March 5, 2006

Beware of Khrushchev's shoe

Posted in Celtic Tiger ·
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Forty-five years ago, Nikita Khrushchev, premier of the Soviet Union, took off his shoe and banged on the table at the UN General Assembly, boasting to the astounded dignitaries: ��We will bury you.�

He was talking about economics.

Khrushchev was convinced, as was much of the rest of the world, that the Soviet Union would overtake the US, and the west in general. This confidence was based on the fact that, in the 1950s, the USSR had notched up double-digit growth rates and looked on course to overtake the west.

This did not happen. In fact, the USSR slowed down in the 1960s, stagnated in the 1970s and collapsed in the 1980s. Why did this happen?

The most compelling explanation is that the Soviet Union�s growth rates in the 1950s had been an illusion based on mobilising huge resources into the economy.

Peasants, women and German prisoners of war were forced to work in industry for the first time and were paid very low wages. So the Russians had more cheap workers than almost any other country.

This did propel the growth rate, but more by perspiration than inspiration.

When Russia started to run out of peasants, the growth rate started to fall. And, because it did not have the capital or money to reinvest, it could not build sophisticated machines to make the peasant workers more efficient.

By the mid-1980s, 20 years after Khrushchev�s antics, the Soviet empire was falling apart.

In the long term, money and people make economies grow. Combine them and it should do the trick. Some countries, like Germany today, have loads of money but not enough productive people and consequently, its growth rate has fallen.

In contrast, much of the Third World has loads of people and not enough money, with well-known tragic results.

Other countries, such as China and India, may be experiencing something like the USSR�s 1950s experiment, whereby huge swathes of previously idle labour are mobilised with apparently miraculous, but ultimately, illusory results. Time will tell.

What do these tales of growth and its illusions tell us in Ireland? They help us to understand why we sometimes get carried away with ourselves, talking about miracles, new paradigms and the like. In contrast, to the �new� theories, there is usually a perfectly logical explanation for economic developments.

For example, in Ireland we are experiencing something like the Khrushchev illusion in reverse. Whereas Khrushchev was fooled by the masses, we are fooled by the money, particularly other people�s money.

The reason the economy is growing strongly, tax revenues are so buoyant, unemployment so low and house prices so high is because we are mobilising so much credit.

We are throwing money at the economy at a rate not seen in any other developed country in the past 40 years. Like the mobilised Russian peasants, the sheer volume of cash is tricking us into thinking that we are experiencing something permanent or, worse still, miraculous.

Let�s examine the figures. Private sector credit, which is how much we are all borrowing, stood at �240 billion at the end of 2005.Our total GDP was �135 billion. This means that borrowings are now running at 180 per cent of our income.

So for every �100 we earn, we are borrowing �180.This is the highest level in the world and, as it is growing at 30 per cent per annum (or about �55 billion), it is also growing the fastest.

Think about this for a moment. Borrowing will grow by �55 billion this year.

That figure is 42 per cent of our total national income. There is no historical precedent for this type of borrowing anywhere in the world at any stage in economic history. Ireland is truly in uncharted territory.

Now let�s project forward a year or two.

Given the level of borrowing, the incentive on the part of the banks to lend more and more and the maturing of the Special Savings Incentive Accounts (SSIAs), which will embolden borrowers further, it�s not unreasonable to suggest that total borrowing could rise to �80 billion for 2007.

This would bring the overall stock of debt in the economy to between �380 billion and �400 billion or something like 230 per cent of GDP. This implies that every 1 per cent increase in interest rates will cost us 2 per cent of GDP in extra servicing.

Which brings us nicely along to last week�s increase in the monthly cost of your mortgage, the second in a matter of months. Is this the last? Is it the second of many? Are we entering a new epoch of higher interest rates around the world?

In Europe, the feeling in financial markets is that rates will rise, but not by much.

In the US, there is a fear that it will ultimately have to raise interest rates if it is to continue to finance its large trade deficit.

