Stimulus for Development

Sean O Riain: Commentators across the spectrum have worried that the April budget will tax and cut so much money out of the economy that we will face serious deflation. There has been a shift in emphasis from the over-riding importance of minimizing the budget deficit to recognizing the need to minimize the deflationary effects of fiscal measures. We are seeing an increasing number of proposals in that regard.

This is not unrelated to a second major political shift – the re-opening of partnership discussions and the potential for working through more complex and multi-layered ways out of this crisis. I can’t see any other institutions that can put together a combination of measures to promote a growth strategy that would accompany fiscal measures.

Without that growth strategy, the fiscal measures will not achieve their desired goal. We will simply end up chasing our tails, raising tax rates on a declining tax base and promoting deflation by combining tax increases, employment reductions, spending and wages cuts in a single year. Immediate measures to restore a degree of fiscal stability and reduce the budget deficit are necessary – but require a strong countervailing growth policy to restore the economy, and even to maintain those narrow fiscal goals.

I am skeptical that a growth plan that is simply based on cutting wages (although it is clear that wages are declining already in some sectors) and waiting for international demand to pick up will work. There are, for example, significant wage and non-wage elements to increasing costs (e.g. energy costs, communications costs and professional fees) and other areas where labour costs are not the critical components of competitiveness. Improvements in energy and professional fees would benefit consumers as well as firms and would make a recovery plan much fairer than an exclusive focus on wages.

But more importantly, our industrial development is very much an unfinished project. We haven’t built the firms and industries that can be the basis of sustainable prosperity and have been struggling in that department since the momentum of the late 1990s was lost. Even with the boom of the past decade, our banking, enterprise and social investment sectors have major structural defects that will weaken the effects of any efforts to increase cost competitiveness. Any growth plan must also be a development plan – even where particularly important to competitiveness, cutting costs will be an element in a growth strategy but will not deliver the development in organizational capabilities that is required.

Is there a way to square the circle? If there is, it needs to be rooted in three crucial features of the current situation

• The efforts to deal with the public finances must be combined with a strategy for growth in a creative multi-year approach.
• These efforts must be located within an integrated solution, as NESC point out. This should encompass solutions to deal with the financial crisis, the fiscal crisis, the economic crisis, the social crisis and the reputational crisis. An exclusive focus on re-capitalising the banking system, cost competitiveness or public sector costs will not generate the economic or political dynamic to get us out of this mess.
• Solutions must not only be adaptive, but also developmental – this crisis has only emphasized the weaknesses of our existing systems. If we simply restore business as usual, then we go back to banks that don’t lend to productive businesses, to a weak industrial base that is stuttering towards the ‘knowledge economy’, to weak systems of social support for workers, and so on. Institutional reforms need to be developed not only for the public sector but for the banking and private sectors.

Each of these aspects of the crisis poses enormous challenges. But each also provides opportunities. There is a chance to make reforms that can set us on a more sustainable path of development. While the current focus is on cost containment, our over-riding medium term goal should be to become a high investment economy. We have in fact signally failed to become an investment economy, just a high growth and high spending economy. This applies equally across the private and public sectors. Non-housing investment is weak and public spending, even with comparatively high public sector wages, has been well below any of the high performing small European economies.

We need a ‘stimulus for development’ plan. This would incorporate a short-term plan for fiscal restoration, linked to a serious growth strategy that will establish bank lending to growing enterprises and support those firms with an enterprise strategy that goes far beyond our excessively narrow industrial base. This should be tied together through a plan for recovery of living standards, particularly among those on lower incomes.

The plan should contain certain key elements.

The first is significant banking reforms. Simply recapitalizing banks that go back to their existing business models will do little for growth – Patrick Honohan has shown that banks contributed little to the Celtic Tiger boom of the 1990s and it is clear that their lending since the late 1990s has been speculative rather than promoting development. The property assets that are now being underwritten by the state should be carefully reviewed to assess the social purposes to which they could be put (a back of the envelope list would include social housing, enterprise centres, libraries and public internet facilities, community facilities). Bank lending should be focused – either through nationalization or regulation - upon much more significant elements of investment in enterprise development. In an era when public funds are under severe pressure, we cannot afford to get as little return from the funds in the recapitalized banks as we have in the past. Simply quarantining toxic assets in ‘bad banks’ won’t deliver this kind of reform – and will still cost us a fortune. We can have our own ‘stress test’ of banking reforms. If the banking system we design won’t invest heavily in the innovation funds proposed in the Smart Economy plan, then our reforms have not done their job.

The second element should address the economic crisis through taking the opportunity to deepen and extend the elements of enterprise strategy that we have in place that have worked in pockets of the economy. Obsessed by the search for the new Nokia to emerge from Ireland, government has neglected the overall infrastructure of learning and innovation. While spending has increased it has not caught up with the historic infrastructure deficits, nor has it kept up with the increasing population or the complexity of the demands of ‘knowledge economies’. We do have institutions that have been successful in this regard. Research council and other funding has boosted research in Ireland to new levels. State agencies have a track record not only in attracting foreign investment but in supporting the growth of indigenous firms. But we have not generalized this model and we have not built the overall system of lifelong learning and high rates of investment that support such enterprises in the more successful European economies. The obsession with big science has led us to stop asking the firms and state officials working to promote innovation across the economy what they need and what supports they can develop for this process. Re-invigorating a general enterprise strategy is something that we have the expertise to do, where we have some track record of success and which is an essential element of the competitiveness of firms and industries. We need this generalized enterprise strategy to address the structural weaknesses of Irish business, that include but go well beyond cost competitiveness issues. There are many suggestions in the Government’s Smart Economy strategy, ICTU’s Ten Point Plan and the various party documents that can contribute to this area.

The third element should be the maintenance of social investment. While we often focus on the positive stimulus effects of capital investment, in an economy when services and human capital are increasingly significant elements of the economy, social investment is increasingly important. This means placing new emphasis on services that support labour market participation – education, training and childcare come to mind and the work of NESC on the ‘developmental welfare state’ maps out a clear path that shouldn’t simply be abandoned at this point. I suspect that, if we could figure out how to estimate the effects of these ‘development services’ embedded within the broader system of public services we would find important multipliers – we know that the investments we did make in education and in industrial policy paid off handsomely.

Enhancing social investment among the lowest and middle income groups reduces inequality, tackles the inefficiencies in the waste of skills and talents in the current system, and improves the prospects of any deal being politically workable. Right now, our institutions work in highly unequal ways. Attacking that inequality will both give us greater fairness and increase efficiency. If we allow communities to become racked by high levels of unemployment now, we - and more importantly those communities - will face the consequences for years to come. The rumoured forthcoming cuts in services to the weakest will increase inequality and also cause significant long-term costs.

This involves an integration of the efforts to tackle the social and economic crises. As NESC argue, we need an economy that is embedded in society. Education and training should be a critical element of the development plan – and at the same time work to re-train those who lose their jobs and reduce unemployment benefit costs as workers end up in education rather than on the dole. The greening of public infrastructure is urgently needed, and offers the chance to re-train construction workers and build ‘green enterprises’ while tackling some of the social costs of collapsing construction employment. There are many ideas in circulation at present but the debate around making them into a cohesive strategy hasn’t really been engaged.

