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.

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.
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.

Another crisis conference — mark your diaries

Since the very timely and successful event organized by Colm McCarthy on January 12, the economic crisis in Ireland have evolved significantly. We’ve had the nationalization of Anglo Irish Bank, the break-down (and relaunch) of the partnership talks, the pension levy, the announcement of next week’s supplementary budget and a steady stream of deteriorating macroeconomic statistics.

No wonder Philip Lane and I feel a follow-up conference coming on.

We’re planning to cover not only the evolving medium term fiscal and growth prospects, but also the impact of the recession on inequality. We’ll also catch up on banking developments since January.

In addition to the organizers, confirmed speakers include John FitzGerald, Brian Nolan and Karl Whelan.

In order to give the budget time to be digested, we’re scheduling the event for the afternoon of Wednesday, May 20th. TCD will host. So mark your diaries now.

As with Colm’s event, it will be under the auspices of the Dublin Economics Workshop, free and open to all, but registration will be required. Send an email to tcdconference@irisheconomy.ie to book your place.

The evanescent taxes still the main source of revenue collapse

Another picture, using the latest Exchequer returns, to illustrate the extent to which the tax collapse is disproportionately concentrated in just three taxes: Corporation Tax, Capital Gains Tax and Stamps. These fell by 56.5% in the first quarter of 2009 relative to the same quarter of 2008. The percentage fall in the remaining taxes was “only” 16.6%. This figure is in nominal terms–no deflation.

For a longer perspective, scaled by GDP, and showing just how systematically reliance switched to these boomtime taxes over the years — and away from the baseload taxes, take a look at the following:

(NB: recall that, because based on Exchequer returns, these do not include PRSI, etc).

Public Sector Pay Cuts

Speaking on today’s News at One, George Lee pointed to informal evidence from the Central Bank of average wage cuts in the private sector of 8%.  He then immediately noted that this raised the question of why there had been no wage cuts in the public sector.  (About 3.20 minutes in.)  George has a well-deserved reputation as an excellent economics reporter, perhaps the best of his kind on these islands, but this statement was unfair and unhelpful.   The pension levy is a wage cut.  It reduced the taxable income of public servants by an average of 7.5%, thus putting public sector workers exactly in line with the private sector figures that George is quoting.

As a public servant myself, I am conscious of the need to be careful when making statements about public sector pay.  However, the bottom line has to be this.  What is useful here is fair analysis of the full compensation package for public servants (including pension packages and the effect of levies) in comparison with the private sector—and the Irish economics profession has provided research of exactly this type.  What is not useful is analysis in which a pay cut is real if it happens in the private sector but not real if it happens in the public sector just because someone chooses to call it a levy.

I expect here that I will get a flood of comments linking the pension levy to the generosity of public sector pay packages.  But this would miss the point I’m making.  There is no link between this levy and public sector pensions.  The only real implication of the levy for public sector workers was to reduce their take-home pay.  Perhaps this step was needed (and perhaps more is needed) but let’s not pretend it didn’t happen.

The G20 London Summit

The prospects for the Irish economy are very sensitive to the resumption of global growth.  The VoxEU website provides some ‘instant’ analytical responses to the London Summit, including essays by some of the key UK civil servants involved in organising the summit:  the link is here.

I will be answering reader questions about the G20 summit on Monday at this website.

More on the Structural Deficit

It seems that the structural balance is going to be the primary target of fiscal consolidation in next week’s supplementary budget, thanks in part to the efforts of some of the contributors to this site, notably Philip Lane and Patrick Honohan. However, despite its obvious intellectual appeal, it is problamatical from an operational point of view: it is very difficult to estimate reliably. As a result, there is a fair amount of variation in current estimates of it for 2009, ranging from the lower bound of the ESRI’s 6-8% of GDP range to John McHale’s 9.6% in his post of March 30th.