For the first time in two decades, Japanese interest rates are on the way up.

Taken together, it is fair to say that the era of low interest rates that has prevailed since the early 1990s is over. It might not be followed by a dramatic spike in the cost of borrowing, but let�s just say that your monthly repayments will not be going down from here.

So where does this leave us? The debt figures convey financial delinquency on a monumental scale, but, more worrying than that is the fact that probably about 80 per cent of all debt is borrowed for the construction sector. The construction sector acts as an amplifier of the initial credit throughout the economy.

By pushing up house prices, credit actually makes us feel richer, so we borrow and spend more. At least 20 per cent of this cash ends up with the government in the form of indirect taxes, so it spends more, amplifying the impact further.

Over 30 per cent of the price of a new house also ends up in government hands.

This process is called the �multiplier� in textbook economics, and it explains the ramifications of an initial injection of cash into the system. As the construction sector employs a quarter of a million people, its boom is also a boom in wages and spending from this sector.

Logically, if there is a slowdown in borrowing – which is likely when a 1 per cent increase in interest rates causes a countrywide increase in servicing charges equivalent to 2 per cent of GDP – then house prices will also fall.

Any downturn in the construction sector from where we are now would have negative multiplier effects throughout the economy, which would be much more widespread in scope than just the sector itself. This process is called �negative contagion�, which is precisely the opposite of today�s situation. In negative contagion, the banks pull in their horns and nothing gets financed.

Now, let�s get back to Khrushchevian mirages. Is our growth rate the Irish equivalent of the USSR�s �miracle� of the 1950s? Well, the major difference is that the Soviets threw cheap people at the economy, resulting in enviable, but short-lived, growth rates.

Today, we are throwing money at the economy: an increase in borrowing equal to 42 per cent of GDP this year achieved for us a growth rate of under 10 per cent.

Obviously, we are not spending our money well.

Of course, the workforce has expanded rapidly but, as the Economic and Social Research Institute pointed out last year, we are now using many more people and much more credit to generate much smaller increases in GDP than was the case a few years ago.

In short, we are reaching the Khrushchevian tipping point where the economic numbers are playing tricks on us.

Next time you hear someone boast of the great performance of the Irish economy, think of Nikita, his shoe, the UN, his dramatic fall from grace and his last days spent in forced exile.


  1. Paul Rux, Ph.D.

    David, your Khruschev article is excellent, as are all of
    your writings. My comment on it is this. Only bubbles
    burst.

  2. Seán

    I have this recurring nightmare, I’m standing on the beach,
    paralyzed, watching people having the time of their lives
    swimming with sharks and everyone is beckoning me to join
    them. I was reminded of this when waiting by the N11 for the
    bus at the beginning of February this year, when a
    transporter loaded with 4×4′s went by, heading off into the
    south. It was cold & wet and the 45 was late,in the
    meantime, 14 more transporters (all full with 4×4′s) pass by
    in quick succession.
    I remember thinking to myself that we have well lost the
    plot in our domestic economy, but the 45 came along and I
    was glad to get in out of the cold.
    Anyway, I reckon the die is cast for our domestic economy,
    with the political parties preparing the ground for the next
    election, nothing will change this course.

    There are other more interesting topics to cover, like
    Eastern Europe’s demographics and what the westward
    migration means for their local economies and future. One
    topic you never seem to cover is how we might have stopped
    this debt bubble from developing in the first place.

    Anyway good article, you are preaching to the converted and
    here is a pair of Mr. Khrushchev’s shoes.

    http://www.brown.edu/Facilities/University_Library/exhibits/khrushchev/images/new33.jpg

  3. Jean Cashman

    “So for every €100 we earn, we are borrowing €180.This is
    the highest level in the world and, as it is growing at 30
    per cent per annum (or about €55 billion), it is also
    growing the fastest”.

