Mr. Tom Considine:

Thank you very much, Chairman, good morning, and members of the committee. I thank you for allowing me to make this opening statement and I'll draw on my witness statement and summarise a number of points - the international and domestic background, the system of financial regulation, fiscal policy and the risks as they were seen in 2005 and 2006.

In relation to the international and domestic background, by 2006 financial markets had become increasingly globalised. They had become accustomed to readily available credit, significant product innovation, greater financial integration in the euro area, large current balance repayments in balances and lower risk premiums. Technology had transformed the efficiency, speed and complexity of financial instruments and transactions. This was supported by a strong belief that new modes of finance had reduced systemic risk. Against that background, Ireland experienced an extended period of strong economic expansion, interrupted only by lower growth rates in 2001 and 2002. Consequently, Irish expectations were high that living standards and assets ... asset prices would continue to advance. This, in turn, was reflected in strong demand for credit in housing. The Department's statement of strategy, particularly fiscal policy, was strongly influenced by the provisions of the programme for Government published in June 2002. The Social Partnership Agreement 2003 to 2005, entitled Sustaining Progress, also had a strong influence on fiscal policy. Fiscal policy, incomes policy and regulation were the key policy instruments available to the Irish authorities to manage the domestic economy within the euro area. This was recognised from the outset of our EU membership. The Department of Finance established an internal working group to examine the implications of EU membership. The report, entitled The Implications of EMU Membership for Various Aspects of Public Policy, was approved by the Minister of Finance for publication in October 1999 on the Department's website. And at page 10 that report states:

The “Celtic Tiger” economy is already having a major effect on expectations in terms of income, taxation and expenditure policy and it is clear that, far from moderating, these pressures are likely to continue to grow. In the circumstances, it will undoubtedly prove extremely difficult to persuade the social partners, interest groups and the public in general to accept a prudent fiscal stance.

Being a euro area member state, the Irish Government had no function in relation to official interest rates or the euro exchange rate. During the period 2002 to 2006 Ireland had a AAA credit rating and Irish banks were able to borrow wholesale funds at competitive rates.

Turning to the system of financial regulation, in October 1998 the Government agreed in principle to establish a single regulatory authority and established an implementation advisory group chaired by Mr. Michael McDowell, senior counsel. The group reported on 19 May 1999 and recommended that the single regulatory authority, or the SRA, should be an entirely new, independent organisation. As a member of the implementation group, I proposed an alternative model on behalf of the Department of Finance. This model located the SRA within a restructured Central Bank and provided for increased autonomy for the regulatory function but under the direct control of the Central Bank board. This alternative model is at appendix II of the report, page 79. In the event the Government legislated for a model with a separate board for regulation but within an overall Central Bank and financial services authority framework. The new model came into operation on 1 May 2003. The Government's White Paper, Regulating Better, was published by the Department of the Taoiseach in January 2004. It identified what the Government saw as the principles of good regulation, namely, necessity, effectiveness, proportionality, transparency, accountability and consistency. The White Paper advised, "The recommendations and actions in this White Paper are best seen in the context of the continuing drive for competitiveness and people's expectations of high quality public services."

The 2006 annual report of the Irish Financial Regulator, at page 26, refers to its approach to regulation in the following terms, "In order to ensure that our regulatory requirements do not become a barrier to competitiveness and innovation, we apply the Better Regulation principles which the Government published in January 2004 [...] and are an active member of the Taoiseach’s Better Regulation Group."

This approach in turn appeared to be aligned to the prevailing EU and wider international belief in the economic benefits of rational self-correcting markets and the merits of financial intermediation.