Accordingly, all estimates of the structural deficit need to be treated with some caution. I think this is especially true of those that imply that a very small fraction of the prospective overall deficit for 2009 is cyclical in nature.

As any fiscal anorak will know, but perhaps not many normal readers, there are two main planks in the estimation of the cyclical (and hence the structural) element of the deficit: (i) the output gap and (ii) a measure of the sensitivity of the budget to the output gap. A word on each.

The output gap. The European Commission estimates that Ireland’s potential growth rate will be negative to the tune of 0.4% this year. This is surely a much lower figure than it is reasonable to use to represent the economy’s potential growth over the medium run. The ESRI’s latest estimate of the latter is 3%. Which one to use in calculating the output gap? If the former, it will mean a relatively small output gap and a correspondingly small estimate of the cyclical element of the deficit. Philip Lane has opted for this approach (see his post of March 26th). However, it can be argued that since the elimination of the structural deficit is properly regarded as a medium-term objective, it is the medium-term potential growth rate that should be used to estimate the output gap. The result is a bigger estimate of the output gap and a bigger cyclical component in the deficit.

The sensitivity measure. It has become commonplace to use 0.4 as the cyclical sensitivity co-efficient, implying that every 1% point change in the output gap changes the budget deficit by 0.4% of GDP through the operation of ‘automatic stabilisers’. The 0.4 is an OECD figure estimated on the basis of data for the 1980-2003 period. It is built up from a set of tax and spending elasticities with the overall tax elasticity computed as a weighted average of the elasticities of four different categories of tax, where the weights reflect the share of each in total tax receipts over the 1995-2004 period. An obvious point about this is that the composition of the 2008/09 tax take is different from that of this historical period.

A more important question is whether the elasticities so estimated accurately reflect the relationship between revenue and GDP in current circumstances. A case can be made for the proposition that the cyclical sensitivity of at least some categories of tax is higher than usual in the current recession. A very interesting comment from Niall on Patrick Honohan’s ‘Credit card sales’ post of March 31st sepaks to this point. He warns of a triple whammy undermining this year’s CT receipts, comprising (i) 2008 preliminary tax refunds; (ii) losses set back to 2007, and (iii) no preliminary receipts for 2009. In the OECD model, CT receipts are estimated to have an elasticity of 1.3. Does this chime with what’s happening out there?

To illustrate the difference that the above two points can make, consider the following arithmetic example. Assume a zero output gap in 2008, a volume decline of 8% in GDP and an overall budget deficit of 12 % of GDP in 2009. Now decompose that deficit into its cyclical and structural components using (i) a -0.4% potential growth rate and a sensitivity co-efficient of 0.4 and (ii) a 3% potential growth rate and sensitivity co-efficient of 0.5 (this being close to the OECD estimate of the EU average, by the way). In the first case, the cyclical/structural split is 3%/9%; in the second it is 5.5%/6.5%.

Taxpayer-Funded Car Scrappage

The retail motor trade is lobbying hard to get the government to introduce a car scrappage scheme, which would encourage people to scrap cars that are older than ten years and purchase new ones: See these pieces in yesterday’s Irish Times and the Morning Ireland interview with Alan Nolan, director of the Society of the Irish Motor Industry.

Willem Buiter discusses the plans of this sort that have been introduced in Germany, France, Italy and Spain.  He doesn’t like them—“This artificial shortening of the economic life of a car seems nuts.  It’s worse than getting paid to dig holes and fill them again.”  The case for these measures in Ireland is even weaker.  Unlike the countries listed above, we do not have car manufacturing, so this measure is largely aimed at helping a thin-margin wholesale and retail motor trade sector.

To be fair, Alan Nolan did put the case for the scrappage scheme articulately, arguing that the scheme would pay for itself by inducing new purchases and VAT revenue.  Economists, however, are always wary of claims about tax cuts and subsidies being self-financing.  In particular, schemes like this suffer from very serious “deadweight loss” problems: The government ends up subsidising lots of people who would be making the purchases anyway.

