After over a decade of extraordinarily high economic growth, Ireland’s economy came to an abrupt crisis in 2008. The country was the first member of the Eurozone to enter into severe recession as a result of the global financial crisis. The housing bubble popped, the economy shrunk by 19.6% from 2008-10, and unemployment rose from 4.7% in 2007 to 14.2% in June 2011. The so-called “Celtic Tiger” was at its knees. Devastatingly, the collapse of the banking system meant that the government was forced to borrow €67.5bn to help bailout its banks and balance the fiscal budget. As a result, governmental debt increased by 320% between 2007 and 2010, which subsequently led to staggering budget deficits as high as 32.1% of GDP in 2010. Ireland’s economy was hurting, and the remedy chosen to save it was austerity.
On the face of it, Ireland’s implementation of austerity in 2010 appears to be a case-study for countries in similar positions of economic crisis. Its GDP grew 35% between 2012-16, and by 2016 its budget deficit was only 0.7%. Ireland’s use of austerity has been lauded by many European policy makers, like former ECB President Jean Claude Trichet, who used its approach as an example for Eurozone countries like Greece to follow. Yet although Ireland’s economy recovered, the question remains whether it recovered because of austerity or in spite of it? This memo seeks to address this policy dispute, by evaluating harsh austerity as an appropriate policy to implement in Ireland’s scenario, and also alternative factors that might been more influential to Ireland’s recovery. I will subsequently assess from the economic rationale I use, whether austerity as severe as Ireland’s was a wise policy.
Ireland’s economic crash was in many ways a product of the “Celtic Tiger” boom. Banks such as the Anglo-Irish Bank and the Bank of Ireland gave out loans in abundance to help support property development in the early 2000s. As a result, the construction and property industry dominated the Irish economy to a dangerous degree, with construction making up 24% of its GNP in 2006, and employing 19% of the labour force indirectly. The global recession popped the housing bubble – house prices plummeted, and swathes of developers were unable to pay back the loans which Irish banks had given out. It was a similar banking crisis to the US – effectively banks were giving out credit far too freely. The result was economic catastrophe, with widespread unemployment and a banking crisis which needed a bailout that led to huge public debt. This is what prompted the use of austerity, as the IMF and the EU made it a condition of their bailout agreement.
Austerity refers to government policies taken during a period of economic crisis to improve the fiscal budget by cutting expenditure and raising taxes. This cuts down rising government debt, which reduces future debt servicing fees, avoids the possibility of defaulting on debt, and provides a sign of economic stability which encourages investment. Specifically, in Ireland’s case the IMF required Ireland to raise tax revenues by introducing taxes on carbon, property, and water, as well as by lowering the income tax brackets. They also demanded that government expenditure be reduced by cutting the number of public sector workers, and reducing social security funding. The austerity that followed was one of the harshest in modern Western European history; 37,500 of public sector staff (10%) were laid off, health spending was cut by 27%, and local authority housing funding was reduced to just €83m in 2013 from €1.3bn in 2007. These cuts also disproportionately affected the poorest in society, as illustrated by the 2013 budget, which increased taxes by 1.3% for workers on an annual salary of €20,000, but by only 0.2% for workers earning €100,000. As a result of the austerity programme, between 2008 and 2014, public spending was cut by €18.5bn, and €12bn in additional revenue was raised. Yet was this harsh austerity and appropriate policy decision that we can attribute Irelands’ economic recovery to?
There was popular conservative economic thought at the time which pointed to the economic benefits of austerity for a crisis economy like Ireland. In 2010, Harvard professors Carmen Reinhart and Kenneth Rogoff published “Growth in a Time of Debt,” which became a pillar in the debate around austerity. Using economic data starting in 1945 from dozens of countries, its thesis is that countries with higher debt-to-GDP ratios grow more slowly, and that a country’s economic growth suffers dramatically after its external debt reaches in excess of 90% of GDP. Once above this level, it suggested that average annual GDP growth was -0.1%. The economic analysis behind the Reinhart-Rogoff model heavily influenced Ireland’s austerity policy as a means of economic recovery. Ireland had debt of 86.3% of GDP in 2010, and a huge budget deficit which was set to raise government debt way above the 90% threshold described in the Reinhart-Rogoff model. Economic theory would suggest that this is because high debt theoretically discourages private investors, crowds out the private sector (if high government spending remains), and cuts into the fiscal budget in the form of debt servicing costs.
