Saturday, January 2, 2010

Economics 02/01/2010: Irish Economy 2010

In the spirit of a fellow economist who posted his published views on 2010 prognosis for Ireland Inc, here is my take on the future, as published in the current edition of Business & Finance magazine. Note: this is an unedited version.

With the Budget 2010 behind us, January beacons as the month that will make or break our hopes for seeing a recovery next year.

Despite all Government pronouncements, the real issues faced by this country in 2009 reached much deeper than the three Super Challenges of the year. Neither Lisbon, nor Nama (until it is finalised) and especially not Budget 2010 will have as lasting an impact on this economy as the job never taken up – the nitty-gritty of managing our economic freefall.

Throughout 2009, our leadership has resorted to the management strategy known as the ‘sandwich’ technique. This involves delivering the requisite bad news sandwiched between quasi-plausible platitudes. Thus, throughout 2009 the Government has sought to soften the news with some ‘positive thinking’ sloganeering and move from one blockbuster campaign to another. In the mean time, taxation burden explosion and general sense of uncertainty have weighted heavily on our economic psyche.

The Budget 2010 speech by Minister Lenihan, peppered with pronouncements of the ending of the recession and exhortations that ‘The worst is now over’ continued the trend. With such modus operandi, deep and necessary reforms simply cannot take place. And predictably they did not take place.

Instead of admitting that unemployment is here to stay and that it will be our younger workers who will be on the dole the longest, Brian Cowen and his side-kicks applied selective filters pronouncing the imminent end of the recession back in May 2009. Bottoming out claims stretched into June, followed by a promise of a ‘positive growth’ quarter before Christmas.

What the country needed most – exports credits and currency risk supports, tax cuts to stimulate jobs creation and a reform of the banking sector to allow deleveraging of the households croaking under the mountain of debts – never took place. Not once have we heard of the need to stimulate entrepreneurship. Not once in the entire year have we been offered a vision to attract new start up companies into Ireland.

Instead, the country received a hefty dose of PR-speak on ‘knowledge economy’ while mothballing new investment in ICT, IT and venture capital funding. Money not spent on real economy went right over the heads of tens of thousands unemployed workers straight to the white elephant of Fas training schemes.

The problem is that amidst this marketing blitz from the Government, the real numbers suggest that the country is far from reaching the bottom of a recession and that we are heading into the period of protracted stagnation with growth bouncing along a flat trend line.

Take the Exchequer returns. A year ago, Exchequer revenue stood at €41 billion. This year the figure has fallen to €34.6 billion – down almost 15.5% in 12 months. Next year, things will ‘stabilize’ at around €34.25 billion, which will remain largely intact into 2012.

2009 Exchequer returns were artificially inflated by two major factors: transfer pricing by multinationals and redundancy payments that were made in late 2008-early 2009. These factors are unlikely to replay in 2010, because our MNCs will be heading into a new investment cycle elsewhere, with much lower incentives to push transfer pricing through Ireland, while the redundancy payments for the next wave of layoffs will be much slimmer. This suggests that some €1 billion worth of income tax and circa €110 million worth of corporate tax receipts factored into the latest Department of Finance projections are not going to materialise.

And this is before we account for the expected declines in 2009 self-employment tax revenues. Over 2009 VAT receipts fell to €10,368 million, down 20.5%. But retail sales contracted by 15% in value. This suggests that up to a quarter of the decrease in VAT payments came from somewhere else, namely – from the depressed business activity. Doing a simple back of envelope calculation suggests that VAT-related activity has fallen some €15bn (roughly in line with our GNP declines), implying the associated decline in corporate tax revenue of some €150-200 million into 2010.

Table below shows estimated 2010 balance sheet for the Government post-Budget 2010. Assuming the Government delivers planned €4 billion in cuts, the Exchequer deficit in 2010 is likely to be in the region of 10.4% (by Department of Finance estimates, adjusting for net savings) and 14.5% (using my projections). And my scenario assumes that only €4 billion worth of expected 2010 banks recapitalization funding will come directly from the Exchequer, with some €5.7-8.4 billion in additional funds financed through new Nama bonds. Department of Finance naively assumes no new recapitalization demands from the banks during 2010.
These figures compound the crisis of 2009. In other words, while the Exchequer deficit might be indeed stabilising in size in 2010, new debt burden is growing. Far from being closer to solvency, we are getting deeper into dependency of borrowing to maintain our public spending.

By various estimates, structural deficit was between 8% and 9% of 2009 GDP. Given that raising tax burden on current net contributors to the Exchequer is simply not feasible, correcting for this will require reducing our public expenditure by some €10-12 billion more in 2010-2011. Every year we delay the remaining adjustment will cost us additional €500 million in financing costs, shaving off 0.3% of our annual GDP. None of this is factored into Department of Finance projections.

As bad as things might be on the deficit front, at the very least we have an idea as to what measures must be taken to address the problem. Things are more complicated when it comes to unemployment. The latest data for Live Register shows that the number of those claiming jobless benefits is again on the rise, following a decline in October 2009. The rate of increases is much slower than in Q1 2009, but this is neither here nor there for two reasons.

