Month: April 2009

Stimulating Investment

A striking feature of the recent Quarterly National Accounts  was the dramatic fall in real investment: a 30.6 percent decline between 2007:Q4 and 2008:Q4.   The growth in real GDP over the same period was -7.5 percent.   Real investment contributed -7.3 percentage points (pp) to this change based on a standard decomposition with 2007:Q4 expenditure shares as weights.   [The contributions of the other components were: consumption (-2.0 pp); government spending (+0.1 pp); inventory investment (-1.8 pp); and net exports (+3.5 pp).]   It is worth noting that this dramatic fall in investment spending was not confined to building and construction.   In its recent Quarterly Bulletin, the Central Bank reports that overall real investment fell by 32.5 percent in 2008 (year-over-year), with building and construction investment down 35.3 percent, and machinery and equipment investment down 23.0 percent. 

Of course, investment is well known to be a volatile component of GDP.   Even so, the large decline raises concerns both because of its role in driving output below potential and also its influence on the medium-term growth path of that potential.  It is worthwhile to consider, then, what policies might be used to support private investment spending. 

One contributing factor to the decline is the contraction in the supply of credit.  Indeed, one of the central motivations for policy interventions to strengthen the balance sheets of the banks is to increase their willingness and capacity to lend.  The Central Bank’s recent Bulletin does report a modest tightening of reported credit standards between 2008:Q3 and 2008:Q4.  But the explanation for the tightening of standards is likely to lie at least as much in the problems with the balance sheets of the borrowers as with the banks.   Moreover, the deterioration in business net worth, profitability and cash flow are likely to have significantly curbed the demand for credit, explaining part of the decline in credit aggregates.

We thus need to look beyond banking policy to policy actions that might strengthen the financial condition of the non-financial business sector.   In considering possible policy actions, it is worth keeping in mind the well-supported finding from investment research that cash flow is strongly related to investment spending – particularly for smaller, less creditworthy businesses.   This is explained by various agency problems that make it hard to raise funds from financial intermediaries – problems that become more intense as the balance sheets of borrowers and the banks become weaker.    

These findings suggest the importance of examining policies that improve business cash flow.  Given the beating that business profitability has taken, cuts in corporate tax rates or investment-related tax breaks would be unlikely to have a strong stimulative effects.  However, one policy that would directly improve the cash flow (and after-tax profitability) of almost all businesses is a temporary cut in employer PRSI rates for all workers.   (Fine Gael has proposed a cut for new hires.  But this would have a very limited impact on the underlying cash flow position of businesses.)   It is hard to think of another single policy with more potential to ease the pressure on investment, production, and employment. 

Hindsight on banking crises

While I would not claim to have been able to foresee the global financial meltdown, triggered by the unprecedented crisis of structured finance, a few of the national systemic crises in Europe, including our own, occurred more or less independently and had a more traditional character.

Could early warning packages, designed to alert regulators in developing countries to the possible emergence of a boom-bust systemic banking crisis, been of use in Europe? In particular could they have provided ammunition for those who were warning about property bubble excesses in Ireland? To explore this, I revisited some old work of my own.

In a 1997 paper, published before the East Asia crisis broke and based on a statistical analysis of worldwide banking crises before 1995, I suggested two simple and readily available systemic indicators as warning flags of a possibly unsustainable banking boom. These are: the loan aggregate-to-deposit ratio and the real growth in private credit. Reluctant to claim too much, I cautioned that these flags should only be thought of as crude preliminary indicators that might generate many false positives.

In a 2000 paper, I showed that these two indicators had both indeed been flashing simultaneously during 1994-96 for all five of the countries most affected by the East Asia crisis of 1997-98. Furthermore, on that occasion there were few false positives: the flags were both raised for only five other (non-crisis) countries out of 139 countries for which data was available.

Now, revisiting this simple two-flag approach using 2004-2006 data on thirty European and selected other high income countries, I find a striking confirmation of its apparent usefulness.

Indeed, of these 30 countries the banking systems of only three countries, namely Iceland, Ireland and Latvia, registered above average values for both flags. Of course these are the three countries which have subsequently experienced the most severe bank-related collapses in Europe.

The two indicators are plotted in the Figure — the straight lines are the mean of each variable. Note how only the three countries referred to are in the top right quadrant.

Iceland, whose banking system collapsed in spectacular manner in October 2008, is the clear outlier, followed by Latvia which is also struggling — with IMF assistance — since last December, to emerge from a bank-led collapse.

Ireland was firmly in the danger zone too on this 2004-2006 data. Maybe I should have taken my crude early-warning system more seriously!

The countries included are: Austria, Belgium, Bulgaria, Canada, Chile, Croatia, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Latvia, Lithuania, Luxembourg, Netherlands, New Zealand, Norway, Portugal, Romania, Slovak Republic, Spain, Sweden, Switzerland and the United Kingdom. These represent all of the smaller EEA countries for which full data is available in IFS (Cyprus, Estonia, Malta, Poland and Slovenia missing), plus Canada, Israel and New Zealand.

Summits and the international system

Brad Setser has a typically thoughtful piece on the relative roles of summits and unilateral action in shaping the international econnomic system here.

Behavioural Economics: Should Policymakers Care?

Behavioural Economics is one of the main drivers of modern economics but we have not spoken about how ideas from this field are relevant to current Irish economic conditions. This is not a blog just for specialists so I am going to try to give some jargon-free sentences on what behavioural economics is and why policy-makers should care. This is purely my own view having researched the area since 2001 and having lectured courses in TCD and UCD on the topic and they do not reflect any attempt at capturing the consensus opinion in this field. I feel very strongly of the view that the absence of an understanding of both psychology and of policy evaluation has damaged Irish policy and that a continued cynicism about the capacities of the Irish public sector to deliver innovative policy is leading many to stop trying to think of innovation. Behavioural Economics combined with rigorous policy design is a partial corrective to these tendencies.

