Patrick Honohan: The impact of the boom and bust on the capital of
households in Ireland
Response by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to the
presentation by M Thomas Piketty, at the Think-tank for Action on Social Change (TASC)
Conference "The Challenge of Economic Inequality to Recovery and Wellbeing", Dublin,
20 June 2014.
* * *
Introduction
For me, a long-time admirer of Thomas Piketty's work and a first-day-of-issue purchaser of
Capital in the 21st Century (Piketty, 2014) there is much to enjoy and admire in this work,
focusing as it does, not only on the distribution of income at a point in time, but in particular
on the evolution of wealth or capital holdings over time, a topic neglected to a surprising
degree in most analysis of economic statistics.
I especially like the historical sweep including the well-detailed comparison and contrast of
the late 19th Century "gilded age" with the more recent "age of financialisation". (We didn't
have much of a "gilded age" in Ireland, but we did have "financialisation" with a vengeance
cf. O Riain, 2014).
I also was intrigued by the documentation of the destruction of wealth - and of wealth
concentration - by war and depression in mid-20th century. (Resonances also here to
Ireland's current experience).
I appreciate the matter-of-fact concern with inequality - especially wealth inequality: I differ
from those commentators who do not see the obvious policy relevance of these matters.
And I like the handling of the contrasting roles of inheritance and accretion through
investment earnings versus "earned income" in generating wealth inequalities.
Finally, as someone who studied macroeconomic dynamics in graduate school, I was very
struck by the neglected relevance of the r - g dynamic (i.e. the dominance and concentration
wealth will grow in the economy if the average rate of return on capital continues to exceed
the rate of growth of economic activity) for interpreting and predicting trends in the
concentration of wealth.
I have to disappoint anyone expecting a "however" at this stage, because (while such an
ambitious book will continue to prompt many debates and questions) for me it is a tour de
force.
Although much of the commentary around Piketty's book has centred on his forward-looking
analysis of the prospects for the size distribution of worldwide wealth in the decades ahead,
other parts have greater immediate resonance for us here in Ireland. I am thinking
specifically about the way in which many of the long data series in Capital show a
pronounced decline in the mid-20th Century. Related to two world wars and the Great
Depression which separated them, as well, perhaps, as to the rise of the "Welfare State",
these collapses occurred both in terms of the aggregate wealth-to-income ratio and to the
concentration of wealth at the top end of the distribution.
If Capital convinces of anything, it surely establishes that looking at major historical
transitions through the lens of data on wealth is very instructive. We also have had disruptive
events in Ireland in the past decade somewhat comparable to the mid-century capital and
wealth collapses in Europe documented by Piketty. As well as tipping the economy into a
deep recession, triggering a surge in unemployment and emigration and crippling the public
finances, our crisis has been associated with large losses in household capital and increases
in indebtedness causing distress. These latter aspects have been the focus of a lot of work at
the Central Bank in the past few years as we have used the limited powers at our disposal
and sought to provide advice to Government to map the best available route to recovery.
Data on the distributional impact of recent economic developments in Ireland
Capital in the 21st Century shows the value of comprehensive data to understand trends in
capital and debt. So, seen through such a data lens, how does the recent boom-and-bust
experience of Ireland compare? Do we have the data? Well, for aggregate household wealth
and indebtedness we do have many of the most important elements (Cf. Cussen and Phelan,
2010, 2011, Cussen, O'Leary and Smith, 2012),1 and I will speak about those aggregate
numbers in a few minutes.
But for how that wealth and indebtedness is distributed, much less is known. To be sure,
systematic collection of income inequality and poverty data in Ireland has been well
established since the 1980s and is carried forward notably in the CSO's SILC survey. The
share of the top few percent of the income distribution has also been tracked over a long
period of time in Ireland, and that data (Nolan, 2007) is part of the World Top incomes
database employed by Piketty.
Using this and other sources there has been extensive work to understand the impact of the
boom and bust on income distribution (cf. McGinnity et al. 2013) on the distribution of labour
market effects of the bust (ibid.), on the distribution of economic stress and material
deprivation (Maître, Russell and Whelan, 2014) and on mortgage distress (McCarthy and
McQuinn, 2011). The question of mortgage distress has indeed been the subject of a large
body of data-intensive analysis at the Central Bank, much of it published (cf. Kennedy and
McIndoe, 2012).
The literature also has emphasised the role of the state in influencing the distributional
impact on disposable income through tax and social welfare policy (Callan et al., 2013;
Maître and Watson, 2013).2
So we do know a lot about changes in living standards, loan servicing and economic stress
resulting from the crisis. But the somewhat different dimension which Piketty has
emphasised relates to assets and liabilities as distinct from income and expenditure - to
stocks as distinct from flows: here we do have aggregate data, but little on its distribution.
We would like to have, as indeed Piketty includes in his book for many other countries and
over a long time period, the size distribution of household wealth. In addition it would be
valuable for the purposes of Government policy to know about the distribution of the different
elements of household wealth as between different income deciles, age categories, social
class, educational attainment, occupational category or economic sector.