The reputational crisis that NESC refers to is also central to the problems we face. However, that reputational crisis is both domestic and international. A plan that addresses the need for reforms across the public, financial and enterprise sectors; that addresses the weaknesses that got us into this position; and that provides a pathway for future development that is credible and allows economic actors to plan and work out new strategies within some kind of stable expectations about the future.

Pushing funds into these areas also has the advantage that the funds are delivered through services that are provided within the economy, avoiding the tendency for stimulus funds to flow straight out of the economy through imports. It combines immediate stimulus with long-term development.

Nor does it require us to develop new skills overnight. Existing evidence suggests that government investment and non-wage consumption has worked to stimulate the economy over the past three decades. Such a strategy draws on expertise that already exists within public institutions - on enterprise development, financing of enterprises and social investment. It does not require the invention of new capabilities on the part of public agencies but on recognizing their value and mainstreaming and extending them.

Can such a plan be funded through external borrowing? Recent discussions on the importance of distinguishing the structural and cyclical budget deficits are helpful here. If we are taking action to restore the balance of the structural deficit (the underlying balance between revenues and expenditure) then cyclical borrowing to support a specific ‘stimulus for development’ will be easier to justify. We certainly need to get the structural deficit in order. However, identifying the cyclical component of the deficit also allows us to identify a space for temporary stimulus spending. It also gives us the chance to develop new institutional capabilities to promote long term development. It is costly but without it, it is difficult to see the austerity measures working.

There is also the opportunity for forming a political coalition to push this through. The fact that the challenges are across multiple areas and years and that the reforms required are institutional as well as budgetary opens up the possibility of trade-offs across these various dimensions of the crisis. The kinds of financial losses being distributed across the economy are going to be difficult to justify without clear indications that we are not returning to business as usual. But this cannot be achieved effectively through pluralist policy-making dispersed across these different policy areas nor through government fiat. If social partnership institutions fail to figure out this integrated strategy, then it seems unlikely that any other set of institutions can deliver a strategy that will work economically and politically.

Reform of tax relief on pensions should be accompanied by pension reform

Jim Stewart: The solution to the current pensions crisis proposed by TASC in its pamphlet Making Pensions Work for People is to introduce an improved basic state pension, and an earnings related top-up scheme. The proposal is that this would be paid for by reducing existing tax reliefs.

Some have suggested that, in the current economic crisis, tax reliefs on pension provision should be given at the standard rate as a means of reducing the government borrowing requirement and maintaining existing expenditures, without any pension reform.

Tax reliefs on pensions need to be reformed for a number of reasons, including their cost:-

(1) Pension related tax reliefs cost €2.9 billion (2006 figures) in terms of tax foregone;
(2) They are of greatest benefit to those with the highest incomes because those with the highest incomes contribute proportionately more than lower income groups and have greater tax relief because of higher marginal tax rates.
(3) Because of tax reliefs and the extensive exemptions from annuitisation, pension provision can be regarded as one of the most tax-favoured means of saving, rather than of pension provision, for example as in the recent case involving the Irish Nationwide. Some of this advantage was, however, lost through investment in high risk assets. In December 2007, the equity allocation of Irish pension funds amounted to 65% overall (and 77% for those pension funds with no investment mandate from trustees).

In addition, pension funds are subject to annual average charges of 1.5% per annum (Green Paper, p. 142). This means that annual charges amount to a substantial proportion of the cost of tax reliefs (50% in 2003).

As a result, due to charges (which are largely independent of investment performance) and losses on investments, many of those contributing to a defined contribution (DC) type scheme over a ten year period, even with tax relief (at 41%), may have been better off investing their pension contribution in a deposit account which does not attract tax relief*. Those who paid tax at the standard rate and who invested in a deposit account savings scheme over the past ten years would be substantially better off.

Giving tax relief at the standard rate rather than the marginal rate would reduce tax induced income inequalities and, in so far as pension provision is in reality a form of savings, reduce distortions in the savings market.

The Irish Nationwide/Fingleton case has drawn attention to exemptions from tax on lump sums paid on retirement. Tax free lump sums should be reduced substantially or removed entirely on private sector pension payments. Lump sums paid in the public sector as part of pension provision should be subject to tax.

There is a crisis in private sector pension provision. Many of those nearing retirement, or in retirement, have suffered large reductions in wealth and income. As a result many are or will become far more dependent on the basic state pension than they planned for. The current basic state pension, at approximately 30% of the average industrial wage, is insufficient to ensure a reasonable level of income replacement on retirement. There are several reasons why tax reliefs for pension provision need reform, but it would be a mistake to reform tax reliefs for pension provision without also reforming pension provision in terms of equity and long-term sustainability. Detailed proposals have been developed by TASC and published in the pamphlet Making Pensions Work for People.

*Example:
Using the following assumptions: negative returns of 2.8% per annum for pension fund returns over the past ten years (see here), average costs of 1.5% per annum, marginal tax rate equal to 41% over the 10 year period and return on a deposit account of 6.5% (5.2% after DIRT of 20%), a pension fund investment has a slightly higher return than a deposit account over a 10 year period.

Dr. Jim Stewart is a member of the TCD Pension Policy Research Group, which has collaborated with TASC on its pension reform proposals

Preparing low and middle income earners for higher income tax

Peter Connell: In last Fridays’s Irish Times Colm Keena, in an article entitled ‘Income data understate contribution of lower and middle-income earners’, published a table showing income and income tax distribution for Irish earners in 2008. It makes for fascinating reading, particularly in the context of the forthcoming emergency budget and advice emanating from many economists to address the issue of many income earners paying little or no income tax. Such is the apparent generosity of the Irish state, we are told, that a worker on a salary of over €45,000, married with two children, is a net beneficiary of the State. As an aside, and to remind us of happier times – at least for the Progressive Democrats-, Michael McDowell’s election literature made great play of this fact just two short years ago during the 2007 general election campaign.

So, the public discourse on this issue appears to be preparing us for significant increases in income tax for low and middle income earners on April 7th. Sean Ardagh TD, commenting on Irish Economy, is perhaps giving us a preview of what we may expect when he states – ‘The political/ideological desire to have all people with an income paying tax and contributing to the general exchequer coffers has merit. When we apply for services we are entitled to, it is satisfying for us to be able to know and to say that we have paid our taxes when we had an income and what we seek is an entitlement, not a handout.’ Just how much satisfaction workers on €35,000 to €40,000 will derive from paying more income tax after April 7th is difficult to guess.

To return to Colm Kenna’s table, the data presented refutes the often quoted statistic that 50% of all income tax comes from earners with incomes of more than €100,000. The corollary of presenting this statistic as fact would appear to be that the Irish income tax system is highly progressive and that high earners are making more than their fair contribution to the national coffers. However, it turns out that the statistic is based on Revenue cases with many couples being treated as a single case. If the data is disaggregated into individual income earners a different picture emerges with those earning over €100,000 contributing 31% of all income tax. The data also reveals that those earning low to middle income incomes in the range €30,000 to €50,000 contribute 28% of all income tax despite earning only 30% of all taxable income.

