04/06/2011: The 'Confidence' trick?

Updated below: In the update below I address one particular point raised by some readers of this blog relating to PMIs and my analysis of these.


As promised in the earlier post, for the fans of the 'If only we were confident in Ireland' school of economic thinking... The school of thought, also known as the 'Green Jerseys', maintains that if confidence is high, then growth and employment will follow, so to get Ireland out of the crisis, positive thinking is needed.

Let's take a look at the data.

Keep in mind that we only have data for the period of May 2000-present and only for Services sector. Of course, Services is the largest sector in the Irish economy and it is more labour intensive, so the conclusions drawn from these observations should be expected to remain broadly valid for Manufacturing as well.

If the 'Confidence' thesis holds, we should expect some strong relationship between Confidence reading in PMIs and employment sub-index of the very same PMIs as well as PMIs main index which captures activity. This relationship might be subject to lags, of course, as Confidence sub-index is self-assessment of the future some 12-mo in advance, while Employment sub-index reflects current staffing levels, and the core PMI reflects current activity. Now, keep in mind that the 12-mo in advance expectations is for a continuum, not spot, in other words, growing confidence means expectations for improving business over the 12 months horizon.

First, consider whether there is a coincident relationship between Confidence and PMIs and Employment sub-indices:
Yes, there is a strong positive relationship between expansion signaling readings of confidence today the future and current levels of economic activity as measured by employment and PMIs. In other words, things tend to be optimistic (pessimistic) when PMIs are booming (shrinking) and employment is rising (falling).

Sounds like the 'Confidence' theory working? Not really - what's happening here is that when things are great, we expect them to stay great, on average. Alternatively, when things are bad, we expect them to stay bad for some time ahead. Which, of course is consistent with the fact that data we have covers 2000-present - two periods of pretty much persistent boom and then bust.

So let's take a look at change from month to month.

• Does change in confidence imply change in current PMIs and employment? (If the 'Confidence' theory is right - it should, as future expected changes in activity should have a positive growth effect on current activity)
• Does change in confidence today imply a change in future PMIs and employment? (If the theory is correct, then it should, with some lag kick in in terms of positive real outcomes)

Sorry, but it appears that a change to higher Confidence in the future in any given month relative to previous month has virtually no relation to either present or future Employment changes or future PMIs. It has a tiny positive connection to present PMIs, however, but barely enough to be called 'significant' from statistical point of view. In other words, we might get all giddy chirpy about the great future we have, and yet it will be unlikely (highly unlikely) - according to the PMIs data - to translate into significant gains in either services activities or employment, neither today, nor in the near future (I tested longer lags up to 12mo and the results do not change by much).

This of course does not mean that positive sentiment is not a good thing for the economy. If positive sentiment is backed by something more tangible - reforms, improved exports, growth in consumer or investor confidence - some real productive fundamentals, then of course it will matter. But that is not the 'Confidence' theory. The 'Confidence' theory says 'negativity hurts economy'. No, folks - it doesn't. You can't talk yourself into a recession. And the 'Confidence' theory claims that if we get 'positive' about the future, things will improve (presumably improve significantly, otherwise, what's the point). This is not what the data is showing.

So what's going on, then? We know that Confidence is associated with performance, but we also now know that at least in Ireland, over the period looked at, changes in confidence are not associated with changes in performance either today or in the future.

Of course, Ireland is a small open economy. Which means it is volatile and is subject to constantly shifting external 'winds' of change. May it be the case that 'Confidence' theory doesn't work in Ireland because our real economy is subject to external forces and shocks? Ok, let's test this proposition. Let's control for contemporaneous backlog of orders, leaving only that component of Confidence that is not influenced by these backlogs. In other words, let's consider that part of our self-assessed optimism (pessimism) that is unrelated to the actual observed increases in new orders (decline in these orders). Furthermore, let's slightly smooth the series tor educe volatility by using a 2mo moving average on all variables.
An interesting result above. The link between confidence and contemporaneous PMI and Employment is now virtually gone (compare the results with Chart 1 above), which exactly supports my conclusions made following Chart 1. What matters to the turning of the economy, folks, is the real economic activity - rising backlogs, new orders, new export orders. What doesn't matter much at all, it appears, is 'Confidence'. So, please, go on, feel great - it might improve your smile, your utility, your view on life - all of which are great results. But don't hold much hope that it will improve the economy and reduce unemployment.

