Patrick Honohan: Good times and bad for a globalised economy -
macroeconomic policy lessons from Ireland
Address by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to The Gilman
Rutihinda Memorial Lecture, Bank of Tanzania, Dar es Salaam, 12 August 2011.
* * *
The lecture draws freely on the output of the Research Project "Turning Globalisation to National Advantage:
Economic Policy Lessons from Ireland's Experience", part-funded by the Irish Council for the Humanities and
Social Scientists and led by Profs Frank Barry, John FitzGerald and Iulia Siedschlag and the author. Thanks to
Eddie Casey, Peter Dunne, Suzanne Linehan, Yvonne McCarthy, Kieran McQuinn and Gerard O'Reilly for
assistance and comments.
The global crisis has left no part of the world unaffected. Tanzania may have weathered the
crisis better than many, but even here an externally-driven credit crunch resulted in a
temporary growth set-back in the period 2008-9. Market turbulence has increased again, but
I do not want to discuss those very current matters today. After all, it is not only the
immediate and direct impact that needs to be considered Arguably more important is to
reflect on the lessons that are to be learnt in terms of how a relatively small economy should
be positioned in regard to global trade and finance in order to survive well from that
experience. In order to learn those lessons, there is no more instructive example than that of
Ireland, albeit a country in a very different state of development to that of Tanzania.
After all, Ireland is one of the most globalized economies in the world, and it consolidated this
position in the period 1986-2007, during which aggregate living standards rapidly converged
to those of the world's leading economies. During that apparently highly successful period
- dubbed the "Celtic Tiger" commentators - ambitious countries at lower levels of per capita
income, such as Tanzania, began more and more to look to Ireland as a potential model
against which to evaluate their own growth strategies.
But Ireland's navigation through the hazards of the emergent global economy hit severe
shoals in 2007-8, since when an acute economic contraction has seen per capita GNP fall
- faster than almost anywhere else - back to the levels of 2000, a return to high net
emigration reflecting job losses and high unemployment, and a loss of access to financial
market access reflecting international financial market concern at the extent of bank losses
and the sustained jump also in other government borrowing.
In the end, while Ireland's engagement with globalization over the past quarter century
cannot be counted a failure, its earlier characterization as a success must now be at least
very heavily qualified. What then are the macroeconomic policy lessons for countries whose
growth ambitions have also been based on a embracing globalization?
In this lecture, I will suggest that policymakers in small open economies need to be
especially alert to the fact that globalization can act to accentuate, accelerate and prolong
macroeconomic trends both in the upswing and the downturn. It's as if globalization acts as a
turbocharger for the small open economy.
Just when things seem to be going very well in many dimensions, you can get into trouble
very quickly and at a time when some of the conventional warning indicators are not flashing.
Rapid and quite protracted growth spurts are possible, based not only on expanding exports
to the vast global market for goods and services, but also on the availability from neighboring
countries or further afield of additional factors of production, whether material inputs, labour
or capital.
I will illustrate the turbocharging phenomenon drawing on the experience of Ireland in the
past two cycles, in both of which serious policy errors were made, allowing an unsustainable
boom to get out of hand. Recovery from the first cycle (in the 1980s) was at first slow, but
then accelerated at an astonishing pace which sowed the seeds of the construction bubble of
the 2000s from the aftermath of which the economy is only now consolidating the early
recovery phase. The lessons are clear: macroeconomic policy in the globalized economy
needs to be even more alert to the dangers of an unsustainable turbocharged boom.
However enjoyable it is while it is in process, the bust - potentially also turbocharged - is
even more painful.
I will also touch on another, not unrelated, globalization-related theme, likely to be even more
relevant to Tanzania, namely the tendency for globalized economies to be structurally
incomplete or "hollowed-out" both in productive capacity (concentration on a limited range of
economic sectors1) and in the repertoire of macro-fiscal and prudential policy tools (as
reliance is increasingly placed on (i) external markets for components or factors of production
and on (ii) external institutions and analyses for the design and in some cases delivery of
policy.) This tendency can feed the turbocharger and restrict the capacity for policy response
to emerging problems.
1. International aspects of the fiscal crisis and recovery of the 1980s
In trade, migration and finance, Ireland had of course been an exceptionally open economy
for a very long time. The large migration flows, especially to the UK and the New World, and
the currency and banking links go back to the early 19th Century at least, with scarcely any
overall interruption. Irish banks parked their excess resources in the London money market
right up to the 1960s - a pattern familiar to many African countries today.
Nor is the current crisis the first (O Grada, 2011) - indeed the potentially turbocharged nature
of the globalized economy is well-illustrated by the rapid recovery from the previous severe
crisis of less than a generation ago, whose onset coincided with the decoupling - for the first
time since just after the Napoleonic Wars - of Ireland's currency from sterling.