This certainly does not sit with the received wisdom that seems to inform much of the debate on taxation leading into the April 7th budget.

What about R&D policy?

Peadar Kirby: Amid all the focus on the flood of different reports on the Irish economy, and the battle between the slash and burn brigade and the stimulants, the new Science Foundation Ireland strategy on 'Powering the Smart Economy' seems to have slipped under the radar of many. This is surprising, as it remains probably the only sector of Irish public spending now that seems to be ring fenced against spending cuts and, of course, it is regarded by the official view as being the centrepiece of trying to position Ireland for economic success once we get ourselves out of the current mess.

Yet, as with so many of the sacred cows of Celtic Tiger Ireland that few dared criticise (stimulating a booming economy, opening the flood gates of credit, establishing new agencies for any problem that emerged, national planning that was simply a list of goodies to be funded), current policy towards R&D does little to stimulate confidence that it can achieve the lofty goals it has set for itself. A more critical examination is greatly overdue.

I have little doubt that the huge increase in state spending and the development of an elaborate institutional infrastructure for it is stimulating worthwhile research. Yet, the links between this research and a wider project of national development are what require more critical interrogation. I have three main concerns:

1) It seems to have escaped notice that Ireland has chosen areas to prioritise for research spending that are exactly the same as those chosen by numerous other countries around the world. I was at a Unesco workshop on research policy in Paris last week and was amazed to hear speaker after speaker referring to ICT and biotechnology as the two priority areas of research for their governments. At least this shows that Ireland isn't out on its own, but it raises major questions about the widsom of concentrating major public spending on areas in which there is intense competition, some of it from countries with much more established research cultures than we have here. Does it not run the risk that the benefits of such research funding will be realised elsewhere with minimal benefits for the Irish economy?

2) To realise its developmental promise, an active and well-resourced research culture requires national companies to avail of the research. In the past, developing countries often developed high-tech research capabilty not in their universities but in public companies. Yet, in an economy so dependent on foreign companies, it seems that much of our research funding ends up as a subsidy by the Irish taxpayer to the research and development capacity of multinationals. As these move their labour-intensive operations to lower-cost locations, we need a much more critical cost-benefit analysis of the developmental benefits to the Irish economy of the priorities that have been set as part of our research policy.

3) To the social scientist, the nature of the research culture that has grown up in Ireland appears far too technical in nature, as if technology alone can result in development. What is missing is any appreciation that all technological or scientific inventions are always embedded in social organisations (companies, services) which structure the ways they are utilised and who profit from them. Yet, to those who fund research in Ireland, these social dimensions seem of no importance. As a result, it is hardly surprising that we get islands of research excellence amid a society of growing social strains and inequalities.

Much more could be said about the nature of the official approach to developing research. Not least would be the observation that a highly instrumental view governs the whole process, which is the very antithesis of the creativity that should drive any true innovation, particularly an innovation that has a concern with broad and sustainable social outcomes. Perhaps the time has come to include research funding in those areas of public funding that require some critical scrutiny.

Two party policies, one consulting report and some new data releases ...

Two interesting publications launched today: Fine Gael's Rebuilding Ireland economic policy document (with, it seems, a privatisation sting in the tail) and the FTI Consulting report on the Irish economy. The press release accompanying the FTI report states that "Further increases in government spending to stimulate the economy are impractical or unavailable due to the deterioration in the public finances, rising borrowing costs, and a perceived risk of default" - a stance which Sli Eile has argued against here. It's the season for economic policy documents: earlier this week, Sinn Fein launched its Job Retention and Creation Strategy - you can read an analysis over at Notes on the Front.

Today also saw the release by the CSO of new data on the fourth quarter of 2008, and preliminary 2008 data.

Responding to the crisis

It can be hard to see beyond the impending budget and the rising crescendo of voices clamouring for cutting our way out of the present gathering economic storm. Conservative commentators and economists have a very simple recipe roughly summed up as:

• cut wages

• cut public spending

• slash borrowing quickly

• sell off public assets

• rescue the banks and the bankers

These responses pass for orthodoxy and have a stamp of authority when recycled through the media – especially particular Sunday journals. This calls for a rounded, balanced and socially fair response. One such response is coming from CORI – the Conference of Religious in Ireland. It takes a similar line on many issues to that of ICTU – especially in regard to tax reform.

An interesting feature of both contributions is the way in which they point, not only to necessary immediate responses to the current crises, but to the need for a fundamental shift in the economic and political philosophy underlying public policy and thinking. The culture of individualism, greed, anxiety and market dominance over human values needs to be critiqued. An alternative needs to be envisioned and practical steps undertaken now. Just as the fall of the Berlin wall marked the end of communism in Europe, the calamitous turn of events with loss of jobs, production, capital values and confidence, marks a new chapter in history and could yet signal a dramatic collapse in the dominance of neo-liberalism. The coming two to three years will be decisive. Truly we are living in extraordinary times and one in which political economy must rise to the challenge with clear principles and clear options and policy solutions for public debate.

Starting with the Budget in Ireland on April 7^th, what are the areas of public spending and taxation that need to be changed now? The National Economic and Social Council has identified five inter-linking crises. ICTU has issued its 'ten point plan'. CORI, in its Briefing Paper, has based its policy approach on 8 key points.

I'll be examining each of these approaches in subsequent posts - but meanwhile perhaps people would like to comment?

Stimulus

1 One of the key arguments against a stimulus package in Ireland is that additional public spending will leak out through imports. In other words additional consumption and investment by the State will suck in more imports and will have little impact on the economy. This argument is made quite apart from other considerations including the critical level of national debt, Maastricht rules etc.

2 The nature of Ireland's small open economy is said to be a break on any home-grown Keynesian stimulus response to the current collapse in consumer confidence. Sometimes, commentators refer to something in the order of 80% of GDP being accounted for by exports. This is misleading. GDP is the value of output in all sectors of the economy where output is measured as 'value-added' = final gross value minus inputs of labour, capital etc. In dividing exports by GDP we are not comparing clike with like. Exports need to be adjusted for factor input like GDP.

3 The CSO recently published Input-Output tables. In Table 5 of the tables (referring to 2005), the 'direct and indirect' import content of each sector can be seen. In many of the manufacturing sectors, the direct and indirect import content amounts to 40-60% of the value of output, or even higher in some cases. But the corresponding figures are a good deal lower in construction (26.5%) and in many of the service sectors - e.g. public administration and defence (12.7%), education (8.7%), health and social work services (16.2%). (There would also be further imports arising from the spending of the employees in these sectors, but these types of figures do indicate which sectors have relatively high or relatively low import content.)

4 Hence, any package aimed at boosting domestic consumption - especially if it is targetted at sectors such as education, health and social work services (exactly those areas of public spending most trenchantly criticised and earmarked for cuts) - can still have a significant impact on employment and consumption. A focused investment programme in labour intensive-infrastructure allied to upskilling would strengthen our human capital base in preparation for a recovery as help stimulate employment and, ultimately, tax revenue.

