May 7, 2006

In the phrase of the great JK Galbraith...

Posted in Celtic Tiger ·

To use the phrase of the great JK Galbraith � who passed away this week – the two-handed economist is now �conventional wisdom�. Much has been made, particularly by JFK, about how hard it is to get a straight answer from an economist. It is alleged that we are constantly referring to �the one hand and the other hand� rather than getting to the point without prevarication. This might be a bit harsh but it is now �conventional wisdom�.

Whatever about the two handed economist, there is such a thing as the two handed economy. Indeed the two handed economy is the place where we all live and work. All economies have two hands: the domestic hand and the foreign hand. In fact, most major economic tools have been created to assess the balance between both. Concepts such as at the current account, the exchange rate, the rate of interest, inflation and competitiveness are nothing more than benchmarking tools to assess which is more robust – the domestic side or the foreign side.

In Ireland, despite being a small open economy which depends on trade for our prosperity, we have joined a monetary union which obscures � but does not make irrelevant – all these economic measurements. This is part of the problem with EMU – it disguises the real state of affairs. In the past, when we had our own currency, economic signals flashed to tell us that either the domestic side was growing too fast or vice versa. So take as an example a situation where we are living above our means and are importing more than we export. In this case, our balance of payments would go into deficit. This would immediately trigger a chain of events which would rebalance the economy. First, our exchange rate would fall, making imports more expensive and second, our interest rates would rise, making borrowing – to spend on imports – more expensive. Both of these would serve to rein in spending and the balance between the domestic and foreign side of the economy would be restored. This is the way many small �tiger� economies work such as Singapore, Malaysia, Norway or Israel.

It is important not just that imports are reined in, such moves in exchange and interest rates also allow the export sector to thrive. There is an inbuilt discipline in the system. This discipline is crucial because the reason our exports might rise to, let�s say, France is that we are more efficient at producing stuff here. Efficiency, we hear a lot about it these days, but what exactly does it mean?

It means that we are more productive and it takes less men and machines to make something here than it does over there. In short, there is more inspiration than perspiration. So if we can make more of the stuff cheaper or we can make better quality stuff, there is bound to be a surplus at the end of the deal. This surplus is the price difference between what we could afford to make the stuff and the price they were prepared to pay for it.

The difference between these two prices can either go back to the workers in the form of wages or the capitalists in the form of profit. Where and how you divvy up this surplus is the bread and butter of modern politics and ideologies. This is the type of caper that is discussed in the Dail, partnership negotiations and party policy papers. How much of the surplus you want to give to each group depends on where you stand on the political spectrum. But politics is the final debate, rather than the starting point. The starting point is productivity, the balance between domestic spending and saving and the savvy of the workforce and the entrepreneurs in the society. This is why economics and economic signals are important. These tools help us to assess where we are and how are we doing.

Apologies for the little lesson in basic economics, but it is important to have a framework in your head before we examine this week�s deliberations. All week, we have been hearing about the partnership process, the new pay deal and whether the unions and employers will get their acts together to get another deal up and running. Doubtless all this is important, but the real issue for the future is where the country is in terms of our economic balance and how we can afford to pay ourselves well in the years ahead. Are we living above our means or not?

Well this year our balance of payments deficit is likely to come in at about 4% of GDP. This is a large figure and a reversal of the surpluses which characterized the economy up until recently. Why is this? It is because the export sector � which drove the economy in the 1990s and early 21st century – is contracting relative to the domestic sector. Because productivity is much higher in the exporting sector (ie semi-conductors) than in the domestic sector (ie construction), this means that the aggregate amount we can afford to pay ourselves will fall in the future. We could choose to postpone this by borrowing. What happens to a country that borrows to sustain a lifestyle? It is precisely the same as a person who does so. Unless what he buys with the borrowing offers him a bigger income than the interest rate he is paying on his borrowing, he will eventually go bankrupt.

Fifteen years ago, Ireland was doing the opposite. Our export sector was generating so much cash that we were entitled to higher wages and profit increases. Today, one of these can only come at the expense of the other. It seems clear that we are not prepared to choose between these two eventualities and we are borrowing as no country ever before to deny the reality. Partnership discussions should be focusing on getting out of this dilemma, but alas they are not. And there is nobody shouting, �Stop�. In the run up to an election we can�t expect politicians to do so, but it would be nice if something else were pointing out the imbalances. But unfortunately, this is where EMU becomes a problem because the early warning signs � higher interest rates, a falling exchange rate or a concern about a balance of payments deficit – are not coming. EMU obscures them and we can�t slow down.

Think about traffic. It has for some reason been particularly bad in Dublin this week. In traffic terms the economy is a bit like a stretch where the traffic lights are broken, but the road is packed. Does that fill you with confidence? For how long?

  1. CiaranMcG

    We may be consuming more than we export – and financing it
    with credit and therefore the import euros have passed out
    export euros, but, ignoring the difference for a moment, how
    sound is the export trend. I mean, is the trend there not
    going up at a respectable rate? If not, is the problem
    simply price – i.e uncompetitive cost base?

  2. Pete

    The USA has been operating as a large single-currency zone
    for many years now, setting a single interest rate for all
    states even though they may be in very different economic
    situations, just like the eurozone now. We should study
    their history to predict what is likely to happen in the

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