But for Ireland, apart from the early work at the ESRI (Nolan, 1991; Honohan and Nolan,
1993), no really systematic nationally representative survey of the distribution of wealth has
been published. There are, of course, various partial analyses, for example the wealth data
from the TILDA survey of older people recently analysed by O'Sullivan and Layte (2011) and
O'Sullivan, Nolan, Barrett and Dooley (2014), and the small 2012 Central Bank household
survey focused on indebtedness (McCarthy, 2014; McCarthy and McQuinn, 2014).
Happily, we will soon know more about the distribution of assets and liabilities of households,
with the data cleaning phase now nearing completion from the Household Finance and
Consumption Survey (HFCS), which was conducted for Ireland for the first time in 2013 by
the Central Bank and the CSO.3
This means that, when it comes to discussion of wealth distribution, we will not have the
luxury of data-free speculation for much longer. So let me hasten to indulge myself!
How did the main components of wealth change in Ireland in the boom and bust?
The financial crisis had a dramatic effect on net worth of households in Ireland...as had the
prior boom. As shown in the figure, measured aggregate household net worth peaked in
Ireland in mid-2007 at €719 billion, up almost €300 billion from five years before. Just five
years later, in mid-2012, it had fallen back to its mid-2002 level. From that trough there has
since been a small net increase again.4 (I will not touch on the assets and liabilities of the
corporate sector, an area which is greatly complicated by the large presence of multinational
corporations; I think that omission does not much distort what I have to say.)
Figure: Main components of household and Government net
worth, 2002, 07, 12 and 13
(€ bn. Source for Household: Cussen and Phelan, 2010 and updated by those
authors; for Government: net financial assets from Central Bank Quarterly
Financial Accounts.)
Households saved throughout this decade, and this tended to increase net worth. But the
up-and-down swing in measured net worth was primarily related to changes in the price of
land and housing.5
The value of housing assets grew much more quickly than household net worth between
2002 and 2007; this was accompanied by a rapid increase in aggregate household debt.
Indeed, by 2007 aggregate household debt represented the third highest ratio to disposable
income among 24 European countries for which data is available (Cussen, O'Leary and
Smith, 2012). The increase in household debt 2002-7 was about the same as the increase in
aggregate household financial assets. But of course this would not be true of individual
households: distribution matters. When the price of property fell back, the debt remained.
The two factors which have transformed what might seem a rather benign valuation blip into
a crippling debt crisis are, of course (i) the distribution issue, namely the fact that different
households were affected in dramatically different ways, depending mainly on whether they
had borrowed to buy over-priced property and (ii) the fact that the Government's net debt
position has also deteriorated by about €150 bn since 2007: a third of it attributable to the
bail-out of bank creditors6 and the rest resulting from the borrowing undertaken, especially
from official sources, in the course of smoothing the transition to restoring budgetary
balance.7
If everyone's assets and liabilities had been affected in the same way, then the return of net
assets to their 2002 level might have seemed relatively painless. But the modest net change
in aggregate household net worth between 2002 and 2012 should not mask an increase in
aggregate indebtedness of over €100 bn. Not everyone borrowed. But for most of those who
did at the height of the price bubble, the devastating effect on their net worth of the
subsequent price fall is the most significant wealth outcome of the crisis. It has sent net worth
into negative territory for many, especially before taking account of future earning potential
(sometimes known as "human capital" in wealth analyses). Current and future earnings have
also been damaged by unemployment.8 Migration flows are also a factor.
The whole size distribution of net wealth moved to the left: pushing those at the bottom into
very negative positions.
While I cannot prove it, I think we may take it (based on what evidence we have) that there
has also been a widening of inequality within the wealth distribution (using conventional
measures of inequality) since the beginning of the millennium.
Furthermore, the churn within the distribution has been substantial. Clearly many people who
had become rich lost all of their gains. Other rich people were relatively unaffected. But the
sizable group which incurred heavy debts to acquire property close to the top of the market
have seen their net worth (even if modest to begin with) wiped out entirely. It's not just a
question of analysing the relative impact of the bust on those who were rich before the boom
versus those who were poor before the boom. Also striking is, for instance, the fact that the
loss of net worth was concentrated mainly on those who borrowed in mid-century.9 This
group was in turn concentrated in the age group 30-45, as is confirmed, for example, by the
data of Duffy and O'Hanlon (2013).
While, as Piketty's account well illustrates, many factors alter the net worth of different
households over time - poor investment decisions; adverse shocks of one sort or another -
this large movement strongly affecting a sizable fraction of society in a short period of time
represents a huge shift in the distribution of household worth, as well as an overall widening
of wealth inequality. It constantly provokes the question: "what more, if anything, can or
should Government policy do about this to alleviate the resulting stress?"
What can or should Government do?
In my experience, this question is inclined to elicit a wide range of responses displaying a
wide range of fundamentally different approaches to questions of ownership and debt. There
are, on the one hand, what may be called "contract fundamentalists" who disregard the
extreme nature of the crisis that has occurred. On the one hand there are those who attach
little importance to conventional principles of ownership and private property.
