Professor John FitzGerald:

I thank the Chairman and thank him for the invitation to appear.

I should say at the beginning that I speak for myself and I do not speak for the ESRI. I will attempt to respond to the questions, which I was asked, on a range of economic issues.

Over the period 2001-07, in a wide range of publications, together with my colleagues, we repeatedly warned about the dangers posed for the Irish economy by the growth of a property market bubble and of the need to use fiscal policy to defuse the situation. If the advice on fiscal policy had been followed, Ireland would probably have escaped much of the damage that was suffered over the recent crisis. However, we did not draw the connection between the growth of a property market bubble and the risks to the financial system. In 2008 in our medium-term review, wefailed to foresee the impending financial collapse. The review had a short shelf life because six weeks later we published the quarterly economic commentary which carried headlines that Ireland was in recession. I am afraid its shelf life was short.

I was asked questions about the economic recovery of the 1990s. Having spent the 1980s dealing with a major budgetary crisis, the economy entered a period of rapid growth in the 1990s. The ground had been prepared by a very substantial improvement in competitiveness and the restoration of order to the public finances in the 1980s.

There were a number of underlying strategic factors in the Irish recovery. These included the completion of the EU Single Market which was particularly important for us at the end of 1992. In addition, there was the effect of investment in education, because Ireland had lagged behind the rest of northern European for a long period. Finally, the rising participation of women in the economy was important. These factors helped to produce a sustained rapid period of growth in the 1990s.

Due to the fact that growth was fuelled from outside of Ireland, it resulted in a substantial movement into a current account surplus of the balance of payments. That meant that savings were enough to fund investment. We did not need a capital inflow to the banking system to fund the very rapid growth because we were living within our means.

A significant part of the growth of the 1990s represented a catch up on the rest of the EU 15. There is an interesting article by Cormac Ó Gráda which was published in the ESRI's quarterly economic commentary which brings this matter out. The interesting thing about Ireland was that bad policy, over a very long period, managed to keep us down. Then we had a recovery in the 1990s which acted as a catch up to probably where we should have been otherwise.

By the end of the 1990s, and into the first few years of the 2000s, the catch up phase was completed and the rate of productivity growth slowed rapidly. While exports continued to grow, domestic demand began to rise quite fast. People reacted to their higher living standards by spending more on consumption and, in particular, investment in housing. This rise in domestic demand was further fuelled by stimulatory fiscal policy which going back to the medium-term review of 1999-2001, and so on, we felt was unwise and a fueling of an already very rapidly growing economy. Rising expectations saw a gradual disimprovement in competitiveness due to wage inflation which adversely affected exports. The current account of the balance turned negative.

I expressed serious concerns about the nature of fiscal policy, in particular in 2001, but it was probably only in 2003 that growth really began to outstrip the potential of the economy, giving cause for real concern. The bursting of the dotcom bubble in 2002 took the steam out of the economy, which we were worried about in 2001, and that postponed the turning point.

I was asked to say something on the external policy environment. With the advent of monetary union in 1999, the ECB took over control of monetary policy so that interest rates were not set to meet the needs of individual economies. They were set as they are today to meet the needs not of Germany but of the EU economy as a whole. Monetary union also facilitated the free movement of capital, as anticipated. It reduced the risk premium, which is the cost of capital. In the 20 years between 1979 and 1999, Ireland paid 2% more on average than Germany, controlling for everything else. There was a risk premium which meant investment was more expensive. We were less competitive than Germany. That risk premium disappeared with monetary union. Prior to monetary union, Ireland and Spain had probably under-invested in housing as we had a higher cost of capital than in countries like Germany or France. Given the demographic profile, we needed to invest in housing. In permitting a more rapid adjustment to the housing stock, the lower cost of capital was beneficial. However, it was the failure to appropriately control this surge in investment which eventually proved fatal.

Monetary union had its benefits, but it required governments to act differently. In our case and in the case of Spain, governments did not act differently. When the property boom got out of control in the period 2003 to 2007, the intensity of the investment went well beyond domestic savings and the counterpart to the deficit was the inflow of funds through the banking system. The demand for credit to fund investment ran well ahead of the ability of the banks to meet from their own domestic funds. However, it proved easy and cheap to borrow additional funds abroad. In the period before monetary union, a constraint on such expansion might have been the exchange risk involved in such borrowing but the experience of EU countries outside monetary union shows that a change in the world economy had taken place. This was partly due to US policy and meant that cheap money was available not just because of monetary union. Estonia and Latvia were not members of the eurozone, but they suffered exactly the same experience of a massive property bubble fuelled by very large investment through the banking system of very cheap money. One should not blame monetary union as it was a worldwide phenomenon of cheap money which governments and central banks failed to manage appropriately.

