Thank you very much, Mr. Chairman. It is a real pleasure to be here in Dublin and an honour to have been invited to appear before this committee and its inquiry into the banking crisis. I have prepared quite a comprehensive statement. I will go through that because it sets out the framework for what the European Commission did at the time and how it read the challenges of the Irish economy before the crisis.
I have been asked to deliver a statement on the role of the European Commission in the Irish economy in the years prior to the crisis. I will structure my statement in two parts. The first part will focus on the economic development in the run up to the crisis, both international and domestic. In the second part, I will review the role of the European Commission in economic surveillance at that time.
When analysing economic growth in Ireland before the banking crisis, it is useful to distinguish two different periods, from the early 1990s until 2000, and from about 2001 until the bursting of the housing bubble in 2007. The first period is often referred to as the Celtic tiger period. It was a period of extraordinarily strong growth. The annual increase in real GDP averaged 7.2% as opposed to just above 2% in the euro area. As a result there was an impressive and unprecedented convergence in living standards. In 1990 gross national income per person stood at around 60% of the euro area average; ten years later it was already above the Euro area average. In the 1990s economic growth was led by exports. Ireland was able to take advantage of the single European market and globalisation. It raised exports in high value sectors such as computers and pharmaceuticals. Thanks to a flexible and English-speaking economy, Ireland attracted significant FDI inflows which boosted productivity growth and enhanced competitiveness. The current account recorded an average surplus of 1.6% in the 1990s. During this period employment growth was brisk with minimal wage pressure since unemployment was relatively high, female participation in the labour force low, and net inward migration flows increased the labour force. The unemployment rate fell from 13.4% in 1990 to 5.6% in 1999. Fiscal adjustment taken in the late 1980s to tackle the very high stock of public debts supported this expansion. Government spending restraint and salary agreements also underpinned wage moderation.
In the 1990s inflation was low, on average 2.3%, close to the average record in the Euro area as a whole. General Government debt fell by half to around 47% of GDP. The year 2000 marked the end of the ICT boom which had pushed growth rates in Europe and the US close to 4%.
By then, Ireland's real economic growth was close to 10%, wages were rising by more than 13% and annual inflation exceeded 5%. From about this point until the onset of the Irish banking crisis there was a striking shift in the Irish economy. The overall growth momentum remained strong, but became largely reliant on domestic demand. Between 2001 and 2007, real GDP growth averaged 5%, as opposed to close to 2% in the euro area. Average inflation increased to above 3%, while it stayed slightly above 2% in the euro area as a whole. Ireland had reached full employment. Wage pressure began to emerge and competitiveness deteriorated, with tight labour conditions.
Subsequently, export growth began to wane and export market share fell. The current account balance deteriorated and by 2007 it recorded a deficit of about 5.4% of GDP. Economic growth became increasingly reliant on construction. Interest rates had declined substantially and access to credit increased with Ireland's entry into EMU. This helped to trigger a boom in investment in housing and commercial property, with rapidly rising property prices. The positive wealth effects from rising housing prices also contributed to buoyant private consumption.
By the mid-2000s, the construction sector, especially its residential housing component, had become very large. Construction investment grew to about one fifth of GDP, the highest in the euro area. Employment growth also became increasingly reliant on the construction boom and the rate of unemployment fell to 4.4% in 2005. The proportion of those employed in construction peaked at an unprecedented level of about 13.5% in 2007. The construction sector benefited from strong inward migration flows, particularly from EU enlargement countries in 2004.
Nonetheless, the labour market remained tight, pushing up wages. The reallocation of resources into the housing sector, which was traditionally labour intensive and employed low-skilled workers, left limited room for improving productivity. House price inflation surged in Ireland and rose more than fourfold between 1993 and 2007, among the highest of any advanced economies.
On the demand side, demographic trends, higher disposable incomes, lower real interest rates and easier access to mortgage finance supported the booming property market. Government policies also played a role through the favourable tax treatment of housing, such as the deducibility of mortgage interest payments. The supply of housing also rose sharply, but eventually beyond the needs of the population. The idea that house prices would increase forever turned into a recurrent and dangerous motive.
One of the main factors which fuelled the housing boom was the rise in private sector credit. The private sector debt-to-GDP ratio rose to over 200 % by 2008. As the bulk of credit was supplied by banks, this led to a major expansion in banks' balance sheets. There was an increase in competition among the banks with many new entrants into the market, lending standards weakened and average loan-to-value ratios increased significantly. Lending to households and property developers soared, boosting private sector debt levels. Domestic banks also engaged in a rapid expansion of foreign activities. At the end, the Irish banking sector was severely oversized relative to the size of the local economy and the fiscal capacity of the Irish sovereign.
