Launch of NERI Quarterly Economic Observer/Facts

The NERI has published, today, its fourth Quarterly Economic Observer (QEO) along with the latest Quarterly Economic Facts (QEF). A link to the full QEO together with a short summary of key points is contained here.

The QEF may be accessed here.

Later today staff of the NERI will present these publications at a special seminar at 3pm (earlier time than normal NERI seminars) in Dublin. All are very welcome to attend. Details are here.

The next (Spring 2013) QEO will be focussed primarily on the Northern Ireland economy while retaining the NERI's all-island mandate in the publication itself.

The effect of marginal tax rates

It has sometimes been suggested that marginal tax rates in Ireland are too high, and that raising them would harm growth. They may affect the incentive to work. It is true that they are 10th highest, of the 34 countries in the OECD. Also the marginal rate hits in relatively low (affecting average earners). Helpfully, the OECD provide the data here.


However, what is the link between marginal tax rates and the economy?

 

As can be seen in the above graph there is no negative relationship between GDP per capita and marginal tax rates. In fact it is slightly positive. Of course this is not conclusive evidence of a positive link, but the evidence certainly does not support the hypothesis that high marginal rates harms GDP.

But does it affect the incentive to work?

No relationship is found between unemployment rates and marginal tax rates in the OECD.

High tax rates are not the problem. In other countries, such as the Nordic countries, high tax rates are used to fund social services such as child care, which make it easier for people to work in the market economy.

The effects of an investment stimulus

Rory O'Farrell: The idea of an investment stimulus got a boost this week. Though people may disagree over the extent to which this is 'new money', it shows that at the very least, the government want to be seen to be pro-investment stimulus.

Coincidentally, this week I presented a working paper which uses the HERMIN model (used by the EU to measure the effects of cohesion funding) to assess the effect of an investment stimulus.

Two interesting things stand out about the announced stimulus. First is the involvement of the European Investment Bank (EIB). Not only do they bring money to the table, but perhaps more importantly they bring their expertise in assessing projects and an independent pair of eyes. They won't be funding any vanity projects.

The second is the off-the books nature of the funding. With traditional financing, the net cost to Government of an investment is considerably less than the headline cost, about 57%. This is as multiplier effects lead to increased tax revenue. Then over the medium term, the supply side effects of higher GDP and tax revenue more than offset interest payments on a project. However, as the projects are 'off the books' and the tax revenue is 'on the books' there will be an immediate decrease in the reported Government deficit. Though this is playing with accounting rules, it means that the government will about €400 million more room to manoeuvre and staying within Troika limits.

Overall, we can expect 17,000 jobs to be created per €1bn invested in a year, and there is a multiplier of 1.6. When designing a stimulus, it is important to front load the investment, and then phase it out. This allows the export cavalry enough time to come over the hill and save us from long term unemployment and stagnation.

How bad is Greece?

Rory O'Farrell: Government deficits can be broken down into two parts: interest payments and the 'primary balance'. The primary balance includes everything other than interest payments; so it includes social welfare, money raised through taxation, salaries etc.

Greece is often portrayed as a basket case that just can't get its act together. However, as can be seen (click graph to enlarge), Greece's primary balance is better than France and Netherlands. Greece's problems are largely due to the legacy of the past.

Is Ireland achieving its targets?

Rory O'Farrell: Sometimes in the debate on the plan with the Troika people point out that we are in recession so the plan has failed. However, the stated aim of the Troika plan is not to return us to growth. The stated aim is to return us to the markets, in order to finance the national debt. Therefore when we criticise the Troika plan we must distinguish between whether the aims are appropriate aims, and whether the plan is achieving these aims.

We are often told that that Ireland is meeting its targets, the plan is on track, and so the plan is achieving its stated aims. Is this the case? In March the EU released its winter review of the Economic Adjustment Programme for Ireland. Page 63 of the document (page 66 according to adobe) shows Ireland getting a clean sheet, hitting 6 out of 6 targets, a performance any hurling All-Star would be proud of.(Click graphic to enlarge)

So should we give the Troika plan a medal? No. Page 62 of the pdf (Adobe page 62, document page 11) containing the ‘Memorandum of Economic and Financial Policies’ shows the original targets from December 2010. Ireland was on target up to 6-months after the plan was introduced, but has missed all other targets. Rather than hit 6 out of six, we score a measly 2 out of 6.

