Friday, May 22, 2009

Economics 23/05/2009: Is Ireland next Finland?

A recent (April 2009) paper by Gorodnichenko, Medoza and Tesar (IZA DP4113) titled “The Finnish Great Depression: From Russia with Love” provides some very interesting analysis of the causes and dynamics of the Finnish economy collapse in 1991-1993 period that contains insights into the current Irish experieince.

During the 1991-93 period, Finland experienced the deepest economic slump in an industrialized country since the 1930s. Between 1990 and 1993 real GDP declined by 11%, real consumption declined by 10% and investment fell to 45%. Unemployment rose from slightly under 4% to a peak of 18.5%, and the stock market fell 60%.

Gorodnichenko, Medoza and Tesar argue that the collapse of trade with the Soviet Union played a major role in causing the 1990s Great Depression in Finland, “since it caused a costly restructuring of the manufacturing sector and a sudden, significant increase in the cost of energy. The barter-type trade arrangements between the USSR and Finland skewed Finnish manufacturing production and investment toward particular industries, and effectively allowed Finland to export non-competitive products in exchange for energy imports at an overvalued exchange rate.” Furthermore, the study also suggests that “downward wage rigidity observed in Finland played a key role in the amplification of the downturn produced by these shocks.”

This is an interesting result. Obviously, trade shock described by Gorodnichenko, Medoza and Tesar does not directly translate to Ireland in current conditions. But some similarities are also evident.

First, just as the Finnish industries exports to the USSR were subsidised by the importing partner via particular pricing mechanisms, so are Irish exporting sectors – especially those dominated by the MNCs are ‘subsidised’ by the presence of the advantageous tax regime and transfer pricing. In other words, if Finnish exporters had to rely on Soviet benevolence in pricing their trade via oil-goods barter arrangements, so are Irish exporting sectors reliant on tax arbitrage. Neither one has a natural (productivity-driven) comparative advantage in trade when compared to other countries.

Second, the same wage rigidity that cost Finland dearly is also present in Ireland. Suffices to say, wage rigidities were also found to be important determinants of the severity and the length of the Finnish crisis by other studies. In particular, labor tax hikes and negative productivity shocks may have been the culprit (Conesa, Kehoe and Ruhl, 2007). Once again, the parallel to Ireland today is striking. By hiking income taxes, Irish Government in effect made it virtually impossible for workers to accept pay cuts, implying that our Government’s reckless policies are amplifying wage rigidity in Ireland. More on this below.

“Finland and the USSR had a series of five-year, highly regulated trade agreements, similar to the agreements between the USSR and its East European allies. These agreements established the volume and composition of trade between the two countries, and by the late 1980s they had evolved into a barter of Finnish manufactures for Soviet crude oil. Roughly 80% of Finnish imports from the USSR in the early 1980s were in the form of mineral fuels and crude materials. More than 90% of imported oil and 100% of imported natural gas came from the USSR.” Sounds familiar? Well, 90% of Irish exports are delivered via tax arbitrage-driven MNCs. Not exactly a ‘Curse of Oil’, but a curse nonetheless.

In a survey of the structural effects of Soviet trade on the Finnish economy, Kajaste (1992, p. 29) concludes that “[Soviet] exports seem to have been exceptionally profitable.” Kajaste (1992) estimated that the prices of exports to the Soviet Union were at least 9.5% higher than those for exports to western markets. Gorodnichenko, Medoza and Tesar found an even larger 36%markup which “suggests that if a Finnish industry redirected its Soviet trade to other countries, its goods would be competitive only if sold at a 10% to 36%discount. Hence, the Finnish economy was subsidized by overvalued prices of Finnish manufactures bartered for Soviet oil so that the effective price of Soviet oil was at least 10% cheaper than its market price.” Well, in Ireland’s case we know that transfer pricing runs ca 15%-18% differential between GDP and GNP. This is, at the very least, a lower bound estimate to the subsidy Irish economy receives from the tax arbitrage-driven exporting activities of our MNCs.

