A research colleague, Brian O’Kelly, and I have been looking at the impact of poor bank regulation in Ireland during 2003-2008, and the Irish credit bubble that this poor regulation fostered, on Irish GDP and other economic measures. I am scheduled to talk about this research down in Kenmare this weekend. I want to make some informal remarks in this blog, based on some simple calculations that are easy to follow.
Here is a simple question: what is the effect on cumulative GDP of the massive distortions in bank lending described in the Honohan report? The good news is that the net cumulative effect, even after accounting for the €50 billion bank bailout costs, is not too far from zero. The bad news is that the GDP benefits were all received during the 2003-2007 period when GDP was artificially increased by these extremely poor bank regulation policies, whereas the GDP costs are in the 2008-and-beyond period.
Consider the Irish GDP real growth record since 2002. During the 2002-2007 period (inclusive) Irish GDP had a very high real growth rate of 7.97% per annum compounded annually (this is aggregate, not per capita). Then the Irish debt crisis hit and over the next three years, 2008-2010, the real growth rate (Eurostat estimates) was -5.21% per annum. But this still leaves the real GDP growth rate over 2002-2010 at a very respectable 3.3% per annum.
The Honohan report (Chart 2.10) notes that without the Irish debt crisis, facilitated by faulty bank regulation, the per annum decline in Irish GDP during 2008-2010 would have been cut by about three-quarters, that is, a decline of -5.21%/4 = -1.3%. This smaller decline reflects the worldwide Great Recession and is not due to Irish bank regulation failures. What the Honohan report’s Chart does not show, however, is the effect of faulty bank regulation on the very high growth rate during the early 2002-2007 period. This growth was substantially based on the massive foreign credit inflow facilitated by the banks (and poor bank regulation) rather than by true underlying productivity growth. Net foreign borrowing by the domestic banking sector increased enormously during this period, rising to 87.5% of previous-year GDP in the third quarter of 2008 when the crisis broke. All this overseas inter-bank borrowing, with the proceeds fed into property development spending, fuelled the big GDP increases of this period in an unsustainable way. To quote from Kelly (2010) “The Irish Credit Bubble”:
“It is this more than tripling of bank lending that accounts for the Irish boom since 1997. Effectively the Irish economy segued from one driven by competitiveness in the 1990s to one driven by a credit fuelled bubble in the 2000s.”
O’Kelly and I estimate that perhaps one-half or even more of the growth during 2002-2007 is a credit-fuelled bubble, which depended upon poor bank regulation (and big immigration inflows to provide labour supporting the capital inflows). If we assume instead good bank regulation and dilute the 2002-2007 growth by half, and the 2008-2010 decline by three-quarters, we actually wind up with 2010 GDP (before bank bailout costs and other deadweight costs) which is 7.7% lower in the absence of the credit-fuelled bubble. This must be adjusted further for the interim GDP during 2003-2007 which was much higher on account of the bubble. Even after adjusting for €50 billion bank bailout costs, and deadweight costs of fiscal adjustment, the cumulative GDP impact of the credit bubble is not that large. It is just that the “good part” of the bubble experience is in the now-distant past (2002-2007) whereas the pain is in the present and future. Note also this analysis is on a total basis not per capita, whereas the per capita figures are more difficult to interpret in some ways.
Needless to say, the Irish credit bubble of 2002-2010 was a terrible economic disaster, clearly caused to a large extent by grievously bad bank regulatory policy (as the Honohan report demonstrates). This binge-based increase and calamitous decline in GDP during 2002-2010 has caused enormous social distress, unemployment and dislocation. From the hard-headed perspective of economic analysis, though, it is interesting to note that the cumulative GDP impact is not that large over the entire period: on the limited metric of real aggregate GDP, the falsely-based gains in the early period roughly match the painful losses in the later period. To quote Paul Krugman, “Economics is not a morality play.” The cumulative aggregate real GDP impact of the Irish debt bubble and debt crisis does not have the “good-guys vs bad-guys” theme that we expect from a well-written morality play.