Government must hold its nerve on borrowing as it reboots economy

Patrick Honhan in The Irish Times today. Based on presentation to the Royal Irish Academy earlier in the week (slides; video).

Central Bank Quarterly Bulletin 3 2020

Guest post by Stephen Byrne, Central Bank of Ireland

Today the Bank published its third Quarterly Bulletin of the year. The report contains a detailed overview of developments in the economy since the publication of last Bulletin in early April as well as our latest macroeconomic forecasts out to 2022.

Given the scale of uncertainty surrounding the economic impact of Covid-19, two different scenarios for the economic outlook are outlined in the Bulletin (see featured image above).

In the “baseline” scenario, the economy reopens in line with the Government’s phased plan, allowing for a rebound in economic activity in the second half of the year. Some containment measures would remain in place meaning that activity would be constrained in some sectors for a longer period. Beyond the initial rebound, recovery is expected to be gradual, in line with a slow unwinding of precautionary behaviour as the effects of the shock on consumers and businesses lingers. The unemployment rate is set to decline from its second quarter peak of about 25 per cent as the year progresses and is projected be around half that level by the end of this year, before averaging just over 9 per cent next year and 7 per cent in 2022.

The baseline scenario sees output recovering to its pre-crisis level by 2022. However, the level of activity will be significantly below where it would have been had the economy grown in line with expectations before the outbreak of the pandemic.

In the “severe” scenario, the strict lockdown period is assumed to have a more damaging impact on economic activity and is not successful in effectively containing the virus. Stringent containment measures would remain in place, or would be re-instated, albeit not as severe as before, based on an assumption that there would be a resurgence of the virus at some point over the next year. In this scenario, there is a subdued economic recovery with a larger permanent loss of output. Unemployment remains higher for longer in this scenario and would average just below 17 per cent in 2020, while consumer spending is projected to fall by around 14 per cent and GDP by over 13 per cent this year. In this scenario, the projected recovery in growth in 2021 and 2022 would not offset the loss of output this year, leaving the level of GDP in 2022 about 5 per cent below its pre-crisis level.

Both of these scenarios assume that a Free trade agreement in goods between the UK and the EU, with no tariffs and quotas on goods, takes effect in January 2021. If such an agreement is not reached, then the EU and the UK would move to trading on WTO terms from January 2021. Box D of the Bulletin discusses the implications of such an outcome.

The bulletin also contains analysis of the impact of Covid-19 on debt dynamics and sustainability, as well as a detailed examination of the regional labour market impacts of the pandemic.

Finally, an accompanying signed article explores alternative long-term recovery paths for the economy and assesses the impact of fiscal and monetary policy supports. The Article considers how hysteresis – or scarring ­­– effects could influence the pace and nature of the recovery. The paper shows that, as a highly open economy, Ireland benefits from the positive effects of monetary and fiscal policy measures implemented abroad. The assessment of the combined effects of domestic and international policy supports indicates that the actions will help to meaningfully reduce the scale of the output loss in Ireland from the pandemic.

Measuring national income in the time of COVID

National accounts are useful.  Yes, they have their limitations, and, particularly in the case of Ireland, can be subject to distortions but they are useful.

One of those uses is measuring changes in living standards.  If the growth of the inflation-adjusted measure of national income exceeds the growth rate of the population then it is likely that living standards are rising, at least on average.  This is usually taken as the real growth rate of per capita GDP (or another variant).

For Ireland, this averaged around one per cent per annum for the first three decades post independence, it rose by an average of three per cent per annum over the next thirty years and has averaged around five per cent per annum in the period since the late 1980s which is where it was before the current crisis hit.  These are useful summaries of our economic performance, though as is well known, such long-term averages do belie some significant volatility that Irish growth rates have exhibited.

2020 seems set to add to that volatility but let’s consider two things that are likely to muddy the link between the change in real per capita national income (as measured by, say,  GNI*), and the impact of the crisis on living standards:

  • Food consumption and the exclusion of domestic household production from national income;
  • Education and the cost-based approach to including public production in national income.

Food Consumption

Restaurants have been closed for dining in since March.  The CSO’s Monthly Services Index shows that the turnover value of services in Restaurants, Event Catering and Other Food Service Activities was over 50 per cent lower in April than in the same month last year.  The contribution to value added and national income from restaurants will be significantly lower this year.

However, this does not mean we are eating less or even consuming fewer food-related services.  The composition has changed.  The CSO’s Retail Sales Index shows that our retail purchases from Food Businesses were 17 per cent higher in April than in the same month last year.  The food we are not consuming in restaurants and other outlets has been replaced by food we are buying in shops.

In the national accounts, both the food and labour inputs are counted when measuring the value added of restaurants.  For food we buy in the shops the domestic labour input used to turn that food into a meal is omitted from national income, but it still contributes to our living standards.

There’s no doubt there’s more to restaurants than the food we eat and the cooking and cleaning services provided to us.  That is why we are willing to pay more for dining in.  But we are still eating the meal we would have had in the restaurant or cafeteria so someone is still doing the cooking and someone is still doing the cleaning.  It still adds to our living standards, it’s just that it has switched from market production to household production.

The drop in living standards implied by the fall in value added from restaurants in the national accounts won’t be as large as the figures suggest.  We have been forced to move to something that does not have its value added included in the national accounts (nor generate as much Value Added Tax for the government which is also counted as value added when measured at market prices.)

And, separately, the employees who would have been paid from that lost value added have had a large part of their income replaced with government transfers.

