When central banks lower interest rates, however, they give the market hope about future consumption based on savings which do not exist. Businesses expand, individuals spend more and invest more. For a while it seems like the economy is growing healthily, however it is based on demand which does not really exist since the savings that promise future growth are absent. When the illusory demand is revealed, many of the expanded businesses realize that they borrowed money in expectation of demand that never existed and now, unable to generate enough revenue to pay back their loans, they go bust:
Investments in them need to be liquidated, some at a total loss. The investments in those long term projects now look like irresponsible speculation on an assumption of future growth. The Austrians call them “malinvestments.”
Just to make it easier to see any correlations, here are the two graphs crudely overlaid:
As predicted, low interest rates coincide with high investment in construction. When interest rates rose, the construction bubble burst. If we look at employment in the construction sector from 2004 to 2007 we see the same rapid rise, stagnation and then decline:
So far so good, we are seeing fairly clear data. The United States, to give another example, also experienced a housing bubble when the Federal Bank kept interest rates low in the early 2000s. Japan, meanwhile, halved interest rates from 1986 to 1987, keeping them low until beginning to increase them in 1989. The country experienced a frenzy of construction speculation; by 1991 the total land cost of a country the size of California was worth four times the total property of the US. In 1980s Japan, as 2000s Ireland, confidence that property prices would keep rising led individuals to take out colossal loans with the belief that they would be able to sell on their homes at a profit and pay off the mortgage:
So Mr. Nakashima, a Tokyo city government employee who was then 36, took out a loan for almost the entire $400,000 price of a cramped four-bedroom apartment. With property values rising at double-digit rates, he would easily earn back the loan and then some when he decided to sell.
Or so he thought. Not long after he bought the apartment, Japan's property market collapsed. Today, the apartment is worth half what he paid. He said he would like to move closer to the city but cannot: the sale price would not cover the $300,000 he still owes the bank.
So why did the European Central Bank keep interest rates low while Ireland was booming, helping to create the disastrous construction bubble?
One problem was that some of Ireland's EU neighbours were not growing much in this period at all, so interest rates were kept low to stimulate their growth. Germany had a consistently high unemployment rate (oddly enough their unemployment is far lower now than it was in the early 2000s). Its GDP slid in and out of recession and its inflation rate was a lot lower than Ireland's.
So the ECB followed policies that attempted to boost those slow-growth countries like Germany, but this badly damaged peripheral countries with differing economies, like Spain and Ireland. The Austrian School economists would have us do away with central banks completely, but at least this crisis raises questions about the ability of a European Central Bank to manage several distinct eurozone economies all at the same time.
For a more complex and nuanced look at the role of euro-membership and Ireland's economic crisis, read Professor Patrick Honohan's Euro Membership and Bank Stability Friends or Foes? Lessons from Ireland.