Why a recession is exactly what the Irish economy needs

Summing up the modern economy into one sentence isn't easy. But George Carlin, the American comedian who died this week at 71, gave as good a stab at it as any of us. "People spending money they don't have on things they don't need."

It's a message that the Irish should ponder, now that they face their first recession since the 1980s.

According to the Economic and Social Research Institute in Dublin, the Irish economy will fall into recession this year as consumer spending, exports and the construction industry all start to contract. The Irish finance minister Brian Lenihan has blamed external factors such as rising oil prices and the credit crisis, while critics have lambasted him and the government for squandering a series of surplus budgets during the Celtic Tiger's good times.

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In reality, neither is correct. The chief culprit is not Fianna Fail, the majority party in government. Neither is it Leroy Armstrong, the trailer-dwelling American who was given a sub-prime mortgage when he couldn't even hold down a job, never mind a monthly credit repayment.

No, the real culprit lies in Frankfurt.

The Irish economy, as we've pointed out before in MoneyWeek, was ticking along just fine before Ireland joined the euro. In 1998, GDP growth stood at 8.7% and inflation at a dreamy low of 2.2%. Interest rates meanwhile, were at over 6.2% and on the rise. Then, as if fourth gear wasn't enough for the economy, the Irish government strapped a super charger to the engine and whacked it into sixth. Ireland joined the Euro.

On joining the euro, interest rates dropped, and by 2000 stood at 4.5%. House prices soared, the building sector boomed and emboldened by the strength of the economy, the Irish binged on the cheap credit made available by the mandarins at the European Central Bank in Frankfurt. Timber decking was slapped onto the back of new build houses in the suburbs and wide screen plasma TVs became a feature in living rooms up and down the country. All of it fuelled by the housing bubble.

Had Ireland had an independent monetary policy, it could have set its own rates, and stopped the madness before it began though judging by what happened in Britain, perhaps not. In any case, what actually happened was that Irish people borrowed enthusiastically against their homes, as the ECB looked to waken the sleeping German economy from its prolonged slowdown. The slumbering factories of the Ruhr Valley, were more important to the ECB than the booming car sales showrooms that ring the outskirts of Dublin city.

Now, Ireland is facing a jump in unemployment form 4.5% to 7% as high interest rates dampen the construction industries prospects and 20,000 people are expected to emigrate this year.

But is the recession such a bad thing? As John Stepek, Deputy Editor at MoneyWeek pointed out on Newstalk Radio, the Irish radio news station on Tuesday, not at all. In fact, it's probably exactly what Ireland needs right now.

Recessions, as the economist Joseph Schumpeter pointed out, are a necessary evil in a capitalist economy. They clear out the unnecessary fat that's built up over years of prolonged economic growth, and are thus the price we must pay for that growth. That's not to say it won't be painful. The bust which follows a particularly wasteful and overblown boom like this one will hurt badly. Plenty of people will lose their jobs.

But gradually, the saving rate will go up and consumers will repair their balance sheets. First-time buyers will relearn the habit of building up deposits rather than stretching themselves on 100% mortgages, and will be able to buy houses at reasonable multiples of their income.

And with national debt standing at 30% of GDP, compared to 130% in 1986, the Irish public finances are in much better shape than they were back then. Unemployment might rise above 7%, but in 1986 it stood at a jaw dropping 17%. The Irish economy is slowing, like the rest of its western counterparts. But overall, it's far from being the European country in the worst position to weather a downturn.