5 However, a stimulus in a small open economy does not work on its own. Crucially, intervention at the international level is an urgent necessity. Hence, the key to any 'New Deal' is:

• international - especially European - coordination

• targetting on areas of high social need (health, education, housing) and relatively low import content

• prioritising labour-intensive projects in the Public Capital Programme

Getting ideological

Paula Clancy: David Quinn is right about one thing: we do need to start asking ourselves what kind of society we want when we come out of the current crisis. I think most of the allegations in his column last Friday are unfounded, but any call for a real debate on the choices facing us must be supported wholeheartedly.

David seeks to blame the Left, in Ireland and internationally, for leading us into the current crisis; to absolve the “free market” of responsibility for the financial system’s destruction; and to transfer the blame instead onto out-of-control public spending.

For the last 15 years or more, economic commentary in Ireland has been dominated by economists promoting the line that inequality is good; public is bad; and, if the market and competition is allowed to do its thing, most of us will be rich. Most of these economists were rewarded handsomely for their pains. Those who were not directly employed by the banks and stockbrokers frequently had secure university posts which allowed time for consultancy services with regular access to industry, finance, government and the news media. Meanwhile, progressives who did warn about the flaws, inequalities and missed opportunities of the Tiger model were sneered at as jonahs, or dismissed as old-fashioned begrudgers, or both.

The attempt to absolve the “free market” and its fundamentalist ideologues of responsibility is more flimsy still. It is perverse to blame regulators – public servants, albeit overpaid – for the failure of a system which we were told was best with virtually no regulation, instead of blaming those running our financial services institutions who pocketed tens of millions of dollars in annual salaries while making what they now admit to be ‘poor decisions’. Last week, in response to an article which similarly blamed the regulators, one correspondent from a financial services firm wrote in the Financial Times “Excuse me, but, in the Anglo Saxon world, we were lectured incessantly – and arrogantly lectured others – that markets worked best when free of government intervention and with minimum regulation”. That says it all.

Out-of-control public spending is the other named culprit. Recent history tells a different story. Former President Clinton balanced the budget before he left office, but did so largely by slashing programmes for the poor. Of course, the second President Bush subsequently ballooned the deficit through massive tax cuts for the super rich and the illegal war in Iraq. The OECD, which has impeccable “free-market” credentials, said that Ireland's “public spending and employment growth has not kept up with population and GDP growth. Government policy has decreased the number of public employees as a % of the labour force and the overall public sector wage bill as a % of GDP. Compared with other OECD countries, government employment in Ireland is relatively low.” And, despite the scaremongering, Ireland’s national debt is not out of control. In fact, on current government projections, it will be only slightly higher than 60% in 2010, compared to more than 75% for the Eurozone as a whole.

It is not that progressives are fixated on a “big state” or “high taxes” per se. We do believe that the pursuit of equality is a sound principle for a successful society and ought to be a primary objective of public policy. Quality public services, universally available, are the single biggest contributor to such a society. For obvious reasons, we have as great, or indeed greater, interest than right-wing ideologues in ensuring that these are efficient, well-delivered and popular. It is, however, a fact that no country in the world has achieved the level of equality and public wellbeing that we should aspire to, with public spending as low as ours.

Our focus on equality is not just a product of the politics of envy. Reducing inequality is good for everybody, not just the worse off. Just read The Spirit Level by Wilkinson and Pickett for proof, across a whole range of measures, that people live longer, healthier and more fulfilling lives the lower the level of inequality in that country, city or community, regardless of wealth or per capita income. Inequality is simply bad for us all.

But there are some grounds for optimism. The election of Barack Obama might just signal the end of a dark age where growth and greed were the gods, and society was just a dump for the little people. Here in Ireland we did not escape the infection of the Reagan/Thatcher virus, so perhaps the slow wake of the PDs signals our recovery moment. The world which follows the current depression will be radically different, and we must recognize that we do not have the planetary resources to accommodate never-ending rampant growth, consumption and greed. We will have to work out an economic and social model which is more collaborative and can generate a better return in terms of individuals’ wellbeing than the consumption and ever-higher GNP model has managed.

Auditors: one of the guilty parties?

David Jacobson: As the crisis progresses (or should that be ‘regresses’?), analyses of its aetiology will no doubt develop in their complexity and, one hopes, will contribute to knowledge and, ultimately, to solutions. There is certainly a growing willingness to attribute blame. Here are some examples plucked from reports in a variety of newspapers and other media.

1. It’s the government’s fault. Policy continued to encourage investment in property development long after it was clear that demand – especially in commercial property – was collapsing.

2. It’s the banks’ fault. They gave loans inappropriately despite the warnings that they should cut back.

3. It’s the regulator’s fault because his office didn’t regulate enough – the light touch approach to regulation in Ireland was inappropriate because it enabled financial service companies to do what turned out to be against their own interests.

4. It’s the auditors’ fault because they approved the accounts of the banks when they should not have done so.

5. It’s the major property developers’ fault because they borrowed money and continued to build long after they should have cut back, given the impending collapse in the property market.

6. It’s the fault of financial markets which are inherently inefficient, under-estimating risk in the upswing, and over-estimating risk in the downswing of the cycle.

7. It’s the fault of the “golden circle”, including top bankers, property developers and perhaps politicians and officials, who were all too greedy, and continued to gamble with what turned out to be public money.

Support for each of these propositions can be found – as well as for a number of others. They could, together, all be correct. And each of them could be developed in interesting ways that link to economic theory, or critiques thereof.

Let us take number 4, for example. The current rules and regulations in relation to auditing can be argued to be seriously defective. One of the theories of economics that has gained a huge amount of support from those who believe in markets is agency theory. In short, this theory argues that people act in their own interest, usually pecuniary. It focuses on contracts and suggests that contracts should be formulated in such a way as to meet the interests of the contracting parties. For example, managers of companies should be contracted to act in the interests of the shareholder – they should act, in other words, to maximize profits rather than their own salaries or perks.

Now consider auditors. Their interest is in obtaining their audit fees. To obtain increasing numbers of clients who will pay them audit fees, they need to act in such a way as to keep their clients happy. Keeping clients happy may not be in the public interest, however. But the client, not the public, pays for the audit. As Jim Stewart (2006) has suggested, if auditing is done correctly, proving that the accounts of a company accurately reflect all the salient details of the business, then the output of the audit can be considered to be a public good. In contrast, perhaps bad auditing is a private good?

This analysis leads to the conclusion that 4 above could be true, and that, moreover, nothing about it should surprise us. A better way of organising and providing the public good of audit output would be to create a greater distance between the companies and the auditors. If it is a public good, the public should pay for it. Perhaps companies could be taxed enough so that the additional taxes could pay for the auditing service.

Ref: Stewart, J. (2006) “Auditing as a Public Good and the Regulation of Auditing”, Journal of Corporate Law Studies, Vol. 6, No. 2, pp.329-359.

