Barry Eichengreen and I have a short piece on Vox comparing the two global depressions that began in 1929 and 2008. Hopefully this one will not last as long as the one 80 years ago.
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.
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.
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.
Davy, Goodbody and NCB have collaborated on this joint report on the Irish economy: you can download it here.