Fiscal Policy for Recovery

The paper presented by John Fitzgerald at the Kenmare conference is available here.

15 thoughts on “Fiscal Policy for Recovery”

  1. 1. ‘Recovery’ – whatever that means, is assumed. Wishful thinking: D-

    2. Mentions ‘models’ a lot. The real world is, like, real! If you have lots of un-employed you have lots of negative income, is this a model? Seems like a fact.

    3. Mentions taxes. We have a ‘business-as-usual’ paradigm about taxes. Only the non-rich pay! How about we scrap ALL tax reliefs, without exception, for every citizen without exception, and levy a tax of 20% on all income, regardless of source. Suck this and see. Modify if necessary. Problem with un-employed – yes! But use your initiative to lessen the worst effects. Is this too difficult?

    4. Introduce a 100% income tax band at E175,000. No exceptions. Oh! No one will work for this. Fine, tell them to **** off. Someone WILL work for this – guaranteed! We DO have lots of, (cough, cough), un-employed persons.

    5. Introduce a Debt Jubilee. If you do not do this, then you will have many Debt Slaves who will not be able to resume consuming. Serious social (and political) upheaval will ensue. This is political nitro!

    6. Throw the zombie banks to the market wolves. Damn the consequences. The sky won’t fall. Remember the 10 week bank strike some time back? We managed fine.

    7. Purchase a case of whatever you fancy, and stay submerged until the worst is over! My recommendation; Ch. Musar, or Sicilian.

    B Peter

  2. This ESRI report is sensational. For that reason, it will be most likely ignored by the media. It is basically saying that, subject to a couple of not particularily onerous conditions being satisfied (described below), the Celtic Tiger is on its way back and will be making its reappearance in about a year’s time. IF the forecasts in this report prove accurate, then JohnTheOptimist’s posts on this site will have been totally vindicated, as will those of some other posters, while David McWilliams and Morgan Kelly will be toast. Should this seem a trifle over-boastful on my part, note that I used the word ‘IF’ to start the last sentence. I’m saying that would be the case IF the ESRI forecasts prove accurate. Those taking a diametrically opposite point of view are, of course, entitled to reject the ESRI forecasts. That’s democracy. But, if they reject them, they ought to specify why, providing the same level of detail as ESRI have done.

    Before proceeding, I would say that it is a bit disappointing that so few have posted on this thread (only one other at the time I’m writing this). This site is read throughout the world, including by Nobel Prize-winning
    economists. It ought to be a showcase for serious debate and analysis of the Irish economy. It looks bad when silly threads about astrologers get far more posts, or threads complaining that the Minister of Finance has called them ‘mediocre’ get scores of economists posting to complain within 5 minutes of their being opened. Yet, this thread relating to a document put out by ESRI, containing the most detailed analysis published to date on the prospects for the Irish economy in the next decade, didn’t have a single post 8 hours after it was opened and, last time I looked, had still only received one post.

    Below, I summarise under various headings what the report predicts. I’ve done this as accurately as I can. But, naturally, if the authors feel that I have misrepresented what they say in any way, I’ll withdraw the offending comments.

    ECONOMIC GROWTH:

    In a nutshell, ESRI forecast that GDP growth will average 5.6% annually and GNP 5.4% annually from 2011 to 2015. That would mean GDP increasing by 31.3% between 2010 and 2015 and GNP by 30.1%. These growth rates are lower than in the peak years from 1994 to 2000, so it might seem that my claim that the Celtic Tiger is on its way back is exaggerated. However, it should be pointed out that these growth rates are from a much higher base. Despite the recession, GDP in 2010 will be twice what it was in 1994 and quadruple what was in the 1980s. A 5.6% growth rate annually from 2011 on adds as much wealth as the 10% to 11% growth rates that were achieved between 1994 and 2000. And, on the same basis, they would add as much wealth annually as growth rates of 22% to 23% would have in the 1980s.

    So that I’m not accused of over-egging the pudding, I should make clear that ESRI forecast these growth rates only if the following two conditions are satisfied:

    (a) That wage levels are cut by a further 5% over the next 2 years (this is on top of the 2% the authors say has allready occurred this year). They say that a total cut of 7% in wage levels over the 3-year period (2009, 2010 and 2011) is necessary to restore competitiveness.