The earlier of the two macroeconomic cycles we look at happened at a point where global
capital markets were still just beginning to move into the high gear that we see today. We
may think of this as Turbocharger Mark 1. It allowed the Irish Government to access foreign
capital to some extent without much by way of credit risk premium, but the fear of a sudden
stop of this capital flow brought expansion to an end and resulted in a painful and protracted
recession through the 1980s.
That crisis had its origin in the turbulent macroeconomic years of the 1970s which
themselves saw Ireland make several severe demand management errors which stifled its
capacity to benefit fully from the opportunities offered by EU (EC) membership from 1973.
New opportunities there were, and especially the higher prices for agricultural produce under
the Common Agricultural Policy. But that was not all: EU membership became a major
channel for transmitting globalization to Ireland.
But the expansionist fiscal response to the stagnation of the 1970s created a huge and
spiralling Government and balance of payment deficit which proved difficult to reverse in the
early 1980s. By this stage, membership of the ERM of the European Monetary System had
broken the currency link with sterling, and the Irish pound was prone to being realigned
against the stronger ERM currencies - something that happened about once a year for the
first 8 years of the system.
It is interesting therefore to contemplate how international factors influenced the fiscal
correction of the 1980s. Although exchange controls still existed and indeed had been
applied with respect to the UK for the first time in anticipation of ERM membership and the
end of the sterling link, the borrowing needs of Government began to exceed domestic
financing capacity (as reflected also in the swelling current account balance of payments
deficit Figure 1). With the domestic market being perceived as almost tapped out - with Irish
pound denominated debt having reached 60 per cent of GNP in 1979 - incremental debt in
the early 1980s was increasingly borrowed from abroad to the point where foreign currency
debt rapidly approached 50 per cent of GNP (Figure 2). Holdings by non-residents of Irish
pound-denominated government paper also grew after the devaluation of 1986, reaching
16 per cent of GNP by the end of the decade. By this stage, international market conditions
and the attitude of international investors to the Irish sovereign as well as to the prospects for
the Irish pound were central influences on interest rates and borrowing conditions.
Soaring Irish pound interest rates in the early 1980s reflected each of these uncertainties.
Irish pound interbank interest rates (three-months maturity) returned on average 21⁄2
percentage points over corresponding German rates in the last ten years of the narrow bank
ERM before the ERM crisis. Credit risk at such maturities was arguably very low in those
years, so that most if not all could be accounted for by devaluation risk. For yields at
longerterm the gap was even higher - a regression approach suggests a spread of about 6-7% in
the mid-1980s (Figure 3): but the influence of credit risk over the longer term would not be
negligible. Interestingly, in those days interest rate spreads reflected devaluation risks more
than credit risks.2
The figure shows two sets of data, shown with triangles and squares respectively. The
triangles can be thought of as measuring credit risk; it is the spread of primary market yield
on Irish Government DEM and CHF foreign currency denominated bonds over
similarmaturity Sovereign bonds of Germany and Switzerland respectively (but terms and
conditions of the debt of different issuers may not be fully comparable - possibly explaining
the negative data points). The squares can be thought of as combining credit and currency
risk; it is the secondary market spread on Irish pound Sovereign debt over German and
Swiss Sovereign issues of similar maturity. The regression lines link these spreads to
currency dummies, liquidity (size of issue) and date (linear time trend). (Source: Peter
Dunne, unpublished note).
Nevertheless, that the country was "living beyond its means" was universally acknowledged.
With the surge in global interest rates following the Volcker anti-inflation policy initiatives of
1979-80, and the subsequent surge in the spread of Irish interest rates above those abroad,
the interest cost of servicing the growing debt provided useful dramatizations of the problem
(cf. Figure 4 showing the share of income tax revenue going simply to pay the national debt
interest.) Turbocharger Mark 1 had reached its limit and the tough process of fiscal and
competitiveness adjustment had to be ground out.
Ireland would have done well to resist the temptations of offered foreign loans on the scale
offered, and adhered to conventional rules of thumb for sustainable fiscal policy. By establish
a pattern of spending that required external financing on a scale that would inevitably
become unsustainable, macro policy generated almost a decade of high unemployment,
emigration and rising tax rates.
Descriptions of the Irish fiscal correction often give credit to the adoption of the Maastricht
treaty's deficit and debt criteria for entry into the euro. But this is wrong. Those criteria were
designed and developed too late to have been decisive in this regard. As shown in Figures 1
and 5, the fiscal indicators had come back onto a clearly convergent path long before these
externally-imposed constraints had been adopted in 1992. Even if they may, however, have
continued to provide a new quantitative reference point for fiscal discipline, they were so far
exceeded in the subsequent run-up to euro entry as to make this point of negligible
significance.