When we are meeting the targets, it is only because the targets are being changed. It is as though the ref sees the sliotar sailing right and wide, and so signals to the umpires to move the posts to meet the sliotar. That’s not lovely hurling.

Chemical solutions to economic problems?

Rory O'Farrell: I feel it rare that I have reason to be thankful to the FF/PD government of 2002-2007. However, they had one policy that was so dramatic, that we can smell the change.

Last Saturday evening, while enjoying the Tall Ships festival in Waterford, a friend and I decided to go for a beer in a popular city centre pub. The lack of indoor seating pushed us outdoors into the 'smoking area'. At one point a stranger interrupted our conversation and asked for a light. I told him I don't smoke, and we looked around the 'smoking area' to find someone who did. We noticed only a minority of people smoking, and in the relaxed atmosphere and dimming sunlight of the summer evening the stranger laughed at how even in the smoking area people don't smoke. Since Charlie Haughey was Minister for Health Ireland has been at the vanguard of restricting the advertising of tobacco, a tradition which continued when Micheál Martin banned smoking in the workplace. The success of these policies are measured by reduced lung cancer, lower levels of tobacco use, and the fact that our policies have been imitated throughout Europe, rather than vice-versa. Let’s hope Micheál Martin is selective in how he emulates his predecessor as both Minister for Health and leader of Fianna Fáil.

In an article from the Sunday Independent that contained errors in as diverse a range of topics as etymology, and statistics, Marc Coleman says "high taxes on drink and cigarettes are not designed to curtail drinking or smoking" and "unless we want another civil war, we have to put an end to highly paid servants of the State using spurious morality to defend indefensible restrictions on our right to live the way we want to live." I am not sure which highly paid public servants he is referring to (certainly not I as I’m not a public servant).

To back up his claim he states "Those in the lowest income decile spend one-tenth of their income on drink and tobacco, compared with 4 per cent for those in the highest income decile." In fact, Table 2 of the 2004-2005 Household Budget Survey gives very interesting details of spending by income group. Marc Coleman does make a silly error when he calculates "the lowest income decile spend one-tenth of their income on drink and tobacco, compared with 4 per cent for those in the highest income decile". He appears to confuse the average gross income for the bottom (top) ten percent with the upper (lower) bound for that group. Accurate data can be seen in the below Figures, 1 and 2. The first shows average weekly expenditure on a selection of items, and the second give the expenditure as a share of gross income (one could argue that disposable income is more appropriate, but as the CSO only gives percentiles by gross income, this was used). Nevertheless, the core point that the poor spend a larger proportion of their income on cigarettes and alcohol than the rich remains.

However is this information shocking to the average follower of the TASC blog? Does it alter the general policy prescriptions for recovery? Not at all. It is common knowledge, that across the world, that the poor spend all their income, while the rich are more likely to save. In fact, the poorest 10% spend more than their income, possibly incurring debts or getting some help from others. The poorest spend less on drink and tobacco, but their income is also lower. It is said that “as with stamp duty and other taxes, the penal levels of indirect taxation are bringing our social contract into disrepute and killing the economy.” As Marc Coleman correctly states, indirect taxation (such as VAT, or excise duty) is usually regressive. This is commonly accepted. A more egalitarian tax policy will boost the economy, by increasing demand in the economy. Other policies, such as maintaining the minimum wage, and proper enforcement of JLCs, can also help boost the economy.

However, Marc Coleman also says “high taxes on drink and cigarettes are not designed to curtail drinking or smoking. It is precisely because the Government knows that the consumption of these products is inelastic that they are easy targets for a selfish state-driven tax trap”. Past governments are open to accusations of economic illiteracy, but if past governments were cynically trying to wring cash from smokers, would they really have banned tobacco advertising and smoking in pubs? It’s not a government conspiracy. Smoking is bad for you.

Of course economics is the study of choices over scarce resources. Irish alcohol and tobacco cost 70% more than the EU average. This is not a problem of structural competitiveness, it is purely due to taxation. As a country we made a choice to put high taxes on these items, and this choice could be reversed tomorrow if we wanted to. If we slash prices on tobacco it is unlikely to be a major boost to competitiveness. Tourists are unlikely to flock to Ireland because 20 John Player Blue no longer cost €8.65 (which coincidentally is the minimum wage). A choice has been made that it is better to tax tobacco highly, and questions of equality are not best dealt with through excise duty.

