Monday, June 9, 2014

9/6/2014: Some Unorthodox Thinking About Europe's & Irish Recessions...

A decade-old classic paper, "Structural Traps, Politics and Monetary Policy", by Robert H. Dugger and Angel Ubide (International Finance 7:1, 2004: pp. 85–116 link here) provides a framework for understanding why in structural crises, monetary easing might be not only ineffective, but actually harmful to the recovery.

Now, recall that we are in a structural recession, in Ireland and across the euro area, and before us, Japan was in the same boat and, by me assessment, still is there.

Dugger and Ubide introduced "the concept of structural trap, where the interplay of long-term economic development incentives, politics, and demographics results in economies being unable to efficiently reallocate capital from low- to high-return uses." From Ireland's point of view, there are three sources of potential trap:
  1. The obvious one: construction and property investment sector - where a lot of resources were trapped in the 2000s in a low-return (long-term) activities and these resources, currently idle, cannot be re-allocated to other sectors of economy due to lack of skills, debt anchors, and frankly put, lack of other sectors to which they can be re-allocated; and
  2. Less obvious: MNCs-led activities. Sure, these are high-return activities from the aggregate economy point of view. But from indigenous economy vantage point, this conjecture may not be true. Some MNCs (notably in manufacturing) engage in both, tax optimisation and value-adding here. But these are dwindling in numbers and activities here. Many services MNCs add a lot of value elsewhere and book it through Ireland to far-flung tax havens.  The end point is that here too productive resources (human capital) are trapped in low-return (from indigenous economy) activity without being able to flow to other, higher return sectors (problem is, again, where are these sectors in Ireland's indigenous economy), and
  3. Less talked about: public sector and semi-state companies.

Per Dugger and Ubide, "the resulting macroeconomic picture looks like a liquidity trap – low GDP growth and deflation despite extreme monetary easing." So far - on the money for euro area and Ireland. The kicker is next: "But the optimal policy responses are very different and mistaking them could lead to perverse results. The key difference between a liquidity trap and a structural one is the role of politics."

Dugger and Ubide show "how, in the Japanese case, longstanding economic incentives and protections and demographic trends have resulted in a political leadership that resists capital reallocation from older protected low-return sectors to higher-return newer ones." Wait, is not the same happening in Ireland? Incentives to boost property of late? Incentives to preserve capital (and employment) in public sectors? Incentives and direct power to protect and increase resources in semi-state sectors? Do you remember the days when Irish media was praising ESB for 'investing' in the economy amidst worsening recession and on foot of higher consumer charges? Do you recall when Irish media was singing 'Nama investment needed' songs?

"If the Japanese case is instructive, in a structural trap, extremely loose monetary policy perpetuates deflation and low GDP growth, because unproductive but politically important firms are allowed to survive and capital reallocation is prevented." Irish Water anyone? Or ESB? Or DAA? Or HSE? Or sprinklings of weaker universities & ITs? Keep going… 

"By preventing the needed reduction in excess capacity, a structural trap condemns reflationary policies to failure by making the creation of credible inflation expectations impossible. Faced with a structural trap, an independent central bank with a price stability mandate should adopt a monetary policy stance consistent with restructuring. If political resistance is high, monetary policy decision makers will need to keep nominal rates high enough to ensure that capital reallocation takes place at an acceptable pace."

Thought provoking, no?

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