First, our army of unemployed is growing much faster than the Live Register suggests because at least 3,800 people are currently due to rejoin Live Register from seasonal part time employment, while 30,300 people on Fas’ full-time training and community employment schemes have little chance of getting a real job any time soon. Factor these in and Live Register-implied unemployment rises to 13.5%, or just 42,535 shy of the half a million mark.

Second, the real unemployment, as opposed to the statistical measure, has already reached this level due to the fact that we are seeing increases in long term unemployment translating into social welfare dependency. The more the Government talks about cutting unemployment benefits, the greater will be the incentives for moving off unemployment to welfare.

And our welfare trap is a potent one. In a note published a week before Budget day, Department of Finance provided an estimate of the replacement rates for various types of welfare recipients in Ireland. Under Department assumptions (which covered rent relief, child benefit, main benefit and some additional payments), majority of categories of welfare recipients received benefits in excess of 60% of the average industrial earnings which currently stands at €33,634 per annum. Once costs of child care and health subsidies are added, all but two categories of recipients earned more than 70% of the average industrial earnings and three categories in excess of 100%. If you also recognise that working today requires payment for transport and food – the two costs vastly lower for those on the dole, all categories of social welfare recipients examined by the Department of Finance earn more than 70% of the average industrial earnings.

It is a simple mathematical conclusion that every person moving from Live Register to the generous embrace of social welfare adds to the financial woes of the state. Budget 2010 has done nothing to address this problem in real terms, while it did strengthen the incentives for transitioning to the dole from unemployment benefits by imposing a shallower cut to social welfare than to jobs seekers allowance.

All in, we can expect this process to continue working through the labour markets in 2010 as well, with employment falling toward 1,750,000-1,800,000 mark and unemployment rising officially to 13.5-14% - the rise arrested by outward migration, transitions to welfare and artificial Fas programmes ‘jobs’ supports.

The risks to the economy are to the downside with the biggest threat of another unemployment spike in Q1 2010 coming from the battered retail and business services sectors. From cars showrooms to Christmas sales counters, Irish retail sector is holding on to a hope of a half-decent holiday sales season. Should this fail to materialise, a wave of layoffs is going to take place in early 2010 as businesses shut doors for good unable to withstand another 11 months of decimated revenues.

The prospect of rising interest rates hangs over the services sector as a double edged sword.

On one hand, inversion of the interest rate curve upward will spell rising cost of doing business as higher borrowing costs will outpace any rise in ECB benchmark rate. In addition, margins rebuilding and high demand for capital will also imply rises in rates charged by the banks regardless of what ECB might do in 2010.

But in addition to borrowing costs, the retail and broader services sector will also be witnessing deeper retrenchment of consumers who will face the need to maintain high precautionary savings at the time of rising mortgages costs and real effective tax rates.

Over the last 11 months, retail sales have fallen by 26.5% in volume, excluding price adjustments. Another 10% or so contraction in demand will see wholesale and retail sectors shrinking by roughly half from 140,000 employees in Q4 2008 to ca 70,000 in Q4 2010.

And the yin-and-yang Budget is not helping this either. While excise duties on alcohol have been brought down and Vat increase of 2009 was clawed back, the increases in transport costs due to carbon levy will eat up any stimulus that could have been theoretically delivered by other measures.

All of the major economic indicators are therefore continuing to point South with little real evidence that the economy is going to return to robust growth any time soon. If confirmed, further slowdown in 2010 will mean that Irish economy will be traveling down recessionary curve for some 30-33 months by the time the Minister for Finance gets to the next round of public sector expenditure cuts. Lacking any serious policies aiming to get us out of this mess, this is a bleak prospect we will have to look forward to in 2010.

Yet, as our exporters experience shows Ireland Inc is more than capable of turning around. What such a prospect needs today is exactly what this column has advocated since July 2008. A rapid and significant cut in our deficits by ca €10 billion in 2010, followed by redirecting Nama-bound cash to deleveraging household budgets, re-capitalization of the banks through equity purchase to guarantee a capital investment and deleveraging stimulus to the tune of €40-45 billion in 2010. Redirecting existent targeted tax relief to a general cut in employer PRSI and income tax levies with a revenue-neutral effect completes the picture.

We need real reforms. Power costs, water rates, local authority charges and other state-induced costs must be cut by 25-40% through consolidation of local authorities and forceful changes to the way our power utilities operate. Airports levies and charges must be slashed to stimulate travel and to alleviate pressure on our middle classes who are straining under the weight of the state burden.

Short of getting down and dirty with far-reaching reforms, Government sloganeering about ‘taking the pain’ will be about as effective as showing reruns of the ER to a heart attack patient.


Kevin Denny said...