It seemed sensible economic policy at the time for Ireland to adopt austerity measures to try and bring down debt and not harm growth. However, there were errors in the Reinhart-Rogoff model which undermines its credibility as policy advice. Amherst economists reworked their calculations to eradicate errors and omissions, and found that the average growth for countries with a 90% debt-to-GDP ratio was actually 2.2%. Even more significantly, outliers affected the model dramatically, and it was found that there was no statistical trend of declined average economic growth between the categories of 30-60% percent, 60-90%, and 90-120%. The economic analysis which influenced austerity in Ireland was faulty, and in light of this, such harsh austerity seems less necessary as a policy, and less of a driving force behind the upturn in GDP growth.
On the whole, harsh austerity is likely to have been a hindrance, rather than an impetus, for the Irish recovery. Cuts in government spending and higher taxes would have led to a fall in aggregate demand in a time when aggregate demand was decreasing anyway due to the recessions’ impact on Irish consumption and investment. This would have compounded the inward shift in aggregate demand and reduced the rate of economic growth, slowing the economic recovery. Austerity was also an inappropriate policy in Ireland because of the country’s inability to pursue expansionary monetary policy simultaneously as a counterweight. As Irish monetary policy is decided by the ECB, it was not able to lower interest rates to 0% (ECB set rates at 1% based on having to accommodate for whole of the Eurozone), or pursue quantitative easing, which would have boosted consumption and investment, and hence aggregate demand. Ireland’s lack of monetary policy also manifests itself in its inability to lower interest rates to manipulate the value of their currency (lower interest rates leads to less demand for a currency, as investors would save their money elsewhere). Ireland implemented an incredibly tight fiscal policy (austerity) without the ability to counterbalance it with expansionary monetary policy that would have both encouraged aggregate demand growth, and an export-led recovery. Austerity without expansionary monetary policy is not a good framework for a recovery, which suggests that the Irish economy must have recovered in spite of austerity rather than because of it.
Having discussed the value of implementing austerity to salvage a wrecked economy like Ireland’s in 2010, it seems unlikely that Ireland can owe its economic recovery to it. The Reinhart-Rogoff model which gave it credibility has been discredited, and economic theory suggests austerity can often be self-defeating and increase debt as a proportion of GDP because of the constraint it puts on aggregate demand (taxes decrease, unemployment benefits increase), and consequently economic growth. This is even something that the IMF acknowledged in a 2012 paper, where they admitted that austerity in Europe had been ineffective at solving the debt crisis.
A far more convincing interpretation of Ireland’s economic recovery places the onus on Ireland’s improved export base thanks to exogenous factors. Ireland’s exports 39% of all its goods and services to the UK and US. The recovery of these economies significantly aided Ireland’s economy, as their main trade partners were importing far more from them. There has also been research to suggest that the Ireland’s main export sectors (e.g. pharmaceuticals and business services) boomed at a convenient moment. Finally, Ireland also received a huge amount of foreign indirect investment over the recovery period as a result of its low 12.5% corporation tax. This FDI helped lower unemployment, increase real wages, and shift out aggregate demand (in contrary to austerity policies). A combination of these factors could have resulted in export-led growth that increased employment and economic output – a more likely contributor to the recovery than austerity measures were.
The implementation of austerity in Ireland was a risky policy because of its potential to turn an economic recession into a depression. Although Ireland needed to reduce the fiscal deficit to a degree in 2010, the severity of the austerity was to such an extent that economic theory would suggest it could have worsened the debt crisis because of its contractionary impact on the economy. Fortunately, Ireland’s economy, aided by its strong current account balance, recovered nonetheless. However, considering positive impact of FDI on its recovery, perhaps a less biting austerity which neither lowered wages as much, nor laid off as many workers, might have resulted in a recovery without the negative social consequences of austerity, such as widening income inequality and the brunt of its impact falling upon the poorest in society.