In the end, to achieve these two objectives, we need new businesses to be created, new markets to be accessed, new products and services to be developed and marketed, and so on, and new reforms implemented. Unfortunately, the 'Confidence' theory can lead us into complacency of avoiding making hard choice to have such reforms, to support our entrepreneurs, our companies and workers.

Ignoring the rain might make getting wet tolerable or even fun, but it won't make you any less soaked.

Update: Some websites contain references to these series of posts on PMIs. In particular, there is an occasional refrain to my view that (1) I would prefer seeing strong (above 60) readings in some sub-indices, and (2) my insistence that an 'improvement' in the sub-index reading from a number below 50 to another, higher number below 50 is not an improvement. Let me explain my views on these 2 points.

1. Readings above 60 are rare, that is true. But PMIs refer to comparative/relative performance metrics. Now, real recovery is not, I repeat - not - associated with growth returning to a long-term trend, but growth overshooting long-term trend as economy goes from negative growth (contraction) to expansion. Thus, for example in the Services series, near-recession of 2001 is returned to growth by PMIs reaching for 60.8 by April 2002. In Manufacturing series contraction in October 2001 to 46.1 is returned to growth with June 2002 reading of 54.5 (so -3.1 from 50 to +4.5 - a ratio of 1.45), contraction of July 2003 (45.8) is returned to growth with a peak of 55.2 in June 2004 (-4.2 to +5.2 - a ratio of 1.24). Now, bottom of the latest contraction was at 32.6 which should be consistent - if we take the above two episodes averages (ratio of 1.35) - with a rise to above 67. We've gone up to 62 in March 2010, but we have not seen this translate into overall economic growth. Hence, my preference would be to see more episodes of 60+ readings in PMIs. Either way, all of the episodes we have on the record so far are episodes relating to either 'near recessions' or temporary declines in the series not associated with a recession at all. Except for the current crisis, that is. O course, this 60 is not a 'hard' target. Read carefully what I said (here): "Either way, of course, I'd rather see PMIs at above 60 reading, than heading for a downward territory". This is a statement of 'truism' - as in: I'd rather see things improve than get worse. Sadly, some anonymous commentators on some of the forums out there are not getting even this simple concept...
2. When the series read below 50, the series show contraction. Thus, for example, a reading of 44 in one month followed by a reading of 46 in the next month does not mean that economy has improved from month to month. It means that the economy has deteriorated at a slower rate. If you are familiar with compounded effects of recessions (expansions), you would know that having a loss of 10% in month 1 followed by a 5% decline in the other month implies a cumulative decline of 14.5%. An improvement would be if following a 10% drop in on month, economy grows by, say, even 1% in the next month, thereby reducing the original decline to a cumulative decline of 9.1%. Let me quote Brad DeLong on this: "Getting worse more slowly is not the same as getting better".

Economics 13/9/10: Our crises are more than academic

This is an unedited version of my article in the Irish Mail on Sunday.

Adjoining the famed Moscow Conservatory there is a trendy Vieneese-styled café set in a quiet side-street of a bustling city center. Kofemania is a little microcosm of today’s young and upwardly mobile Moscow. On a late night break from the week of the Irish Trade Mission here, I was meeting a group of friends. Half a dozen of us, from different walks of life, crammed into a small booth were having a lengthy chat about life in general and our futures in particular. In our late 30s-early 40’s, one way or another, we can all relate to the topics of our children and our own and their futures.

For the first time in my life, I found myself being a deeper pessimist in the company of my Russian friends.

