21/7/2012: Two links on Information Theory and US Manufacturing

Two very interesting posts on Information Theory in economics from http://infostructuralist.wordpress.com
1) First post on Rational Inattention, and
2) Second post on Robustness

Another superb article from the Foreign Policy journal on the future of advanced economies competitiveness in manufacturing: link.

21/7/2012: Globe & Mail July 2012: Italian dilemma

My article on Italian debt v growth dilemma for Globe & Mail: link.

21/7/2012: Sunday Times July 15 - No growth in sight

This is an unedited version of my Sunday Times column for July 15, 2012.

This week, the Central Statistics Office published long-awaited Quarterly National Accounts for the first quarter 2012, showing that in January-March real Gross Domestic Product fell 1.1 percent to the levels last seen around Q1 2005. Gross National product is down 1.3% and currently running at the levels comparable with Q1 2003 once inflation is factored in. Rampant outflow of multinational profits via tax arbitrage continues unabated, as GDP now exceeds GNP by over 27 percent.

There is really no consolation in the statistical fact that, as the National Accounts suggest, we have narrowly escaped the fate of our worse-off euro area counterparts, who posted three quarters of consecutive real GDP contraction since July 2011. Our true economic activity, measured by GNP is now in decline three quarters in a row in inflation-adjusted terms.

Our real economy, beyond the volatile quarter-on-quarter growth rates comparatives, hardly makes Ireland a poster child for recovery. Instead, it raises some serious questions about current policies course.

Save for Greece, five years into this crisis, we are still the second worst ranked euro area economy when it comes to overall performance across some nineteen major indicators for growth and sustainability.

Our GDP and GNP have posted the deepest contraction of all euro area (EA17) states. Assuming the relatively benign 2012 forecast by the IMF materialise. Q1 results so far point to a much worse outcome than the IMF envisions. Total investment, inclusive of the fabled FDI allegedly raining onto our battered economy, is expected to fall over 62% on 2007 levels by the year end – also the worst performance in the EA17. Despite our bravado about the booming exporting economy, our average rate of growth in exports of goods and services since 2007 is only the fifth highest in the common currency area.

Ireland’s unemployment is up by a massive 220%, the fastest rate of increase in the euro zone. Employment rate is down 20% - the sharpest contraction relative to all peers. Other than Estonia, Ireland will end 2012 with the steepest increase in government spending as a share of GDP – up 18% on 2007 levels. We have the second worst average structural Government deficit for 2007-2012 excluding banks measures and interest payments on our debt. By the end of 2012, our net Government debt (accounting for liquid assets held by the state) will be up more than eight-fold and our gross debt will rise 354%. In both of these metrics Ireland is in a league of its own compared to all other member states of the common currency area.

The latest data National Accounts data confirms the above trends, while majority of the leading economic indicators for Q2 2012 are also pointing to continued stagnation in the economy through June.

Purchasing Manager Indices (PMI) – the best leading indicator of economic activity we have – are signalling virtually zero growth for the first half of 2012. Manufacturing PMI has posted a robust rate of growth in June, but the six months average remains anaemic at 50.7. The other side of the economy – services – is under water with Q2 activity lagging the poor performance achieved in the first quarter. 

In the rest of the private economy, things are getting worse, not better. Live register was up, again, in June, with standardized unemployment now at 14.9%. Numbers on long-term unemployment assistance up 6.8% year on year. Factoring in those engaged in State-run training schemes, total number of claimants for unemployment benefits is around 528,600, roughly two claimants to each five persons in full employment. Construction sector, the only hope for many long-term unemployed, posted another monthly contraction in June – marking the sharpest rate of decline since September 2011. Retail sales, are running below 2005 levels every month since January 2009 both in volume and value terms. Despite June monthly rise, consumer confidence has been bouncing up and down along a flat trend since early 2010.

