January 26, 2009
Are we waltzing ourselves up an economic cul-de-sac without realising it? Are we making a bad situation worse?
The way things are going, our economy could contract by 10 per cent this year. This figure may sound apocalyptic but not unimaginable, given the pace of current job losses, emigration and price falls. There seems to be – among the economic fraternity at least – uniformity about the need to slash government spending. On many levels, this is understandable, but is it the right thing to do?
The following might be heresy, but let’s think about it anyway. Will history look back and say that, in 2009, the Irish government should have been spending more, rather than cutting back?
When all economists are singing from the same hymn sheet, there is a dreadful risk that the pitch will be off-key. This is particularly the case when many of them were cheerleading the boom until not so long ago. In fact, not since St Paul was on the road to Damascus have there been such conspicuous conversions to the ‘‘we all knew it couldn’t last school’’. Enough. On the surface, the mainstream arguments seem to be pretty sensible. State spending is going out of control.
The rest of the country can’t afford it. The private sector is getting hammered, so it is not just an economic question but also a moral question about who shoulders the burden. These are all logical points of view. But the major concern is, if there is no demand coming from any where else, will the downturn here not simply be exacerbated by reducing state spending significantly now?
Unlike many, I am agnostic on this – or, maybe more accurately, open to persuasion. But think about it for a second. The boom in Ireland mirrored similar booms in most Anglo-American economies. Our property obsession put us at odds with much of the eurozone in terms of recent experience. Spain is the exception, but that country was downgraded by Standard & Poor’s, the rating agency, last week.
In the Anglo-American world, the response to the housing bust has been a massive increase in state spending and an equally dramatic loosening of monetary policy. Exchange rates have been allowed to find their own level and, in the British case, this is some 30 per cent below where it was in 2007. In both countries, there are two hands of macro-economic policy at work – fiscal policy and monetary policy. Think about what is happening here.
Monetary policy is jammed by our dysfunctional banks. When they talk about the ‘‘systemic’’ importance of banks, what they mean is that the banks operate as an arm of monetary policy. Without them, monetary policy can’t work. So it doesn’t matter how low interest rates go, the banks are in no position to pass on the benefit because their balance sheet is so weakened that they are zombies. So Ireland is now operating without a monetary policy. Minister for Finance Brian Lenihan is a one-handed policy maker.
Worse still, our exchange rate is wildly overvalued, so we can’t hope for export led growth. Even when the world recovers, this overvalued exchange rate will ensure that fewer Irish exporting companies make it through this recession to be in the position to export anything in the years ahead. The only thing that Lenihan has at his disposal is fiscal policy.
So you see our conundrum. Every way we move, we are snookered. If Lenihan cuts back on government spending, nothing will replace it and demand will fall further. Unemployment rises, as does other social welfare spending and soon, whatever cuts he makes are wiped out by falling revenue and rising spending. Raising taxes exacerbates the demand dilemma further.
Traditionally, as in 1987, the fiscal contraction led to a significant capital inflow, which allowed interest rates to fall significantly. Borrowing costs came down, private sector lending increased and, crucially, the banking system, which was working, pumped money into the economy. Thus there was an immediate positive impact on the economy.
This time there will be no positive. Some economists argue with some validity that the spread of our bonds over German bonds will fall significantly if we have a fiscal adjustment. This, they say, will be the monetary dividend from cutting spending now. But even with the risk premium built into Irish bonds, we are still borrowing at below 6 per cent. This is significantly lower than where the US government typically borrows.
It is hardly a reward for good behaviour and, as the banks are zombies, there won’t be any impact on demand other than downwards. The adjustment will fail and fail again.
But does it have to be like this? Do we have to embark on a policy which makes the worst recession in a century worse? According to ‘conventional’ wisdom, the answer is yes. This is the same conventional wisdom that told us the boom was solidly founded and that joining the euro was a brilliant move for Ireland as it would give us ‘permanently’ low interest rates.
These are the same people who predicted that Polish workers laying blocks were all you needed to validate semi-ds in Dublin trading at prices of 40 times annual rents.
If we look at economic history, we see that no small country ever recovered successfully from debt deflation by cutting spending and sticking with a hard currency. The evidence from Sweden and Finland in the early 1990s is particularly instructive. Both countries suffered from the same boom-bust cycle as we did. Their banks went bust and had to be nationalised, like ours. And the initial policy reaction from everyone – the government, the trade unions, the media establishment and the senior civil servants -was that the government must reduce spending and the hard currency link to the Deutschmark must be preserved at all costs.
This adjustment failed, as ours will do, because it is intellectually incoherent unless you are prepared to entertain massive unemployment and serious social unrest. Unemployment went to 19 per cent in Finland and the budget deficit to 14 per cent of GDP. Finally, someone shouted stop to this masochistic madness.
Against all their advice, the two governments broke their currency arrangements and reflated the economy by allowing both currencies to fall. The countries recovered quickly and again, against all conventional wisdom, the competitive edge the countries garnered endured. Their banks’ capitalisation worked a treat as well.
Both countries, being small trading economies, had significant foreign debts too. Yes, these did go up, but the revenue associated with the recovery more than covered the increased debt service. Neither country suffered any long-term ramifications in terms of access to foreign capital in the future.
In the light of our own banking travails, much has been made of Sweden and Finland’s bank recapitalisation and recovery plan. What most of this discussion fails to mention is that the devaluation and subsequent printing of money by both central banks did the trick. Is it worth considering here? Surely not; it might mean replacing mantras with hard thinking. That would be far too much to ask as the economy heads for a 10 per cent contraction.