Basically, behavioural economics focuses on the application of psychology to economic behaviour. Increasingly, it is focused on why people make decisions in key domains relevant to economic policy. A trend has been the development of the view that policies need to be designed rigorously with respect both to potential evaluation and with respect to actual psychological principles and that such policies should stand or fall on the basis of whether they work. A recent Economist article put this at the heart of the next ten years of economics arguing that the union of behavioural economics and policy evaluation represents the most dynamic tendency in economics. Just because the Economist says it, doesnt make it so, but we should give this work credence in thinking about a potential Irish recovery.
Economist article
The most developed literature that can be applied in Ireland is the one on pensions. John McHale wrote a great piece a few years ago summarising some of the literature up to then on behavioural economics and pensions and its relevance to the Irish situation. It did not seem to have much of an influence on the debate, which is a shame. In general, financial decision making is the first area that really should be looked at if policy makers want to take behavioural economics seriously. Tax codes, legal codes, social welfare entitlements and so on are need to be gone through not just from the point of view of accounting waste. We need to look in depth at what financial incentives exist for people and how people interpret these financial incentives and whether people are disincentivised by the framing of these processes. Several experiments in the US are starting to show that simple questions of how instruments are framed, the cognitive complexity of application forms, the nature of the default setting can all have dramatic effects on behaviour. As pointed out by Akerlof and Shiller, the interaction of the psychology of financial decisions with the regulatory structure generates a lot of the negative effects seen on financial markets.
McHale Article

Secondly, behavioural economics is also focused on the outcomes of people’s decisions and, in general, is not wedded to the view that consumption is a good measure of people’s well-being. Focusing on well-being directly is increasingly a concern in behavioural economics.  In particular, looking directly about how factors such as health, unemployment, aging and so on determine well-being is increasingly a guide to developing policy. The UK have taken seriously the idea that things like home foreclosure and unemployment are not just economic events but are also psychologically distressing and have been provided psychological therapy on a more wide ranging basis than before, based on recommendations from this literature. Several other policy ideas derive from looking closely at well-being and these should not be dismissed lightly and certainly not without some debate.
Thirdly, behavioural economics is increasingly focusing on actual policy experiments in real world contexts. My own opinion is that this is the prime way in which economics can positively impact recovery in Ireland. In particular, well-designed micro-policy experiments in areas such as health, financial decisions, based on sound principles about how people actually behave is the main thing we can take from this new literature. This does not necessarily mean more government intervention (it may mean less). However, it does mean far more active discussion of specific micro-level policies in areas such as education, training, innovation and so on. A focus purely on expenditure to the absence of actual outcomes and process is characterising a lot of the current debate and this is damaging.
Some recent popular works written by leaders in the field that people might be interested in if they want to understand the potential relevance of behavioural economics to current policy are linked below.

Ireland is Internationally Competitive: Guest Post from Ronnie O’Toole

The ESRI’s analysis as released last week contains a very useful emphasis on the fact that Ireland’s Current Account deficit is fast approaching zero. However, the report also contains a seeming inconsistency, arguing as it does that that the current account imbalance is proof that Ireland has a substantial competitiveness deficit (page 2).

If both are true, could this mean that the vanishing deficit is proof that the competitiveness problem has dissipated over the last year or so? Ok, not necessarily, as the reason could be that a structural competitiveness problem could be temporarily masked by unusually high household ‘recession’ savings.

However there is another explanation. A CA deficit can come about with a very large domestic imbalance, even if a country has no external competitiveness problem. Does this simple description accurately characterise the Irish economy in 2009?

Finding out which explanation is more likely can be helped by decomposing the structure of the CA deficit that had emerged by 2007. In other words, we were importing more than we could afford for some reason – can examining those same imports help us understand why we were importing them?

Most imports go into intermediate production, so it is not easy to link each import with an ultimate end use. However using the CSO input-output tables allows us to estimate pretty well where imports were ultimately destined.

Such an IO analysis results in a stark conclusion. In 2000, final demand for GFCF induced imports of €10bn. By 2007, this had risen €8bn to €18bn. The large scale construction activity was pulling in a huge amount of imports which (ultimately) we could not afford. Add in the imports from construction workers spending wages etc, and it is very easy to see that the scale of growth of importing linked to construction could easily explain the vast bulk of the €10bn deficit that had emerged by 2007.

In contrast, while imports for the export sector increased (allowing for income repatriation), exports increased at a far faster rate. The net contribution of exports in 2000 was €21 bn, by 2007 this had risen to €33 bn.

This does not seem to be consistent with the view of an economy that had by 2007 supposedly developed a chronic competitiveness problem. Other measures would back this up – consider the UNCTAD’s measure of inward investment, which put Ireland second only to Singapore in 2007 (see NCC report).

As the construction boom source of domestic demand disappears, so too has the deficit, and well before any cost measures could possibly have an effect in terms of improving our trade performance. This is happening before our eyes in the trade figures, yet the virtually unanimous view of the Irish economic community that Ireland has a chronic competitiveness problem remains. This view is actually based on very little data – relative CPI/wage indices over the last decade or so. Without knowing where we stood competitiveness-wise at the start of this period, or relative productivity since, this proves very little.

Does all this logic (if true) change the current ‘competitive devaluation’ policy proscription much? Possibly not. The domestic imbalance is so large that a very large stimulus will be needed to reduce unemployment once again. However, if I am right, and Ireland is far more competitive that generally believed, then the upswing when it comes might be more dramatic and persistent than we could think to hope for as of today.