Although the main outlines of the Irish macro-financial crisis of 2008-13 may be well known (e.g. Donovan and Murphy 2012, Whelan 2014), many significant details are less well known, some aspects remain disputed, and some are often misunderstood. My new book (Honohan 2019) seeks to complete the picture. It proceeds to focus on the key role of the central bank, seeking to draw wider lessons for the appropriate conduct of central banking in small countries.
Fiscal austerity: Allocating blame
The main cause of the Irish crisis was certainly the wave of reckless bank lending which preceded it; but most of the fiscal austerity measures did not go to pay for the bank losses. Even without the bank losses, measures were going to be needed to make up for the large hole that had opened up in the public finances when the flow of tax revenue from the property bubble suddenly ceased, revealing the unsustainability of the reductions in income tax and of the spending increases that had been embarked during the property boom of the previous few years.
Where the banking losses had a big impact was in accelerating the need for the government to adjust its budget. The income tax and levy increases, the cutbacks in spending on public services, and the public servant salary reductions could have been spread out over a longer adjustment period if investor confidence in Ireland had not been tipped-over by the progressive disclosure of such heavy banking losses.
Likewise, the Troika programme did not cause Ireland’s austerity; it eased it. Ninety per cent of the job losses had happened by the time the Troika arrived. By providing loans when the private market would not, the programme allowed the government to make the fiscal adjustments in a more orderly and gradual manner. The choice of what taxes and spending measures to target was largely one for the government. The Troika had suggestions, some of which they pressed vigorously, but for the most part they were content with any reasonable choice of measures as long as the net impact on the government’s deficit was sufficient.
While it is easy to point to design shortcomings in the euro, the Irish crisis cannot be blamed on membership of the euro area. As with previous exchange rate regimes, economic performance depended on the accompanying fiscal and regulatory policies being well adapted to the new regime. Ireland’s fiscal and regulatory policies in the first decade of the system fell far short of what was needed to stay safe.
Managing the euro area crisis
But management by Europe of the euro area crisis as a whole was also poor.1 Even governments with sufficient headroom terminated their countercyclical fiscal spending too soon. The ECB’s response, though vigorous, failed at first to recognise and fully understand the severity of the unfolding crash. The actions taken both by the ECB and the Eurogroup ministers lacked clarity and persistence. In many cases, censoriousness and lack of trust permeated the approach from officials on the creditor side. At first, the official lending to Greece, Ireland, and Portugal was at rates of interest that did not make sense. Only later was a more reasonable approach adopted.
Indeed, standing back, it seems clear that two alternative and diametrically opposed approaches to the euro area crisis could have been chosen by European policymakers. If adopted early enough, either might have worked better overall than the path followed. As far as the banking losses and the Greek government debt are concerned, a single-minded policy either of default or of collective socialisation at the European level might have allowed a speedier and less costly recovery from the crisis than the compromise middle course that was adopted.
As far as Ireland was concerned, after the expiry of the initial bank guarantee, the Irish Government would have willingly seen losses imposed on the unguaranteed senior debt of the failed, gone-concern banks Anglo and INBS. As several participants subsequently realised, it was wrong-headed of the ECB to prevent this (and inconsistent with the general policy on bank resolution subsequently adopted in Europe). They likely hope that their acquiescence in the complex financing arrangements around the subsequent liquidation, which have worked for Ireland even better than hoped, has made amends.
Lessons for the role of the central bank in a small country
When the euro began, some had asked: why does Ireland still need its own central bank? It was a fair question. Central banks are about money and credit, and these aspects of the Irish economy have long been globalised. But the euro did not make national central banks redundant. Instead, Ireland’s experience, both before the euro and during the past 20 years, provides an instructive case history or what central banks are for; what they can and cannot do (in Ireland’s case both at the national level and as part of the eurosystem).
As in other countries, crisis management brought the Central Bank of Ireland, long accustomed to a largely passive role, into unfamiliar territory. For a while it assumed a much greater prominence in the economy and society. Ensuring that the country would not slide further into a semi-permanent slump of over-indebtedness was the first priority. No longer deferential to the banks, the central bank nevertheless found, as in other countries, that it was a difficult and slow job to get the banks to acknowledge the scale of their prospective losses; to deal with non-performing borrowers in a fair, sensitive and sustainable manner; and to eliminate sharp practice and worse vis-à-vis their customers – behaviour engendered by a long-standing culture of corporate entitlement.
The effective central bank, however small, will not be passive. Maintaining price and financial stability, whether or not it is underpinned by an exchange rate peg, requires determination and vigour in acting against public or private actions that put that goal at risk. Insufficiently forceful or consistent central bank actions can allow the emergence of damaging bubbles and other spending excesses. In this respect, the adage that banks are global in life but national in death needs to be qualified. Banks can facilitate or even stoke up a national bubble despite globalisation. This means that, even in a small country, national macroprudential and microprudential policies must be pursued actively to ensure that banks do not create havoc.
A central bank’s independence from government does not mean its indifference to non-financial aspects of national economic performance or to the ability of the national government to pursue a coherent macroeconomic policy. The central bank is an arm of the state, albeit not of the government. There are occasions, especially during crisis, when the central bank needs a deep understanding of the policy and capacity of the government, so that it can act as a trusted policy adviser and, without pandering to political short-termism, can cooperate with government policy to achieve its mandated objectives more effectively (Tucker 2018). This applies also within the euro area where the potential conflicts of objectives can require careful management.
Clearly, the central bank in a small country must understand that it is constrained by market forces and international conventions. All too often, defiance of these constraints results in a whiplash. But this implies that success in achieving a central bank’s national goals must be sought by active manoeuvring within these constraints and working with the grain of market functioning and international financial diplomacy.
Donovan, D and A E Murphy (2012), The Fall of the Celtic Tiger, Oxford University Press.
Honohan, P (2019), Currency, Credit and Crisis: Central Banking in Ireland and Europe, Studies in Macroeconomic History, Cambridge University Press.
Mody, A (2018), Eurotragedy: A Drama in Eight Acts, Oxford University Press.
Tucker, P (2018), Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State, Princeton University Press.
Sandbu, M (2015), Europe’s Orphan: The Future of the Euro and the Politics of Debt, Princeton University Press.
Whelan, K (2014), “Ireland's Economic Crisis: The Good, the Bad and the Ugly”, Journal of Macroeconomics 39B: 424-440.
 Particularly harsh assessments are contained in Mody (2018) and Sandbu (2015).