Erin Go Broke

For much of the 1990s and 2000s, Ireland was celebrated as an economic success story: the “Celtic Tiger” was growing at a pace the rest of Europe could only envy. But the miracle came to an abrupt halt in 2008, as Ireland found itself facing a huge banking crisis.

Like the earlier banking crises in Finland, Sweden, and Japan, Ireland’s crisis grew out of excessive optimism about real estate. Irish housing prices began rising in the 1990s, in part a result of the economy’s strong growth. However, real estate developers began betting on ever-rising prices, and Irish banks were all too willing to lend these developers large amounts of money to back their speculations. Housing prices tripled between 1997 and 2007, home construction quadrupled over the same period, and total credit offered by banks rose far faster than in any other European nation. To raise the cash for their lending spree, Irish banks supplemented the funds of depositors with large amounts of “wholesale” funding—short-term borrowing from other banks and private investors.

In 2007 the real estate boom collapsed. Home prices started falling, and home sales collapsed. Many of the loans that banks had made during the boom went into default. Now, so-called ghost estates, new housing developments full of unoccupied, crumbling homes, dot the landscape. In 2008, the troubles of the Irish banks threatened to turn into a sort of bank run—not by depositors, but by lenders who had provided the banks with short-term funding through the wholesale interbank lending market. To stabilize the situation, the Irish government stepped in, guaranteeing repayment of all bank debt.

This created a new problem because it put Irish taxpayers on the hook for potentially huge bank losses. Until the crisis struck, Ireland had seemed to be in good fiscal shape, with relatively low government debt and a budget surplus. The banking crisis, however, led to serious questions about the solvency of the Irish government—whether it had the resources to meet its obligations—and forced the government to pay high interest rates on funds it raised in international markets.

Like most banking crises, Ireland’s led to a severe recession. The unemployment rate rose from less than 5% before the crisis to more than 14.8%, where it remained throughout 2012.

Quick Review

• 
  Although individual bank failures are common, a banking crisis is a rare event that typically will severely harm the broader economy.
• 
  A banking crisis can occur because depository or shadow banks invest in an asset bubble or through financial contagion, set off by bank runs or by a vicious cycle of deleveraging. Largely unregulated, shadow banking is particularly vulnerable to contagion.
• 
  In 2008, an asset bubble combined with a huge shadow banking sector and a vicious cycle of deleveraging created a financial panic and banking crisis, as savers cut their spending and investors hoarded their funds, sending the economy into a steep decline.
• 
  Between the Civil War and the Great Depression, the United States suffered numerous banking crises and financial panics, each followed by a severe economic downturn. The banking reforms of the 1930s prevented another banking crisis until 2008.
• 
  Banking crises usually occur in small, poor countries, although there have been banking crises in advanced countries as well. The fall of Lehman caused a banking crisis and a financial panic in the shadow banking sector, leading investors to shift back into the depository banking sector.

Check Your Understanding 18-2

1. • Question

     Regarding the Economics in Action “Erin Go Broke,” where did the asset bubble occur?
     

     A.

     The asset bubble occurred in Irish real estate.

     B.

     The asset bubble occurred in Irish stock.

     C.

     The asset bubble occurred in Irish experimental markets

     The asset bubble occurred in Irish real estate.

   • Question

     Regarding the Economics in Action “Erin Go Broke,” which of the following correctly describes the channel of financial contagion?

     A.

     The channel of the financial contagion was the longterm lending that Irish banks depended on from the housing lending market.

     B.

     The channel of the financial contagion was the longterm lending that Irish banks depended on from the limited state lending market.

     C.

     The channel of the financial contagion was the shortterm lending that Irish banks depended on from the wholesale interbank lending market.

     The channel of the financial contagion was the shortterm lending that Irish banks depended on from the wholesale interbank lending market. When lenders began to worry about the soundness of the Irish banks, they refused to lend any more money, leading to a type of bank run and putting the Irish banks at great risk of failure.

2. Question

   As described in Economics in Action “Erin Go Broke,” the Irish government tried to stabilize the situation by guaranteeing the debts of the banks. Was this a questionable policy?

   A.

   *Yes

   B.

   No

   Because the bank run started with fears among lenders to Irish banks, the Irish government sought to eliminate those fears by guaranteeing the lenders that they would be repaid in full. It was a questionable strategy, though, because it put the Irish taxpayers on the hook for potentially very large losses, so large that they threatened the solvency of the Irish government.