Meanwhile, net voted government spending, excluding interest payments on Government debt and banking sector measures, is up 1.9% year on year in the first half of 2012 against the targeted full year 3.3% decrease. Government investment net of capital receipts is down 19.1%. This means that net voted current expenditure – dominated by social welfare, and wages paid in the public sector – is up 3.3% on same period 2011, against projected annual decrease of 2.2%. Although not quite the emergency budget territory yet, the Exchequer performance is woeful.

And the headwinds are rising when it comes to our external trade. By all leading indicators, our largest external trading partners are either stagnant (the US), shrinking (the Euro area and the UK) or rapidly reducing their imports from Europe (the BRICs and other emerging economies).

The question of whether Ireland can grow its economy out of the current crisis is by now pretty much academic. Which means we need radical growth policy reforms.

Look at the global trends. In every five-year period since 1990, euro zone average annual real economic growth rates came in behind those of the advanced economies. As a group, other advanced economies grew by some 15 percentage points faster than the euro area during the pre-crisis decade. Both, before and since the onset of the Great Recession, euro area has been a drag on growth for more dynamic economies, not a generator of opportunities. Within the euro zone, the healthiest economies during the current crisis – Germany, Finland and Austria – have been more reliant on trade outside the euro area, than any other EA17 state.

This is not about to change in our favour. Data for China shows that the US now outperforms EU as the supplier of Chinese imports. Europe’s trade with BRICs is deteriorating. Combined, BRICs, Latin America and Africa account for less than 5% of our total exports. In the world where the largest growth regions – Asia Pacific, Africa and Latin America are increasingly trading and carrying out investment activities bypassing Europe, Ireland needs to wake up to the new geographies of trade and investment.

Given the severity of economic disruptions during the current crisis, Ireland requires nominal rates of growth in excess of 6-7 percent per annum over the long term. To deliver these, while staying within the euro currency will be a tough but achievable task. This requires drastic increases in real competitiveness (focusing on enhanced competition and new enterprise creation, not wages deflation alone) in domestic markets, including the markets for some of our public sector-supplied services, such as health, education, energy, transport, and so on. We also need aggressive decoupling from the EU in policies on taxation, immigration and regulation, including that in the internationally traded financial services, aiming to stimulate internal and external investment and entrepreneurship. We must review our social policies to incentivise human capital and support families and children in education and other forms of household investments.

Like it or not, but the idea that we must harmonize with Brussels on every matter of policy formation, is the exact opposite of what we should be pursuing. We should play the strategy of our national advantage, not the strategy of a collective demise.

Box-out:

Recent decision by the Government to introduce a market value-based property tax instead of the site value tax is an unfortunate loss of opportunity to fundamentally reform the system of taxation in this country. A tax levied on the property value located on a specific site effectively narrows the tax base to exclude land owners and especially those who hold land for speculative purposes in hope of property value appreciation lifting the values of their sites. In addition, compared to the site value tax, a property levy discourages investment in the most efficient use of land, and reduces returns to ordinary households from property upgrades and retrofits. Perhaps the most ridiculous assertions that emerged out of the Government consideration of the two tax measures to favour the property levy is that a site value tax would be less ‘socially fair’ and less transparent form of taxation compared to the property tax. By excluding large landowners and speculative land banks owners, and under-taxing properties set on larger sites, a property tax will be a de facto subsidy to those who own land over those who own property in proximity to valuable public amendments, such as schools, hospitals and transport links. By relating the volume of tax levy to less apparent and more numerous characteristics of the property rather than more evident and directly comparable values of the adjoining land parcels, the property tax payable within any giving neighbourhood will be far less transparent and more difficult and costly to the state to enforce than a site value tax. In a research paper I compared all measures for raising revenues for public infrastructure investments. The study showed that a site value tax is an economically optimal relative to all other tax measures, both from the points of capturing privately accruing benefits from public investment and enforcement. This paper was presented on numerous occasions to the Government officials and senior civil servants in charge of the tax policy formation over the last three years. 