The lending boom by the Irish banks was facilitated by the international context during this period. Banks increasingly funded themselves easily on external wholesale markets as cross-border financial flows boomed in the international financial system, supported by low global interest rates. Moreover, EMU had eliminated currency risks within the euro area and this contributed to rising cross-border borrowing. As credit expanded faster than deposits, Irish banks became increasingly dependent on international market funding, leading to an unbalanced funding structure. This left banks vulnerable to the eventual tightening in international capital markets. Ireland was not the only such case; similar developments took place within the euro area in Spain.
The role of the Irish financial supervisor and regulator during the boom years has been extensively analysed and assessed by many observers. I understand there have been dedicated sessions on this issue in this forum. I, therefore, do not intend to elaborate at length. It may suffice to say that I agree with those who conclude that the domestic financial supervisor did not acknowledge and address the risks associated with the credit and housing boom. I also believe that the supervisors in the originating countries share some of the responsibility, but this is not to detract from the primary responsibility of the domestic supervisor, which has been widely acknowledged in Ireland.
More generally, supervisors in a number of member states did not seem to care sufficiently about the risks of rapid year-on-year loan growth, the increasing concentration of investment in the construction sector and the relative size of their banking sectors compared to GDP, and Ireland is probably the most extreme example of what can happen when these problems are ignored. More generally, supervisors in many member states were concerned almost exclusively with micro-prudential supervision, that is, checking the soundness of individual banks, and there was insufficient attention placed on macro-prudential supervision, that is, risks to the financial system as a whole.
The housing and lending boom also impacted Irish public finances. Government spending rose sharply as a percentage of GDP, financed by the additional tax revenues linked to the housing boom. The budget was in surplus as of 2003 and the general government debt declined to a low of 24.6% of GDP in 2006. We know that the structural budget balance, that is, the balance net of temporary components, was expansionary and contributed to the overheating of the economy. Revenues became overly reliant on the property market and the income tax base shrank due to successive tax cuts. This left the budget exposed to the ensuing downturn in the property market.
I have given the committee our assessment of the most important economic developments in Ireland in the years preceding the crisis. Let me now move on to how economic surveillance was implemented at the EU level during the boom period. I will start with the surveillance instruments that were available prior to 2007 and then move on to the question of how they were used in practice.
The European Commission acts as the guardian of the EU treaty. Within this general mandate, the Directorate General for Economic and Financial Affairs is the service in charge of economic policies. It carries out its duties, under the supervision of the competent member of the Commission, by monitoring and assessing economic developments in the member states, reporting on the findings of our assessment to member states directly and to the public at large and initiating specific surveillance procedures for member states where economic developments move outside or risk moving outside the perimeters laid down in EU legislation.
In the pre-crisis years, the EU framework for economic surveillance was a reflection of the principles enshrined in the Maastricht treaty. The treaty, which entered into force in 1993, laid the foundations of the economic and monetary union. Monetary policy was entrusted to the ECB while fiscal policy remained a prerogative of the member states, but to be carried out in line with commonly agreed rules.
The treaty also included a general provision, according to which member states "shall regard their economic policies as a matter of common concern and shall coordinate them within the Council". In the years following the entry into force of the Maastricht treaty, the EU strengthened fiscal surveillance via the Stability and Growth Pact. The same did not happen to structural policies. This asymmetry was not an oversight. It was a reflection of the macroeconomic paradigm prevailing at the time in Europe and beyond.
This paradigm, sometimes referred to as the "great moderation", reigned until 2007, the onset of the most severe economic and financial crisis in post-Second World War history.
According to the great moderation paradigm, overall macroeconomic stability was to be ensured by meeting two overarching conditions; one, low, steady inflation and, two, prudent and sustainable fiscal policy. Experience in advanced economies since the late 1980s corroborated this view especially when compared to the more unstable 1970s and early 1980s. Countries that kept their fiscal houses in order with inflation reasonably low and stable followed a relatively small path of macroeconomic development. Other macroeconomic compartments such as the financial sector, house price developments or the current account were not thought at the time to create major problems of their own. They were expected to be restrained by prudent monetary and fiscal policies. Today, we know this is not the case, but until 2007 the focus on macroeconomic surveillance in the EU was clear. The ECB looked after price stability with a very strong mandate and the European Commission monitored national fiscal policy making against the parameter of the Stability and Growth Pact, SGP.
