Friday, 25 March 2011

Pavlov's dogs and barking mad economics

Michael Burke: Ivan Pavlov and his work are widely misunderstood. In English he is most usually associated with the phrase ‘Pavlov’s Dogs’ , used to imply an unthinking and customary response, a conditioned reflex. In fact, the great physiologist’s work was both extensive and groundbreaking in a number of areas.

Even in the caricature of his work, what conclusions could have been drawn from research which showed the dogs still panting for food after the twelfth time when the whistle had blown and there was no food?

The question came to mind in relation to the preview of the GDP data over on Irish Economy where characteristically strong opinions were not matched by strong convictions about growth. This was just as well. In real terms, GDP fell by 1.6% in the quarter and is 14.6% below its peak level prior to the recession – 3 years ago.

For 12 quarters mainstream and official economic opinion has expected government spending cuts to produce growth. It has produced contraction. ‘Pavlov’s dogs’ were smarter.

This is a new low-point for the economy - and for mainstream economic thinking. Some may be inclined to designate this a ‘double-dip’, but in reality this is just an accounting quirk. The positive quarter of growth sandwiched either side of contraction implicit in the phrase is a mirage – entirely accounted for by a rise in unwanted inventories in Q3, as was argued at that time.

Instead, some may be inclined to see a chink of light from the GNP data. Real GNP rose for the third consecutive quarter, up 2%, and now stands 2.7% higher than a year ago – although it is still 14.1% below its peak. But this too is more an accounting function than any reflection of rising domestic activity. The key components of growth fell- personal consumption -0.4% in Q4 to a new low, 11.1% below its peak. Investment (gross fixed capital formation) also fell 2.3% in Q4 to a new low, 60.7% below its pre-recession level. The total decline in investment from peak is now €27.6bn, which is the same as the total decline in GDP (€27.7bn) and exceeds the decline in GNP (€22.8bn). The entire slump is accounted for by the investment collapse. Inventories also fell once more.

So, where does rising GNP come from? Current government spending rose by an annualised €72mn in Q4, but in a €138.4bn domestic economy that really doesn’t add up to much. Infamously, government spending in this economy is falling- a quarterly rise a blip, when the numbers forced onto welfare rise at a faster rate than the welfare entitlements are cut. Maybe they got complacent when unemployment ‘steadied’ at 13.7%. If so, the surge to 14.7% will have them looking for the axe once more.

In any event, government spending has been in a downtrend since mid-2008 and fell by 2.1% while GNP was rising. Therefore all the activity components of GNP have been falling, personal consumption, investment, inventories and government spending.

The reason GNP has risen is because Net Factor Income from the Rest of the World has been rising. More accurately, the drain on growth from this source has been falling. This outflow has declined by over €7bn this year alone (annualised), much greater than the €5.3bn rise in GNP from Q1 to Q4. The reduction in this outflow is that Irish residents (ie Irish banks) are paying less interest to overseas residents. There is simple reason for this- overseas residents have taken their money out of Irish banks. They are too risky. This will probably continue, and so boost GNP artificially. But the real indicators of activity are all still contracting.

Yet this does not correspond to the dominant mainstream view. We have been repeatedly told that spending cuts would restore confidence both at home and abroad and so lead to a recovery. We were also told that cuts were a matter of urgency, to restore that confidence. But what immediately happened was that the economy contracted further and government finances collapsed as a result.
Now, the new government is about to embark on a repeat of the experiment which has already failed- 12 times. Pavlov’s dogs were smarter.


Slí Eile said...

@Michael We can take encouragement from yesterday's peaceful demo in UK
minus the bits after that took the media attention and which had nothing to do with the TUC. there is an alternative to banjaxing an economy and a society. This message needs to go out loud and clear across all of Europe.

Rory O'Farrell said...

@ Michael

Thanks for the breakdown of the data. Would the following be fair to say:

Due to the run on Irish banks expensive funding from investors is being replace with cheaper short term funding from the ECB?

Michael Burke said...

Sli Eile

It was a very large peaceful demo, proprotionately almost half as large the Dublin demo in December, a fair reflection of the differing political level of the two societies.


that's correct. Although a broader definition might include future costs- the FT reported the ECB's price for restructuring this short-term debt would be a permanent veto over this government's economic policy.

Slí Eile said...

@ Michael I am not sure that withdrawal of deposits explains the reversal in GNP fortunes. The CSO note throws some light: 'GNP result impacted by Foreign earnings of Irish Resident PLCs Net factor income outflows increased by some €1.1 billion between 2009 and 2010 transforming an annual GDP decline of 1.0 per cent into a 2.1 per cent decline in GNP. These increased outflows over the year were the result of higher
net profit outflows and increased interest payments on Government debt. However, the impact of inflows of profits earned abroad by Irish based Public Limited Companies, highlighted last quarter, offset to some extent the negative impact of these outflows.'

Michael Burke said...

Sli Eile

Thanks, I did see that, but wasn't sure what to make of it. The BoP data, where all this should be clear, are murky.

One thing we do know, fom the central bank, is that non-resident deposits have been plummeting, although this is not at all relfected in the BoP data.

But I take the point. A less categorical assertion as to the source of the decline in NFIFA would be more appropriate.

Seamus Coffey said...

Hi Michael,

I go through the BoP data here. I think the CSO explanation holds up. Looking at the BoP data the outflow of "reinvested earnings" on "direct equity investment" declined substantially towards the end of 2010.

I don't think the rise in GNP has much to do with the ECB money. The outflow of "other investment income" which includes interest on deposits actually increased in the last quarters of 2010.