The Role of Over-Lending in the Financial Crisis in Ireland

Before the 2008 financial crisis, banks in Ireland embarked on an over-lending strategy, which finally led to the 2009 financial crisis in the country. Although other international factors were attributed to the crisis, one internal factor that stood out was over-lending. The crisis led to the decline in property prices, an increase in the prices of food, and massive unemployment due to the fact that most companies could not sustain their respective wage- bills. In the aftermath of the crisis, the relevant authorities.

Gerlach-Kristen and Merola (2019), stated that if households are not capable of smoothing their consumptions, the drop in the in aggregate expenditure can lead to a vicious circle in regards to the failing output, falling asset prices and the increase in credit constraints as a measure to limit the effects of the financial recession. In order to determine how credit constraints emerged and spread, the authors used a small DSGE framework that linked the household's exposure to credit to the value of the security it has to bargain. In this case, the authors used housing as collateral. The other data used in the model included household consumption, debt, and leverage. If the value of a house declines, the leverage ratio of a domiciliary, demarcated as the remortgage debt, which is comparative to its housing capital rises. If the leverage proportion is more than the determined loan to value ration used by financial institutions that accept loan applications, then the household is rendered as credit controlled. It then fails to smooth consumption and therefore relies on the investments to deleverage. The same effect is also present even in a case where households only expect a decline in the future prices of houses and are currently not facing any credit constraints in the meantime. Friedman (1957), gives a varied explanation in the sane, which is in case the permanent income declines, there is a high likelihood that consumption will also decline stated by the permanent income hypothesis. Lastly, Aron et al. (2012) stated that consumption can fall due to the liquidity or credit limitations.

The model established by Gerlach-Kristen and Merola (2013) depicts that credit constraints in an economy can arise from the failing prices of properties, which in turn reduces the value of the collateral and ultimately increases the leverage ratio of indebted households. The prediction of the model state that households experiencing negative equity will consume less than what the average household will consume. The model reveals that households are likely to stop smooth consumption even if they only assume a deterioration in the prices of houses in the impending days and presently are not yet faced with a credit limitation. In short, the model suggests a role of precautionary savings. Such insights can be used by policymakers to help in the formation of economic guidelines, especially when there is a negative slant in the households' expenditure. Figure 2 depicts the consumption and income by age, and it was clear that younger households were affected more as compared to their older counterparts. It reveals that younger Irish households acquired their property during the boom phase, and in the crisis most of them had negative equities and therefore could be trying to re-establish their financial statements. Therefore, policy makes must establish the relevant policies that would address the suffering experienced between these age gaps.

In reference to data and information collected from Ireland, it is clear that an economic crisis that goes together with by property bust, the consumption smoothing is mostly disrupted for mortgage household that is highly leveraged in the market. One policy to reduce the effect of credit constraints is, therefore, to constrain the exposure household can take, for example, to enforce a maximum governing loan to loan value. Among the European countries that share the same features highlighted in Ireland include, Spain and Italy, while countries such as Portugal and Greece gave had contrary features, especially when looking it from the perspective of Real Per Capita Consumption Expenditure as shown in Figure 1. Apart from these findings, a study by Kang and Sawada (2003), revealed that just as people in Ireland, Koreans also coped with financial shocks by reducing on their consumption on luxury goods, but unlike the Irish, Koreans maintained their expenditure on food, and other basic household needs.

Reference

Aron, J., Duca, J.V., Muellbauer, J., Murata, K. and Murphy, A., 2012. Credit, housing collateral, and consumption: evidence from Japan, the UK, and the US. Review of Income and Wealth, 58(3), pp.397-423.

Friedman, M., 1957. A Theory of the Consumption Function. number frie57-1. In ‘NBER Books.’.

Gerlach-Kristen, P., and Merola, R., 2019. Consumption and credit constraints: a model and evidence from Ireland. Empirical Economics, 57(2), pp.475-503.

Kang, S.J. and Sawada, Y., 2003. Credit Crunches and Household Welfare: The Case of the Korean Financial Crisis. CIRJE Discussion Paper Series, 234

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