    (b) That the next budget contains a fiscal adjustment of 3% of GDP (or €5 billion), and a further adjustment in 2011. But, beyond that, ESRI now say that cuts in public expenditure need be less severe than previously thought as economic growth will be higher than previously thought and, in particular, need be less severe than those recommended by An Bord Snip Nua.

    In my past posts, I have argued against wage cuts and public expenditure cuts. However, I have now changed my mind. My previous opposition was based on forecasts at the start of this year (by Central Bank, ESRI and the Department of Finance) that inflation would average 2.5% to 3% in 2009. However, its currently -3% (HICP) and -6.5% (CPI). So, the sort of cuts that ESRI envisage are not particularily onerous against those rates of inflation. In some of my posts on other threads recently, I’ve criticised the failure by economists to make accurate inflation forecasts for 2009. In their report, ESRI acknowledge this failure and say: “The failure to foresee the fall in consumer prices meant that the inflation rates underlying the budget for 2009 were much too high.”

    While I can now go along with ESRI’s suggestion regarding wage cuts, I’m puzzled by one thing. ESRI say that so far wage levels have fallen by about 2%. And, they may well be correct, I simply don’t know. However, in the Irish Times today, the IBEC economist says that wage levels have allready fallen by 11%. I don’t know which of ESRI or IBEC is correct. But, were it the case that IBEC was correct, then I assume that ESRI would see no need for futher wage cuts beyond that, at least in the private sector.

    I have done some further quick calculations NOT in the ESRI report, but based on the assumption that their forecast growth rates prove accurate.

    (a) By 2007, GNI (repeat: GNI, not GDP) in Ireland was 14.5% above the EU15-average and the third highest in the EU after Luxembourg and the Netherlands.

    (b) Assuming ESRI’s forecasts for the falls in GDP and GNP in 2008, 2009 and 2010 prove accurate (I have posted on other threads that I think they are over-pessimistic and Davy, NCB, BoI and NIB now agree, but I won’t nitpick here and I’ll assume the ESRI ones do prove accurate), by 2010, GNI in Ireland will be just 4% above the EU15-average and down to the fifth highest in the EU after Luxembourg, the Netherlands, Austria and Sweden.

    (c) Assuming ESRI’s forecasts for GDP and GNP growth rates from 2011 on, given in this report, also prove accurate, by 2015, GNI in Ireland will be over 20% above the EU15-average and the second highest in the EU after only tiny Luxembourg. Compared with 2007, Ireland will have overtaken the Netherlands. Sorry about that, Richard Tol. For these calculations, I have assumed average annual growth of 2% in the EU15. This is line with the average annual growth rate the EU15 has experienced since the late 1970s. Given that their demographics are deteriorating, and their populations of working-age are falling, I think 2% is quite generous.

    EMPLOYMENT:

    Extrapolating the ESRI forecasts, which are given in terms of average annual percentage growth in employment, I calculate that ESRI are forecasting a net increase of 300,000 in the number in employment between 2010 and 2015.

    MIGRATION:

    The ESRI report doesn’t contain any forecasts for migration. But, a previous one (posted here a few weeks ago) forecast net emigration of around 150,000 in total between now and 2015, but with resumed net immigration from 2016 on. While this might occur, I can’t see that it is consistent with their forecasts for GDP growth and employment growth. If their forecasts of average annual GDP growth of 5.6% and average annual employment growth of 60,000 from 2011 on prove accurate, then I think a resumption of net immigration will occur long before 2016, possibly as early as 2011 or 2012.

    BALANCE OF PAYMENTS/NATIONAL BANKRUPTCY:

    ESRI are forecasting an average balance-of-payments SURPLUS of 3.5% of GDP from 2011 to 2015 and of 4% of GDP from 2016 to 2020. If this forecast proves accurate, then all these media predictions and scaremongering stories about Ireland going bust and the IMF having to be called in are so much nonsense (Mary Harney, please note). As anyone with understanding of economics knows, the measure of how solvent a country is in relation to the outside world is determined by its balance-of-payment surplus/deficit rather than its budget surplus/deficit. Which is not to say that a budget deficit is a good thing. Of course, its not and measures should be taken to eradicate it over a reasonable period of time. Hoever, its an internal deficit – such a deficit could exist in an island economy with no contact whatever with the outside world. The balance-of-payments is the one that measures the external surplus/deficit. The ESRI report sums up the situation much better than I could. This is what it says: “The move into balance-of-payments surplus has major implications for the economy and the sustainability of recovery. With the Government borrowing 12% of GDP next year, the balance of payments means that the private sector will be NET acquiring foreign assets (or repaying debts) amounting to over 13% of GDP” and later it says: “At present consumers are insecure and are saving like mad.”