There is no chemical solution to an economic problem.

Comparative prices for the EU

Rory O'Farrell: Eurostat has brought out an interesting publication today on comparative prices.

This index is based on consumer expenditure, so one should look at the detail. Ireland is still relatively expensive, the 5th most expensive in Europe for consumers.

There are some puzzling figures that often occur in these comparisons. Ireland imports clothing and electronics, but these are relatively cheaper in Ireland. We export food and non-alcoholic beverages, which are relatively more expensive. Its unclear quality is adjusted for, though they do their best. For example, I certainly consider Irish butter (and dairy products in general) to be of a higher quality to that available in Belgium. However, electronic goods can probably be easily compared across countries.

What I find most interesting is that restaurants and hotels are 29% above average (Italy is 7% above the average). This is interesting as in 2008 labour costs for Italy and Ireland were identical for this sector, and in Italy they have relatively increased. So the cause of higher prices must lie elsewhere (such as food prices, excise duty on alcohol, or rent).

Ireland is the most expensive for cigarettes and alcohol. But this needn't worry us to much from a structural competitiveness standpoint, as the high excise duty is part of our social policy which aims to curtail the consumption of such items.

Its also interesting to make a comparison to 'comparative price levels' which is an index based on the whole economy (including government and business expenditure). Here, in 2010 the Irish level is only 12.1% above the EU average, and 6.3% above the EU15 (the lowest for about 10 years). This shows that consumer prices are more out of line than prices faced by business and government.

Stiglitz on the Irish crisis

Tom McDonnell: Joe Stiglitz's preface to a new collection of essays on Exiting from the Crisis makes for interesting reading. The publication (to which PE's Rory O'Farrell also contributed) is available for download here.

Professor Stiglitz mentions Ireland in the preface, noting that:

“Ireland has faced a crisis largely because it followed the standard free market orthodoxy: unfettered markets led to a bloated financial sector which put at risk the entire economy; while politicians boasted of the growth (the benefits of which were not uniformly shared) they took little note of the risks to which they were exposing the economy. The core lesson of Ireland’s experience – and that of the US – is that one cannot rely on unfettered markets or self-regulation.”

Interesting IMF paper

Here is an interesting paper that formalises an idea that many of us would agree with, that inequality caused the crisis.

Unfortunately the IMF policy prescriptions seem totally separate to their analysis.

How good is our export performance?

Rory O'Farrell: The government's policy (its probably overly generous to call it a policy, more the rationale give for their various mistakes) is to increase employment through exports. The government is going all out to promote the idea that exports are booming, (for example, look here).

Unfortunately, the truth is different.

The latest data from the CSO (available here) shows an improvement in our trade surplus. This is necessary to repay all the debt the country has borrowed (public and private). I previously explained the importance of the current account here. However the latest figures show the improvement is purely due to a drop in imports. This isn't necessarily a bad thing. For example substituting Belgian Leonidas chocolates with much tastier Gallweys' chocolates from Waterford will reduce imports and increase employment. What is a bad thing however is that (seasonally adjusted) exports have dropped 2% in October. Exports peaked in July, and have not recovered.

Exports in other countries decreased by more than ours during the recession, so the 'resilience' of our exports is an achievement. Also, there was a bounce as exports recovered from their decrease following the financial crisis. However, if we are really gaining competitiveness one would expect exports to grow along with the economies of our trading partners. Also (seasonally adjusted) exports were actually higher in March 2007, despite prices being far higher then.

The folly of cutting infrastructure spending is shown by the stagnation of our exports. Even if wages are cut, firms will not be attracted to one of the wettest countries in Europe where they turn off the water supply at 7pm. Why pay someone €7.65 to mop the floors when they can't get a bucket of water?


UPDATE: I've come across some new data from Eurostat (available here). It compares the growth in exports between the periods Jan-Sept 2009 and Jan-Sept 2010. Worryingly, with the exception of Luxembourg, Ireland is the worst performer.

Are Irish Managers up to the task?