On fiscal policy, over the four years 2002-2006, each year the Department of Finance engaged with the Minister on the preparation of the budget strategy memorandum that was submitted by the Minister to the Government at mid-year. The Government decision, based on that memorandum, formed the basis for the preparation of the spending, taxation and borrowing ... and deficit-surplus framework for the upcoming budget. Government Departments were required to submit their spending proposals by early autumn, based on that Government decision. The Department of Finance would also prepare an estimate of the cost of funding the existing level of public services during the following year and this would be used as a reference point in discussions with Departments-Ministers in the lead-up to the budget. The budgets for 2003 and 2004 were difficult because, in each case, Departments were required to prepare their pre-budget expenditure figures at a level significantly below what the Department of Finance estimated it would cost to fund existing service levels during the following year. For the 2003 budget, the required reduction was €900 million and, in the case of the 2004 budget, the corresponding figure was €500 million. In the case of the 2004 budget, line Departments contended that the Department of Finance base was €2.1 billion too low. These two budgets were naturally unpopular and subject to criticism.

When it came to preparing the 2005 budget, the political pressure to ease up on what were seen as expenditure cuts was very strong. In addition, the pressure was more difficult to resist because the economic recovery from the 2001-2002 downturn was more firmly established. Against that background, Government decided, on the recommendation of the Minister for Finance, that Departments should prepare their Estimates for 2005 on the basis of the Department of Finance Estimates of the cost of funding the existing level of services in 2005 and that, in addition, €900 million would be provided to cover the cost of the budget day social welfare and tax changes. In the event, the budget strategy memorandum targets were exceeded by approximately €1 billion in gross terms. The budget day tax package accounted for almost €580 million and gross public expenditure accounted for the remainder of the €1.9 billion. The year-on-year increase for gross voted public expenditure was just over 9%.

In preparation for budget 2006, the Department tabled a paper for the ministerial management advisory committee of 2 February 2005 entitled, "Draft Framework for Developing the Budget Strategy Memorandum 2006-2008". I enclosed a copy with my witness statement. That paper recommended that the target for capital expenditure be about 5% of GNP and that gross voted current expenditure be increased by 6.6% over its 2005 level. In the event, the 2006 budget strategy memorandum was based on an increase of about 7.5% in gross current expenditure and gross voted Exchequer capital of 4.6% of GNP. Post-budget, the gross voted current expenditure increase was 10.9% and gross Exchequer capital was 4.7% of GNP. From a sustainability viewpoint, gross voted current expenditure is particularly important because of the difficulty in reversing welfare, pension and pay increases once granted. The gross 2006 cost of the budget day tax package was €763 million.

During each of the four years ending 31 December 2006, the general government was in surplus and these surpluses ranged between 0.4% of GDP in 2002 and 2.9% of GDP in 2006. During the same period, the general government debt declined each year as a percentage of GDP from 32.2% in 2002 to 24.7% in 2006. The European Commission recommendation on the Irish stability programme update of 22 February 2006 to the Council of Ministers stated, "The fiscal position can be considered [as] sound and the budgetary strategy provides a good example of fiscal policies conducted in compliance with the Stability and Growth Pact."

On taxation of housing and property, the 2005 Budget Statement delivered by the Minister for Finance in December 2004 announced that the Department of Finance and the Office of the Revenue Commissioners would undertake, in 2005, a detailed review of certain tax incentive schemes and tax exemptions in the areas of property and housing.

Arising from the review, the Minister for Finance in his 2006 Budget Statement announced a broad range of changes including the ending of a number of property based tax incentive schemes, subject to certain conditions. The main condition was that the period during which the qualifying expenditure can be incurred was extended to end July 2008. This extension was limited to projects that had already satisfied the terms of the particular scheme. The Minister also introduced with effect from 1 January 2007, a new measure to limit the use of tax breaks by those with high incomes.

Turning to risks, publically acknowledged in 2005, the annual financial stability report was produced jointly by the Central Bank and the Financial Regulator. The two boards came together to approve the document. Despite this level of co-operation, I consider that the single board structure, recommended by a minority of the McDowell group, was the best option and in the aftermath of the crisis, the Government reverted to a single board structure. The 2005 financial stability report published on 1 November 2005 identified the primary risk to be credit growth and indebtedness levels. This risk was placed ahead of the risk in unanticipated and sudden fall in residential property prices because of a moderation in house price growth since the 2004 report. However, the report notes the emergence of tentative evidence that this moderation may not have persisted and goes on to state that if house prices were to accelerate this would increase the risk of a sharp correction to house prices.