    What this means is quite simple. Irish consumers have stopped spending and are ‘saving like mad’. This has resulted in the budget deficit rising as tax receipts fall. But, it also means that the balance-of-payments is moving into surplus and consumers are repaying debts abroad. That’s why, despite all the alarmist commentaries in the media, the Government hasn’t had the slightest difficulty in financing its budget deficit this year. At the various bond sales organised by the NTMA, Irish Government bonds have been snapped up faster than tickets for World Cup Qualifier. In contrast, some other countries, with lower budget deficits, have struggled to finance them. The reason: Ireland may have temporarily a large budget deficit, but it is awash with savings (as consumers stop spending). In saying this, let me repeat that it is far from an ideal situation. It would be much better if consumers saved less and started spending and the budget deficit went down. And, indeed, the ESRI report predicts that they will do just that over the next few years.

    NAMA:

    The ESRI report doesn’t contain any forecasts for the success of NAMA. However, it does contain forecasts for those things that will impinge on the success of NAMA. As NAMA is a project for a decade, lets look at the ESRI forecasts for the decade between 2010 and 2010. ESRI forecast:

    (a) Between 2010 and 2020, GDP will increase by 55%.

    (b) Between 2010 and 2020, the number in employment will rise by 420,000.

    (c) Between 2010 and 2020, wages in terms of euros will increase by 45%.

    It is self-evident that, if these ESRI forecasts prove accurate, NAMA has every chance of being a success.

    SUMMARY:

    To repeat, all the forecasts in this post are not my forecasts. They are ESRI’s. I’m condensing as best I can the forecasts in the ESRI document that Philip Lane has provided a link to. In this instance, I’m merely a humble messenger. As I said at the start, if the authors think I have misrepresented in any way what they say, I will withdraw the offending comments. Those offended by optimistic forecasts, please take your complaint to ESRI, not me. As it happens, however, I do agree with the forecasts in this ESRI document. So, just to summarise them, if the ESRI forecasts prove accurate, then:

    (a) The economy will be growing by 5.6% annually from 2011 to 2015.

    (b) Employment will be growing by 60,000 annually from 2011 tto 2015.

    (c) The balance-of-payments will be in massive surplus for the whole decade from 2011 to 2020.

    and this one I’ve extrapolated from the ESRI forecasts (its not in the actual document):

    (d) By 2015, GNI in Ireland will be over 20% above the EU15-average and the second highest in the EU after only tiny Luxembourg

    As Gerry Adams might have said, but probably didn’t:

    “The Celtic Tiger, it hasn’t gone away, you know.”

  3. @John The optimist

    I don’t remember the ESRI predicting the current downturn back in 2007 – I’m open to correction. So why should they be right now? I take their forecast with the same pinch of salt I take everyone else’s.

