Success of the Irish Government and the European Central Bank - Article Example

Economy of Ireland Success of the Irish Government and the European Central Bank in running the Irish economy over the last 2 years Ireland is a small and modern economy mostly dependent on trade. Though a fast growing economy till 2007, it was hit hard by the financial crisis of 2008. This can be seen clearly from the fact that in 2008 its GDP fell by 3% and in 2009 by 8% (cia.gov). Realty and construction sector were hit the hardest as property prices fell by 50% in 2008 from the 2007 peak (cia.gov). Agriculture which was once an important sector is today a diminished one. In 2008 the COWEN government moved to guarantee all bank deposits, recapitalize the banking system, and establish partly-public venture capital funds in response to the countrys economic downturn (cia.gov). The quick response of the Irish government along with that of European Central Bank (ECB) was much applauded. Major impact of the financial crisis was felt by the banks because of the explosion in the real estate asset bubble. As the big banks had lent out blatantly, they were at the brink of collapsing completely. The government could not have allowed this as it would have led to even further economic turmoil. With an aim of continuing its efforts in stabilizing its economy, the government announced the setting up of National Asset Management Agency (NAMA). The basic idea behind setting up this agency was to use it like a bad bank. It would take over all the “toxic” assets of Ireland’s big banks in return for sovereign bonds (globaleconomiccrisis.com 2010). This in effect meant that the Irish tax payers were actually paying for the bad debts. However as per the policy makers, the positives of this policy were that the big banks will not collapse and will be back in business soon and start performing their normal credit and loan cycle. This was highly criticized by the economists and the public as the government was effectively using the tax payers’ money to fund the private sector losses. What the public was getting in return were vague promises by the politicians of the policy’s potential of putting the economy back on track. The validity of this public skepticism can be seen from the fact that at the time of establishing NAMA, the authorities believed that the toxic loans being acquired for the “bad bank” would need to be discounted by 30% (globaleconomiccrisis.com 2010). However, the actual discount as per recent estimates is 47% (globaleconomiccrisis.com 2010). The government has now declared that on the whole these bad loans have cost the tax payers € 32 billion which turns out to be $ 43 billion at current exchange rate. This when converted to individual contribution by the Irish population of 6.2 million, comes to $7000 per head (man, woman and child). This is a huge burden on the people who are already suffering in an economy plagued by high unemployment. Another problem facing the government was the reduction in revenues on account of capital levies. As the government depended more on capital taxes for their revenues, the collapse of the real estate market lead to decrease in revenues further worsening the situation. As Ireland is a member of the European Union (EU), it does not have much leverage in pursuing its own monetary or exchange rate policy decisions. The only instrument in which the government has any discretion is the fiscal policy. The government under pressure from ECB has had to resort to fiscal tightening policies which include reduction in government wages, increasing taxes and adding levies. This again leads to dissatisfaction in public as the step has been seen as another burden on the general public for the errors made by highly paid financial engineers of the banking system. Had the country not been a member of EU it could have devalued its currency to be able to balance out its fiscal position. The ECB on its part has been indirectly funding the deficit of Irish government. The Irish banks have availed ECB funding for purchase of around € 7 billion worth of Government bonds so far. This accounts for around 26% of debt disbursed by the bank. The banks have to pay 1% to the bank while they earn 5% from the government bonds. They have also been allowed unlimited funding by the ECB (MacManus 2009). ECB has also been lowering its prime rate to as low as 2%. In fact, since May 2009, the rate has been kept at 1% to help boost recovery in European markets. Though this kind of monetary adjustment does not have immediate impact and takes around 4-6 months for the positives to flow in, nevertheless it has its affect in the long run. However, all these efforts by the government and the ECB don’t seem to be going in the right direction. Average Irish household is one of the most indebted in Europe as it faces negative equity of €43,000 (moneyguideireland.com). The unemployment rate which is currently at 12% is expected to reach 15% by 2011. A quote from Fitch rating report says “the poor state of public finances has left the government no room to use fiscal measures to support the economy.”  (moneyguideireland.com). The credit worthiness of Irish banks has fallen substantially and hence the interbank lending rates have risen despite the opposite direction of the ECB rates. This shows that the benefits of ECB’s reduced rates have not yet reached the Irish households. Another bad news for the government is the fact that the total private and public debt is expected to reach 300% of the GDP which in no way is any sign of recovery (moneyguideireland.com). The Irish economy is forecast to contract 1.5 percent in 2010 and will probably post the Eurozone’s biggest budget deficit (moneyguideireland.com). Main macroeconomic policies used by the Irish Government and the European Central Bank over the last two years The economic crisis has changed the direction of ECB’s focus from inflation to deflation. The main focus of its monetary policy has been to increase liquidity and decrease prime rates. Ireland has a disadvantage owing to the fact that it is asymmetric in its economic position as compared to the other economies of the EU. Thus, the impact of ECBs interest policies is not