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Things are beginning to look ugly

Though many observers are rightly concerned about Spain, it may be Ireland that becomes the next serious test of EMU’s one-size-fits-all monetary policy. Alan Ahearne, Eurointelligence 6/4 2008

Bertie Ahern’s ten-year tenure as Ireland’s prime minister coincided with the country’s extraordinary economic boom. But as so often happens during prolonged booms, large imbalances eventually emerged, especially in the housing market.

As Ahern gets ready to depart following his resignation last week, these imbalances have begun to unwind—and things are beginning to look ugly.

Fuelled by excessive credit growth and misguided tax breaks for property, Ireland’s housing boom became a bubble. Interest rates that were inappropriately low for a fast growing economy were also a major factor. Calculations using Taylor rules suggest that policy interest rates of around 10 percent were called for in Ireland over the period 2003-2006 to contain overheating.

It follows from some simple arithmetic that the Irish economy is likely to fall into recession this year. Since new homebuilding accounts for roughly 10 per cent of GDP, the slump in completions will subtract 4 percentage points from growth this year.

In a study of dozens of property cycles across 18 industrial countries since 1970, my former colleagues at the US Federal Reserve and I found that consumption typically weakens markedly during housing downturns, as unemployment rises and households tighten their belts.

Ahearne, Alan, John Ammer, Brian Doyle, Linda Kole, and Robert Martin, (2005)
“Monetary Policy and House Prices: A Cross-Country Study”,
International Finance Discussion Papers 841. Washington: Board of Governors of the Federal Reserve System (September).

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