The report went on to conclude, “The stability and health of the Irish banking system appears generally sound, according to the standard indicators of financial health such as asset quality, profitability, solvency, liquidity and credit ratings.” This view was broadly shared by the IMF and the OECD. The IMF executive board published an assessment of the Irish financial system in August 2006. That assessment stated, "Directors welcomed the Financial System Stability Assessment Update, which finds that Ireland’s financial sector soundness indicators are generally strong and that the major lenders have adequate buffers to cover a range of shocks." In March 2006 the OECD economic review of Ireland had stated at page 118, "The most likely scenario is that prices stabilise and the housing market stays flat for some years."

Regarding the fiscal situation, the 2006 budget material made clear that as a small open economy, Ireland was particularly vulnerable to changes in the world economic outlook. Among the significant international and domestic downside risks highlighted was the following:

Given the loss of competitiveness in recent years, the economy is vulnerable to any further deterioration. In addition, the fact that the construction sector now accounts for a historically high share of economic activity and employment, implies that the economy is vulnerable to any shock affecting this sector.

In this context, the December, 2005 ESRI Medium-Term Review, 2005-2012, included an economic assessment of a housing shock. The ESRI stressed that the assessment was not a forecast. For illustrative purposes, it calibrated a housing price shock with a fall in house prices of approximately one third in 2007 and with house prices only beginning to recover after 2010. They analysed the potential impact of these major changes on the economy over the period 2007 to 2010. The study concluded that annual housing completions would not fall much below 40,000 and GNP would fall sharply in 2007 but remain above 1%. Unemployment is shown increasing sharply and peaking below 12% in 2009 before beginning to ease back, with the rate of wage increases falling sharply to just above zero. Considering a scenario where the Government allowed the deficit to rise without responding, the paper concluded that the impact on the public finances would be quite large, with a peak Exchequer deficit in the range of 4.5% to 5% of GNP in 2009.However, despite the acknowledged risks, the consensus view remained that the external environment was broadly positive, with international forecasting agencies projecting continued strong growth in the world economy in 2006 and 2007.

In summary, against the background of the financial stress tests and the outcome of the ESRI assessment of the fiscal impact of a severe housing shock, the available safety margins seemed to be more than adequate.

In a budgetary context, this safety margin can be summarised as follows: in 2006, the general government surplus was 2.9% of GDP and the general government debt was the second lowest in the euro area at less than 25% of GDP when the Stability and Growth Pact reference point was 60%. Ireland had a AAA credit rating, was financing a major capital programme from current revenue, and, by end-2006, the National Pensions Reserve Fund had a balance of €18.9 billion. The then consensus view of economic commentators, including the EU Commission, the IMF and OECD, was that the domestic and international economic outlook was broadly favourable. The Government's 2006 budget had included measures designed to help ease pressure in the property market and these pressures were further eased by increasing interest rates and the requirement on banks to hold higher capital against some higher risk loans. Measured by reference to 2006 GDP, the safety margins I have outlined above had a value of up to €95 billion. However, that safety margin and the measures taken in 2006 proved to be inadequate in the face of the crisis that reached seismic proportions in September 2008. In this regard, I note a conclusion of the US Financial Crisis Inquiry Commission report of January 2011:

...the ... inconsistent handling of major financial institutions [by the US Government] during the crisis - the decision to rescue Bear Stearns and then to place Fannie Mae and Freddie Mac into conservatorship, followed by its decision not to save Lehman Brothers and then to save AIG - increased uncertainty and panic in the market.

We now know that Ireland did not have a sufficient safety margin in place to withstand the domestic and international pressures that emerged in September 2008. In the event, our exposure to private sector debt and the direct and indirect impact of the property crash on the Exchequer were more than we could manage without outside assistance. I very much regret that I did not see that as a likely outcome in June 2006 or earlier. Thank you for your attention. I am happy to assist the committee and to answer your questions.