Like its Irish counterpart, Russian economy had a tough couple of years since the global financial crisis hit the country in the second quarter of 2008. However, amidst the crisis Russia has managed to deploy significant economic reforms – financed by a prudent fiscal policy during the boom. Their austerity programmes are offset by tax cuts, disposals of state assets and continued capital stimulus.

Since the beginning of 2010, the country economy has expanded at approximately 5% annual rate of growth, despite enduring the worst drought and wildfires in over 200 years. Moscow is enjoying a robust revival: city economy is up some 8% in real annualized terms since January this year, the local authority no longer runs a deficit and capital investment programme was underpinned just two days ago with a robust 12-yea bond placement for ca €500mln yielding less than Irish Government debt, despite being denominated in rubles. People are spending, taking holidays abroad, buying cars, and are genuinely almost over the “recession gloom” when it comes to their outlook for the future. There is even a pick in investment in second homes in Spain and France taking place as a friend of mine, running a specialty real estate agency has told me. Tight credit conditions during the crisis are easing gradually, but steadily and not a single of my friends has switched their banks accounts to foreign intermediaries or altered the mix of currencies they hold - a sure bet that they do not expect significant pressure on the ruble or a ramp up in inflation that currently runs modest (by Russian standards) 5.5-5.7%.

My fiends are fully convinced that their lives are going to be just fine and their kids future will only get better. The generational game of renewal and raising of expectations – the hallmark of any society that enjoys a sense of confidence in its future – is well underway in Moscow.


It's a different story for us in Ireland.

This week’s admission by Alan Dukes, that the bank’s final expected loans losses can top €39 billion became the final straw for many people here, as well as for myself. Follow up admissions by the Government that the fiscal reforms of quangoes, promised back in 2008, are not happening made it clear that the policy path we are taking hardly amounts to much more than a waiting game in a hope for a miracle of the externally driven turnaround.

Over a year ago, I publicly estimated that the total losses in the Anglo will reach up to €38.6 billion. My total estimate of the net losses in Irish banking crisis since March 2009 has remained around €50-53 billion. There’s little to be gained from having gotten the estimates right. The sheer extent of the economic destruction that befell Ireland over the last three years is now hitting my own home, hard.

A third year into an economic equivalent of the Perfect Storm, the reality of our economic collapse remains unchanged. Worse – the storm, using Bertie Ahern’s turn of phrase, is only getting stormier.


All in, the combination of banking and fiscal hell we are currently living through will exact an economic toll unseen by this country since the age of the Famine. Courtesy of the consistent and persistent policy failures spanning the last decade and continuing to-date, my own family, like a million other ordinary taxpayers’ families in Ireland have been turned into an army of serfs bound by the state to the rapidly sinking Titanic of our banking and fiscal policies. The very hope of seeing my children living in a world of higher social and economic standards – that cornerstone of any family raison d’etre – is now under a real threat.

Within the last 12 months, the new wave of unemployment is wiping clean the ranks of professional, highly educated younger services sectors workers. The social mobility ladder that provides hope for our and our children future has collapsed.

Tens of thousands of students are now actively seeking to emigrate out of Ireland. Five years ago, less than one in ten in my Trinity classrooms intended to go abroad in search of starting careers. This summer, the number rose to about three quarters. By my estimates, over 200,000 people have left this island in the last 24 months and some 300,000 more are on the verge of emigrating, held back by the shackles of negative equity and rapidly rising debt.

For our middle class, just as for my own children, education was supposed to be a sure bet for achieving a steady progression to economic and social well being. Today, this is no longer the case.


Both myself and my wife hold advanced post-graduate degrees and have achieved above average careers with over 15 years of steady growth. Yet, back in the Autumn of 2008 both of us have almost simultaneously lost our main jobs. Four subsequent months, spent living in the hell of uncertainty, were some of the toughest periods we ever endured. Throughout these months, the fear for the future backed by our steadily declining savings was compounded by the complete absence of any leadership from our policymakers.