    Great article but I have a question – in arriving at the
    above statistic, is it just personal borrowing or is it
    all national borrowing. For example, would it include the
    huge sums being borrowed and invested in pension related
    property, ie. the many very high net individuals or groups
    buying up London and the like?

    I get very worried when I see profitable business seeing
    their property being more valuable than the actual
    business itself, Jurys being an example.
    _____________________________________________________
    On an aside, you interviewed my daughter for a research
    job last year and she left her glasses with you. You e-
    mailed her to say you had them – can I collect them
    sometime? – She is now working with UBS bank in London.

    Jean Cashman

  4. Don Con

    Hi David,

    Another excellent article, but why do you stop short of
    explaining how banks can lend ever increasing sums to
    individuals? I see this as the pump inflating the bubble
    and it seems to go unchecked.

    Had banks been restricted to the central banks guidelines
    on debt to income multiples (3.5:1 single etc), prices
    could not have risen so much. Instead banks now use
    affordability calculations. It would be nice to see
    exactly what these involve, but if memory serves the banks
    said it would enable better quality underwriting. It’s odd
    then that this has coincided with the average DTI ratio
    approaching double what it used to be.

    I guess that using ‘affordability’ means that banks
    determine the monthly repayment a borrower can afford at
    origination. If this is the case, then the ECB rate
    increases should have an immediate impact on the amount of
    credit a borrower can get (monthly repayment on 300k 35yrs
    @3% = €1,664. The same loan @3.5% has a monthly repayment
    of €1,740. To get back to a monthly repayment of €1,664
    over 35yrs you have to reduce your loan amount to €287k).

    Unfortunately I haven’t heard any of the Bank economists
    mention this. It must not be one of their fundamentals, so
    I must be wrong.

    Thankfully we have a regulator. Does anyone know what role
    IFSRA plays in monitoring the extension of credit? Surely
    they must have somebody running models/simulations – though
    I have my doubts. I’d like to think that one of the
    parameters might test what impact a reduction in lending
    would have on net monthly salary via reduced government
    revenue from housing. Or what about a more simple one from
    last year: parents complaining that they can’t afford a
    childminder. Why didn’t IFSRA tell the government that
    these parents were telling porkies as banks have allowed
    for this in their affordability calculations.

    I think the banks now find themselves committed to ensuring
    house prices keep rising. This is for a number of reasons
    including maintaining profits, keeping debt write-offs to a
    minimum (distressed borrowers can sell voluntarily and
    remain in black), and enabling equity release. Though as
    you point out this can’t continue indefinitely.

    Time to get back to my eggs.

    Don Con

    PS. Given that the average house price is so high, perhaps
    it’s time to start quoting increases as an amount rather
    than a percentage. When I hear house prices in Dublin
    increase by 1% in a month, it does sound much until you
    remember that’s 3.5k (and that’s the average not fancy).

  5. Rob Morris

    IS THIS HOW WE ROLL?
    The multinational invasion to our shores is a
    Fairly recent event and welcomed by most people
    As a positive global indicator that were doing
    Alright. What are we really doing that’s alright?
    Well for the most part we have been asleep consumed
    With our own foppishness.

    Ireland wake up and smell the coffey, actually don’t
    bother, that wont really be necessary, with the arrival of
    starbucks and 30 branches nation wide it should keep us
    alert for years to come and serve to Lubricate the wheels
    of corporate Ireland well into the next millennia
    Starbucks is one to watch in 2006 and beyond despite the
    crap Coffey We need starbucks like we needed Mickey D’s in
    the 80’s again It’s a global indicator that things are
    looking up. We are a hip, chic nation and ready to embrace
    modernity and all its trappings, don’t worry about the
    cost! Make mine a double expresso Grande Mocha Latte.

    Yes Ireland too is a nation like any other world player we
    will stand up For what we believe in we have core values
    that we hold dear and like Khrushchev we too may have
    balls to back it up minus the shoe, come on now What was
    he thinking?

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