In practice - and this is part of the underlying mid-20th Century story shown by Piketty for
Europe - sudden and major debt crises on this scale around the world have often been
accompanied by a surge of inflation and currency depreciation. Such surges have had the
effect of lowering the real burden of indebtedness and passing some of the real losses to the
holders of monetary assets. Unanticipated inflation is a crude mechanism of redistribution,
though, and typically results in output costs in subsequent years as monetary authorities
struggle to bring it back under control. In any event, it is not an option for Ireland.
Because it too reached the limit of its debt capacity (for the reasons mentioned above), the
Government has little room left for policies involving net additional spending, so in practice it
is limited to broadly cost-neutral adjustments to tax and spending. Along with this limited
capacity, there has been little appetite for a transfer from taxpayers to those indebted
households who can still afford to service their debts.
Personal insolvency legislation has, however, been modernised and streamlined, offering
viable options for over-indebted borrowers. Ideally, though, lenders should be, and
increasingly are, negotiating more favourable arrangements than bankruptcy that restore
borrowers to a sustainable position, while husbanding (as is their responsibility) the capital of
the bank and avoiding unwarranted losses from concessions to borrowers that can afford to
pay - concessions that would largely fall on the banking system's largest shareholder, the
State. I need hardly recall that walking this tightrope has been a very slow process.
Some home-owners have seen their income situation deteriorate to the point where they can
no longer afford to service the mortgage debt. Fortunately, the number of involuntary
owneroccupier repossessions has so far remained low: given the sharp fall in property prices
between 2007 and 2012, it can make sense for lenders to avoid repossession even for a
homeowner who can no longer fully service the original debt.
Banks have been pressured by the Central Bank, within the limitations of prudential
regulation and their constitutional property rights, to accelerate the conclusion of sustainable
loan modification solutions where the existing contracts are no longer viable. Gradually - too
gradually - we are seeing progress on this front. Banks are obliged to comply with the
Central Bank's code of conduct on mortgage arrears in arriving at sustainable solutions in a
fair and transparent way. This remains a focus of our close attention at the Central Bank.
Indeed, we have examined many options in the attempt to accelerate the process of
achieving a return to sustainability.
Could a one-size-fits-all debt modification scheme be devised to deliver wholesale loan
modifications speedily for unaffordable debt? Despite our best efforts at the Central Bank, we
have had to conclude that no blanket scheme can be devised that would be both viable and
effective in current circumstances. No workable schemes have been devised that do a good
job at hitting the target of those who really need assistance; and blanket schemes would be
extremely costly for the State (over and above the large injections which it has already made
into the banks). Unfortunately, then, this work has not displayed a way forward.
To the extent that the lenders do not provide adequate workouts for unaffordable debt, it falls
on the personal insolvency legislation to deal with this problem. The recent great
liberalisation of this legislation was badly needed and it provides a benchmark context
against which lenders must negotiate workouts. Is it enough? Clearly things are working
slowly and too many creditors still adopt a "Victorian" approach to debt modification where
the borrower cannot pay. On the other hand those debtors who can pay are beginning to
realise that the State is not likely to impose on the rest of society the costs of investments
gone wrong for those who can afford to take the losses.
The question of how best to deal with the overhang of household debt generated by the crisis
has been extremely fraught. It involves political as well as technical decisions and judgment.
The role of the Central Bank relates solely to the technical and here I hope we have provided
advice that has helped maximise the overall room (in terms of aggregate economic
resources available) for national political choices. We have contemplated many alternative
approaches: While few people can be fully satisfied with the outcome to date, there do not
seem to be any better paths.
Discussions about the distribution of household assets and liabilities has rightly focused on
those with little or no net wealth, and also on middle-income householders who borrowed
more than they can afford to acquire over-priced property. Still, there are also important
questions about the wider economic impact of changes in wealth higher up the scale. Many
Irish families of moderate wealth also saw their capital shrink dramatically in the crisis as
property investments made in the boom, and inherited bank equity investments, lost value.
Given the traditional importance of family funds in underpinning start-up finance of small
firms, will this loss of wealth have an adverse effect on investment by small firms now and in
the coming years? Are alternative financing mechanisms, including those being put in place
by Government, going to be enough to fill this gap?
Concluding remarks
Before closing, I need to emphasise that today's discussion of assets and liabilities,
prompted by Thomas Piketty's work, should not allow us to neglect the other ways in which
the crisis has had a severe effect - for example, through loss of employment or reduction of
social benefits, to mention just the financial costs - on many households too far down the
income scale to have accumulated any significant net assets. Indeed, some of the affected
persons have emigrated and no longer show up in the national statistics.
As for the future, how important Piketty's r - g dynamic will be in coming years in Ireland is
hard to know. Certainly for r the return on bank deposits will remain low for the period ahead,
and some of the bounce-back value of Irish property and business assets will accrue to the
foreign buyers so much in evidence. The context for g of this will, of course, be the growth
recovery in the European Union and the euro area, underpinning employment and income
growth in Ireland itself.
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