Pay Cuts and Deflation

Paul Sweeney: Many economists and commentators are still arguing, very strongly and with great certainty, that pay cuts will be the major part of the solution to the economic crisis.

This post, my third on competitiveness and pay, will explore the belief that pay cuts will not have a deflationary impact on the economy. Thus, it is argued, pay cuts would not make things worse.

Pay in Ireland has been rising more rapidly than in competitor countries though Irish pay levels still remain lower than most, though not all, competitor economies and pay levels are not as important in our competitiveness as other issues, especially now.

Wage costs are just one aspect of competitiveness, as most economists agree. It is more important to look at unit labour costs or productivity (though that is far from the end of the complex issue). There has been much discussion of falling productivity in Ireland. Yet the data shows it has not been falling. It has been stagnant. It has not been rising. It would be better if it were rising, especially if it is rising in competitor countries and as the euro has risen.

Yet the latest OECD data shows that the level of productivity in Ireland was third highest after the US and Norway. The Irish Central Bank publishes a table which shows relative unit labour costs, in a common currency, for Ireland in 2009 was down at 67 (from 100 in 1995). It has been around this for the last four or five years years. A different Bank table, (on unit costs relative to the main trading partners), has also been stable at 99 for 5 years. With the growth in construction and in services, sectors with low productivity, during the domestic boom since 2001, productivity increases were difficult to achieve. With a deep recession, this may be even more difficult, due to labour hoarding.

With the chasm between public spending and plummeting revenue (thanks to the government’s obsession with tax cutting in the boom), the issue of pay reductions in the public sector, where it is the major cost, is generally accepted. The Transitional Agreement includes a pay deal signed by Government, employers and unions, only last September. The Government reneged on it and IBEC indicated that it would like not to pay it.

Yet many leading companies, where they can, are paying it. Some companies like CRH, which declared operating profits of €2bn, do not have a problem paying it. In other multinationals (MNCs), where pay is not significant in terms of total costs, they are paying it too. Many MNCs operate on intra-firm transfers and are not particularly price or even currency sensitive. The industrial relations newspaper, IRN, has listed around 70 leading firms which are adhering to the deal. Yet unions accept that in this deep recession, many firms, especially in services, will have difficulties. They are doing deals, as per the agreement, on inability to pay, on freezes, etc. If there is not negotiation at national level between the main players, based on fairness and shared understandings, actors may be forced to take hard positions.

Importantly, competitiveness is about much more than wages and even unit labour costs. I believe the major issue of Irish competitiveness is the lack of credit for firms, due to the collapse of the banking system, compounded by the Government’s decision to take a staggering €7bn out of the public purse (which is EMPTY) and give it to the collapsing Irish banks.

I think the second issue of competitiveness is Ireland’s appalling international reputation, ruined by a few of our enterprise leaders and by the Government's light regulation, light tax regime. There is also a domestic reputational issue too, where all Irish business leaders have been tarnished by the few, just as they are trying to impress their employees on the need for cooperation in facing really serious economic problems. Rebuilding Ireland’s reputation will be a key competitive challenge. But many political and enterprise leaders are still in denial on this vital issue.

There is a certain attraction to achieving a once-off reduction in total Irish consumer costs. These are a substantial 14% higher than the EU15 average for goods and over 23% above for consumer services. They are even higher against the average of the total of the 27 member states. But would it work by only cutting wages, even if this were possible?

What really exposes the class prejudice of these economists is that they only seek pay cuts for employees, and have no interest in demanding that the rest of the economy (which includes those who profited so greatly and who included those who caused the crisis) contribute. Is it simply that labour is the largest chunk of national income and is perceived as easiest to squeeze?

Or is it that Ireland would need a CAB-like Prices Commission to really police lawyers, solicitors, pharmacists, retailers, wholesalers etc. to force them to bring down prices and that this would be “state interference “ in the market? Some businesses will reduce prices because they have to, but others will not, especially when they can get away with it. A CAB-like Prices Commission is what is required in these exceptional times to ensure fairness in such a cost reduction mission. Or is it as simple as the fact the some economists would abhor state interference in the prices mechanism in these trying times, but that they have not such ideological qualms on the price of labour?

But what about the impact of this strategy for wage cuts only, if it were to be implemented? If workers concede major wage cuts, but the other sections of society do not, will it result in considerably reduced domestic prices? It is unclear that it will. The transmission machine if not working as any shopper will tell you. The fall in sterling was not passed though to consumers.

Some economists are predicting the prices will fall to minus 4 or minus 5% in 2009. Yet these are the same economists who predicted prices would fall, just as negotiations on the previous two national agreement were underway. They got it wrong each time. Much was made of the fall in consumer prices in February of -1.7%. But behind the figures was a decline in the rate of decrease from a substantial -1.7 in January to -0.4 in February. And the HICP (without mortgages) was still positive. Nonetheless, prices are likely to fall this year, but who knows by how much? Profiteering is part of the Irish business psyche. No economist has shown that wage cuts in profitable firms will not go straight to the bottom line - not to consumers.

Retail sales fell by 4.5% - the largest amount in 2008 since 1982 and excluding motors, it was the largest fall ever recorded. Retail sales had previously grown by plus 5/6% for years. Wages make up €80bn or over half per cent of national income, so would major cuts in wages depress domestic demand further? And tax revenue too. Many businesses will be forced to close down, leading to a deflationary spiral.

Then those who think wage cuts alone will reduce our cost base so much that exports will then “take off” and replace the now collapsing domestic demand. But do they not know that international trade is now in decline? Trade, which grew at a multiple of economic growth for decades, is now actually declining.

Germany, Europe’s biggest economy and the world’s biggest exporter, is seeing its exports plummet. “German manufacturing is in freefall” says the Financial Times. Domestic demand is stagnant and growth is falling. Overseas orders for capital goods were down as massive 48.2% in the year to January.

So who is going to snap up the now bargain Irish exports, brought down so much in price, (it is fervently hoped) by cuts in wages? Few, I fear. International demand is flat or mainly declining. Even if the fine economic models are tweaked and squeezed to show a happy outcome, in the real world, there a danger that this strategy of wage cutting could make things worse.

It is hoped that the real solution, a big stimulus package, will be made in London on 2nd April. But it is not looking as if the stimulus to be agreed by the G20 will be anywhere near adequate. In the meantime, Ireland’s international reputation is in tatters.

Only the workers can save the Irish economy by agreeing to massive wage cuts! Or so some economists appear to believe.

So who's to blame? An Icelandic saga

Terry McDonough: I came across the following very interesting reference from Ann Mayhew on the institutional economics AFEEMAIL list. Enjoy.