the same as that on other major economies like France and Germany. Ireland never had its own monetary policy from the beginning. The impact of recession has been much higher on Ireland as compared to the other EU economies. This can be seen from the fact that Germany and France have already begun the process of pulling out of it while Ireland’s first quarter returns in ‘09 showed that the economy had shrunk by 8.5%. Its unemployment rate is still 12% and it has a large budget deficit. The aim of the government as per the Stability and Convergence Program which they submitted at the end of 2008 under the framework of Excessive Deficit Procedure set a 5year timeline to bring the deficit below 3% of the GDP (Larkin). This they tried to do during the last two years by reducing public expenditure. There was an increase in taxation with the aim of increasing revenues. On the spending side, the public spending went on decreasing over the years. For example early child care spending was halved; Overseas Development Aid was reduced to 0.48% of the GNP and so on. There was no stimulus to the rapidly contracting private sector. The government did not provide for any export credit of foreign exchange risk support. This was a very critical support required for the growth of the industry. Since the economy is export oriented, a boost to this is very important for bringing it back on track. With the increase in taxes, the middle class was hit the most. In fact, the policy of taxing those who earn more was followed. However, this is not a very encouraging theory as it taxes those who are most productive people and have above average skills. This reduces demand from this sector of people and hence overall reduction in consumption. In 2009, 4% of top earners – many of whom are wealth and jobs creating entrepreneurs and business owners – paid 50% of total income tax (Gurdgiev 2009). This shows that jobs growth oriented economy was not being promoted. This kind of tax structure is very detrimental to the overall recovery. The government on the whole was following deflationary policy to contain the deficit. Though both fiscal policy by the government and the monetary policies by the ECB were aimed at encouraging consumption and hence growth, this was not actually seen in the real terms. This was mainly because Ireland did not fit in the same economic model as the other EU economies and needed specific monetary measures for its economy. Cuts to unemployment benefits in excess of reductions to social welfare implied that people in long term unemployment were transferred to social welfare schemes which further increased the cost to the exchequer. Because of the high focus on increasing revenues, the government did nothing to address the issues of uncompetitive costs imposed onto businesses by the country’s state-owned utilities and suppliers of services as well as excessively high charges and rates of local authorities (Gurdgiev 2009). These again are inflationary pressures on local businesses which actually should be reduced if economy needs to be revived. On the Banking sector front, the government did not do much provisioning. This means that when the banks need new capital (which they will eventually need), there will be a huge impact on budget deficit. The government will then have to use NAMA and issue Sovereign bonds. This will further increase Ireland’s dependence on ECB goodwill. Another expectation of the government from the banking sector by route of NAMA is to force them to lend aggressively to SMEs as well as the household which is reeling under tremendous pressure on account of lack of access to cheap funds. However, there is a very low possibility that the banks will actually do this. There needs to be better incentive for them which will prompt them to divert their lending in this direction. Another form of tax that was introduced, as per budget 2009, was the carbon tax. Though the main idea of this type of tax is to encourage people to move to cleaner fuel and eventually reduce their own tax burden, in this case this seems to be an indirect form of long term revenue generation as the likelihood of switching to greener alternatives is not much. This is mainly because the way Ireland has developed over the years (high capital investments, poor planning and zoning and absurd spatial development), manufacturers and consumers do not have much space to switch over to eco-friendly options (Gurdgiev 2009). If you add to this the cost of switching to the green technology (which is generally expensive), the people hardly have any motivation to take on this extra cost burden in this time of crisis. Thus, in effect, this carbon tax is another way of introducing a new levy under a different name. One positive impact of the government’s macroeconomic policies has been that the country’s exports have risen as compared to the other economies of the EU. This is a very good aspect as it will have a positive impact on the trade deficit. However, the impact of this has been countered by the fact that the government has not been able to do much on aspects of government spending and consumption. The government has also been focused on attracting multinationals and has been providing them incentives to set up shop. This is a good strategy to help boost employment and get more investment within the country; however this is not a very long term strategy. References cia.gov, The world factbook - Europe:Ireland, viewed on April 27, 2010 https://www.cia.gov/library/publications/the-world-factbook/geos/ei.html globaleconomiccrisis.com 2010, Ireland’s Banking and Economic Crisis: Toxic Loans Surpass Estimate of Irish Government, viewed on April 27, 2010 http://www.globaleconomiccrisis.com/blog/archives/997 Gurdgiev, C 2009, Economics 16/12/2009: Budget 2010 Analysis, viewed on April 27, 2010 http://trueeconomics.blogspot.com/2009/12/economics-16122009-budget-2010-analysis.html MacManus, J 2009, ECB funding 25% of Irish deficit indirectly, data reveal, viewed on April 27, 2010 http://www.irishtimes.com/newspaper/finance/2009/0919/1224254861624.html moneyguideireland.com, ECB Interest Rate History, viewed on April 27, 2010 http://www.moneyguideireland.com/category/ecb Read More