Just as Irish economy decline has been spectacularly fast, Finnish economy collapse was “quick and deep. Imports of oil from the USSR fell from 8.2 million tons in 1989 to 1.3 million tons in 1992. Exports tumbled down by 84% over the same period. …The loss of Soviet exports caused total exports to fall, suggesting that the goods were not redirected to other counties. After the collapse of trade with the USSR in December of 1990, entire industries had to be reorganized throughout the early 1990s.” Hmmm, you would say that Ireland is a different case in so far as we are not facing a possibility of an abrupt collapse in demand for our (MNC’s) exports. True. But we might see a total collapse in supply of exports by MNCs, should our tax arbitrage advantage be eroded by:
1. Higher domestic costs f production;
2. Higher domestic taxes leading to more rigid and inflationary wage processes;
3. Lower cost of production elsewhere;
4. Lower taxes elsewhere; and so on…

Per Gorodnichenko, Medoza and Tesar, “to fully understand the reaction of the Finnish economy to the collapse of the Soviet trade, it is important to examine the Finnish labor market because of its very high degree of unionization. In 1993, approximately 85% of workers belonged to unions and almost 95% of workers were covered by collective agreements (Böckerman and Uusitalo, 2006). Since most employers are organized in federations, the wage bargaining normally starts at the national level. If a federation or union rejects the nation-wide agreement, it can negotiate its own terms. Typically, agreements allow upward wage drift if firms perform well. Although the government does not have a formal role in the bargaining process, the government usually intermediates negotiations.8 Not surprisingly, Finland is often classified as a country with highly centralized wage setting (e.g., Botero et al 2004).

Just as in the case of Ireland’s public sector since 2008, Finnish “unions did not agree to cut nominal wages in 1992-1993, which were the peak years of the depression. Instead, wages were frozen at the 1991 level.” Irony has it, Mr Cowen is doing exactly this, except, unlike Finland, Ireland is currently running deflation, which means that public sector wages are rising in real terms through the downturn. In Finland, “given that inflation was quite moderate in the 1990s, real wages fell only to a limited extent. These findings are consistent with Dickens et al (2007) who cite Finland as the country with one of the greatest downward wage rigidities… Rigid wages amplify the contraction in demand in the short run. As consumers purchase fewer goods, firms demand less labor which entails further contraction of demand and the spiral continues. In summary, a combination of higher costs of producing goods, as well as a fall in demand magnified by rigid wages leads to large short-run multiplicative effects on the initial shocks.”

What is even more interesting is that Gorodnichenko, Medoza and Tesar show that output and economic activity in Finland during the 1990s crisis was, in the short run, sensitive to changes in the elasticity of substitution between capital and labour (loosely speaking a measure of relative labour productivity in the sectors where capital and labour are substitutes). When changing the degree of wage stickiness, the study “found that wage stickiness plays a very important role. In particular, the key parameter governing the response of the macroeconomic variables to the [crisis] is the persistence of real wages”. More specifically, “in the case with fully flexible wages, the recession is short and shallow. For example, output, employment, investment and consumption fall only by 2-5% and there are hardly any dynamics after the first year. Thus, the response of investment, output, consumption and employment is small when compared to the response of these variables in the data.”

Now, “when wages are rigid, the shock reduces the marginal product of labor and firms would like to hire less labor at the current wages or to keep employment fixed but cut wages. If wages are rigid, the adjustment occurs via quantities and the model can capture sizable decreases in output, consumption, investment and labor. The recession is considerably deeper when wages are inflexible.” Guess what: this is exactly what is happening in Ireland today, so next time you see Brian Cowen talking gibberish about his policies delivering for Ireland, remember – per Gorodnichenko, Medoza and Tesar (and per all conventional economics) not cutting public sector wages leads to higher private sector unemployment and deeper recession.

One would expect someone with Alan Ahearne’s grasp of basic economic theory to make an argument against Mr Cowen’s insistence not to reduce public sector wages, but hey – when you are being paid some serious dosh, you might forget economics for a while…

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