There was also an instrument to co-ordinate economic policies beyond public finances, the so-called broad economic policies guidelines. However, this instrument amounted to soft co-ordination with no enforcement power. With benefit of hindsight, there is little consolation to be gained from the fact that not only Europe followed the great moderation paradigm in implementing monetary economic policy. It is important to underline that, with very few exceptions, the economic profession at large relied on this paradigm.
In the case of Ireland, how was the EU economic surveillance framework applied in this country in the years preceding the 2007 onset of the crisis? I will start in 2000 for three reasons. First, the SGP entered into force only in the late 1990s. Only since then can we speak of a functioning EU fiscal surveillance framework. Second, the early 2000s coincided with the onset of the second and less healthy part of the catching up process in the Irish economy. Third, in 2000, the Irish Government adopted a draft budget for 2001 which brought Ireland onto the Commission radar screen for the first time, signalling potential macroeconomic problems. Against this backdrop of clear signs of overheating in the Irish economy, budget talk was expansionary and risked adding fuel to the fire. On Wednesday, 24 January 2001, the Commission issued a critical opinion on the 2001-2003 stability programme. It concluded the Irish fiscal policy was inconsistent with the broad economic policies guidelines adopted by the European Council six months earlier. Those guidelines had asked Ireland to avoid further overheating of its economy by containing public expenditure. In parallel to the critical opinion on the Irish problem, the Commission also recommended to the Council to ask the Irish Government under article 99(4) of the Maastricht treaty to take countervailing measures in the course of 2001. The ECOFIN Council adopted the recommendation on Monday, 12 February 2001. As some of you may remember, the recommendation was not very well received in Ireland at the time and it was not implemented. Many in the economic profession derided the Commission, accusing us of focusing more on decimals rather than acknowledging the strength of the Irish economy.
As guardian of the treaty, the Commission played its role well, based on the information available at the time. There was a clear inconsistency between the Government's budgetary plans on the one hand and the economic policy guidance endorsed by the European Council on the other. Picking up on this inconsistency, and within the existing surveillance framework, the Commission put in motion the relevant wheels and the Council followed. At this point, I should stress that all EU surveillance documents, including the Commission technical assessment, the stability programmes updates, the Commission recommendation for a Council opinion and the Council opinion, are all available on the website of the DG.
In retrospect, the assessment of whether the 2001 Council recommendation to Ireland was a good idea or not is less clear cut, even controversial. As we know, the ICT bubble burst in the course of 2001, triggering a sharp economic slowdown in the US and Europe. Ireland was also affected. Quarterly GDP growth moved from more than 13% in question one of 2001 to almost stagnation in question four. With the Irish economy cooling off so abruptly, the Council's call for a tighter budget to avoid overheating did not seem particularly appropriate any longer. Later in 2001, when the assessment of the 2002 budgets and stability programme updates were due, the Council reviewed its assessment. On a
recommendation from the Commission, it issued an opinion that approved the budget plans of the Irish Government. The Council still urged Ireland to aim for a neutral fiscal stance. However, the assessment no longer raised any major issues. The case of the 2001 recommendation under Article 99(4) of the treaty for Ireland was closed.
At the time, the Commission was right in stressing the need to avoid a pro-cyclical fiscal expansion in a boom period, even if due to the unexpected burst of the ICT bubble the recommendation turned out to be ill-timed. In the subsequent years, the Commission did not shy away from taking a critical view of Irish fiscal policy-making. On the contrary, the annual technical assessments of the Commission of the successive stability programme updates regularly expressed concerns about strong Government expenditure growth and only moderate budgetary improvements in the face of a solid economic recovery. In the years after 2001, Commission recommendations for a Council opinion on the Irish stability programmes consistently urged Ireland to strictly control public expenditure, including through the implementation of an effective expenditure framework. The first such call was already included in the 2002 Council opinion, but did not fall on fertile ground in Ireland. Helped by the growing influx of revenue from the housing boom, the Government successively increased expenditure and lowered taxes.
