For a country which accounts for less than 0.25 per cent (that is, less than one four-hundredth) of the world economy, Ireland has attracted a disproportionately large share of world attention over the past couple of week, as it confronts the massive cost of cleaning up its failed banking system (which has blown the budget deficit for this year out to a mind-boggling 32% of GDP) in the midst of a recession which is now in its third year, during which its economy has shrunk by 17% and its unemployment rate almost trebled, from less than 5% to nearly 14%.
Ireland is now implementing another round of swingeing expenditure reductions, tax increases, and a raid on its national pension fund, in order to comply with the requirements of the bailout package from the IMF and the European Union announced last weekend. Not only is that causing considerable unrest among the Irish people at the implied erosion of national sovereignty, but it is also likely to prolong the current recession.
Ireland’s woes illustrate a point, which I have made before, that one of the principal lessons of the global financial crisis is that inappropriately low interest rates can be as damaging as inappropriately high interest rates.
Once Ireland joined the euro area at the beginning of 1999, short-term interest rates in Ireland were no longer set in Dublin in accordance with Irish conditions, but rather in Frankfurt in accordance with conditions across the euro zone as a whole. Thus Irish short-term interest rates fell from the 5½-6% range in which they had remained during the second half of the 1990s (which the Central Bank of Ireland had deemed appropriate for an economy that had been growing at rates of 8-11% per annum) to 3.0% (which the European Central Bank considered appropriate for an economy that had been growing at around 2½% per annum). And from then until the onset of the financial crisis, short-term interest rates averaged 3¼% per annum in Ireland, as they did across the euro zone, even though Ireland’s economy grew at an average annual rate of almost 6% (compared with less than 2% for the euro zone as a whole) and Irish inflation averaged 3½% per annum (compared with 2¼% per annum for the euro zone as a whole).
Because Irish interest rates were substantially lower than they should have been for an economy growing as fast as Ireland’s was, Irish households and businesses borrowed (and Irish banks lent) far more than they would otherwise have done, resulting in (among other things) an unsustainable property boom in which Irish house prices more than doubled in less than seven years (they have since fallen by almost one-third).
Much the same thing happened in Portugal, Spain and Greece.
The European Central Bank can’t be blamed for this: it has only one interest rate at its command, and it can’t set different interest rates for different parts of the euro zone any more than the Reserve Bank of Australia can set different interest rates for different parts of Australia. Just as the interest rates which the ECB deemed appropriate for the euro zone as a whole were “too low” for Ireland, they were arguably “too high” for Germany, where economic growth averaged just 1½% per annum between 2000 and 2007, inflation averaged 1¾% per annum, and house prices barely moved at all.
In federations such as Australia or the United States, where regions with quite divergent economic structures share a common currency and interest rates, the government’s budget provides a means of offsetting the impact that a common monetary policy may have on different parts of the economy.
In Australia and the United States, the personal and company income tax systems collect relatively more revenue from regions experiencing strong economic growth while the social security system distributes relatively more to regions which are in some way “missing out”.
The euro zone has no corresponding mechanisms (although the IMF has this week recommended that they should develop some). The Irish Government could have run sufficiently tight fiscal policy to offset the consequences of inappropriately loose monetary policy, but it didn’t: as the beleaguered Irish Finance Minister Brian Lenihan has explained, “when we had it, we spent it”. Ireland’s ‘structural’ budget surplus averaged just 0.6% of GDP between 2000 and 2007. Spain, Portugal and Greece were even worse: they all ran large structural budget deficits during this period.
There are two important lessons for Australia from all of this. First, on the assumption that the mining boom continues for a number of years, it is almost inevitable that interest rates will be “too low” in Western Australia (in particular) and “too high” for much of south-eastern Australia, as they were during the first phase of the mining boom in 2005-07. That’s why Perth property prices rose by almost 75% during that period, in the process giving Australia’s fourth largest city the country’s second highest real estate prices, while property prices in other capitals rose by less than 20%, on average, during the same period.
So we - and Western Australians in particular - should be thankful for mechanisms like the Commonwealth Grants Commission which redistribute some of the GST revenues away from WA towards other States (and which will redistribute it back to WA when the mining boom is over), complementing the effects of the Commonwealth income tax and social security systems at the individual level.
The second lesson is the one spelled out by Reserve Bank Governor Glenn Stevens in his address to the 50th Anniversary dinner of the Committee for the Economic Development of Australia (CEDA) on Monday evening - that the government should seek to run “considerably larger budget surpluses in the upswings of future cycles than those to which we have been accustomed in the past”, and that consideration should be given to “the management of any net asset positions accumulated by the government as part of such an approach … in a stabilization fund of some sort”. This is something I have been advocating since 2005 - although the idea actually goes back as far as the Biblical prophet Joseph, who (according to Chapter 41 of the Book of Genesis) advised Pharoah that “20% of the produce of the land during the seven plenteous years [should be] laid up … as a reserve for the land against the seven years of famine which are to befall the land … so that the land may not perish through the famine”.
Australia has often thought of itself as "the lucky country", at least since Donald Horne coined that phrase in the 1960s (with an ironic intent not recognized by most Australians, then or since). But if we don’t want the current boom to end with the luck of the Irish, then we need to think carefully and boldly about how we use our current run of luck.
This article was first in the Business Section of the Melbourne Age on December 1, 2010