General Government measures include local authorities, non-commercial state sponsored
bodies, the National Pensions Reserve Fund (NPRF) and the Social Insurance Fund, whereas
the Exchequer Balance only includes Central Government transactions. The General
Government measure also includes elements of accrual accounting while the Exchequer
Balance is a cash-based measure.
2. The Irish economy's golden age: meeting global demand in the 1990s
The near miraculous turnaround of the Irish fiscal and growth environment in the late 1980s
has been the subject of a considerable amount of research.3 From the present perspective,
what is clear is that it depended heavily on Ireland's globalized status. Without the potential
and actual surge in exports and export-oriented investment, the turbocharged surge of
trendfollowing foreign investment in Irish government paper driving down long-term interest rates
and the easy availability of labour not only from the pool of the unemployed but from the pool
of returnees and other potential migrants from abroad, the Irish economy could not have
moved into the Celtic Tiger phase with barely a hesitation related to the 1992-3 ERM
currency crisis.
In retrospect the mid 1990s can be seen as a macroeconomic "Golden Age" for Ireland
(Honohan and Walsh, 2002). Yet it must not be thought of as an era to which the economy
could even expect to return, or even to have sustained. This was Turbocharging 2.0. The
rapid growth rates represented a catch-up as the economy finally approached the production
frontier by achieving essentially full employment (and with the traditional farming sector no
longer quantitatively significant). The important continuing role played by inward FDI in this
period confirms the ability of the globalization links of the economy to generate a powerful
turbocharging effect. Indeed, the FDI boom helped suck in migrants from non-traditional
sources for the first time, with the share of non-nationals in the total population eventually
reaching a relatively high 13.8% by 2007 - from a position where Ireland had had one of the
mo re ethnically homogeneous societies in Europe (Figure 6).
The heavy reliance in this period on inward FDI provides some evidence of the monocultural
tendencies of the globalized economy. The sectors contributing by far the largest part of the
growing exports and manufacturing output were highly concentrated in a small number of
SITC codes corresponding to subsectors of pharmaceuticals and IT assembly and others
well positioned to take advantage of the special tax environment. This concentration had the
potential to create concentration risks, though these do not seem to have materialized to
date.4
Such was the success of the Irish economy in this period of the 1990s that the former
currency weakness which had characterized the Irish pound in its first 14 years of
independence vanished. Instead, despite the +/-15% margins adopted against other ERM
countries and despite the absence of any explicit or implicit indication of a policy stance, the
Irish pound displayed a degree of nominal and real average exchange rate stability during
the 1993-99 period, with a small appreciation against the DM in preparation for euro
membership in 1998. In contrast to the later period, and to many other country experiences
of rapid growth, currency fluctuations for the Irish pound did not generate a loss of
competitiveness in this period.
By the late 1990s, though, the economy began to slip out of balance, in a way which was
largely home-grown, though some foreign shock factors did continue. Fiscal policy became
rather more procyclical; the dependence on volatile or insecure taxes increased, as
centralized wage settlements continued to be bought by income tax concessions. The
external shock of euro membership lowered nominal and real interest rates by removing the
exchange risk premium which had persisted since the early 1980s - albeit on a reduced
scale. The sense that lower interest rates could be projected for the indefinite future
rationalized a willingness to pay more for one's home. The seeds of the property bubble had
been sown.
3. The economy over-inflated by foreign credit 2000-2007
As Ireland joined the monetary union in 1999, its status among the most globalized
economies in the world was confirmed. In the following years, its finances would be
submerged in those of the euro area - with international flows often not even being
separately measured and assessed as attention focussed on the euro area as a whole. The
idea that much of macro policy had been largely outsourced to the European Central Bank
took hold in policy circles. A sizable fragmentation of policy thereby occurred: domestic
policymakers no longer took full ownership of macro issues. Finance Minister McCreevy's
stated views about fiscal policy ("when I have it I spend it") disavowed any stabilization role
for fiscal policy.5
Interest rates were now fully imported from the rest of the euro area (as had been the case
with sterling before 1979). After years of relatively high nominal and real interest rates, the
new regime lowered the cost and enhanced the availability of credit to Irish borrowers. Not
surprisingly, the change resulted in an expansion of the most credit-dependent sector,
house-building and property development.
The story of the property price and construction boom that ensued (it began around 1997 in
anticipation of the monetary changes) has been often told (cf. for example Honohan, 2009;
Whelan, 2011). Here it is most relevant to emphasize the globalization dimension. Not only
did Ireland import a huge volume of funds through the banking system, but it also imported a
newly relaxed approach to the prudential supervision of mortgage lending. The scale to
which the Irish credit bubble eventually grew was also certainly facilitated by the absence of
exchange rate risk. Together with another key element of globalization: the absence of any
fear of exchange controls, this ensured the fuel for a turbocharged monocultural expansion of
the Irish economy (call it Turbocharger 3.0) at a time when its previous, somewhat more
broadly-based and certainly more sustainable, export driven growth was naturally slowing.
