The Economy:After a bright start, the US sub-prime lending crisis and a downturn in the housing market mean we are now peering into the gloom, writes Paul TanseyEconomics Editor.
The economy was a game of two halves. With the wind behind it, the economy put in a muscular performance during the first half, scoring large gains in exports and employment. As the second half advanced, the economy lost its shape. From August onwards, the US-induced sub-prime lending crisis began to punch holes in midfield, while the defence started to crumble under the weight of the housing slowdown. Nonetheless, the economy emerged from 2007 with a result. When the numbers are finally counted, economic activity, as measured by real Gross National Product (GNP) is likely to have increased by more than 4 per cent, while more than 70,000 people will have been added to the national workforce.
The economy entered the year with a strong tailwind behind it. Real GNP advanced by 6.5 per cent during 2006 and this forward impulsion carried over into the current year. The Budget, delivered in December 2006, added a further dash of pre-election expansion to the economy. The Tánaiste and Minister for Finance delivered presents to everyone in the pre-election audience. Income taxes were cut and social welfare benefits were increased handsomely. The ultimate cost was an increase of more than 12 per cent in the Government's day-to-day spending.
Economic sentiment in the first half of the year was optimistic, buoyed by the competing election promises of politicians to raise future living standards, and by the more concrete payouts from SSIAs. As the May election approached, the air was thick with promises of tax cuts, improved public services and higher social welfare benefits. Few read the small print. Close inspection revealed that the plethora of promises would only be delivered if economic growth for the next five years averaged 4.5 per cent or so each year. To put it at its mildest, this outcome is now a remote possibility.
The public were on much firmer ground with the payouts from their SSIAs. More than 1.1 million Irish savers opened five-year SSIA accounts between May 2001 and April 2002. On maturity, in excess of €15 billion was released to savers in the 12 months ending April 2007, with the payouts heavily concentrated in the spring of this year. This large wad of folding money stood equivalent to about one-sixth of annual personal consumer-spending in Ireland.
The mother of all consumer booms was predicted on the back of the SSIA cash releases. While personal spending on goods and services remained very buoyant throughout 2007, it did not ascend the heights predicted.
Consumers turned out to be canny and conservative; they held their fire on the spending front. Some paid off outstanding credit card debts; others re-deposited at least part of their SSIA payouts. Nonetheless, with real disposable incomes and employment both rising at a decent pace through the year, the volume of consumer purchases is estimated to have increased by some 6.5 per cent during 2007.
WITH THE GOVERNMENT opening its wallet prior to the election, the volume of Government consumption - net current Government spending on goods and services - also exhibited an increase, of 4.8 per cent during 2007.
Domestic demand has three components - personal consumer spending, Government consumption, and gross fixed investment. The first two remained buoyant throughout the year. The performance of the third deteriorated as the year progressed. One word explains the deterioration in fixed investment: housing.
The rise and rise of housing completions provided substantial impetus to the boom in domestic demand in the years after 2003. By 2006, the number of new completed houses reached a peak at 88,000. The supply of new houses was well in excess of underlying demand, which is determined by the rate at which new households are formed. In these circumstances, the market became increasingly dependent on investors - buy-to-let and buy-to-hold - to sweep up the surplus.
At the end of 2006, personal investors in the Irish housing market accounted for 25 per cent of all outstanding residential mortgages. By this year, they had almost had enough. At the same time, new home buyers were deterred from purchasing by the unexpectedly steep rise in house prices during 2006 and by the increasing cost of mortgage interest. The combined effect of both of these trends caused housing demand to slump. In the first six months of 2007, outstanding mortgages held by private households - including private investors - increased by just 4.6 per cent.
The housing boom was over. Despite the enticing financial titbits offered by the Tánaiste - first, the abolition of stamp duty for first-time house purchasers, then the introduction of increased tax relief to compensate for rising mortgage interest rates, and finally the revamp of all stamp duty rates in Budget 2008 - buyers could not be induced back into the market.
As purchasers stopped buying, builders stopped building. Through the second half of 2007, the news from the house-building front deteriorated daily. By the end of the year, the Department of Finance was anticipating that housing completions in 2007 would fall in the range of 70,000-75,000. However, construction on the vast majority of these completions commenced in 2006 or even earlier. Given the long lead time involved in construction, the real effect of the housing slowdown will not manifest itself until 2008.
In 2006, housing comprised one-half of all gross fixed investment in Ireland, and investment accounted for 30 per cent of domestic demand. Thus, housing makes up some 15 per cent of domestic spending. With housing looming so large in the domestic economy, the impact of a housing shock on overall domestic economic activity is self-evident. Overall, when the numbers are finally crunched, gross fixed investment will have done well to stand still during 2007.
THE OTHER SHOCK that revealed itself in the second half of the year was the US sub-prime lending crisis, prompted initially by bad lending to bad credit risks in US mortgage markets. However, the crisis escaped the confines of the United States for two reasons: innovations in financial markets and globalisation.
Bankers are salespeople. They sell loans. In the past, only the threat of bad debts constrained their loan-selling activities. But innovations in financial markets allowed financial institutions to bundle up a batch of loans and sell them on to others at a healthy commission. All at once, such securitisations allowed financial institutions to escape the responsibility for the loans they had made.
In selling the loans on, that became somebody else's problem. So, loan quality and even the checking of customer compliance with basic lending terms deteriorated. This gave rise to the ninja mortgage, where home loans were proffered to those who had No Income, No Jobs and no Assets.
Financial globalisation ensured the US sub-prime crisis went international. Many of the purchasers of contaminated sub-prime products were European banks. Suddenly, non-US banks began to realise that they had infected assets on their books. Liquidity dried up as assets were written down and banks became increasingly unwilling to lend to one another on wholesale money markets. The US crisis had metamorphosed into an international credit crunch. Cash had regained its throne.
Central banks, with the European Central Bank (ECB) adopting the most aggressive stance, sought to loosen liquidity by injecting massive amounts of credit into international money markets. The US central bank - the Federal Reserve System - cut interest rates three times since the summer, lopping a full percentage point off official interest rates in the process. The Bank of England also cut the cost of money. Only the ECB refused to yield, holding interest rates through the latter part of the year at a firm 4 per cent. However, it did forego its forecast increases in interest rates - much to the relief of Irish borrowers.
As the year came to a close, the crisis triggered by US sub-prime lending was entering a second stage. In December, Swiss bank UBS announced a $10 billion (almost €7 billion) asset write-off. Banks remained reluctant to lend to one another. The depth of the crisis was demonstrated by the singular decision of the world's major central banks to act in concert by injecting an additional $75 billion (€52 billion) in liquidity into global money markets.
AS THE NEW year approaches, there is a real threat that the financial crisis will spill over into the real economy of output and employment, investment and exports.
In years to come, 2007 will be remembered as the last year of the boom, which, with one intermission, stretches back to 1994. Its first phase, lasting until 2001, was powered by expansive export growth. Its second stage, from 2003, was driven by a surge in domestic spending, led by house-building. Now, the domestic boom is drawing to a close. Descending from the dizzy altitude of exceptionally high growth rates over the past decade, the best that can be hoped for now is a soft landing.