Mr. Nolan argued that since the scheme is limited to cars over 10 years old, the owners of these cars were unlikely to be in the market without this measure.  I think this could go either way.  Some people are happy to drive old cars but there is also the fact that old cars are far more likely to irretrievably break down, so their owners have no choice but to buy a new one (or take the bus …)

Beyond this small issue, there is an important general point that the government needs to be very wary of allocating increasingly scarce fiscal resources on this kind of special interest group subsidy.

Irish Household Indebtedness

Sarah Carey’s article in today’s Times raises a useful point. While figures for average levels of debt are available—and show a huge increase in debt-to-income ratios since the turn of the decade—this average ratio isn’t very useful for informing us about median debt burdens or, more importantly, about the fraction of households close to financial distress. Sarah is correct that, as of now, these statistics are not being collected in Ireland. Surveys are being used to provide estimates of these figures for Italy, Spain and the US and a survey of this type would be very useful here. I’d like to add a couple of observations about this issue. Continue reading “Irish Household Indebtedness”

Unemployment Up to 11% in March

Today’s release shows that the standardised unemployment rate, which is based on the Live Register, rose to 11% in March from 10.4% in February.  Over the past three months, the unemployment rate has risen by 2.4%, compared with an increase of 1.4% over the previous three months.

In terms of projecting GDP for the year, these figures suggest to me that the current “consensus” figure of something like a 6 percent (average-over-average) decline for 2009 is highly optimistic.  It is hard to see this huge jump in unemployment as consistent with anything other than a substantial contraction in output in first quarter.  With output having fallen by around 7 percent on a Q4-over-Q4 basis last year (whether measured on a GDP or GNP basis) the cumulative loss in output from peak has perhaps already reached 10 percent as we speak.

Once you factor in the contractionary effect of the upcoming budget, it is hard to see the economy producing a quick turnaround after the first quarter.  Working through the various scenarios along the lines of my post from last week, it’s very hard to see an average-over-average growth rate better than -8% this year and very easy to imagine scenarios that are worse.

An aside on the term ‘macro’

A few years ago, when Ben Bernanke’s appointment was ushered through the US Senate with hardly a murmur, Michael Evans—author of a once widely-used textbook called Macroeconomic Activity—quipped, ‘Macroeconomics, unless it messes up, doesn’t matter very much any more’.  Macro is no longer passé, however, so TCD’s Antoin Murphy is lucky in the timing of his The Genesis of Macroeconomics (just out, Oxford University Press). 

 

As Antoin points out the term ‘macroeconomics’ was coined by Ragnar Frisch in 1933.  Frisch also invented ‘microeconomics’ and ‘econometrics’, as well as some other terms that never caught on.   But ‘macroeconomics’ was still unfamiliar enough in 1945 for an article in the American Economic Review  to use it with the ‘macro’ bit in inverted commas.  It might never have caught on but for the Great Depression and Keynes’s General Theory.  Ironically, though, Keynes himself does not seem to have keen on the term.  Who was the first Irish economist to use it?

 

If JSTOR is to be trusted, the first use of the term in an academic journal was by Jan Tinbergen in 1936 (in ‘Sur la determination statistique de la position de l’équilibre cyclique’, Review of the International Statistical Institute, 4(2) (1936): 173-188).  Tinbergen, by the way, shared the Nobel Prize with Frisch in 1969.  The term was slow to catch on: one JSTOR ‘hit’ before 1940, three in 1940-44, and forty-four in 1945-49.  The story thereafter, as reflected in JSTOR, is summarized in the accompanying table.   Will these ‘interesting times’ reverse the apparent downturn in usage?

 

Year          ‘Hits’
1935-9 1
1940-4 3
1945-9 44
1950-4 149
1955-9 217
1960-4 436
1965-9 959
1970-4 1639
1975-9 2806
1980-4 4429
1985-9 6385
1990-5 7368
1995-9 8028
2000-4 7186