The Irish Times carries an interesting report on the mediocre performance of Irish management. This is consistent with previous reports (available here). This also raises important questions about the increase in inequality during the boom and the increase in management pay over that of workers.

In general management in MNEs operating in Ireland is better than SMEs, and the countries with the best managers are the US, Germany, and Sweden. Given that our labour market has much more in common with Germany and Sweden than the US, Irish managers should look to these countries. Rather than seeking confrontation with unions, working with them is usually a more successful approach. The Luas is an excellent example of cooperation.

There are better ways to improve competitiveness than cutting wages. However, are Irish managers up to the task?

Over the top lads: Why Intelligent People are Getting it Wrong

Rory O'Farrell: During a walk through Passchendaele in Flanders one is confronted by monuments to the stupidity of man.

During the First World War defence was the most successful strategy. However the commanders at the time were schooled in an earlier age, before defence had been mechanised. Their training and prior experience led them to believe that attack was the only way to win a war. By 1939 and 1940 much had changed. The French generals during the start of the Second World War had gained their experiences and training in the trenches. They did not realise that attack had been mechanised, and invested millions of Francs in the Maginot Line. Those in charge look to their past experiences for solutions to current problems, and can persist in viewing current problems through expired modes of thinking.

Fortunately we are not at war, and our troubles are minor in comparison. However the psychology of those commanding our economic policies is perhaps not so different to those of past generals.

During the Great Depression most economists had been schooled in the belief that economic problems are problems of supply. Politicians persisted with using flawed policies for several years. During this time Keynes showed that the problem of the Great Depression was one of demand. In the post-war years economists came to believe almost all economic problems were ones of demand, as these were all the problems that had experience of. However, when the oil crisis hit, and the supply of oil was reduced, demand side policies could not end stagflation. Economists and policymakers at the time lacked the mental tools to deal with stagflation. Now most economists active today have been trained during a period when supply side policies have held supremacy. However, the current economic problem, in Ireland and the rest of the world, is a demand problem caused by the financial crisis.

When all one’s experiences have been of a certain problem, it is hard to conceive of current problems as different to those in the past. During the First World War, when throwing 50,000 soldiers at the German machine guns did not work, the generals threw 100,000 soldiers at the problem. Alternative solutions could not be conceived. The strategy failed because the strategy was wrong, regardless of how obvious it may appear now.

The EU and Irish government use economic models to provide ‘insights’ into solving our problems. However the models being use ignore the core causes of the crisis, namely the lack of demand due to a poor distribution of income. Even where the IMF correctly identifies problems, such as substandard infrastructure, they can not bring themselves to offer demand side solutions (like stimulating demand by investing in infrastructure). When their policies fail (such as current Irish bond prices remaining prohibitively high) they offer nothing other than the same policies applied more intensely. They are using models for a different crisis to the one we face.

Despite 11 failed attacks on the Isonzo in northern Italy during the First World War, in which hundreds of thousands died, the Italian elite continued with their failed policies, ignoring alternative solutions. Mark Thompson, in his superb narrative of the Italian Front describes their mode of thinking as follows:

The corollary of paternalism is infantilisation. What bound journalists, ministers and staff officers was a deep conservative assumption that ordinary people – unlike themselves – were incapable of grasping their true interests.

Over the past months we have been told that a budget and four year plan must be passed prior to a general election. The thinking of the governing elites has not changed much in 100 years.

Could someone please send the IMF the Spraoi Christmas Annual?

Rory O'Farrell: During my childhood in 1980s Ireland, one of the highlights of the school year was the arrival of the Spraoi Christmas Annual. Among the many life skills it taught were ‘join the dots’ and ‘spot the difference’.

Twenty years later the IMF have produced a similar publication termed ‘Lifting Euro Area Growth: Priorities for Structural Reforms and Governance’.

Just like Spraoi it makes use of colour, this time to show Ireland’s economic problems. We have two structural reform gaps marked red, infrastructure and network regulation. Given our lack of investment in such things as broadband this is perhaps unsurprising. When it comes to labour market inefficiency we get a green light, the IMF don’t see that as a major problem.

