Using financial variables to estimate the Irish output gap : do they make a difference?

Potential output estimates during Ireland's pre-2007 housing boom showed narrowing output gaps and positive structural budget balances. These results helped to create a false sense of security among domestic policy makers. It took a deep economic and financial crisis to learn that Ireland had been building up huge imbalances and that its public finances had feet of clay. The misjudgement of economic conditions and the underlying budgetary position derived from the specific nature of the boom in Ireland in the 2000s. Ireland's housing and construction boom was a credit fuelled bubble, facilitated by light-touch banking supervision, which fed sharp increases in government revenue and expenditure. Although some indicators prompted warnings from the European Commission and others, established methods for estimating output gaps did not reveal the full extent of the imbalances growing in Ireland in the run-up to 2007. This is because such methods are geared towards tracking conventional business cycles and do not really gauge the economic and fiscal impact of a rapid increase in financial variables such as bank credit and property prices. Indeed, broadly stable inflation rates and capacity utilisation close to normal at the time pointed towards a 'soft landing' for Ireland. In this Economic Brief, we estimate what we call the financial output gap in Ireland. We follow an approach proposed by Borio and others (2013) that allows us to take into account financial variables. We obtain estimates of the financial output gap that would have supported a more cautious assessment of economic conditions and in turn of the underlying fiscal position in Ireland in the years leading to the crisis. This conclusion holds using both historical data available today and data available in 2007 at the height of the Irish housing boom. At the same time, some health warnings are in order. Although the approach works well for the 2000s, it produces estimates that are less plausible when compared with conventional business cycle estimates for the late 1980s and the early 1990s. Thanks to improvements in the EU's economic and fiscal governance rules introduced in 2011, financial variables now receive greater attention so that the build-up of credit-fuelled housing booms can now trigger relevant EU surveillance instruments.