    My view on whether Ireland can return to 5.6% annual growth is tempered by the following
    1. A fair proportion of GDP growth in the first 5 years of this decade stemmed from the construction boom. We’re not going to see one of those for a while. I know you’ve looked at construction employment in the stats but that doesn’t include all the ancillary businesses that benefited from the building boom. Sherry Fitz just reported a pretty big loss.
    2. Another element of GDP growth was the increase in government spending. It is going to decrease substantially over the next few years.
    3. We had huge immigration from new EU accession states in the first 5 years of the 21st century. This boosted consumer demand and demand for rental accomodation.Again I don’t see that happening in the near future.
    4. There was a huge expansion of credit in the first 5 years of this decade which helped fuel the growth. The banks when they do get money I hope will be more careful about lending it out. And as a previous poster has pointed out there a lot of people out there who’ve maxed out on credit and won’t be able to participate in any consumer led boom any time soon.
    5. Exports should lift with world recovery which is a positive. But is world recovery guaranteed by 2011? Signs from the US are very mixed. Double dip is a distinct possibility. How much of the recent recovery was driven by the huge stimulii pumped in by various governments This only works if it kick starts spending again.
    6. Interest rates are likely to rise over the next 2/3 years. This isn’t going to boost consumer spending.
    7. What happens to Sterling will be a major factor. Check the drop off in tourists from the UK this year as just one effect.
    8. Sentiment. A lot of people have lost a lot of money over the last 18 months. Yes they are saving but the assumption that they’re going to spend the same way as they did before is a big one. It’s going to take quite a while to build up the savings that were lost again. I owned a house during the 1992/93 currency crisis. Interest rates went to 18%. It makes you cautious for evermore.
    9. Taxation – one way or another we are going to be paying more : carbon tax, property tax, university fees, lower children’s allowance. Not going to boost activity either.
    10. Deflation is also quite a problem. In our fledgling business prices have dropped by as much as 15% over the past year. We’re actually increasing sales but the average sale has dropped.
    11. Commercial Rents. These went crazy in the 10 years from 1997 to 2007. To give you some idea – on a 30000sq ft retail warehouse they went from about €7 per sq ft to over €30. These need to adjust down but Nama may prevent this.
    12. Finally I don’t belive wage cuts are necessarily the answer, they don’t improve productivity. Job cuts do. I don’t have first hand experience of many people taking pay cuts, mostly pay freezes. What does happen is when there is a vacancy it is filled by someone on lower pay. There would also be less bonuses out there while share options from a couple of years ago are useless.

    There’s a lot to turn around before the Celtic Tiger starts roaring again. 2011 looks too soon to me.

    And no I’m not the ESRI so I can’t produce a pile of figures to back up my views. What I am is a businessman who has been in the real world since 1991 and experienced one currency crisis, one dot com bubble, one huge boom, and one huge recession plus a little recession. But overall Ireland has taken huge steps forward. We should be able to do it again but we can’t be complacent and expect it just to happen.

  4. The Celtic Tiger got a bit swollen and has fallen into the water. If we keep a steady course and make a few harsh decisions and above all, include everyone who needs help, we will be set fair to recover faster than other parts of the EU. Thr low tax policies that work for trading companies may not work for individuals, especially when someone else sets the interest rate. Corporations that trade are probably more rational than recently wealthy individuals? But those low rates are much more attractive to industry than R&D incentives. Note that the O’Bama (He is an Offaly man!) initiative on attacking tax havens has helped Ireland. The low tax rate is a very wise policy. But it does not justify or allow us to afford stupidity.

    But NAMA will break us. Anglo-Irish alone has done this nearly already. Only the President can now save us from further damage.

  5. Unfortunately I don’t have the technical expertise to contribute meaningfully to this thread but like John the Optimist, I am surprised at the lack of posts from the Big Dogs.

    On a semi-related note, what is the likely impact of the Chinese economic miracle on Ireland over the next five years?

    I understand that there isn’t a huge amount of direct trade between us but is it likely to have significant indirect effects- for better or worse?

  6. The current pre-occupation amongst economic policymakers internationally concerns the likely negative impact of financial crises on potential growth rates and permanent effects on the level of potential output following financial crises. This has been motivated by the experiences of, for example, Korea (1997), Sweden (1991) and Thailand (1997) not to mention Japan. In each of these cases the level of GDP failed to return to its pre-crisis trend following a financial crisis.

    There’s a very informative discussion of this topic in the latest IMF WEO (Chapter 4)
    http://www.imf.org/external/pubs/ft/weo/2009/02/index.htm

    A key element of the IMF work is that the standard models used to estimate the potential growth rate and level of capacity in the economy (which John discusses) are especially poor in the advent of a financial crisis. Yet John’s paper appears to suggest we should use these models to think about the likely potential growth of the Irish economy going forward? Furthermore, we should expect ‘higher growth in actual than in potential output in the recovery phase from 2011 to 2015’. – between 5% and 6%. This is certainly a very rosey view of Ireland’s prospects.

    In contrast, The IMF’s key conclusions are that

    ‘The path of output tends to be depressed substantially and persistently following banking crises, with no rebound on average to the pre-crisis trend over the medium term. Growth does, however, eventually return to its pre-crisis rate for most economies.’

    and the depressed output path tends to result from long lasting reductions of roughly equal proportion in the employment rate, the capital to labour ratio and TFP.

