It used to be said that the difference between Ireland and Iceland was just one letter and a few months, but there is more, writes DAN O'BRIEN

TWO SMALL north Atlantic island economies. Two financial crises of historically enormous proportions. Two IMF-backed bailouts. Two peoples stunned by their reversals of fortune and fearful of what their uncertain futures hold. Ireland and Iceland have a lot in common.

But how much have their economies had in common since their bubbles burst and what acounts for the differences in performance? This column attempts to answer the first question. Next week’s column will tackle the second.

Any rigorous comparison of how the two economies have fared must consider many relevant indicators to arrive at a rounded picture. Output, employment and wealth are the most important of these.

On the most basic measure of output – gross domestic product (GDP) – both economies have experienced very similar declines over similar periods. GDP levels in the two economies peaked within three months of each other in the second half of 2007. Both reached a low point (thus far) in the second quarter of 2010. Iceland’s peak-to-trough decline in GDP was 15.1 per cent, Ireland’s slightly smaller, at 13.3 per cent.

Headline GDP, though, does not illustrate how bad the collapse has been for either economy, because of the effect of imports.

When a country imports less, its GDP rises, all other things being equal. But buying fewer foreign things that are better, cheaper or simply unavailable at home is a sign of economic weakness, not strength. The huge declines in imports in both economies reflect extreme contractions in their domestic economies.

Strip out imports (and exports) from the GDP numbers and you are left with domestic demand, usually a better indicator of conditions on the ground. Icelandic domestic demand reached a low point in the second quarter of 2010, having contracted by 36.3 per cent. Ireland’s low point was the third quarter of 2010, by which time the decline had reached 27.2 per cent.

Disaggregating the domestic demand numbers shows that the composition of the contraction was very different in the two economies. In Iceland, most of the contraction was the result of a 27 per cent decline in private consumption – that is spending by households on goods and services. In Ireland the peak-to-trough decline in private consumption was 10.7 per cent.

One reason for Iceland’s consumption collapse was the huge decline in real wages as a result of the inflationary shock of the króna going into freefall. While the price level was 1 per cent lower in Ireland in December 2010 compared to January 2008, it was 38 per cent higher in Iceland over the same period (as measured by the EU’s harmonised inflation rate in both cases). Very high interest rates, which were hiked to 18 per cent in an attempt to stabilise the currency, further hit heavily indebted Icelanders.

In contrast to Iceland, a collapse of investment accounts for the biggest share of Ireland’s contraction. Here, the building frenzy far exceeded anything that happened in Iceland. For instance, annual housing completions at the height of the bubble were running at more than four times the long-run average. In Iceland at the peak, new housing output was about twice the long run average.

When the building boom came to a shuddering halt in Ireland, spending on construction – which is classified as investment in the GDP numbers – crashed. This explains why the employment shock in Ireland has been considerably worse than in Iceland, despite the smaller output shock. One in seven jobs has disappeared in Ireland, Iceland has lost one in 10. More than half of the decline in Irish employment since the crisis began has been caused by the 155,000 fewer people working in construction.

If the sort of financial crisis experienced by the two economies severely affects output and employment, the impact is greater still on wealth – i.e. the value of assets less liabilities.

Irish figures illustrate the impact. Net financial wealth of Irish households fell by 55 per cent from late 2006 to early 2009, a far larger peak-to-trough change than registered in any output or employment measure.

Since then, half of that wealth decline has been clawed back owing to the paying down of debt, which reduced liabilities, and a rise in the value of assets – mostly of non-Irish assets held by pension and insurance funds.

As Iceland’s statisticians are only now preparing figures on sectoral balance sheets, direct comparison is impossible. But there are indicators which allow a partial comparision to be made.

One is equity prices. Iceland’s main share index suffered one of the largest falls anywhere when the crisis broke, losing 95 per cent of its value over the course of the crash. It has since recovered almost no ground.

Dublin’s main index lost four-fifths of its value. It has since made up some ground, standing at 70 per cent of peak.

One balance sheet problem which Iceland has faced but which Ireland has been spared is the effect of currency depreciation on foreign liabilities. In the era of cheap money and risk blindness before the crisis, banks, corporates and even households exposed themselves to exchange rate risk by borrowing in foreign currencies.

When the Icelandic currency depreciated by more than half, their króna-denominated liabilities ballooned.

Plans for debt restructuring of the household and corporate sectors are now well advanced after an extended period of forbearance while the structures and mechanisms to do this were designed and put in place.

In summary, Iceland has suffered more seriously than Ireland by every major measure other than employment. Why this is so will be addressed here next week.