Public Education 

For market-provided services the value added is essentially the value of the output produced less than cost of intermediate consumption. 

The value of market output is estimated using the prices people for it.  After intermediate consumption has been subtracted from total revenue, value added is divided between labour through compensation of employees, government through taxes on products, and capital through gross operating surplus.  Net operating surplus remains after a deduction for the consumption of fixed capital (depreciation).  The additional value added that goes to users above the price paid (consumer surplus) is not measured. 

Still, value added is a useful concept and represents a large share of the living standards and welfare benefits of the goods and services we produce and consume in market settings.

This does not hold for publicly-produced services such as education.  These are paid for from general taxation.  We do not have prices and revenues to provide an estimate of the value people place on these services (nor how much they would be willing to buy).  Market prices might be absent but they do contribute to living standards.

The value added for public services in national accounts is essentially the sum of compensation of employees and depreciation, that is, it is the cost not the benefit that is included. 

The value added of education is simply put at the pay bill for teachers and the cost of maintained school buildings.  No benefit above that is included in national income aggregates.

Schools have been closed since the middle of March.  Just like restaurants there has been a switch to domestic production.  Yes, some online supports have been provided but the value of this is unquestionably lower (just as we are only willing to pay lower prices for takeaway meals).  The shift to home-schooling has had a huge impact on living standards.

However, the value added of publicly-provided education services will be largely unaffected.  The fact that the school children aren’t in school doesn’t matter for national accounts; all that matters is that teachers get paid.

Conclusion

The provisional Quarterly National Accounts for Q1 2020 show that constant price gross value added in Distribution, Transport, Hotels and Restaurants was down 10 per cent compared to the first quarter of 2020.  This reflects the forced closure of most of these services towards the end of the quarter.

On the other hand the gross value added in Public Admin, Education and Health was up four per cent compared to the same period a year ago.  This is despite the fact that schools were closed from the 12th of March.

This isn’t necessarily an argument to change the way national accounts are compiled.  Should household production be included in national income? Maybe.  Should the added value of public services be more than pay and depreciation costs? Maybe. For the time being we’ll be satisfied with an understanding of what the figures as currently compiled actually mean.

The drop in value added from restaurants doesn’t mean that we are not eating.  The stability in value added from education doesn’t mean that our kids are being taught.  National accounts are useful and the changes in the aggregates can be a useful proxy for changes in living standards. But not always.

Potential Output and Output Gaps

 

Happy new year to all. In case some of you missed it, the Department of Finance published two working papers (by Gavin Murphy, Martina Nacheva and Luke Daly) just prior to Christmas looking at the ever topical issue of Ireland’s output gap. Both papers can be accessed at this link. The first paper takes a detailed look and review of the main methods used to estimate the cyclical position of an economy. The authors highlight the diversity of modelling approaches used across institutions both within Ireland and abroad. The second paper outlines in detail the methodology used by the Department to produce estimates of the output gap for Ireland. To date, the Department has used the European Commission’s harmonised approach (i.e. common to all EU Member States), which has at times resulted in counterintuitive estimates of Ireland’s cyclical position. This research seeks to develop more plausible estimates taking better account of the nature of Ireland’s small open economy. Such work will enable the Department to better evaluate the appropriate fiscal stance and the sustainability of public finances over the medium term.  For those with an interest in macroeconomic modelling and forecasting as well as fiscal policy related issues, the papers offer an invaluable source of information into what can be a complex area.

 

New Central Bank Quarterly Bulletin

Today, the Bank published its fourth quarterly bulletin of the year (Quarterly Bulletin (QB4 – October 2018), containing new projections to 2020.

The economy continues to grow at a robust pace and momentum has picked up since our last set of published forecasts (July). Economic activity remains underpinned by robust and broad based growth in employment and incomes. In turn, underlying domestic spending has gained further momentum reflecting strong consumption and (underlying) investment expenditures. Overall, we see underlying domestic demand growing by 5.6 per cent this year, before moderating to 4.2 per cent in 2019 and 3.6 per cent in 2020. In GDP terms, we expect growth of 6.7 per cent this year, 4.8 per cent in 2019 and 3.7 per cent in 2020. The labour market continues to move towards full employment with the headline unemployment rate expected to be below 5 per cent in 2019 and 2020.

While the outlook remains favourable, a number of significant downside risks remain. On the domestic side, the main vulnerabilities relate to the cyclical strength of the recovery. On the external side, risks centre on Brexit and any further disruptive changes to international tax and trading regimes given the openness of the Irish economy.

Aside from the normal outlook and commentary, the Bulletin contains a number of Boxes highlighting research on some key issues. These include pieces on Brexit, the international economy and risks relating to Corporation Tax flows. The Bulletin also contains a chapter on financing developments in the economy and a signed article examining financial risks and buffers in the Central Bank.

Boxes

  • Macroeconomic Implications of the UK Government Brexit White Paper: A Preliminary Analysis (Box A – page 13)
  • International economic outlook (Box B – page 17)
  • Risk related to Corporation Tax Flows (Box C – page 33)

On the financing side of the economy, there are pieces on:

  • Income Statement Statistics and Ireland’s Banking System (Box A – page 48)
  • Retrocession: Reinsuring the Reinsurer (Box B – page 52).

Signed Articles

The Bulletin includes a signed article by Doran, Gleeson, Kilkenny and Ramanauskas (2018), on “Assessing the Financial Risks and Buffers of the Central Bank.”