This would suggest to me that Ireland’s labour market regulation (such as the minimum wage) does not cause a problem, but we should probably invest in infrastructure. This would also create jobs and reduce future problems of long term unemployment. On page 22 the IMF report suggests we need to

“Raise employment to avoid persistence of current high unemployment rate; and

Improve competitiveness to promote exports as a sustainable source of growth”.

Yes, they seem to have mastered joining the dots. Our infrastructure deficit and network regulation doesn’t help our competitiveness position.

However, the specific measures they suggest are as follows.

To promote employment labour market:

• Introduce gradual decrease of benefits over time of unemployment spell and stricter job search requirements
• Provide more resources to the unemployment agencies (FÁS) to provide efficient job search assistance to the growing number of unemployed
• Review the level of minimum wage to make it consistent with the general fall in wages

And to improve competitiveness:

• Reform planning and licensing systems in network industries, so as to increase competition in sheltered services sectors
• Focus public resources on high-priority projects in the knowledge-based economy

So, no plans for infrastructural investment. We just get supply side solutions for demand side problems. Have the IMF learned how to spot the difference?

Ireland's forgotten deficit

Rory O'Farrell: What is the bottom line for the Irish economy?

It is well known that the economic bubble was inflated by borrowed money, largely in the private sector. What is largely being ignored is that the total economy, public and private sector, is still being financed from abroad.

Ireland has successfully managed a trade surplus in our recent history, exporting more than we import. We have had a steady income. However, for most of the 21st Century we have shown a Current Account deficit. But why is this important? The Current Account in the National Accounts in many ways is similar to the current account a private citizen has in a bank (it is complicated in that it measures flows rather than stocks). It measures the day to day items of the national economy. It includes our trade balance, but crucially for Ireland, it includes some of our day to day expenses in the global economy. Each quarter the Irish economy must send money abroad to pay interest bills and the profits to multinationals. Given our liabilities, Ireland has to run very fast to stay still. Even having a trade surplus of €10 billion may not be enough push us back in the black.

Though the fiscal deficit is important, the Current Account serves as the bottom line for the economy as a whole. If we want to pay back our private sector debt (such as in Anglo or AIB) without just lumping it onto the National Debt, we must show a Current Account surplus.


What can be done?

It is inevitable that our debt overhang will resolve itself eventually, but as with everything in economics there are choice as to how to deal with the issue. Continuing with government policy will lead to debts being resolved through bankruptcy.

The most obvious way to reduce out international liabilities would have been to allow private sector debt stay private, and allow the bank bondholders take a hit. This would have been the correct thing to do. Unfortunately this is getting more and more difficult to do as the Government added private debt to the public debt.

We can increase exports. Unfortunately this is difficult, though not impossible. We cannot change demand from abroad but we can make ourselves more competitive.
One suggested way is to lower wages. However how would this benefit the current account? It might increase inward investment in the medium term, but as wage rates are already competitive it is unlikely it would have much of an effect. Also, as our export sector is dominated by multinationals cutting wages would simply increase the profits that are sent abroad, so a wage cut could actually harm our Current Account position. Alternatively we could try reduce non-wage costs by investing in public infrastructure.

We can reduce imports. This is something we have far more control over. One possible way is through massive Government cut backs to kill off domestic demand for imports. This is a strategy that was pursued by the IMF in South America, but they have moved away from this. The social consequences are too severe. Also a social wasteland does not make for a good export platform, so such a tactic could also reduce exports, and not improve the Current Account balance. As most government spending is done domenstically. There is some leakage abroad, but government spending can be targetted in a way to minimise this.

The government could look at which income groups spend the most on imports and increase their income tax rather than that of other groups. Also Ireland imports a disproportionate amount of goods, mainly due to our dependence on foreign energy. Investing in alternative energy is a good substitute, but also the simpler solution of public transport and cycle lanes would reduce the amount of fuel we import.

Finally we can reduce capital outflows and have one big inflow. Repatriating the National Pension Reserve Fund would be the obvious inflow. But what of outflows? Saving does not always equal investment. We should look at which income groups save their money abroad and tax them more. This will help to keep money in the domestic economy, and reduce our external liabilities.

It may be argued that this policy is protectionist, but we simply cannot afford to keep importing at the rate we have been.

Are the IMF so bad?

Rory O'Farrell: Obviously, they don't have such a great past record, but here is an interesting speech by Dominique Strauss-Kahn, Managing Director of the IMF (and a French socialist).

