Monday, 26 September 2011

On premature optimism

Terrence McDonough: On Thursday, some positive Irish growth figures provided an island of optimism in a sea of bad international economic news. Any such optimism is grossly premature. It is certainly true that the transnational sector of the Irish economy has been performing well for some time. Indeed this has been true for much of the downturn. Business-friendly spokespersons have failed to observe that this continuing success is an indication that there is no need for the obsessive pursuit of “competitiveness,” often used as a code word for declining wage rates and deteriorating working conditions for the ordinary employee.

The current market turmoil is intimately related to the fact that the prospect of a second dip in the ongoing economic crisis has not concentrated the minds of American and European policy makers. Instead it has promoted policy chaos and political infighting. The upshot on both sides of the Atlantic is the promise of more austerity. This can only serve to shrink Irish export markets. The IBEC optimism that Ireland can carve out a larger share of a shrinking pie amounts to nothing more than whistling in the dark.

What is the Irish government’s response to this situation? It can be easily summed up as a three point programme. Point number one is to sustain the health of the private banking system through the injection of public money. Point number two is the elimination of the budget deficit, primarily through cuts and secondarily through regressive tax increases on the ordinary Irish citizen. Point number three is to restore competitiveness through driving down wages. It is contended a low cost economy with a low spending, responsible government and a newly healthy banking system will set the stage for a recovery in investment, growth and employment. The problem is this programme will not work and will only succeed in making the crisis worse.

With apologies to Steven Spielberg, saving private banking has proved to be a mission impossible. Indeed, it has been the most manifest and abject failure. The previous government’s first response was the disastrous bank guarantee. This was followed by NAMA, designed to relieve the banks of toxic assets, replacing them with government bonds. The cleaned up banks were then to get lending again. The storm of protest which broke over this plan failed to stop it, but forced the government to acquire the assets at a much more substantial discount than originally planned. This only made sure the government would be forced to recapitalize the banks.

The forced recapitalization has not produced the desired results. Lending both to Irish households and non-financial businesses has not recovered and in fact has continued to decline. An Irish Central Statistics Office (CSO) study compared access to finance in 2007 and 2010. It found some decline in loan applications but identified a much bigger decline in loan approval rates which were 95% in 2007 but only 55% in 2010. Significantly, 61% of businesses believed that banks were less willing to provide finance. The Irish Small and Medium Enterprises Association (ISME) latest quarterly survey found that along with an increase in requests for credit, the rate of refusals was 54%. The deleveraging programme under the EU/IMF bailout programme requires the banks to shrink their assets by 72 billion euros by 2013. As loans are one class of assets, this hardly encourages new lending.

While it is unclear whether the government’s strategy has resulted in increased bank lending, there is no question that these actions have resulted in a substantial increase in the level of Irish government debt. In the establishment view this only lends urgency to the deficit cutting effort of programme point two. In addition to bailing out the banks, the government has been busy holing the public lifeboat.

Expenditure will be cut and taxes will be raised. The major unanswered question, however, is whether these actions will succeed in reducing the deficit. The belief that expenditure cutting reduces deficits is based on a false analogy with the family budget. If you cut spending and increase revenues your deficit would fall. It is not necessarily the same with the government’s budget. Spending cuts (and to a lesser extent tax increases) tend to damage demand in the economy, stifle growth, and lead to lower levels of economic activity and employment. This impairs government tax revenues and consequently may fail to reduce the deficit. It could conceivably actually lead to higher deficits. As unemployment rises, increased social benefit spending tends to counter cuts in other areas. Prof. Victoria Chick and Ann Pettifor have recently evaluated a century of UK data concerning the possibility of improving government finances by cutting expenditure. They find that “when expenditure rises comparatively rapidly, the debt ratio falls and the economy prospers, and when it levels off, the debt ratio worsens and macroeconomic indicators are less favourable.” Contrary to much conventional wisdom, “fiscal consolidations have not improved the public finances.”

The government’s third point involves deep-sixing wages. The previous government’s attack on the poor through the reduction in the minimum wage was beaten back. Perhaps recognizing the old government’s mistake was in mounting an across the board assault, the new government has singled out those covered by the Joint Labour Committees. Unfortunately, there are sound economic reasons why wage cutting in the Irish economy is far from a good thing.

First, falling wages directly damage demand, cutting sales and creating further unemployment. An environment of wage cutting creates insecurity and reduced spending.

A second factor is that falling wages will compound the problem of our high levels of indebtedness. Falling incomes means that debt payments will take an ever larger percentage of income.

Thirdly, stable wage rates provide an anchor in the economy. All other prices are tied to them. Falling wages can cause falling prices which can trigger further falls in wages and prices. This is called deflation by economists. What’s wrong with falling prices? Would you buy a product now if you expected it to be cheaper in the future? Would you pay today’s prices to invest now if you could only eventually sell your product at tomorrow’s lower prices? Deflation has the potential to seize up an economy. Finally, falling wages will not recreate the Celtic Tiger. It is true that lower Irish wages initially contributed to attracting foreign investment. But it is not possible to wind the clock back to 1987. Much has changed. There are even lower wages available elsewhere and, with the enlargement of the EU, available not so far away.

While these three programmatic points are the essence of the austerity programme imposed by the EU/IMF, the elite consensus is that “these are things we would have to do anyway.” Indeed, the current government strategy is identical to the last government’s strategy. Thus the current policy represents a political consensus involving all the main political parties, Fine Gael, Labour and Fianna Fail. This political consensus is indicative of similarly wide-spread agreement among business, media, and academic elites.

Ireland has been seeking a neoliberal path out of a neoliberal crisis. That it has been joined in this effort by most of the Western economies makes it no less nonsensical and even less likely to succeed. Eventually, truly innovative and difficult measures will have to be taken. Debt forgiveness, monetary independence, publicly-owned banks and government job guarantees need to be put on the agenda. Irish elites have been echoing Margaret Thatcher in contending that there is no alternative. International investors have an alternative. They are moving their money into US bonds, Swiss Francs and gold. They are not political radicals, but they are sending governments a message. It would be wise of both governments and academic pundits to stop trying to ignore it.


Robert Sweeney said...


On the issue of monetary idependence, have you any thoughts on Martin Wolff's recent article 'Why breaking up is so hard to do'?

Terry said...

For Ireland, the heart of Wolff's comment is here:

"As the story broke, there would be a run on all its liabilities. The government would have to limit withdrawals from banks, if not close them outright. It would also need to impose capital controls, in violation of treaty obligations. It can redenominate debt contracted domestically. But it cannot do so for debt contracted abroad. Many corporations would then go bankrupt. A report from UBS estimates the total economic cost in the first year at 40-50 per cent of gross domestic product."

The first part of this is simply correct. Banks would have to be temporarily closed, capital controls imposed. Domestic debt would be redenominated. Corporations and people with foreign debt may have to be bankrupted, but legal provisions need to be made so that this is in the form of restructuring rather than liquidation of the enterprises involved.

The UBS report has been kicked around too much. It assumes no debt default. It assumes no nationalization of banking. It assumes retaliation by trading partners. It assumes that devaluation if it occurs will be totally ineffective in boosting exports. In my opinion it has more to do with the effect of an exit on Swiss banking than anything else.

The final comments that there is a European alternative to exit is correct, but can Ireland wait for Merkozy to agree with Martion Wolf?