more competitive.

Signs of progress under the programme are becoming more evident:

    • Growth has resumed, driven by an impressive resurgence in Irish exports. Ireland now enjoys a large surplus on its current account.
    • Despite the fact that domestic demand remains weak, there have been recent positive developments with respect to a number of key economic indicators, including retail sales and manufacturing and services PMI numbers. There are some signs of stabilisation in housing markets. Employment growth has resumed, and unemployment has stabilised, albeit at a high level.
    • Investor sentiment towards Ireland has improved considerably. Spreads on Irish government bonds have come down dramatically and Ireland has begun its return to the bond markets, by successfully issuing both short term and longer term debt. Ireland recently benefited from a positive change in its rating outlook from Fitch Ratings. This was one of the first positive actions towards any euro area sovereign since the crisis began. Irish semi-states and banks are also able to issue long-term debt once more.
    • The June 29th 2012 euro area summit conclusions were seen as positive for Ireland. Heads of state and government recognised the need to break the link between banks and sovereigns and mandated the Eurogroup finance ministers to examine the situation of the Irish financial sector with a view to further enhancing the sustainability of the well-performing adjustment programme.

Despite these achievements, challenges remain. Ireland's budget deficit is still among the largest in the euro area, and it also has a high level of government debt. Unemployment is increasingly long-term in nature. Irish financial institutions have not yet reached full capacity to support the recovery through new lending, including to SMEs which can play a key role in future job creation. Continued steadfast implementation of the EU/IMF programme will be needed to address these issues. 


Last update: 06/12/2012  |Top