    For these reasons I find John’s assertion, based on the cost production function approach, that the Irish economy may grow between 5% and 6% unconvincing.

    The IMF have identified several factors that help to predict the medium term output losses.

    i) the short-term output loss is a reliable predictor of the medium term outcome
    ii) a high pre-crisis investment share is a good predictor of large medium term output losses
    iii) economies that apply macroeconomic stimulus in the short-run after the crisis tend to have smaller output losses over the medium run
    iv) there is some evidence that structural reform efforts are associated with better medium-run outcome,

    There has been of course considerable variation between countries in their experiences following financial crises. So there are many caveats around these conclusions.

    Nevertheless, I think we should admit that financial crises are a special case, and that the ‘normal’ methods used to estimate potential output are unlikely to be very helpful. There certainly seems to be a large gap between the IMF’s and Johns views. And certainly Irish fiscal policy should not be based on the assumption of 5%-6% in the medium term!

    What does this suggest for Ireland inc?

  7. Thanks for the useful comments.
    The forecasts for 2011-15, set out in my DEW paper, were drawn from the paper published last May – “Recovery Scenarios for Ireland”. In it I and my colleagues (Adele Bergin, Thomas Conefrey and Ide Kearney) published two alternative paths –a more optimistic scenario where the world economy recovers next year and a more pessimistic one where the world recovery is delayed till 2011. Since we published, it seems more likely that the first of these scenarios for the world economy will prove closer to the truth. However, these are only point forecasts – reality will not replicate either forecast. My own assessment is that the “world recovery” scenario is a central forecast in the sense that things are as likely to be better than it as worse than it. However, there is much more room for things to be substantially worse than substantially better.
    Our “World Recovery” scenario adopts the OECD (Economic Outlook) approach, which sees a step down in potential output as a result of the crisis, while the impact on the future growth rate in potential output is felt likely to be limited.
    The “prolonged recession” scenario in that paper may prove pessimistic about the timing of the world recovery (it will begin in 2010). However, there is a possibility that the IMF pessimistic scenario could also turn out to be correct, with the world recovery, when it occurs, being less vigorous than normal. The resulting loss of output by 2015 arising from slower world growth would be similar to that in our “prolonged recession” scenario.
    This discussion highlights the uncertainty involved in forecasting. Nonetheless, if interpreted correctly, forecasts are an essential input for policy makers in formulating budgetary policy.
    Fiscal policy should be formulated on a “no regrets” basis. As stated, the forecasts come with wide margins of error. What if the recovery scenario did not happen and it was 2012 before the light appeared at the end of the tunnel (the alternative scenario considered in Bergin et al., 2009a)? Under those circumstances a second tough budget would be needed in 2011 (with more tough medicine later) and a tough budget in 2010 would not have been “wasted”. If, on the other hand, the recovery proved more robust than suggested above, it would mean that the 2010 budget might be the last major deflationary budget but it would still not have gone “too far”.
    Potential Output
    The combination of the bursting of the property market bubble and the world financial crisis has had a substantial impact on the endowment of labour and capital in Ireland. This has served to permanently reduce the potential output of the economy. This reduction has been driven by four factors:
    • To the extent that there is a long-term effect on world growth rates there would be a knock on effect on Ireland. However, as indicated above, we take the OECD view on world growth. Our “prolonged recession” scenario gives an indication of the significant additional costs which would arise from a delayed world recovery (or from a weaker than normal world recovery).
    • A significant part of the capital stock has been rendered obsolete through the closure of many businesses. While new investment will take place in the recovery phase, it will take much longer to put in place this new investment than it has taken to write off the investment due to the closure of existing businesses. We have factored this into our forecasts.
    • The dramatic increase in government indebtedness will result in a major increase in the burden of taxes. The deadweight effects of the increased tax burden will adversely affect the economy’s productive capacity. This has also been factored in.
    • The rise in the risk premium on borrowing has not only raised the cost of borrowing for the government but it will also affect the cost of capital for all borrowers. In turn, this means that the optimal level of the capital stock has been reduced and, with it, the potential output of the economy. If the banking crisis is resolved rapidly and the public finances are returned to a sustainable path then this premium will fall. Nonetheless we have factored in a significant premium out to 2015 (Table 2 in Bergin et al.). If the crisis is not resolved and the cost of capital remains elevated for private investors (and the government), this would definitely affect investment and the growth rate of potential output.
    • Finally, the return to growth in potential output envisaged in our forecast assumes a flexible economy, especially flexible wage rates. If nominal wage rates do not fall as the model would suggest, then the adjustment process will take significantly longer than estimated, with elevated unemployment levels being prolonged beyond 2015.