This fear still remains a part of our daily lives. Hope for a recovery today is contrasted by the vacuous and occasionally outright insulting statements from high podia about imminent ‘turnarounds’ and ‘patriotism’, and the ‘hard choices’ allegedly being made the country leadership that is painfully unable and patently unwilling to make any real decisions.


The crisis we face is not a temporary, but a structural one. In order to unwind a roughly 700,000 strong-army of surplus workers who are out work or grossly under-employed, Ireland will have to more than triple our entire exporting sector – a feat that even during the Celtic Tiger era would have taken some 25 years to achieve.

By the time my children finish their education, some 20 years from now, our family will have spent over two decades in a state of perpetual struggle to pay for the legacy of our banking sector collapse and fiscal policy fiascos, to cover the costs of bankers and bond holders bailouts and to unwind a massive pile of private and public debts accumulated through the erroneous and egregious policies we have pursued since 2001-2002.


To finance ever-increasing social welfare and public sector pay bills, a family like ours will be pushed into massively higher taxes on income, property and everyday necessities.

The numbers are frightening. Frightening to the point of getting me worried about even my own family ability to endure this crisis.

Nama and banks rescues alone will add some €110,000-120,000 to our family debt pile through state-accumulated liabilities. Property and assets collapses in the end will contribute another loss of €300,000 to our net worth. The benefits of free education and children-related allowances will be gone, implying a life-time loss of roughly €120,000 for our family. At current yields, the debt accumulated through the deeply flawed banks recapitalizations and Nama, plus egregious current spending deficits will impose an annual interest bill of €12,000-15,000 on our family by 2014. Interest on the state debt alone will cost us every year the same as our children’s education.

American philosopher and writer, Ayn Rand once said that: “It only stands to reason that where there's sacrifice, there's someone collecting the sacrificial offerings. Where there's service, there is someone being served. The man who speaks to you of sacrifice is speaking of slaves and masters, and intends to be the master.” Recall Minister Lenihan’s statements about the need for ‘patriotism’ in his two Budget 2009 speeches. With the events transpiring around us today, Rand’s words are now no longer a catchy turn of a phrase.

Our pensions – supported solely by our personal savings – will be a shadow of their current expected value as funds returns will remain stagnant over the years of painfully slow growth, caused by the disastrous policy choices. Inflation, imported from the rest of the Eurozone, will mean that the real value of our savings will be declining over time.

Our healthy demographics – normally a reason for optimism in economic future – can end up driving this economy deeper into slow growth scenario. By the time my children will be finishing their university degrees, today’s middle-age workers will see their pension ages extended in order to reduce the exchequer pensions liabilities. This means that twin peaks of new job markets entrants between 2020 and 2030, Irish workforce will swell with educated, but inexperienced professionals unable to locate a job because their retirement age parents have no option but to continue working into their seventies.

This scary trend is well underpinned by today’s reality, including that of my own household. Save for a sizeable mortgage, our family is completely debt-free for the moment. Myself and my wife have good private sector jobs and earn well above the average family income. On the paper – we are doing fine.

Our future liabilities are massive, courtesy of the Government mismanagement of fiscal balances since 2003, the Croke Park deal, the Social Partnership-led pillaging of the growth years, the banks rescues, Nama and the chronic lack of real reforms in the state-controlled sectors.

Banks bailouts are already having a direct effect on our family. Amidst historically low interest rates, our mortgage has grown throughout 2010 and is likely to rise even more comes 2011, just as the negative equity continues to bite deeper and deeper into our ‘investment’ which value has shrunk roughly 40% since the time we bought into it. By my estimates, the spreads between the ECB base rate and the average variable rate mortgage charges will rise from 2.5-3% today to 4% by the end of the next year. After that, the ECB will start hiking its rates, with a distinct possibility of our mortgage finance costs more than doubling within a span of 15 months.


As an economist, I am all too familiar with the long term nature of the fiscal, house prices and banking crises that were are experiencing today.

