26/12/2013: Ireland's Technical Recovery: Sunday Times, December 08

This is an unedited version of my Sunday Times column from December 08, 2013



In his address to the Rogers Commission investigating the explosion of the Space Shuttle Challenger, Nobel Prize-winning physicist, Richard Feynmann outlined the birds-eye view of the causal relationship between the man-made disasters and the politicised decision-making. Per Feynmann, "For a successful technology, reality must take precedence over public relations, for nature cannot be fooled".

The laws of reality apply to social sciences as well, independent of PR.  Recent events offer a good example. While lacking longer-term catalysts for growth, Irish economy did officially exit the recession in Q2 2013. Yet, the real GDP remained 1.2 percent below the levels attained in Q2 2012. Glass is half-full, says an optimist. Glass is half-empty, per pessimist. In reality, final domestic demand, representing a sum total of personal consumption of goods and services, net government expenditure on current goods and services, and gross fixed capital formation, fell in the first half of 2013 compared to the same period of 2012. This marked the fifth consecutive year of declines in domestic demand. Recession might have ended, but we were not getting any better. The only consolation to this was that the rate of half-annual declines in demand has been slowing down over the last four years.

Data since the beginning of the fourth quarter, however, has been more encouraging and, at the same time, even more confusing. However, as in physics, in economics every action generates an opposite and equal reaction: an economy battered by a recession sooner or later posts a technical recovery.

Thus, the reality of Irish economy today suggests two key trends. One: a build up of demand on consumer side has now reached critical mass. Two: jobs destruction has now run out of steam. Some real jobs creation has started to show through the fog of official statistics. With this in mind, let me make a short-term prediction. While in the long run we are still stuck in the age of Great Stagnation, over the next year we are likely to witness some robust spike in our domestic economic growth.

Consider the data. Based on National Accounts, during the period from January 2008 through June 2013, and adjusting for inflation, Irish households cumulated shortfall in consumption spending compared to pre-crisis trends from 2000 stood at around EUR1,600 per every person residing in Ireland. Over the same period of time, shortfall on fixed capital investment by Irish firms, households and the State amounted to EUR16,400 per capita. In other words, some EUR83 billion of domestic economic activity has been suppressed over the duration of the current crisis. Even if one tenth of this were to come back, Irish GDP will post a 6.75 percent expansion on 2012 levels.

And, at some point, come back it must. Durable goods consumption has been cut back down to the bone over the last five years, as were purchases of household equipment, furnishings and cars. Depreciation and amortisation of these items are cyclical processes and we can expect a significant uptick in demand some time soon. That said, volume of retail sales was still down 1.4 percent year on year in October, once we exclude motor trades, automotive fuel and bars sales.

At the same time, purchasing power of consumers is not increasing, despite some positive news on the labour market front. Deposits held by Irish households were down at the end of September some EUR1.22 billion compared to the same period a year ago. And they were down again in October. Credit to households is continuing to shrink: in 12 months through October 2013, total credit for house purchases was down 3.1 percent, while credit for consumption purposes fell 9.3 percent.

The good news is that we are now seeing some increases in total employment in the economy. As of Q3 2013, some 58,000 more people held a job in Ireland than a year ago. Excluding agricultural employment, jobs growth was more moderate 33,000. These are the signs of significant improvements in the jobs market. However, three quarters of new jobs created were in average-to-low earnings occupations.

On another positive, however, jobs are being created in the sectors that previously suffered significant declines in employment. Key examples here are: accommodation and food services and construction.

In contrast to the employment news, earnings data offers little to cheer about. Average weekly paid hours across the economy have stuck at the crisis low in Q2 and Q3 2013. Average weekly earnings are down 2.4 percent on last year. These pressures on households’ incomes are exacerbated by hikes in taxes and charges imposed in Budget 2014.

Overall, consumption reboot is still being held up by continuous decline in after-tax incomes.

However, pockets of growth in our polarised and paralysed economy are feeding through to the aggregate statistics. This process is aided by the fact that as the rest of the economy has flat-lined, isolated growth in specific sectors and geographical areas became the main driver for national aggregate statistics.

One example of this process is visible in the property markets, where a mini-boom in residential and commercial properties in parts of Dublin is driving restart of the markets in a handful of other cities, namely Cork and Galway. Dublin residential property prices are up 18 percent on crisis period trough. In commercial markets, 2013 is shaping up to be the best year for transactional activity since 2007. On foot of this, construction sector Purchasing Manager Index, published by the Ulster Bank, stayed above the expansion line in September and October.