It wouldn't have been so out of place at the recent TASC conference.

Leo Varadkar and Capital Programme Stimulus

Leo Varadkar has an interesting piece in the Sunday Business Post, available here.

Basically he suggests that we get the fiscal changes over quickly (basically in one or two budgets), and he proposes almost all the changes come about through cuts, rather than tax increases. With everything done people would supposedly have something to look forward to.

What is interesting is that he makes a clear distinction between capital and current spending (something that I think has been missing from the debate). To offset the damaging effects of contracting current spending, he proposes increasing capital spending.

I disagree with Leo Varadkar in putting all the changes on the expenditure side (I would put most of the emphasis on taxation, and increase inheritance tax significantly), but I do agree with the idea of distinguishing between current and capital expenditure and using capital spending to boost the economy while getting current spending back on track.

I suppose it is important to further refine the idea, by getting the structural deficit, rather than current deficit, back on track. This would mean that for the next few years we would still run a deficit on the current side as unemployment is above the structural norm, so we would pay higher levels of unemployment benefit, and also receive a lower tax take. This would be just the normal reaction of the 'automatic stabilisers'. A problem with targeting the structural deficit is that it is hard to calculate, and it is affected by the actions we take today. If we allow long term unemployment to fester, then we will have larger structural unemployment resulting in a need to have higher taxes, or lower spending over the long run. But if we improve our infrastructure and long term growth potential this means we can afford higher current spending today. But in debating our fiscal plans I think its important to clearly differential between the overall fiscal deficit, the current deficit and the structural deficit, and be patient in explaining to people their differences.

So overall I think it would be feasible to create a plan that:
1) Gets our structural deficit back on track in one or two budgets
2) Achieves this mainly through adjusting taxes (really I mean increases, but I may as well get in on the political jargon)
3) Offsets the negative effects by increased capital spending
4) Allow the citizens to vote on the plan so its implementation gains credibility with the bond markets.

Irish Inequality during the 20th century

Rory O'Farrell: There has been some discussion on this site about top income shares in the US. Thanks to a book, Top Incomes over the 20th Century, edited by Atkinson and Piketty (and the chapter referring specifically to Ireland by Brian Nolan), this data is available for Ireland.

The first figure shows wage shares for the top 0.1 per cent income shares. So back in 1913 for the UK, the top 1,000th of the population had about 11% of the income (or 110 times more than if everything was shared equally).

Irish data ends in 1990, but not to worry. The second figure shows income shares for the top 1 per cent for as recently as the year 2000. At the turn of the millennium, in Ireland the income share of the top 1 per cent was 10 times greater than if income was shared equally.

Both graphs show a similar pattern (though more pronounced for the top 0.1 per cent). There has been much analysis done on these patterns (in particular by Atkinson and Piketty, but also by other authors) and the general findings are as follows:

• Inequality decreased in most countries from 1914 to 1945 due to the turmoil of World Wars and the great depression. The greatest effects tend to be in countries hardest hit by World Wars.
• Inequality was kept low by progressive taxation and inheritance tax. The important role of inheritance tax is shown that Germany inequality was quite high (inheritance tax was low there), allowing capital to concentrate over generations. Also in France and the US the importance of capital income in top shares declined (despite a stable share of capital income). This was due to less concentrated capital holdings.
• English speaking countries have shown an increase in inequality since the 1990s, but continental European countries have been relatively stable.

We see the crucial role of inheritance tax. After the 1980s this was reduced in the US, so concentrations of capital ownership will probably increase over time. We can also hypothesise over whether high inequality leads to banking crises (like 1929 and 2008), and the role of equality during the ‘economic miracles’ after the Second World War.

Looking at the evidence, there are some interesting policy implications for Ireland. If we wish to reduce inequality over the long term we need long term solutions. An increased inheritance tax has the long run effect of breaking up inherited wealth concentrations. This means that control of resources will be decided more on merit and less on whose someones parents are. This will allow for a better funcioning economy. Also, if labour taxes reduce work, or capital taxes reduce investment, we need not worry too much that inheritance taxes will reduce our death rate.

Also, what was the cause of the Irish post-war decrease in inequality? Perhaps those with an interest in history can make some suggestions.