21/7/2012: Sunday Times July 8 - ESM deal for Ireland

An unedited version of my Sunday Times column for July 8, 2012.

Last week’s Euro zone rush to make some sort of a deal on the common currency debt crisis was originally heralded as a ‘path-breaking’ event. A week on, and the markets have largely discounted the deal, while internal disagreements between the member states are tearing it to shreds.

Within a few days following the summit, heads of Bundesbank, Deutsche Bank and Commerzbank came out opposing the core premises of the deal, including the banking union. Finnish, Dutch and Estonian governments strongly disagreed with the ideas of ECB engaging in direct purchases of sovereign bonds, and equal treatment of ESM debt alongside private bondholders. German and Slovak leaders have pledged to respect these countries positions. Austrian parliament’s approval of European Stabilisation Mechanism (ESM) fund came with some severe conditions attached, also altering the June summit conclusions. Lastly, the ECB’s Mario Draghi was clearly guarded about the deal implications for the ECB independence during his press-conference this Thursday.

Meanwhile, the markets have moved from an euphoric reaction to the deal last Friday back to shorting the euro zone by Thursday, despite the ECB interest rate cut.

Despite these, and other developments, the Irish Government continues to put much hope on the June 28-29 deal. Rhetoric aside, the new deal can, at the very best, allow Ireland to convert some of our government debts into the debt held against Irish consumers and mortgage-holders.

The Government assumes that under the deal, ESM will be allowed to retrospectively cancel government debts relating to banks bailouts and convert these into debts held against the banks themselves.

Assuming this is correct, even though the actual agreement does not mention any retrospective actions, Ireland will be able to move some unknown share of its €62.8 billion total exposure to the banking crisis off the government debt account. The Government has already admitted that it is unlikely to recover any of the NPRF funds ‘invested’ in the banks. Which leaves us with roughly €30-35 billion of promissory notes and other debts that can be in theory restructured via ESM.

On the surface, this looks like a great opportunity, to reduce our official Government debt from 117% of GDP to just over 100% of GDP.

However, the problem with this proposition is that it ignores the actual nature of the deal and the likelihood of such a deal going through.

Let’s start from the latter point.

For Ireland to restructure such a large amount of debt, will require one of the following two options. Either all of the states involved in ESM should be given similar retrospective considerations of past sovereign recapitalisations of the banks , or Ireland must be deemed to be a special case, warranting special intervention.

The former will mean that Germany, Belgium, the Netherlands, Austria, not to mention Spain, Portugal, Greece and Cyprus will all have to be granted access to the same restructuring process as Ireland. These states have collectively pumped some €400 billion worth of taxpayers’ funds into their own banking systems during the crisis. ESM’s lending capacity is €500 billion. In other words, ESM will effectively have not enough funds to cover the second bailout for Ireland and extensions of bailouts for Portugal and Greece, let alone provide any backstop for Italy and Spain.

Italy has just raised its forecast budget deficit for 2012 by some 50%, while Spain will require €7-10 billion of additional fiscal cuts to meet its 2012 target. Greece has been lax on tax collection during May and June elections. The likelihood of these countries needing additional funds in 2013-2014 is rising, just as ESM lending capacity is shrinking.

The latter possibility would require making a convincing argument that Ireland’s case is unique when it comes to the hardships of recapitalising the banks. In addition, it will require proving that we desperately need special help. This can only be done by admitting that our deficit and debt adjustments, as envisioned in the multiannual programme with Troika, are not sustainable. This would contradict all Troika assessments of the Irish fiscal stabilization programmes to-date.

Now, let’s take a look at the more important point raised above – the point about the actual nature of this deal. In a nutshell, even if successful, the restructuring of our banks-related debts via ESM, as envisioned by the Government, will accomplish little in terms of lifting the burden of unsustainable debts off the shoulders of the economy.

The reasons for this conjecture are numerous.

