Ireland is one of the world’s great economic success stories of the past half-century, which makes this week’s finalization of an 85 billion euro bailout seem somewhat odd. But the constellation of factors that have allowed the average Irishman to become richer than the average Londoner (approximately $62,000 against $56,000 per capita at the peak in 2008) is changing. Now, Dublin must choose between an outside chance of maintaining its wealth versus having control over its own affairs.
Nearly every country needs three things if it is to be economically successful: relatively dense population centres to achieve economies of scale, some sort of advantage in physical resources to fuel development, and ample navigable waterways and natural ports to achieve cost efficiency in transport that over time leads to capital generation. Ireland has none of these. As a result, it never has been able to generate its own capital, and the costs of developing infrastructure to link its lightly populated lands often have proved crushing. The result has been centuries of poverty, waves of emigration, and ultimately subjection to the political control of foreign powers, most notably England.
That began to change in 1973. That year, Ireland joined the European Economic Community, which would one day become the European Union, and received two boons it had lacked: a new source of investment capital in the form of development aid, and guaranteed market access. The former allowed Ireland to build the roads and ports necessary to achieve economic growth, and the latter gave it — for the first time — a chance to earn its own capital.
In time, two other factors reinforced the benefits of 1973. First, Americans began to leverage Ireland’s geographic position as a midpoint between their country and the European market. Ireland’s English speakers, rock-bottom labour costs and declining corporate tax rates proved ideal for U.S. firms looking to deal with Europe on something other than wholly European terms. Second, the European common currency — the euro — put rocket fuel into the Irish gas tank once the country joined the eurozone in 1999. A country’s interest rates, one of the broadest representations of its cost of credit, are reflective of a number of factors: market size, indigenous capital-generation capacity, political risk and so on. For a country like Ireland, interest rates traditionally had held above 10 per cent, and regularly breached 15 per cent in the years before EU membership. But the euro brought Ireland into the same monetary grouping as the core European states of France, Germany and the Netherlands. By being allowed to swim in the same capital pool, Ireland could now tap markets at rates in the 4-6 percentage point range. (At present, European rates stand at a mere 1.0 per cent).
These two influxes of capital, juxtaposed against the other advantages of association with Europe, provided Ireland with a wealth of capital access it had never before known, and the Irish made the most of it. The result was economic growth on a scale it had never known. In the 40 years before EU membership, annual growth in Ireland averaged 3.2 per cent. That growth rate picked up to 4.7 per cent in the years after membership, and 5.9 per cent after the Irish were admitted into the eurozone in 1999.
There was, however, a downside to all this growth. The Irish had never been capital-rich, so they had never developed a robust banking sector. Just five institutions handle 60 per cent of domestic banking in Ireland. As such, Ireland lacked a deep reservoir of experience in dealing with the ebb and flow of foreign financial capital. When the credit boom of the 2000s arrived, these five banks acted as one would expect: They gorged themselves, and in turn the Irish were inundated with cheap mortgages and credit cards. The result was a massive consumption and development boom, particularly in residential housing, unprecedented in Ireland’s long and often painful history. Combine a small population and limited infrastructure with massive inflows of cheap loans, and real estate speculation and skyrocketing property prices ensue.
By the time the bubble popped in 2008, Irish real estate in relative terms had increased in value three times as much as the American housing bubble. In fact, it is even worse than it sounds. Fully half of outstanding mortgages were extended in the peak years of 2006-2008, a time when Ireland became famous in the annals of subprime for extending 105 per cent mortgages with no money down. Demand was strong, underwriting was weak, and loans were made for properties whose prices were wholly unrealistic.
The massive surge in lending activity put Ireland’s once-sleepy financial sector into overdrive. By the time the 2008 crash arrived, the financial sector held assets worth some 760 billion euros, about 420 per cent of gross domestic product (GDP) (about half again as much as the European average), and overall the sector accounted for nearly 11 per cent of Irish GDP generation (about twice the European average), and is only exceeded in the eurozone by the banking centre of Luxembourg.
Of those banking assets, sufficient volumes have already been declared moribund to require some 68 billion euros in asset transfers and recapitalization efforts (roughly 38 per cent of GDP). STRATFOR sources in the financial sector already have pegged 35 billion euros as the midcase amount of assets that will be total losses (roughly 19 per cent of GDP). It is worth noting that all these figures actually have risen in relative terms as the Irish economy has shrunk by an annualized average of 4.1 per cent ever since the peak, making it only about nine-tenths the size it was at the peak. In comparison, the U.S. economy shrank by “only” 3.1 per cent overall during the recession, and recovered to its pre-recession peak in early 2010.
So long as the financial sector is burdened by these questionable assets, the banks will not be able to make many new loans. (They must reserve their capital to write off the bad assets they already hold). In hopes of rejuvenating at least some of the banking sector, the Irish government has forced banks to transfer some of their bad assets — at relatively sharp losses — to the National Asset Management Agency (NAMA), a sort of holding company the government plans to use to sequester bad assets until they return to their once-lofty prices. But considering that, on average, Irish property values have plunged 40 per cent in the past 30 months, the government estimates that the break-even point on most assets will not be reached until 2020 — assuming they ever do.