"Happy New Year" indeed! Your reference to real reforms doesn't mention the labour market. I know there are references to the replacement rate above but its important not to forget the potential for active- as opposed to passive- labour market policies (ALMP). While FAS might not be a stellar provider of ALMPs its important to realize that there are real costs to letting a huge number of- particularly young- people remain unemployed for a long time.
My sense is that the debate amongst policy makers- and their critics- has been overly concerned with the macro' side and the banking sector.
Its also important to remember policy complementarities: the effectiveness of one policy (say changing the UB rate or the minimum wage) depends on other policies.

TrueEconomics said...

Kevin, a quick reply. You are right, active labour market policies can work, albeit on a very limited basis. As a macro person, I omitted these in terms of specific mention, bunching them into general reforms - including the reform of Fas (as in cut its budget by 50% and refocus the organization to providing money for training and education to be delivered via universities and ITs, and supervision of these services quality and delivery).

I would suggest we focus first on big issues:
(1) lack of tax and cost incentives to create jobs - cut taxes on employment and cut costs of doing business in this country - especially those in the areas supplied by our state-owned near monopolies;
(2) lack of incentives to get off the welfare - for all able-bodied adults, cut welfare benefit (to below unemployment benefit) and cap welfare payments to an equivalent of 10 years for the life time;
(3) reduce upper marginal income tax so education actually pays in this economy;
(4) provide meaningful merit-based grants for higher education and re-introduce the fees to make sure those attending universities do not elect to pursue degrees in underwater basket weaving;
(5) tie in the receipt of welfare benefits (say 20%) by parents to their children performance in school and socially - so if you are raising a delinquent, you do not get full benefit;
(6) cut the minimum wage - by 30% - to induce jobs creation for the younger unemployed who lack skills;
(7) provide means tested, progressively priced - childcare and early education benefits;
(8) ringfence some social welfare benefits to purchase of only education, healthcare and retirement - by allocating a proportion of payments into an electronic, ringfenced account from which only these services can be purchased (no buying booze with this money) and allow annual savings to be partially credited back to the account, to make certain people spend wisely;
(9) create some compulsory work/study programmes for able-bodied adults on long term welfare - social work corps of sorts - to replace community spending system in place;
(10) cut the number of bureaucracies dealing with the issues of unemployment and social mobility - starting with local authorities: reduce the number of local authorities to 7: Greater Dublin, South, South-West, West, Midlands, Border, North West, but also stretching in voluntary sector - setting a requirement that at least 50% of the funds must be raised privately.

This, of course, is not exhaustive, and I would love to learn what can be done more specifically on the active policies side, so any suggestions?

Best, Constantin

Anonymous said...

Re your additional points above I would add to two previous posts on immigration I made on your blog recently.

As in the world economy where there are large structural imbalances such as the trillions of dollars of US Treasuries held by Japan and the US dependence for cheap imports from china, there are now developing large structural imbalances within western economies .
The structural imbalance I refer to is the almost immediate access to social welfare for immigrants from the accession 10 countries and the granting of full social welfare rights to almost 100,000 illegal immigrants under the IBC/05 scheme.
It is unlikely these people will ever make a positive contribution to our economy if a balance sheet is produced enumerating their costs to the state.

In previous times when countries such as the US experienced immigration,whether legal or illegal ,welfare was unavailable to them.
This forced them to work and critically to create work through innovation.This ensured their immersion in the countries culture was necessary for survival and assimilation for most was made in one generation.
Now due to social welfare its possible for immigrants ,legal and illegal,to live comfortably without working and to maintain immediate and daily contact with their home countries and culture through internet,skype,tv etc.
There is no need to even try to assimilate.

I suspect this will create more educated but resentful malcontents here such as the nigerian terrorist who tried to blow up the US airliner.

Denis said...

Happy New Year, Constantin!

First of all thanks for continuous contribution to the sanity of the nation.

There is no doubt that the government’s denial of the bleak economic reality and its incapability to take medicine in full and promptly will bring additional hardship to the residents of Ireland rather sooner than later.

The recent article in NY Times mirrors your arguments in the post and in the Sunday’s piece exactly and looks at the same issues from international perspective. (

At this critical moment of history Ireland needs leaders who are capable of doing right thing; time is up for poorly qualified managers who are not trying hard enough to do things right.

Have a good one!


Anonymous said...

HI As a buyer from irish related stores in usa noticed last year more chinese made jewelry on show at the trade show in january than irish made product .If i want to buy that type of irish jewelry dont need ireland can buy cheaper in ny.Always thought that the irish trade show was to promote irish goods .Was very disheartning and for me as a major buyer no point in going .Even called the trade board said they were trying to do something hope soon or nothing irish will be at the show and that would be very sad and one more notch in irelands downfall .Thank You .Sean

patrick said...

Well !I am going home to the UK. What I see here is madness, come all you how what free welfare money. "TO IRELAND". Come fast before its all gone.
Patrick (Irish).

PS: You only sign on once every 8 weeks so you can live anywhere you like. PADDY PADDY. "MADNESS" Ryan air will do well....