Firstly, ESM will still require repayment of all the debts transferred from the Government to the fund. Except, instead of the taxpayers, the onus for repaying these debts will fall on Irish consumers.

Even an undergraduate student of economics knows that when the market power is concentrated in the hands of a small number of players, any taxes and charges imposed onto them will be passed directly to consumers. Now, recall that under the Irish Government plans, Irish banking system is moving toward a Bank of Ireland, plus AIB duopoly. In such an environment, the repayment of banks debts to the ESM will simply involve higher banking services costs to mortgagees and bank accounts holders.

Only a regulated duopoly, under certain conditions, can be prevented from gouging consumers to pay charges, and even then imperfectly. Yet, under the deal, the Government will be ceding control over the banking sector to the ESM (who will own the banks and their debts) and the ECB (who will act as the pan-Euro area supervisor of the banks). This means we can expect mortgages and banking costs to rise and with them, foreclosures, personal insolvencies and business liquidations to accelerate.

Secondly, per Irish Government statements, last week’s deal will allow for relieving the burden of the banks debt and promises to restart our economy back to growth. If the former proposition, as argued above, is questionable, the latter is outright bogus.

Ireland’s crisis is not driven by who owns the banks debts. It is driven by too much debt accumulated in all of the corners of our economy: households, companies, Government, and the banks. But the swap of banks-related debts from the Government to the ESM will not reduce the volume of this debt.

And the Irish economy will have an even lower capacity to repay these debts after the swap.

The Government is already committed to taking €8.6 billion out of the economy between 2013 and 2015. Most of it - €5.7 billion – is officially earmarked for ‘cuts’ to the Government expenditure. However, majority of the expenditure cuts are really nothing more than a concealed tax, as these cuts reallocate the costs of services to the households. In the Budget 2012, single largest expenditure reduction measure was a hike on private insurance costs of medical services.

On top of this, further €1.5-1.8 billion will have to be clawed out of the economy due to changes in the EU funding and reductions in state revenues from banks guarantee and support schemes.

In short, put against the reality of Ireland’s struggling economy and battered by the internal disagreements within the euro zone, the so-called ‘seismic’ deal is now turning into a storm in a teacup.

Box-out:

Ireland’s much-awaited ‘return to the bond markets’ on Thursday was greeted in the media by a number of erroneous reports. The truth is simple as are the questions surrounding the NTMA motives for the auction. Firstly, Ireland returned not to the bond markets, but to a short-term T-bill market. Very short-term, in fact. The two markets are significantly different to pretend the auction was a major breakthrough. Greece, in May this year – amidst the on-going collapse of its economy and political turmoil, also ‘returned’ to the T-bill market. As did Portugal in April when it faced an unexpected need for banks supports. Ireland itself last dipped into this market back in September 2010, while facing an impending bailout. T-bills auctions, therefore, are not exactly the vote of confidence. Secondly, 3 months-dated bills are effectively risk-free and do not constitute a recognition of Irish economic revival. Instead, they are backed by the Troika funds. As per questions raised, one that stands out is why did NTMA need this auction to take place in the first place? There is no need for the Government to borrow any money short-term, as our receipts of the Troika funds are regular, fully funded and without any uncertainty. It appears the whole exercise was about a public and investor relations management by the Government. Thus, the only apparent net positive from the auction is that we did not get rejected by the markets. Then again, neither did Greece in May or Portugal in April.

21/7/2012: Sunday Times July 1, 2012 - Not a 'stimulus' again...

An unedited version of my Sunday Times article from July 1.

One of the points of contention in modern economics is the role of fiscal spending shocks on economic growth. Various empirical estimates suggest Irish fiscal multiplier at 0.3-0.4, implying that for every euro of additional Government spending we should get a €1.30-€1.40 in GDP uplift. However, these are based on models that do not take into the account our current conditions. Despite this fact, Irish policymakers continue talking about the need for Government to stimulate the economy, while various think tanks continue to argue that Ireland should abandon fiscal stabilization or more aggressively tax private incomes to deliver a boost to our spending.

