Saturday, 13 March 2010

Slash and Burn

Paul Sweeney: Michael Burke is correct in saying that competitive devaluation does not work. It does not matter what so many economists think, or what financial markets think (I find it amusing that some commentators believe that markets think) - the Irish Government is pursuing a slash and burn policy of deflation. Not only is it not working; but it is increasing shop closures, factory closures, joblessness, depressing the state’s tax revenue and will undermine the very foundations of NAMA, some recovery in property values.

It is well known that you cant deflate your way of a recession. There is a difficulty for a small open economy in introducing a stimulus. Indeed, even in the US, the $787bn economic stimulus, the largest in American history, has had its issues. It was not greatly successful, as only 34 per cent of the total was spent in 2009. That partly reflected the large role of infrastructure and its slow spend-out. Yet this stimulus prevented a steeper decline.

There is a delicate balance between the slash and burn cutting of this government and sensitive policies to stimulate domestic demand or, at the very least, not to depress demand further.

Slashing low paid earnings and cutting welfare cheques is the best way prolong the recession. Even the ESRI admitted this when it advocated the deflationary process, admitting that the downside was that it would prolong the recession and add to unemployment and reduced tax revenue. If people have less money in their pockets, they spend less, so shops have less customers, order in less stocks, the owners spend less and so the deflationary spiral continues.

Thus government’s policies of unilaterally cutting wages and welfare are deflationary - throwing more people out of work. Many economists have recently fixated on wages as if thet were the only component of competitiveness. There is no doubt that wages are a large component of that big service industry – the public sector. While a difficult balance has to be struck between the level of cuts, and where they fall, and raising taxes, this government has greatly erred in punishing the poor, low paid public servants and in reducing capital spending when there was an alternative way.

Cutting wages of public sector workers and cutting social welfare cheques for the poorest, while reversing the proposed cut in pay for the very top 700 public servants, reversed undermined any moral authority the government elite had.

Last year €1.3bn was to go into the Pension reserve as in 2008. Instead this vast sum was front-loaded and a total of €7bn was taken from our pension reserve fund and paid out in subsidies to the failed banks. Little of this money is seeping back into the real economy. This action was massively deflationary.

It is said that perhaps a further €10bn more may have to go into the banks in subsidies in the near future. The value of having a banking system is beyond dispute, but why is there no assessment of the deflationary impact of these handouts? Ireland could pay 574,712 people the minimum wage for a year to fill Ireland’s potholes for this €10bn. It would be far less deflationary than putting this cash into the banks, but especially the zombie banks, Anglo and Nationwide.

The indicators of the deflationary impact of the recession combined with government policies are clear. For example, the collapse in imports. These went from €49bn in the first 10 months of 2008 down to just €37bn – by a quarter - in the same 10 months in 2009.

Thus through the collapse in imports, it can be seen how the crisis has hit consumers, businesses and the economy. From the data, it is clear that Irish people do not have money to buy imports. This is partly due to the deflationary policies.

Further, retail sales are plummeting and with a collapse of 14.1% last year. Of this the value of goods fell by 18% in 2009. It is clear that the bottom has not been reached. People are afraid and those with a little are holding on to it - knowing that worse is coming. In 2009, production was at 93% of its 2005 levels. Production was down over 5% in 2009, or 14% in traditional industry, while the modern sector rose by 5% in 2009 (largely exported), compared to large increases in previous years.

Private investment has fallen through the floor. Total investment this year will be €20bn, down from €50bn in 2007. Much of this is construction-related, but the rest is also way down too. For example, machinery and equipment is down by over 40 per cent in 2010 on 2007.

Thus the state should step in. The National Development Plan was ambitious, and in spite of reductions in it, it is still relatively large. However, it could and should be even larger to compensate for the collapse in private investment. There is much to be done in Ireland and the payback is large.

Joseph Stiglitz said: “In a recession, you want to raise (or not decrease) the level of total spending – by households, businesses and government – in the economy. That keeps people employed and buying things, and makes it more likely that businesses will want to invest to serve that consumer demand. However, state spending reductions have the opposite effect: Each dollar less that the state spends generally reduces consumption by the same amount.”

While it is complex and difficult to nurture domestic consumption in an small open economy, we are seeing a precipitous fall in it. So much more should have been done to ensure it did not collapse like this. As domestic demands falls further and more lose their jobs, tax revenue falls further, and things gets worse, maybe a realisation will dawn on our discredited elite. But by then, recovery will be so much more difficult.


greenasgold said...

It appears that there is a deliberate impoverishment of the people of this country going on. It's intent is to drastically reduce wages and benefits along with the financial responsibilities of the elite and their associates in the banking and development sectors. It is extremely cynical and seems to be in the context of a picking off of smaller countries in Europe like Iceland and Greece along with Ireland. One wonders if they are a test bed for a wider economic strategy.

Joseph said...

I can only say 'hear, hear' to the article. But what will it take to get the government to act. They seem hell bent on destruction and clinging on to power.

greenasgold said...

There is an assumption of failure on the part of the government.Is there a possibility that the government is acting but to the detriment of the people and the advantage of the elite?

Slí Eile said...

@Paul. Very good post. I think that we can distinguish between two types of deflationists - those who take pleasure in it (who want to reduce the size of the public sector as much as possible in a way compatible with a low-tax economy) and those who do not take pleasure (among I would count Philip Lane, Garret Fitzgerald, John Fitzgerald). The latter would support some measure of counter-cyclical intervention but see it as unattainable for economic and political reasons at this time (debt, EU, markets etc). Hence, deflation is most regrettable - they would say.
Reflationists have work to do -
testing empirical claims on multiplier impacts, leakages and assumptions about what happens on world markets including bond market yields. However, I think that the argument for redirecting spending into productive investment beats the day. Unemployment is too high a price otherwise.

As for the markets - they are dumb - based as they are on greed and fear. Give them a coherent plan to reflate intelligently and show progress - what do they care. Wax on on about pain and adjustment and they will fall for that too for a while but not too long. Really, we can't run a society and dismantle a meagre public service by cowering down before these market gods who are like a rabble hounding and chasing but never coherent themselves.
Its a bit like the fantasy in that film 'A beautiful mind' ....

paul sweeney said...

Since I wrote this post I started Stiglitz new book "Freefall." Joe is quite critical of Obama and of the economists who make up his team team. He is scathing of the "conservatives" as he calls them. Yet here, conservative economiste hate to be described for what they are. To me it seems that the the tide has gone out for conservatives. They are no longer the mainstream except here in Ireland. Stiglitzt really sticks ti to them. He defends his use of their attacks."Corporte Welfare". Are we too polite or too few?

Conor McCabe said...

"Are we too polite or too few?"

both, I fear.