Based on what we know about fiscal crises, our debt to GDP ratio will peak at over 125-130% around 2015-2017. At these levels, any economy, even a highly competitive one, would suffer a catastrophic decline in long term prospects for growth.

In the end, Ayn Rand was right – the sacrifices and patriotism of our politicians’ speeches has turned the people of this country into serfs to the vested interests of Social Partnership and banks’ elites. They speak of a sacrifice, intending to be the masters. My family, and millions of other ordinary people around this country are now just meaningless pawns in their game for survival.

Economics 22/8/10: Fundamentals of investing in IRL Inc - IV

This is the last post in the series of four that presents fundamentals comparatives between Ireland, Switzerland and Luxembourg. The first post (here) covered analysis of current account dynamics, the second post (here) dealt with General Government balance, third post (here) highlighted differences in GDP and income. This post deal with residual fundamentals such as inflation, unemployment and population.

In terms of inflation we are not doing too well. Since 2000 Ireland remains expensive. More expensive than Switzerland, despite our massive bout of deflation. This, of course, does not account for the fact that Swiss residents get much better quality public sector services than we do, for less money spent. But that's a matter of a different comparison that I touched upon earlier (here, here and here).

So Chart 12 shows our inflation performance.

Chart 12:

You wouldn't be picking Ireland for your investment if you were concerned with real returns or with effects of inflation on economy's ability to carry debt.

If population growth is really a longer term dividend, we should expect Ireland Inc to overtake Switzerland by now in terms of prosperity (Chart 13). After all, our 1980s and 1970s'-born cohorts are currently at the peak of their productivity. But recall per capita GDP... so far, there isn't really any evidence that growth in population leads to higher growth in GDP once scale effects are taken out of equation.

Chart 13:

Would you have invested in Ireland's debt if you were thinking about Ireland's ability to repay on the basis of lower costs of unemployment and greater proportion of labour force at work? Take a look at Chart 14.

Chart 14:

Well, not really. Swiss and Lux make for a much more compelling case here and not just in the current crisis environment.

So here's our real problem that is not a function of cyclical dynamics, but a structural one. Our employed are carrying much greater burden of providing for the rest of our population than Switzerland (Chart 15).

Chart 15:

Factor in that Irish public sector is larger, in relative-to-population terms than Swiss... and you have an even greater discrepancy in terms of the true earning capacity of the Irish economy.

Which brings us to the issue of productivity and back to the topic of exporters carrying the burden of the entire economy out of the recession. Apart from the construction boom, economy-wide income per person working is lower in Ireland than in either Switzerland or Lux since the 1980s. Even at the peak of the largest real estate bubble known to any other European country in modern history, our 2008 GDP per person employed was still not that much greater than that of Switzerland (Chart 16).

Chart 16:

May be, just may be it was because our wealthy developers all wanted a fine Swiss watch, while no Swiss investors wanted our bungalows in Drogheda or apartments in Tallaght? which is the same as to say - the Swiss are productive to the point of the rest of the world wanting their goods and services. We are productive only to the extent of the rest of the world wanting goods and services produced by MNCs and few indigenous exporters based here. But their productivity is high in gross terms and low in net terms (recall current account analysis in the first post). Unless we can dramatically increase the number of exporters while simultaneously upping the net value added in their operations to Swiss levels, there's no chance external trade can carry this economy out of the recession.

Economics 22/8/10: Fundamentals of investing in IRL Inc - III

This is the third post in the series of four that presents fundamentals comparatives between Ireland, Switzerland and Luxembourg. The first post (here) covered analysis of current account dynamics, the second post (here) dealt with General Government balance. This post will highlight differences in GDP.

Once again, think of an investor making a choice between sovereign debt of three countries. Fundamentals about current account (external surpluses generated by economy - subject of the first post), government balances (second post), economic income and growth (present post), as well as unemployment, population and income per working person (following concluding post) all help underpin the economy ability to repay its sovereign debts.