International research on this matter is more advanced, although it too leaves much room for a debate.

June 2012 IMF working paper titled “What Determines Government Spending Multipliers?” by Giancarlo Corsetti, Andre Meier and Gernot Muller (June 2012) studied the effects of government spending on the economy under the variety of macroeconomic conditions.

What IMF researchers did find is that the initial conditions for stimulus do matter in determining its effectiveness – an issue generally ignored in the domestic debates about the topic.

Under a pegged exchange rate regime, similar to Ireland’s but still allowing for some exchange rate and interest rates adjustments, trade balance is likely to worsen in response to a fiscal stimulus, while output can be expected to rise. Domestic investment and consumption will decline in response to the positive stimulus shock. These factors are likely to be even more pronounced in the case of Ireland’s currency ‘peg’ that permits no adjustment in real exchange rate except via domestic inflation.

The role of weak public finances in determining the effectiveness of fiscal spending stimulus is also revealing. The study defines fiscally constrained conditions as the gross government debt exceeding 100 percent of GDP and/or government deficit in excess of 6 percent of GDP. Both of these are present in the case of Ireland. On average, the study shows that consumption response to fiscal stimulus is negative-to-zero following the stimulus, but becomes positive in the medium term. Impact on output and investment is negative. The core reasons for the adverse effects of fiscal expenditure on economic performance are losses from stimulus through increased imports of goods and services by the State, internal re-inflation of the economy through inputs prices, plus the expectation from the private sector consumers and producers of higher future taxes required to cover public spending increases.

In the case when financial crisis is present, increase in Government spending results in a positive and strong output expansion, rise in consumption and, with some delay, rise in investment. However, net exports still fall sharply and the stimulus leads to the inflationary loss of external competitiveness in the economy.

The problem with the above results is that the IMF study still does not consider what happens to a fiscal stimulus in a country like Ireland, combining a strict currency peg, exclusive reliance on trade surplus for growth generation and characterized by historically high levels of fiscal imbalances and financial system collapse. In other words, even the IMF research as imprecise as it is, is far from conclusive.

These are non-trivial problems in the case of Ireland. Official estimates for fiscal policy multiplier in this country range between 0.38 (European Commission) and 0.4 (Department of Finance).  These are based on relatively simplistic models and are, therefore, likely to be challenged by the reality of our current conditions. A more recent study from the Deutsche Bank cites Irish fiscal multiplier of 0.3 without specifying the methodology used in deriving it. Either way, no credible estimate known to me puts the fiscal multiplier above 0.4 for Ireland.

In short, Government stimulus is not exactly an effective means for raising output, even at the times when the economy can take such stimulus without demolishing the Exchequer balancesheet. And lacking precision in estimating the fiscal multiplier, the entire argument in favor of fiscal stimulus is an item of faith, not of scientific analysis.

In my opinion, Ireland does not need a Government expenditure boost. Instead we need a policy shift toward stimulating domestic and international investment, plus the public expenditure rebalancing away from current spending toward some additional capital investment.

Quarterly National Accounts clearly show that the problem with the Irish economy is not the fall off in private or public consumption, but a dramatic collapse in private investment. While private consumption expenditure in Ireland has declined 13.6% relative to the economy’s peak in 2007, net expenditure by Government is down 12.0% (including a decline in public investment). However, overall private investment in the economy is down 67%. 2011 full year capital investment was, unadjusted for inflation, at the level last seen in 1997, while consumption is down ‘only’ to 2005-2006 levels and Government spending is running at around 2006 levels. With nominal GDP falling €33.5 billion between 2007 and 2011, our investment declined €32.6 billion over the same period, personal consumption dropped €12.8 billion, while net Government expenditure on goods and services is down a mere €3.4 billion. Between 2007 and 2011, total voted current expenditure by the Government rose 12%, while total net voted capital expenditure fell 44%.