The result was a world-beating construction and property price bubble - barely interrupted by
the global downturn of 2001-2 (see Figure 7). Economic growth became dominated by the
new monoculture of construction, growing as it did to employ directly in construction over
13 per cent of those at work.

Although Ireland could expect to import medium term inflation rates in line with the rest of the
euro area, the external weakness of the euro in its early years, combined with the booming
national economy meant that inflation in Ireland soared to an annual rate as high as 7 per
cent briefly. Once again, the outsourcing of anti-inflation policy meant that such an outturn
did not result in an aggressive domestic policy response, and in 2004 the EU Commission
launched an excessive deficit procedure against Ireland, reflecting the fact that budgetary
policy had even relaxed in the face of booming domestic demand conditions.
The current account of the balance of payments remained surprisingly moderate during the
boom. This reflected in part the continued strong export performance of the remainder of the
economy, and the fact that a large segment of the funds borrowed from abroad by the banks
was ploughed back into foreign property investment by the banks' borrowers, large and
small.
Without the construction boom fuelled by credit sourced from abroad by the banks, the
economy would doubtless have grown more slowly in the 2000s. But the underperformance
after 2007 more than offsets the gains of the property bubble-driven growth. The 2008-9
recession would have been less severe, and the recovery from 2010 would not have been
weighed down by the overhang of indebtedness.
The post-Lehmans global contraction certainly provided a dramatic illustration of exposure to
external shocks. By that time, however, the globalization turbocharger was already working
in reverse as Anglo and other banks struggled to refinance their foreign borrowings. Indeed,
a partial decoupling of the globalized economy was under way as money markets began to
fragment and the limitations of the monetary integration in Europe became evident.
4. Concluding remarks
Ireland's increasing globalization in the 1980s and 1990s both helped lift the economy from
decades of under-performance and demonstrated its new ability to generate full employment
and compete effectively at the production frontier. One aspect of this was the intimate
engagement with the European Union since membership in 1973 had helped enrich
administrative and political capacity as well as resulting in a vital flow of development funding
through the structural funds especially from the late-1980s to the end of the millennium. By
then the wider forces of globalization had begun to act as a kind of turbo-charger for the
economy, amplifying the competitive, export-led growth period and the subsequent
residential construction and property price boom. This helped achieve rapid living standards
convergence through the attainment of full employment, but also fuelled an overshoot which
could not be managed down given the debt vulnerabilities which had accumulated and which
proved unsustainable through the global crisis.
International convergence of economic and regulatory policies towards liberalization and
light-touch, unfortunately embraced also by Ireland (Honohan et al., 2011), and ridiculously
easy availability of credit from abroad (eventually helped by the removal of exchange rate
risk across the euro area) were key factors in the international environment that masked the
vulnerabilities associated with the emergence of evident imbalances in the trend towards a
construction monoculture: extreme house price inflation, a skewed revenue base for the
Government accounts and a seemingly inexorable erosion of wage competitiveness.
A score-card on the role of globalization in the latest downturn shows a more mixed picture.
Despite the fact that international trade was badly hit worldwide in the macro-shock of late
2008, Irish exports held up well and provided a stabilizing force in the evolution of aggregate
demand both in that downturn and in the subsequent couple of years. The severe contraction
in the numbers at work was somewhat mitigated by the continued availability of jobs abroad,
both for recent immigrants who wished to return to their place of origin and others who sadly
resumed the historical pattern of seeking employment opportunities abroad when few were
available at home.
The eurosystem has also picked up the pieces on the downside: stepping-in to fund the
liquidity deficit as the excessive bank borrowings from the global financial system drained out
when markets lost confidence in the Irish Government's capacity to both bring its regular
deficit under control and pay for the mounting losses of the banking system.
Globalization is a powerful transmitter of economic conditions and know-how, facilitating
convergence of living standards. It can also act as a buffer against specific national shocks.
But, amplified by globalization, the danger of the anonymous market overshooting is
considerable. National governments can be powerless against consequences of such
overshooting. Greater explicit mechanisms of external discipline and co-insurance at the
supranational level can help cope with these risks. For Ireland, the European Union already
goes some distance in this direction, but more is needed. Regional initiatives in Africa,
including the NEPAD of the African Union and the East African Community are presumably
best positioned to perform this function in relation to Tanzania.
Like Ireland, Tanzania too has the potential to reap the macroeconomic advantages of
globalization to speed convergence towards better living standards and poverty reduction.
But policymakers will want to be on their guard against the risks of being turbocharged into
unsustainable spending patterns.