Another example is continued expansion of ICT services and MNCs-dominated manufacturing sectors. This week's release by the Investec of the Purchasing Managers Indices for manufacturing and services showed that in November, both sectors continued to grow. The series are volatile, but the shorter-term trend since Q2 2013 is now clearly to the upside.

All of which begs a question: Are we about to witness a Celtic Tiger rebirth from the ashes of the Great Recession, or is this a recovery that simply compensates for a huge loss in economic activity sustained to-date?
My feeling is that we are entering the second scenario.

Firstly, Irish economy is not unique in showing the signs of recovery. Other peripheral euro area economies, such as Spain, Portugal and even Greece, are also starting to stir. And all of them follow the pattern of recovery similar to that which took place in Ireland: foreign investors are followed by domestic cash-rich buyers of assets; exports uplifts are slowly building up to support domestic activity.

Secondly, given the extent of economic losses during the Great Recession, we can expect a bounce and this bounce is likely to last us some time. As argued above, over the years of the crisis we have built up a massive backlog of consumer and investor demand for everything – from durable consumption goods to assets, including property. This build up can lead to a rush-into-the-market of consumers and investors in H1 2014.

However, beyond this bounce-back period, serious headwinds loom.
In particular, latest mortgages arrears figures suggest that banks are predominantly focusing on forced sales as the main tool for dealing with the problem. These forced sales are yet to hit the markets. The same data also shows that non-foreclosure solutions are far from being sustainable even in the short-term. Over the last 12 months, the percentage of mortgages that have been restructured and not in arrears remained basically unchanged.

Further into 2014, if wages and earnings continue to decline or stagnate, the next Budget will become an even harder pill to swallow than Budget 2014. This can translate into the renewed decline in investment and consumption in the economy.  Latest exchequer figures through November this year are encouraging on the receipts side, although the safety cushion relative to both 2012 and Budget profile is thin. Tax revenues for eleven months were only EUR214 million (or 0.6 percent) ahead of profile. One third of this ‘over-delivery’ is accounted for by November payments of 2014 property taxes. Meanwhile the expenditure side is also saddled with risks. According to the latest projections from the Department of Public Expenditure and Reform, Government’s total current spending in 2013 will stand at EUR 51.15 billion or EUR2.54 billion higher than in 2007.

In addition to addressing the above spending risks, budgets for 2015-2017 will also have to deal with squaring the circle on temporary public sector pay moderation savings. As these come to an end and as demands from the public sector trade unions rise once again, economy can find itself once again at a threat of renewed tax hikes.

On a greater scale, monetary policies around the world remain a major problem. In the euro area, money supply remains tight despite record low interest rates and unprecedented funding measures that injected over EUR1 trillion worth of funds into euro area banks in 2011-2012.  Irish banks might have received a clean bill of health this week, but they are not in the position to restart lending any time soon. In the US, Federal Reserve's tapering is on the agenda for 2014. If pursued aggressively, it can lead to a rise in the cost of borrowing world wide, potentially inducing a fall-off in the capital markets. For Ireland, this can spell a further reduction in investment as foreign investors continue exiting Irish Government bonds and shying away from Irish private sector assets.

For now, however, the above risks are still to materialise. Before they do, enjoy our technical recovery.


Note: the above article was publish well before the now-infamous The Economist piece calling Irish economic recovery 'a dead cat bounce'. My view, as expressed above is not that this is a 'dead cat bounce' but rather that it is a technical correction up, toward longer-term equilibrium trend. It is quite possible that the recovery will gain momentum and will turn out to be a full recovery, but it is not, in my view, a 'dead cat bounce' (or a recovery that is likely to turn to a renewed downside).

Box-out:

A recent research paper published by the Centre for Economic Policy Research studied interactions between large firms and SMEs in driving regional-level innovation in the US. As is well known, large firms generate spin-out ventures whenever innovations developed at the larger firm level are deemed unrelated to the firm's core activities. Thus, a concentration of larger firms activities in a region can be expected to increase the potential for small spin-outs formation. On the other hand, small firms generate demand for innovation, increasing spin-outs profitability and survival potential. The study finds that differences in innovation output across metropolitan regions of the US over 1975-2000 can be largely attributed to the co-existence of these effects. These findings offer us significant insights into the potential role for business partnerships between Irish SMEs and MNCs in driving innovation-focused growth. For one, the study shows that optimal innovation policies are dependent on the specific stage of innovation culture development in the economy. For example, an economy with a significant presence of larger firms, such as Ireland, should focus on policies designed to stimulate formation of new ventures and spin-outs instead of spending resources on attracting even more large firms. Last week, this column suggested using tax incentives for SMEs and MNCs to stimulate equity investment in entrepreneurial ventures and spin-out. The above evidence from the US suggests that we might want to give this a try.