In the March 9, 2009 issue of THE NEW YORKER there is a very interesting and highly readable account of the financial disaster in Iceland by Ian Parker. One of the people interviewed by Parker was Hannes Holmsteinn Gissurason, described by Parker as a libertarian professor of political philosophy and a free-market intellectual who had considerable influence and wrote “How Can Iceland Become the Richest Country in the World?” Gissurason claims as his heroes Margaret Thatcher and Friedrich Hayek on whom he wrote his Oxford dissertation. Toward the end of the article, Parker reports on a conversation he had with Gissurason about the collapse of Iceland’s banks and economy during which Gissurason blames the disaster on “ten to fifteen guys [who] overreached themselves.” Parker goes on to quote Gissurason as making this, to me, breathtaking statement:

“. . . some of us are to blame indirectly, because we created a climate in which the entrepreneur was applauded. The businessman, the guy who takes over companies, asset-stripping—he was a hero in Icelandic folklore that was created by some of us who strongly supported the free market. . . . Indirectly, I take some blame for it, but, if you think about it, it’s not my fault. It’s the fault of the left-wing intellectuals, who should have been giving a counter-view!. . . You can’t blame people for their successes—you have to blame those who fail. We were too successful with the free-market philosophy.”

So there, left-wing intellectuals, take that! And, I assume that Oxford is proud of the logical rigour they instilled in their fine students.

Values, Prices and Economics

Oscar Wilde once complained that 'economists know the price of everything but the value of nothing'. Well, the same could be said about current day markets and their over-pricing of risks (and under-pricing formerly). We are now in the era of dictatorship by the markets - let's bow down and offer sacrifices at the shrines of Moody's, Standard and Poor, IMF etc - because if you don't swallow the bitter cup of wage cuts, reductions in social welfare and cut-backs in frontline public services - you will get worse from the real and ultimate masters of economic fortune.

There is, however, another sense of price-value mismatch in the world of Robinson Crusoe economics - much of what passes for empirical economics is little more than value-laden theorising. Worse still, the value of human persons, communities and relationships takes a very secondary seat to the price of the 'factors of production' and the market-clearing solution based on implicit values that need to be challenged again and again. Economics needs to be cleaned up - this time on the basis that people really do matter.

The incredible shrinking billionaires and other stories

This story has made all the papers, but the Guardian probably has the most succinct account: apparently the number of billionaires on the planet has contracted from 1,125 to 793, while the amount of money they control has plummeted from $4.4 trillion to a mere $2.4 trillion. So one club is shrinking - but in Monday’s Irish Times, Colm Keena offered a fascinating insight into another club, showing how the finance industry has been able to influence policy-making at the very highest levels. His story concerns the Revenue’s decision to tax contracts for difference back in 2006 … and the speedy reversal of that decision within a matter of weeks, following contacts between the sector and the then Assistant-Secretary of the Department.

Following the Government’s reversal of its decision the “market responded positively”, and the then chief executive of the Irish Stock Exchange contacted the then Assistant Secretary of the Department to thank him and suggest doing lunch.

A portrait of business as usual in boomtime Ireland ...

Meanwhile, in the States it’s good to see that a number of economists – including Jagdish Bhagwati, otherwise well-known for his opposition to fair trade proposals – have come out in favour of passage of the Employee Free Choice Act, draft legislation that would strengthen the trade union rights of US workers.

Borrow, Tax and Spend?

“This notion that the economy is self-stabilising is usually right but it is wrong a few times a century. And this is one of those times . . . there’s a need for extraordinary public action at those times.” Thus Lawrence Summers is quoted in the Financial Times yesterday (Europe Rejects Extra Stimulus Appeal)

What of borrowing in Ireland?

Last December, in its publication 'Building Ireland's Smart Economy', the Government stated that 'It is likely that borrowing to pay for day-to-day services will be in the region of €9 billion next year. This is not sustainable or sensible' (page 44).

Alongside borrowing for 'day-to-day' spending a borrowing requirement of an additional €9 is required to cover what is termed capital spending. The total borrowing requirement is estimated at €18 billion against a backdrop of a projected figure of about €180 billion in Gross Domestic Product (all figures based on the Department of Finance Addendum to the Irish Stability Programme Update January 2009 - which is probably somewhat out of date two months later). This gives a figure of just under 10% of GDP. Set against the 'Growth and Stability' limit of 3%, the conclusion drawn by many conservative commentators is that we must retrench rapidly through a combination of tax hikes and spending cuts.

A number of points need to be made in this regard:

The application of an EU fixed limit of 3% in the current recessionary climate is clearly inappropriate, and this is conceded in practice by all concerned;

The borrowing requirement of very roughly 5% of GDP for 'capital' purposes is 'sustainable and sensible' on the grounds that such spending is a contribution to vital social and economic infrastructure which can yield long-term fruits (and a stream of repayments).

The borrowing requirement of another, additional, 5% of GDP for 'current' purposes is justifiable if it contributes to economic and social well-being at a time of crises. It could be viewed as a type of economic stimulus as well as a necessary measure to defend the quantity and quality of public services. An objection could be made to the way in which public (and national) accounting mis-specifiy spending on areas such as health and education as 'current consumption'. Spending on education and health represents investment in human and social capital, and this should be reflected in the way we look at public spending and measure the difference between 'day-to-day' spending and 'capital' (for the future) spending.

When commentators refer to a huge hole of €20 billion in our public finances they rarely mention that this includes 'capital' spending, for which borrowing is quite acceptable, as well as 'current spending' (for which borrowing is acceptable in a counter-cyclical strategy).

However, a prudent course is to constrain borrowing to around 10% and possibly reduce it to 8% - through a graduated series of tax-raising measures aimed at widening the tax base, increasing marginal taxes for higher-income earners and beginning the process of tax reform in regard to property, local and capital taxes of various kinds. Is some reduction in public expenditure required? Not if it means reductions in spending on:

• Key social infrastructure such as health, education and affordable accommodation
• Social transfers to those in need

If there are some areas of public spending that can be pruned and efficiencies made, then that needs to be done rapidly. On top of all this, there is scope to defer payments to the Pre-Funding for Future Pension Liabilities of about €1.5 billion per annum. Based on the Department of Finance's own estimates, Total Gross Government Debt will go to over 50% in 2009 compared to 25% in 2008 (and levelling off at around €65billion towards 2011/12). This is still manageable if fiscal policy is adjusted, wisely, to protect the incomes of those who are vulnerable to poverty, safeguard jobs in the public and private sectors, shift taxes towards those who do not pay their fair share currently and provide an economic stimulus to sectors and areas of investment that will bring Ireland forward in terms of jobs, environment and worthwhile social services.

The thinking that got us into this crisis is not the thinking that will get us out of it.

Who’s for some expansionary fiscal contraction?

Peter Connell: The mini-budget that we can look forward to in three weeks time will, I’m sure we’ll be told, ‘constitute a necessary first step on the road to economic recovery’. It will ‘position the economy to take advantage of the global upturn when it happens’. Apparently, the budget will ‘give us a renewed confidence in our ability to see out the recession’ and encourage us to go out and spend for Ireland. But wait, isn’t it also supposed to extract €4 billion out of the economy in the form of taxes rises and public expenditure cuts? And this is on top of the €2 billion in cuts already in place. So how will this piece of magic work? You take €6 billion out of people’s pockets but, somehow, they’ll feel more confident about the future and start spending their money.