As the Government deficit remained below the Maastricht limit of 3% of GDP, the post-2001 Council opinions did not identify any formal conflict with existing EU fiscal rules. At the same time, the Commission assessment did indicate a few points which, with the benefit of hindsight, turned out to be crucial. For instance, the Commission regularly stressed the uncertainty surrounding estimates of the structural budget balance for the Irish economy - that is, the budget balance net of temporary components. After 2002, the Commission noted several times that the Irish Government's targets for the general government budget balance may not have been particularly ambitious in view of the very solid recovery of economic growth. Underlying this message was the sense that the structural fiscal position was weaker than the official estimate suggested, but there was no way to substantiate this view. The method agreed by the ECOFIN Council in 2002 to estimate the structural budget balance for the purposes of EU fiscal surveillance did not signal any specific problem for Ireland.
The second point the Commission underlined clearly in its post 2001 assessments was the strong contribution of construction to economic growth. In its 2005 assessment of update of the Irish stability programme, the Commission identified the very high valuation of existing housing stock and a possible sharp downturn from the extended residential construction boom as a downside risk to the economy and public finances. A year later, the Commission's assessment of the 2006 update explicitly referred to unsustainable levels of residential construction. Together with very high residential property prices, the construction boom was thought to carry the risk of a sharp downward adjustment in the wider economy.
Then again, the identification of risks linked to the construction boom did not translate into concrete surveillance actions. The EU economic surveillance framework at the time was centred on public finances and Ireland complied with existing rules. I am not trying to argue that the Commission saw everything coming, but could not do anything. What I am trying to say, however, is that the Commission did, within its remit, pinpoint issues which in retrospect turned out to be important, but then, even if we had anticipated the end of the economic boom and the beginning of a collapse in Ireland before 2007, we would not have had the legal tools for asking Ireland to take any corrective measures.
However, the lack of legal instruments was not the real constraint for EU surveillance. The real constraint was our limited understanding at the time of what could really endanger overall macroeconomic stability. Yes, we understood that the Irish housing boom would not be sustainable, but in line with the great moderation paradigm, we, as others, did not anticipate that the end of the housing boom could give rise to the dislocations that eventually emerged after 2007 which later led Ireland to ask for financial assistance from the EU and the IMF. The financial sector was thought to simply channel funds in an efficient manner to where the real economy needed them. Dangerous excesses were thought to originate only in monetary and fiscal policy making. This is evidenced by the fact that between 2001 and 2007 no Commission assessment of the Irish stability programme updates reviewed developments in the banking sector. Assessment of financial stability was not part of the broad economic policy guidelines process. Financial stability risks were mainly thought to be an issue for individual banks, not for the economy as a whole. Moreover, financial supervision was a national prerogative. My colleague Mr. Mario Nava, who came before the committee earlier this month, clarified this point. He stated that in the 2000s the EU regulatory framework followed a principle-based approach that was embodied in the principle of minimum harmonisation. National supervisory authorities were responsible for applying and enforcing the minimum prudential requirements set out in EU directives. We worked under the assumption that national supervisors and regulators would be well equipped to address any nascent stability issues in the banking sector. We assumed they would do their job in a conscientious manner.
The post-2007 financial and economic crisis showed us the hard way that our conceptual framework of the macro economy was incomplete. Ireland was a particularly drastic example, albeit not the only one. The sudden drop in residential house prices undermined the viability of most Irish banks and exposed a striking lack of supervisory and regulatory rigour. The Government had to step in with its deep pockets to stave off the collapse of the financial sector and the economy as a whole. Later, the Government's pockets had to be filled with international financial assistance as access to financial markets at sustainable rates had been lost. The rest is now history. At the end of 2013, Ireland successfully completed the EU-IMF financial assistance programme. While important challenges remain, the country is back on track towards balanced and sustainable growth.
As regards EU economic surveillance, the post-2007 financial and economic crisis has not been wasted. As you are aware, the EU immediately launched an important and far-reaching reform process to upgrade and complete its economic governance structure. First, the EU surveillance framework has been strengthened with the so-called six-pack. Secondly, the scope of EU surveillance has been extended to include all relevant instruments beyond public finances; this was achieved with the introduction of the macroeconomic imbalances procedure. This was also part of the six-pack initiative. Since 2001 the Commission has consistently monitored member states with imbalances in all areas of the macro economy. Third, the banking union was introduced, including in particular the Single Supervisory Mechanism and the Single Resolution Mechanism.
It would go beyond the scope of my intervention today to go through the details of all these institutional innovations and what they meant for EU economic governance. My colleague Mario Nava outlined the regulatory response at the EU level to the crisis. It may suffice to say that they constitute a major step forward. I am convinced they will help us not to repeat the mistakes of the past. I apologise for the length of my statement. Thank you for your attention.
