Antoin Murphy: Virulent seeds of a crisis that brought Ireland to its knees

The property market crisis emerged as a result of excessive optimism by the government, developers and property purchasers in the virtues of bricks and mortar. The first phase of the Celtic Tiger emerged in the second half of the 1990s when the Irish economy produced GDP growth rates that were exceptionally high, averaging over 8 per cent.

These growth rates, along with Ireland's entry into the eurozone at the start of the new century, generated higher levels of confidence. Increased incomes, low interest rates and immigration produced a new demand for property.

When the property market started its inevitable downward path in 2007/8, events in the US – most notably, the collapse of Lehman Brothers – focused attention on the fragility of the Irish banking system which had been borrowing excessively in the short-term international financial markets and lending long-term to finance property market acquisitions.

The property market in effect produced the second crisis, namely the banking crisis. The freezing of international interbank lending that emerged from the collapse of Lehman Brothers blocked Irish banks from the international money markets and also triggered off an incipient capital flight out of the Irish banks.

Faced with the possibility of a systemic failure of the Irish banking system, the Irish government decided on September 29, 2008, to provide a blanket guarantee for depositors and bond holders of the Irish banks.

This decision was a crucial one. In the short term, it stopped the capital flight and appeared to stabilise the banking system. It could be argued that it was necessary because without it the Irish banking system would have collapsed. However, the blanket insurance guarantee contained the very virulent seeds that have blossomed to produce the current financial crisis. Guaranteeing depositors and bondholders also involved taking a strong view on the quality of the bank's assets.

This view was woefully wrong. The banks, their auditors and the Financial Regulator grossly overvalued their loan books. The quality of many of their loans to large-scale developers proved to be embarrassingly wrong, ultimately wiping out the capital of the Irish banks and leaving deep holes in their balance sheets. Nationalisation of Anglo Irish, along with 95 per cent nationalisation of Allied Irish Bank and a sizeable government shareholding of Bank of Ireland, has still not solved the problem of the acutely weak balance sheets of Irish financial institutions. This weakness has led to the withdrawal of some deposits by corporates from the Irish banks, forcing the European Central Bank to provide up to 100 billion euros of funding to the Irish banking system.

The property and banking crises generated in turn a third crisis – the fiscal crisis. The success of the property market had produced a ready source of tax revenue for the government in the form of stamp duty, capital gains tax, VAT, etc. The collapse of the property market greatly reduced the Exchequer's finances. This, combined with the downturn in the economy which reduced income tax and increased social welfare payments, produced a sizeable budget deficit. To finance this deficit, the government will introduce a strongly deflationary budget on December 7 as well as a commitment to a four-year austerity programme.

The financial markets have pushed up the spreads between Irish and German government bonds to very high levels with the yield on 10-year Irish bonds moving over 9 per cent at one stage last week. Initially the perceived reason for this was the markets believed that the Irish government would be unable to finance the budget deficit band would have to have recourse to the European Financial Stability Facility (EFSF) in much the same way as Greece was obliged to access it earlier in the year. Such recourse to the EFSF involves surrendering a great part of a country's fiscal sovereignty and is an option which Irish policy-makers wish to avoid. I believe that they can do so because of three factors:

There is already funding in place which obviates the need to borrow internationally until June 2011;

The government can finance part of the deficit by drawing down five to six billion euro from the Irish National Pension Reserve Fund;

Changes in legislation relative to Irish pension and insurance funds could enable these institutions to become sizeable purchasers of Irish government bonds.

The Irish economy is in a fragile state at the moment. This should be a cause of concern for the UK. It must be remembered that British exports to Ireland are greater than the totality of its exports to the Brazil, Russia, India and China. What is bad for Ireland is also bad for the UK.

There are still strong positives for the Irish economy. First of all, the multi-national sector is producing one of the best European export growth performances. Secondly, the population understands the need to address the excesses of recent years. With understanding from our European partners, who realise that Ireland's problems are shared by many other countries, there is hopefully scope to put in place policies that will stabilise the Irish economy.

Antoin E Murphy is an Associate Professor of Economics at Trinity College Dublin. His most recent book, The Genesis of Macroeconomicsitalics, was published by Oxford University Press in 2009.