The turning point was 2003, but one can argue about it. The current account of the balance of payments was in deficit that year, though the size was small, but wages had been rising rapidly for a number of years and the loss of competitiveness was beginning to take a toll, notwithstanding that it was not yet that serious. House prices in 2003 returned to growth at more than 10% a year and the demand for credit was outstripping the ability of the banks to fund it. One began to see the banks borrowing abroad in the inter-bank market to fund the expansion of credit. The demand for housing, however, had a real basis in terms of the rising population. House completions at nearly 70,000 were running ahead of the actual increase in population and there was no sign of the rate of increase in house prices slowing. An important factor driving that was what I call the "user cost". People expected house prices to rise in future which made buying a house much better than renting because rents would go up. That proved self-fulfilling and produced a bubble effect. Over the period to 2007, the current account deficit ballooned reflecting the fact that domestic savings were not enough to fund the investment boom. We had to borrow from abroad, which resulted in increasing vulnerability for the banking system and a rapid rise in household indebtedness.

It is impossible to identify when the bubble became irreversible. The last chance to stop it without disaster was probably in 2006. By the end of that year and moving into 2007, house prices were far above their equilibrium level and collapse became inevitable. I have provided the committee with a detailed appendix which I will not go through here. It shows that the dangers were apparent, even if disaster was not certain. One further factor which aggravated the cost of the collapse was the fact that the building and construction sector was like a tumour which grew and grew, squeezing the rest of the economy. Fortunately, it turns out not to have been cancerous and we are getting over it. However, real jobs were squeezed out in the rest of the economy. This contrasts with the situation in the UK, which also had a property bubble. However, they did not allow any building so that when prices collapsed, there was not a collapse in a large part of the economy. The expansion of the building sector in Ireland meant that it had to bid resources away from the rest of the economy. This was done through inflation which made the rest of the economy uncompetitive. This killed off a significant number of firms and jobs in the exporting sector. These jobs did not seem important at the time and nobody noticed they were going in the absence of news headlines, but they have proved crucial. We really need those jobs today.

I turn finally to the policy response. The dangers the economy faced as a result of the over-inflation of house prices, the build-up of debt and the loss of competitiveness in the economy were foreseeable and foreseen. The build-up of the bubble could have been prevented by appropriate fiscal policy or by appropriate prudential action by the Central Bank and the regulator, or both. Either one of these policy instruments, if appropriately deployed, could probably on its own have prevented disaster. Both together would have prevented disaster. On fiscal policy, I note that from 2001 onwards in many publications, I and my colleagues pointed to the need to tighten fiscal policy. Instead, in an economy that was growing strongly and well above potential, fiscal policy pumped money into the economy in six out of eight budgets. There is a graph which shows this. When the economy was growing rapidly, successive Governments pumped money into it, which greatly aggravated the situation. If instead the Government had run a deflationary fiscal policy, as we recommended repeatedly, and built up a substantial surplus, it would have taken the steam out of the housing market and reduced pressure on the labour market. The case of Finland is instructive. Having experienced the same disaster we did only 20 years earlier, it ran up a current government surplus of 5% to prevent a repetition.

In addition to operating a much tighter fiscal policy in the 2001-07 period, I recommended using specific fiscal instruments to take the heat out of the building and construction sector. We recommended getting rid of all building incentives and, possibly, taxing mortgage interest payments. The UK Treasury visited us and published a paper in 2003 which said that if the UK joined monetary union it would need to use fiscal instruments to manage the housing market. The Treasury recommended using stamp duty, but the problem with that is it would lead to higher household debt. My feeling was that taxing mortgage interest payments would discourage people from taking on debt. As people would end up with lower debt, it would be a better instrument. Either way, one could have used fiscal instruments to take the heat out of construction. A further result would have been a smaller balance sheet in the banking sector. If the building sector had not been allowed to grow and fewer houses had been bought at lower prices, the banking sector would not have been vulnerable.

I will not go into banking regulation and macro-prudential policy in detail. It was the other instrument which could have been used. There were a range of ways the Central Bank and the regulator could have stopped the growth in credit, as demonstrated by research from within the Central Bank itself by Kieran McQuinn and Gerard O'Reilly. They wrote a number of papers on how credit growth is important in fuelling house prices. If the credit channel had been choked off in 2003 to 2007 by the regulator, it would have halted the rise in house prices or, at least, achieved an appropriate moderation. Policy instruments were available.

By 2007, it was probably too late to prevent a major crisis from occurring in 2008. However, if urgent action had been taken in the form of a tightening of fiscal policy or regulatory action, it would have reduced the subsequent damage. It would have reduced the indebtedness of the household sector by stopping the boom earlier. If people who bought in 2007 had not bought, they would not be in difficulties today. The bloated balance sheets of the banks would have been smaller. However, if policy makers ever considered such action, which I do not think they did, they might have decided that bursting the bubble deliberately in 2007 or early 2008, with serious consequences, was much less attractive than hoping for redemption by delaying action. It became politically difficult even at the best of times to take action once things had gone that far. If any action had been taken in 2007, it would probably have left a smaller problem to be dealt with.