This FT article reports an interesting development in Latvian policy, where the interplay with foreign-owned banks and currency policy are important features.
Category: EMU
Today Thomas Conefrey and myself publish a working paper entitled “Managing Housing Bubbles in Regional Economies under EMU: Ireland and Spain”. It is available here .
With the advent of EMU, monetary policy can no longer be used to prevent housing market bubbles in regional economies such as Ireland or Spain. However, fiscal policy can and should be used to achieve the same effect. This paper shows that the advent of EMU relaxed existing financial constraints in Ireland and Spain, allowing a more rapid expansion of the housing stock in those countries to meet their specific demographic circumstances. However, the failure to prevent these booms turning into bubbles did lasting damage to the two economies, damage that could have been avoided by more appropriate fiscal policy action.
The failure to tighten fiscal policy in Spain and Ireland in the early years of this decade laid the ground for the housing market bubbles in the two economies. The Stability and Growth Pact proved a distraction: government budgetary balance was not an appropriate fiscal target for those two economies. By contrast, Finland, having learned from its mistakes twenty years ago, ran substantial government surpluses to prevent domestic overheating. Specifically in relation to overheating in the housing market, we consider that a temporary tax on mortgage interest payments (first suggested in 2001) should have been used to target overinvestment in housing, investment which seriously crowded out the traded sector of both economies. This tax would have mimicked an increase in interest rates. Obviously it will be a very long time before such a tax might be needed in either Spain or Ireland to limit overinvestment in housing.
The paper shows that demographic circumstances in both Spain and Ireland meant that it was appropriate that investment in housing in those two economies should have been somewhat higher than in their neighbours. Even after the housing bubbles have burst, the relatively low endowment of housing infrastructure in the two economies (relative to adult population) means that there will be a need for additional investment in the next decade, when the current excess supply has been worked off.
In the paper we also include a graph taken from our paper “Recovery Scenarios for Ireland” published in May which, inter alia, considered likely housing demand over the coming decade. Our model included estimated 2009 population numbers which were quite close to the latest estimates published by the CSO. We assume that between 2009 and 2015 there will be cumulative net emigration of up to 120,000. Our analysis would suggest that the underlying population increase would lead to somewhat higher demand for housing than Brendan Walsh has estimated in a recent post for the period to 2015. In addition to the pure “demographic” effect we also factor in some increase in headship on the basis of the recent rise in the number of households, which possibly reflects falling rents.
The ECB has just released the book version of its 2008 Central Banking Conference, with the theme of ‘ten years of the euro.’ It includes a range of interesting papers and discussions, plus a contribution by myself on ‘EMU and Financial Integration.’ You can download the book here.
David Begg criticises the ‘deflationary’ strategy in an article in today’s Irish Times (you can read it here). In reading this article, it is helpful to remember that the term deflation requires subtle interpretation for a member of a monetary union. In particular, the main substantive issue is whether real devaluation is a necessary part of a recovery strategy, where real devaluation means a decline in relative wages and prices in Ireland relative to our trading partners. For a low-inflation monetary union, an individual member country may require a temporary period of deflation in order to attain a significant real devaluation.
David Begg argues that there is little evidence that deflation facilitates recovery. However, there is a strong body of evidence that real devaluation is helpful. Just taking Irish economic history, the devaluations of 1986 and 1993 were contributory factors to economic growth.
It is certainly true that the global recession means that the level of external demand is low. It is also true that the re-orientation of spending in the world economy towards Asia and away from the United States does not help Ireland, given the nature of trading patterns. However, these external factors simply underline the scale of the negative shock that Ireland is enduring.
It is also true that high levels of household debt means that deflation carries an extra cost in terms of raising the real burden of debt repayments. However, the single biggest risk factor in debt repayment is unemployment and a strategy that minimises the growth in unemployment through the restoration of competitiveness dominates.
The real question is whether there is a credible alternative. If Ireland had run a counter-cyclical fiscal policy during the good years, there may have been room to do more in terms of counter-cyclical fiscal expansion now. However, the scale of the fiscal deficits and the fragile state of international bond markets mean that significant fiscal expansion cannot be entertained.
Rather, the focus has to be on restoring international competitiveness through real devaluation (plus other measures to fight monopoly power in the economy and improve productivity). This will stimulate not only the export sector but also the domestic nontraded sector, since the level of domestic consumption will be boosted if Ireland can establish a sustainable growth path. In relation to the export sector, the gain will not only be in terms of the performance of existing sectors and firms but also in relation to the ‘extensive margin’ (new firms exporting for the first time, sectors emerging as internationally competitive). In turn, suppliers of domestic services to these firms will gain, such that the employment impact will be wider than just the export sector itself.
The European Commission has released its 2009 report on Public Finances in EMU: you can get a summary (plus a link to the full document) here.