The answer is – it’s all down to expansionary fiscal contraction. The theory is that cuts in public spending will lead citizens to believe that taxes will also fall and, on that basis, private spending will increase. In the current Irish context, given that there is a commitment to raise taxes, the most we can say is that consumers will belief that taxes will rise less than they might otherwise do if public spending were not cut. Some economists argue that expansionary fiscal contraction helps to explain the turn around in the Irish economy after 1987 when net government borrowing fell as a percentage of GDP from 10.4% in 1983-86 to 4.2% in 1987-90. Average GDP growth rose from 1.9% in the first period to 5.7% in 1987-90. QED. Well, maybe not. It’s now generally accepted the post 1987 recovery had a lot to do with external factors including falling international interest rates and an upturn in the global economy.

The point is that we need to be as clear as possible about the impact of a combined €6 billion cut in public expenditure and rise in taxation. Has anyone done the sums yet on the impact on government revenue? On how many businesses will be forced to close that otherwise might survive? On the damage that will be inflicted on the productive capacity of the economy? To what extent will the provisions of the mini budget deepen the real crisis which is in the real economy? The government appears to have made an absolute commitment to keep the deficit in 2009 below 10% of GDP, hence the mini budget. Across much of the media the need to stick to this figure is accepted without question. Given the likely impact of that budget in three weeks time on all our futures the public discourse needs to move to another level.

Krugman on bad banks / good banks

Following on from Terry McDonough's post on bank nationalisation, Paul Krugman makes some interesting points on the whole bad bank/good bank argument here. Any comments .....?

We can't go back to 'bad banks'

With all the discussion of 'good' and 'bad' banks - see the excellent posts by Terry McDonough on this site and Karl Whelan at irisheconomy.ie - it is worth considering some of the other elements involved in a good bank other than simply a strong asset base. Because if all we do is restore AIB and BOI to their positions before the crisis, then we do not necessarily get 'good banks' that will support economic development.

More on the background to bank lending and state financing of businesses here.

Exchequer Returns Emphasise Need for Growth Strategy

Yesterday's exchequer returns mark the end of Ireland's tax strategy since the end of the 1990s. As capital gains taxes collapse and stamp duty returns are all but eliminated, corporation tax is also dropping as Ireland is particularly vulnerable in this area given the amount of transfer pricing and profit shifting for tax purposes within our corporate sector.

This marks the end of what has been a strategy for public revenues that could only work during the boom times. We are now faced with a heavy reliance on income tax and VAT at a time when both are falling (see table below)



Capital gains taxes and corporation taxes won't be improving any time soon (and many of the great and good will be writing off their other taxes against capital losses for years to come). Stamp duty revenues are gone.

We can expand the tax base - carbon taxes and property taxes are the obvious candidates. If a property tax is introduced, we should consider a credit for stamp duty paid in the past ten years (reducing revenue but increasing ability to pay - and fairness). The recent QNHS employment figures show job losses among the younger age groups, who are likely to be carrying heavy mortgages. Any property tax increases would need to be accompanied by anti-foreclosure measures.

We can raise income taxes - some of this has happened already and more is on the way. But we need to be careful how and where we do this.

As Aedin Doris notes in her comment here: "Remember that the tax-free portion of income is pretty much set to exempt those working full-time, full-year on the minimum wage; if 38% of the working population aren’t paying tax, it’s because we have a lot of people working part-time and/or on low hourly pay".

And of course, those people working for these low wages are particularly likely to suffer from the lack of the social, collective goods that come with strong public services in other countries.

This leads her to conclude:

"In my view, widening the tax net should be considered only after all possible tax expenditures have been pruned away, and the extent to which any one individual can benefit from them strictly limited."

So let's clean out a lot of those tax reliefs. Their incentive effects, which were often minimal or perverse, are largely irrelevant these days when stimulus will be much more important. The government cut the state agencies it didn't like pretty quickly when it wanted to - let's have a quick run at the tax reliefs this time around.

The crux of the matter is that this gap is too huge to close with cuts and tax increases, even though those will play a part. We have scope for borrowing, given our low debt ratio but this will give a few years 'breathing space' at best.

What can close the gap is growth. After all, in 1987 we introduced some cuts but the public finances improved when we managed to generate growth. We need to be crafting a stimulus plan for growth, incorporating fiscal measures and programmes that generate employment and are geared towards the medium to long term developmental needs of the economy and society (education and training, greening the infrastructure and economy, small business development, innovation, urban design, caring and other social and reproductive work, and more). Bell and Blanchflower suggest a plan for the UK while Block and Keller propose 'stim-novation' measures, combining stimulus with innovation policy, for the US (see also this report from the Information Technology and Innovation Foundation). We have barely begun this discussion.

Our growth cannot free ride on international trends as it did in the 1990s - it will have to be based on developing new capacities and forms of participation in the economy that keep people attached to the labour market through the recession, meet social and economic needs, and build capabilities that will serve us well when recovery comes. Fixing the financial system so that private investment is forthcoming will be an essential part of this process. Public investment - and therefore borrowing - will be crucial.

This is the kind of debate that might have occurred were the institutions of social partnership playing a central role in the process. ICTU's ten point plan is perhaps the only attempt at such a plan to this point. It is a debate we need to have urgently.

Economic Sociology on the Financial Crisis

Fred Block traces the evolution of the sub-prime crisis in this very clear exposition of the problem. Donald McKenzie of Edinburgh University makes the key point that the subprime mortgage crisis was a relatively small and localised part of the financial system - what set off the spillover effects was the collapse of faith within the investment world in the 'public facts' that had been shared until then.

There are a selection of European economic sociology perspectives in the latest issue of the online newsletter Economic Sociology.

An earlier issue in 2007 also examined various issues to do with the sociology of credit, finance and investing.

Comfort from US Heritage Foundation: we may be broke, but we’re economically free!

Paula Clancy: Looking for something else on the web, I came across Ireland’s entry in the 2009 Index of Economic Freedom, published by the right-wing Heritage Foundation in the United States. According to this entry, the Irish economy is the 4th freest in the world – and 1st in Europe. The report was obviously prepared some time late last year, and transports one back to a halcyon age where “Ireland’s efficient business environment continues to attract significant foreign investment” and our “competitive financial system [….] facilitates dynamic entrepreneurial activity” while “all financial institutions are in private hands” and Irish banks are “well capitalised”.

The report also lauds our “flexible labour regulations” which mean that “dismissing a redundant employee is relatively easy”, and notes approvingly that “the overall freedom to conduct a business is well protected under Ireland’s regulatory environment”.

With an astonishing lack of prescience, the Heritage Foundation – whose mission is to “formulate and promote conservative public policies based on the principles of free enterprise, limited government, individual freedom, traditional American values, and a strong national defense” – fails to discern even the glimmer of a dark cloud in this vista of economic freedom.

Now that the clouds are here, I guess we can comfort ourselves with the thought that we may be broke – but at least we’re economically free.

Socio-economic dimensions of the worsening employment picture

Sean O Riain: There is a helpful post over at irisheconomy.ie by Brendan Walsh outlining the worsening employment picture as reflected in the latest Quarterly National Household Survey.

One of the comments by Liam Delaney also provided this link to an excellent Bell and Blanchflower paper on unemployment in the UK and the need for jobs focussed stimulus, among other policy measures.