  8. @John Fitzgerald

    “Finally, the return to growth in potential output envisaged in our forecast assumes a flexible economy, especially flexible wage rates. If nominal wage rates do not fall as the model would suggest, then the adjustment process will take significantly longer than estimated, with elevated unemployment levels being prolonged beyond 2015.”

    But, what if wage rates fall faster than the model suggests? Will that mean that the adjustment process will take significantly shorter than estimated?

    In this report, ESRI assume that wage levels have fallen by 2% so far and call for a further fall of 5%. Sounds sensible. But, in the Irish Times yesterday, the IBEC economist said that wage rates have allready fallen by 11%. I’m not saying that IBEC are right and ESRI are wrong. It may well be that ESRI are right and IBEC are wrong. But, suppose for the sake of argument, that IBEC are right and wage levels have indeed allready fallen by 11%, how would this affect the outlook? Surely, it would mean that the return to 5.6% annual GDP growth would occur earlier than 2011? Could this explain why the fall in GDP in the first two quarters of 2009 and the rise in unemployment in the past six months have turned out much better than forecast earlier this year? Is there any way of resolving why IBEC and, indeed, other employers’ organisations’ figures for the fall in wage levels are so much greater?

  9. @John Fitzgerald

    Thanks for your response.

    I had a couple of points.

    First, the IMF study indicates that the TFP contribution to potential output growth is likely to fall after a financial crisis. Table 1 in your article indicates this is not the case. The smoothed ‘contribution’ to GDP growth from TFP remains at 1.3 through 2010-2015. I had a leaf through the original paper but I wasn’t sure if you’re pessimistic scenario incorporates a lower TFP contribution to potential growth.

    If not, is there a risk that the TFP contribution will decline for a period of time, and hence potential output growth also?

    Second, your estimate of potential growth (non-inflationary growth) appears to be based on the premise that GDP growth will have to rise above potential to close half the gap between current output and the pre-crisis trend in output.

    The Korean, Swedish, Thailand and Japanese episodes provide case studies where this gap did not close (or increased) following financial crises. Hence, the pre-crisis trend level of output may not be a good guide to judge future potential output growth. And this question has motivated the IMF study. Has anyone looked at the issues the IMF raise in their article in the Irish context? e.g. what is the actual and desired level of the capital stock post crisis, and what was the pre-crisis share of investment accounted for by GDP?

    I would expect that one plausible pessimistic scenario would be one in which output growth resumed slowly to potential and remained there but with little closure of the gap between current output and the pre-crisis trend. Does your pessimistic scenario embody this?

  10. @John the optimist
    “Is there any way of resolving why IBEC and, indeed, other employers’ organisations’ figures for the fall in wage levels are so much greater?”

    Personally I suspect they’re overstating it for their own purposes as all interest groups do. You do wonder where they get their data. They will say from their members but this is less likely to be accurate or comprehensive as the quarterly CSO surveys. I’d probably go with the ESRI. As I’ve said before, I’m not seeing much in the way of pay cuts in the businesses I’m involved with or the people I know in business. Mostly pay freezes and job cuts. Those pay freezes are likely to extend into 2010.

    At the higher end of management bonuses will play a part – you have to assume bonuses for 2009 will be much lower than 2008 and this will wash through at the end of 2009/start of 2010 when most bonuses are paid. Should see this in income tax figures for December.

    Next big figure to watch is October income tax – self employed, Case V (rental) and other income all has to be paid by 31 October. I would expect this to be down on the basis of falling rents and harsher conditions for SMEs. We’ll see.