Adding a Government investment stimulus of €2 billion would have an impact of raising net capital expenditure by the Exchequer in 2012-2014 to the levels 22.4% below those in 2007 and will lift our GDP by under 1.8% according to the EU measure of fiscal multiplier. However, factoring in deterioration in the current account as estimated by the IMF, the net effect might be closer to zero. Based on IMF model re-parameterized to our current conditions, the net result can be as low as 0.1% increase in GDP.

Again, the problem here is the effect of capital spending on our imports. As a highly open economy, Ireland imports most of what it consumes. This includes Government and private capital investment goods – machinery, materials and know-how relating to construction, assembly, installation and operation of modern transport systems, energy and ICT, etc. Some of these imports will continue well beyond the period of actual investment. In other words, using fiscal stimulus to finance public capital investment risks providing some short-term supports for lower skilled Irish labour and few professionals with the lion’s share of expenditure going to the multinational companies supplying capital goods and services into Ireland from abroad.

The fiscal cost of such a stimulus, however, would be exceptionally high. Between 2008 and 2011, Irish Government has managed to cut €4.3 billion off the annual capital spending bill while increasing current spending by €662 million. This resulted in total voted spending reduction of only €3.6 billion. A stimulus of €2 billion on capital investment side will throw the state back to 2009 levels of expenditure, erasing two years worth of consolidation, unless it is financed out of cutting current spending and transferring funds to capital programmes. The extra capital spending will lead to further retrenchment in private consumption and investment, as households and businesses will anticipate relatively rapid uplift in tax burdens to recover the momentum to the fiscal consolidation. This, coupled with already committed €8.6 billion in further fiscal adjustments in the next three years, will further reduce growth effects of the stimulus and shorten its positive effects duration.

Overall, the right course of policies to pursue today requires restructuring of the debt burden carried by the real economy, starting with household debts and stimulating, simultaneously domestic and foreign investment into small and medium enterprises and start-ups. Instead of focusing on the less labor-intensive MNCs’ investments, we need to put in place tax and institutional incentives to increase inflow of equity capital, not new debt, to Irish businesses. Such incentives must target two areas of investment: investment into activities associated with new jobs creation by the SMEs, plus investment into strategic repositioning and restructuring of Irish SMEs to put them onto exporting path.

Lastly, if we really do want to have a stimulus debate, the discussion should not be focusing on creating a net increase in the public expenditure, but on the potential for reallocating some of the funds from the current expenditure side of the Exchequer balancesheet to capital investment.

  

Box-out:

The latest Index of Failed States published this week ranks Ireland the 8^th best state in the world. Our overall score in the league table was helped by extremely high performance in some specific indicators. Surprisingly, according to the Index authors, we are having a jolly good time throughout the crisis. Allegedly, Ireland’s problem in terms of emigration is relatively comparable to that found in New Zealand and Germany. Our economy, heavily dominated by MNCs exports in pharma, medical devices and ICT sectors ranks higher in terms of the balance of economic development than majority of the advanced economies that have more diversified and domestically anchored sources of growth. Our ‘balanced development’ model, having led us into the current crisis, is allegedly more sustainable, according to the Index, than that of Canada – a country that escaped the Great Recession. In terms of poverty and economic decline we are better off than France, Japan and New Zealand, which had a much less severe recession than Ireland over the last 5 years. In quality of public services, we are better than Belgium and the UK, and are ranked as highly as Canada. And our elites are less factionalized than those in the vast majority of the states of the Euro area. In short, according to the Foreign Policy, index publisher, Ireland is a veritable safe haven within a tumultuous euro zone, comparable to New Zealand, Luxembourg, Norway and Switzerland. We rank well ahead of Canada, Australia, the UK and the US, as well as all other states that currently receive tens of thousands of Irish emigrants.