Because Ireland’s banking sector is so large for a country of its size, there is little that the state can do to speed things up. In 2008 the government guaranteed all bank deposits in order to short-circuit a financial rout. This decision was widely lauded at the time for stemming general panic, but now the state is on the hook for the financial problems of its oversized domestic banking sector. And this is why Ireland’s budget deficit in 2010 after the year’s bank recapitalization efforts are included stood at an astounding 33 per cent of GDP, and why Dublin has been forced to accept a bailout package from its eurozone partners that is nearly another 50 per cent of GDP. To put this into context, the American bank bailout of 2008-2009 amounted to approximately 5 per cent of GDP, all of which was U.S.-government funded.
European banks — all of them — have stopped lending to the Irish financial institutions as their creditworthiness is perceived as nonexistent. Only the European Central Bank, through its emergency liquidity facility, is providing the credit necessary for the Irish banks even to pretend to be functional institutions — 130 billion euros by the latest measure. All but one of Ireland’s major domestic banks have been de facto nationalized, and two already have been slated for closure. In essence, this is the end of the Irish domestic banking sector. Simply to hold its place, the Irish government will be drowning in debt until these problems have been digested. Again, the time frame looks to be about a decade.
The Road From Here
A lack of Irish-owned financial institutions does not necessarily preclude economic growth or banks in Ireland. Already, foreign institutions operate more than half of the Irish financial sector, largely banks that manage the fund flows into and out of Ireland to the United States and Europe. This portion of the Irish system — the portion that empowered the solid foreign-driven growth of the past generation — is more or less on sound footing. In fact, STRATFOR would expect it to grow. Ireland’s success in serving as a throughput destination had pushed wages to uncompetitive levels, so somewhat ironically, the crisis has helped Ireland re-ground on labour costs. As part of the government-mandated austerity measures, the Irish already have swallowed a 20 per cent pay cut to help pay for their banking problems. This has helped keep Ireland competitive in the world of trans-Atlantic trade. To do otherwise would only encourage Americans to shift their European footprint to the United Kingdom, the other English-speaking country in the European Union but not on the mainland.
But while growth is possible, Ireland now faces three complications. First, without a domestic banking sector, Irish economic growth simply will not be as robust. Foreign banks will expand their presence to service the Irish domestic market, but they will always see Ireland for what it is: a small island state of 4.5 million people that is not linked into the first-class transport networks of Europe. It will always be a sideshow to their main business, and as such the cost of capital will once again be considerably higher in Ireland than on the Continent, consequently dampening domestic activity even further.
Second, even that level of involvement comes at a cost. Ireland is now hostage to foreign proclivities.
- Ireland needs the Americans for investment, and so Dublin must keep labour and tax costs low to keep the Americans interested, but not so low as to endanger income it needs to service is newfound debt mountain. Ireland also dares not leave the eurozone, if it did the Americans would just use the United Kingdom as their springboard into Europe, despite the fact that leaving the eurozone would allow them more flexibility in dealing with their euro-denominated debt.
- Ireland needs the European Union and the International Monetary Fund (IMF) to fund both the bank bailout and emergency government spending, making Dublin beholden to the dictates of both organisations despite the implications that could have on the tax policy that attracts the Americans.
- Ireland needs European banks’ willingness to engage in residential and commercial lending to Irish customers, so Dublin cannot renege upon its commitments either to investors or depositors despite how tempting it is to simply default and start over. So far in this crisis these interests — American corporate, European institutional and financial — have not clashed. But it does not take a particularly creative mind to foresee circumstances where the French argue with banks, the Americans with the Germans, the labour unions with the IMF or Brussels, or — dare we say — London, one of the funders of the bailout, with Dublin. The entire plan for recovery is predicated on the intentional surrender to a balance of foreign interests over which Ireland has negligible influence. But then again, the alternative is a return to the near-destitution of Irish history in the centuries before 1973. Tough call.
Third and finally, even if this all works, and even if these interests all stay out of conflict with each other, Ireland still has much in common with maquiladoras, the foreign-owned factories in Mexico at which imported parts are assembled by lower-paid workers into products for export. Not many goods are made for Ireland. Instead, Ireland is a manufacturing springboard for European companies going to North America and North American companies going to Europe. And this means that Ireland needs not just European trade, but specifically American-European trans-Atlantic trade to be robust for its long-shot plan to work. Considering the general economic malaise in Europe, and the slow pace of the recovery in the United States, it should come as no surprise that the Irish economy has already shrunk by about a tenth since the peak just two and a half years ago.
For Business Insider’s exclusive Pipeline deal on STRATFOR subscriptions (50% off), click here.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.