  11. Comment 2
    @ B Woolley
    There are two ways of presenting the long-term impact on potential output of the current crisis. One can assume either a wipe out of some capital stock and a once off reduction in potential output with unchanged future growth in potential output or else one can assume that the growth rate of potential output (TFP) is reduced. (There is obviously a spectrum of possibilities within these two extremes.)
    While these are, in principle, separable mechanisms in terms of economic theory, in practise it is not easy to distinguish them. In implementing a reduction in potential output in a scenario the same effect on the level of potential output in the terminal year can be achieved by different combinations of these two mechanisms.
    The OECD and my colleagues have tended to show it more as a once off loss in potential output and then left the growth rate in potential output largely unchanged. (The IMF is putting more of the effect into the reduction in the growth rate of potential output.) The OECD approach, shown in Figure 1 in our May report, is to show it primarily as a permanent reduction in potential output. However, it could be argued that the wipe out of capital stock and the fall in the labour force would not warrant such a big once off fall in potential output but would, instead, lead to lower growth over the period to at least 2015.
    Our numbers in the May research paper are derived using the HERMES model. Some of the key mechanisms are:
    The wage rate equation shows the equilibrium wage rate adjusting to prices, taxes and unemployment in Ireland and in alternative labour markets. The equilibrium level of output in manufacturing sectors and in the tradable services sector is a function of world output and Ireland’s competitiveness (including labour costs) relative to competitor countries. Investment in manufacturing to produce the “optimal” output is a function, inter alia, of the cost of capital. Labour supply is endogenous – a function of the returns to working in Ireland relative to alternative labour markets.
    In our world recovery scenario we have used a world forecast along the lines suggested by the OECD and the IMF. This will be the primary driver of recovery in Ireland. Domestic demand reacts with some delay and is affected by the fiscal deflation. An improvement in competitiveness eventually results in an increased share of world output being produced in the manufacturing and market services sectors in Ireland. The speed with which competitiveness improves affects the speed with which output recovers and, most importantly, the growth in employment.
    The model simulations take into account:
    1. The possible damage to the world economy as a result of the crisis, as incorporated in the OECD and the IMF forecasts.
    2. A higher risk premium for lending in Ireland relative to the Euro area.
    3. The lower capital stock as a result of the dramatic collapse in investment.
    4. The effects of higher taxes, especially taxes on labour, on competitiveness.
    5. The effects of the tightening of fiscal policy.

  12. @Stuart

    That is interesting that you think IBEC up the figure for their own ends?

    I can well believe you are right.

    Would this be common practice in Ireland? I remember IEA predicted in May that the volume of exports would fall by 14% in 2009. I rubbished their prediction on this site, and I’ve certainly been proved right. But, if such organisations (and, of course, unions do it as well), why are all their phoney claims and predictions always reported in the media as if they were genuine?

    Another of my predictions that has been proved right was where I said in my first post: “This ESRI report is sensational. For that reason, it will be most likely ignored by the media.” Not a mention of it in the media since it was released. Its clear from his absurd column in today’s Irish Independent that DavidMcWilliams hasn’t read it either. I wonder does he ever read anything on the Irish economy other than his own books. I gather the ESRI report was read out at the Kenmare conference, so Morgan Kelly at least must be aware of its contents.

  13. @John the Optimist
    I reckon it happens all the time on all sides. If an interest group – IBEC, IEA, farmers, ICTU, SIMI, RGdata want something out of the government they present a dooms day scenario. No one ever seems to check and newspapers report this stuff as fact without checking it up. No one says you cried wolf last time why should we believe you this time. It fills newspaper columns and they love the more extreme stuff.

    I listened to an interview with I think a statistician on Newstalk the other day. He was from the Uk and he cited as his example a headline that said “Up to 65,000” could die from swine flu in the UK next year. The actual study said between 3000 and 65000 could die. Not quite so exciting.

  14. mark the realist i like both voews but being realistic i dont think the irish economy will grow by 5 Per cent between 2011 to 2015 reasons why the celtic tiger is finished it was the result of a building boom in ireland so it was a false now you wont see a building boom for at least 10 years also a lot of multinationals are leving Ireland for low cost economies like india and morocco so there are going to be a lot of unemployment for at least 10 years Tourism is suffering as well so for Ireland to have a growth rate of 5 Per cent it a bit pie in the sky to me a little bit unrealistic mark the realist

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