There are some elements of the worsening jobs picture that Brendan's post doesn't bring out that are worth mentioning (most of this is also in my comment on Brendan's post over at irisheconomy.ie)

The sectoral spread of the job losses is pretty wide - construction and production industries losing the most but also retail trade and hotels and restaurants and financial and business services. While Eastern European workers are particularly hard hit, the losses extend to Irish born workers in very large numbers.While all regions see increases in unemployment rates, there isn't any closing of regional gaps and the midlands appears to be hit worse than other regions.

Also, the losses fall particularly heavily on craft workers and production workers among men and clerical, sales and service workers among women. Given that these occupational groups are often married to each other there is a potential here for a nasty concentration of the effects of job losses - although that would obviously take some further examination. There seems to be a strong rationale here for the kind of jobs focussed stimulus that the Bell and Blanchflower paper discusses and for further education, training and related schemes.

The job losses are also particularly bad among younger male and female workers, those most likely to be carrying negative equity in their homes and the heaviest mortgage payments. All kinds of potential problems there - and a strong prima facie argument for planning to prevent foreclosures. These will be problems for the people concerned but also potentially for the banks - their difficulties at the moment appear to be mainly due to loans to developers, but there is a lot of potential trouble stored up in the mortgages they gave out.

The data from the QNHS can be found here:

Liberal Policy Choices to Blame for the Crisis

Sean O Riain: The dishonesty and incompetence of individuals in charge of running and regulating our financial system has been spectacular. However, it should not distract us from the roots of the current economic crisis in a set of policy decisions taken in the late 1990s, under the banner of economic liberalism. Fuelling the building bubble, giving a free hand to financial speculation, and cutting taxes failed to generate productive investment, weakened households and has ultimately brought us to the perilous state in which we now find ourselves.

Since the late 1990s economic growth has become increasingly dependent on the speculative financial and property boom. Meanwhile the tax structure became dependent on taxes linked to the boom – stamp duty, capital gains and VAT, among others. When the speculative bubble burst, both private and public investment were hard hit. Tackling the crisis will involve financial measures but, more importantly, a re-orientation of the economy towards development of productive and innovative firms, creating a more sustainable tax base and significant investment in the skills and well being of the population. This crisis is so severe that we cannot cut our way out - although cuts wiill surely play a part, the core of a strategy has to be investment in growth through upgrading.

The booming Celtic Tiger of the late 1990s depended upon a whole set of measures to coordinate the economy – significant initial spending on social and regional infrastructures; social pacts that coordinated wages, taxation and employment; an industrial policy where state agencies worked closely with firms to develop them; and public subsidies for social services such as education, mortgage relief and pensions, that played an important part in the growth of the new middle classes. Just when we needed to invest further in strong international businesses and skilled workers, supported by better resourced public services, we turned away. We rode a wave of property and financial speculation and cut taxes so the public finances became dangerously addicted to continuous growth.

In 1998 capital gains tax was cut from 40 to 20%. Capital surged into the economy, with bank lending between 1998 and 2007 increasing almost five fold. But where did this capital go? 67% of the increased bank lending went into property (construction, developers, mortgages). A further 14% of the increase went into lending between financial institutions. While the rest of the increase was spread across different sectors, relatively little investment went in to the productive sector. In 2007 less than 1% of bank lending went in to high tech - computer hardware, software and research and development.

This showed up in investment. While capital investment increased from 22% of GDP in 1998 to 26% in 2006, that increase was entirely taken up with construction as non-housing investment decreased as a percentage of economic activity. Spending on technology by manufacturing businesses increased only marginally between 1998 and 2007. Underneath the boom, the financial, speculative economy was overwhelming the productive, innovative economy.

But the boom also masked serious problems in the public finances. Irish tax revenues in both 2000 and 2006 were 32% of GDP, well below the EU average of 40%. What was more serious, however, was the changing structure of tax revenues. Revenues shifted so that an increasing proportion of taxes came from taxes on turnover and growth – the percentage of taxes from VAT, stamp duty and capital gains taxes grew from 35.7% in 2001 to 44.3% in 2006. By 2008 the tax structure was dangerously vulnerable – when growth slowed, the revenues from capital gains, corporate taxes, VAT and stamp duty collapsed.

Despite the rhetoric, the current crisis is not generated by excessive public spending. Irish public spending remains among the lowest in Europe. Public spending on health, education, pensions and social protection are all only around the OECD average, or worse. This despite the fact that we face massive accumulated infrastructure deficits, from twenty to thirty years of underspending - remember that in the 1990s around a third of public spending went to pay off the national debt.

In fact, this low public spending in Ireland threatens Ireland’s future – when this crisis is over, the winners will be those who have weathered the storm and continued to build knowledge economies supported by high quality public services. But Ireland is now poorly placed to be among them, despite entering the millennium with a booming high tech sector, improving public investment, managed inflation and having resolved the public debt.

Where do we go from here? By all means, let us tackle waste in the public service – where it actually exists. But this is not the problem, nor the solution. To build the knowledge society that we have long been promised will require much greater investments in education, in innovation policy, in developing small firms, in child care, in supporting 'return to learning' among laid off workers, in providing the high quality public services that will sustain our workforce and benefit their employers. Our budget deficit may make it difficult to inject major additional financial stimulus this year but we should use the maintenance of public services as a form of financial stimulus that will help us through the short-term and simultaneously be an investment in future development. A pause on foreclosures and other measures to maintain household living standards will improve both social and economic outcomes. As the crisis eases, we will need to rebuild the tax structure so that the top rates of tax will have to be raised to generate more sustainable government revenues.

At the same time, we need to restructure the banking system so that investments in the productive economy are the main thrust of banking activities, rather than financial speculation. Unfortunately, the sale of the banks to private equity firms, whether privately or government held, seems to have come back on the policy agenda. If the banks receive significant private equity investment, we may well end up with a banking sector owned by international financiers and governments - but with their risks guaranteed by the Irish taxpayer. These private equity owned banks would be highly unlikely to make the kinds of investments in new and growing firms that have now been belatedly recognised as a critical contribution of the banking system. Ironically, while the government was promoting a speculative private financial system over the past decade, its own industrial development agencies have put their funds to much better use in growing firms and priming new funds for supporting start-up companies.

Choices were made in the late 1990s that diverted the economy away from industrial upgrading and new investment priorities onto a path of speculative booms, a weakening tax base and public finances that were dependent on boom-time growth rates. In tackling this crisis we must not reinforce the weaknesses this model has created. Trying to go back to where we were before the crisis will not generate the kind of growth we need to get through this time. Instead we must take the opportunity to rebuild and extend private and public investment so that sustained economic and social development is possible.
Professor Sean O Riain teaches at NUIM

Poll results .... and some questions

Based on the results of our poll - which is now closed - 72 per cent of our readers believe that AIB and Bank of Ireland should be nationalised. Of course, this poll was hardly scientific, but it does throw up a number of questions, as Sli Eile noted on Tuesday. See also Terry McDonough's post on Wednesday. Any comments?