So far, we have shown that:

1. By external balances metric, Ireland is a much poorer performer than either Switzerland or Lux;
2. By sovereign balances metric, Ireland is a much poorer performer than either Switzerland or Lux

Now, consider GDP metrics. We all heard that we are one of the richest economies in the entire world. Is this really so?

Let me put a caveat here - analysis of GDP figures for Lux is a bit tricky, since Luxembourg official stats exclude all those people who work in Luxembourg but reside outside its borders. So the best benchmark here is Switzerland. Sotake a look at the 'Celtic Tiger' vis-a-vis Switzerland. 2002-2007 growth rates are virtually identical in both. But since 2007 - we have been a basket case, while Swiss have been ticking along nicely, like a fabled clock.

Chart 8:

And this is highlighted in each country share of the world GDP as well: we have 61% of Swiss population and 886% of Lux's population (Chart 9). Yet we have - in absolute terms - 54% of Swiss global share of GDP and 438% of Lux's. PPP-adjusted, our GDP is just 28.8% of Swiss and 400% of Lux's. In current prices-measured GDP, Ireland's GDP is 42.2% of Swiss and 400% of Lux's. So that population growth dividend isn't really working for us so far.

Chart 9:

Per capita GDP in current prices (Chart 10):

Chart 10:

• 2008 peaks in all three countries: Luxembourg=USD118,570.05, Ireland= USD60,510.00, Switzerland= USD68,433.12
• Peaks recovered by: Luxembourg= USD119,048.05 by the end of 2015, Ireland= USD60,729.66 by the end of 2019, Switzerland= USD69,838.79 by the end of 2010.
  

So it will take Ireland 9 more years to regain its income per capita 2007 levels, which were below those of Switzerland to begin with. Note: 2016-2020 forecast was performed assuming no recession between 2010 and 2019.

Of course, we were a stellar performer in terms of GDP growth prior to 2006. That's one fundamental where we did shine. But stripping out construction sector contribution in 2001-2007, we are not that spectacular (Chart 11)...

Chart 11:
The fourth and last post will conclude by making comparisons across other variables, such as inflation, population growth and labour markets.

Economics 22/8/10: Fundamentals of investing in IRL Inc - II

This is the second post in the series of four that presents fundamentals comparatives between Ireland, Switzerland and Luxembourg. Post I (here) covered analysis of current account dynamics. The present post will deal with General Government balance.

Now, let's check IRL's sovereign solvency position. Chart 5 illustrates:

Chart 5:

Again, if you are an investor hoping to get repaid on your bonds, you wouldn’t really go for Ireland as a place to park your money. Except during 1996-2001 and 2003-2007. But then, get out as fast as you can in 2007. All in, Ireland Inc hasn't paid its bills since 2007.

Let's see if the Government has been running operations consistent with long term attractiveness to sovereign investors. To do so, suppose we invested in the bonds written against General Government balances. Since timing matters, let us take two scenarios: investing €1.00 in 1980 and investing €1.00 in 1995, holding to 2010 or 2011.

So cumulative returns on countries sovereign balances from 1980 are (Chart 6):

• 2010: Ireland=28.5%, Switzerland=32.2%, Lux=43.3%. Ireland gap to best performer = -14.8%
  
• 2011: Ireland=25.4%, Switzerland=31.9%, Lux=41.1%. Ireland gap to best performer = -15.7%
• 2010-2011 gap deterioration for Ireland = -0.9%
  

Chart 6:

Chart 7 shows cumulative returns from 1995 are:

• 2010: Ireland=-12.2%, Switzerland=-1.1%, Lux=-3.85%. Ireland gap to best performer=-11.1%
• 2011: Ireland=-11.1%, Switzerland=-0.9%, Lux=-5.1%. Ireland gap to best performer=-10.2%
• 2010-2011 gap improvement for Ireland = +0.9%
  

Chart 7:

So a portfolio of 50:50 split between 1980 investment and 1995 investment written against Irish Governments' fiscal positions since 1980 would have lost to investor 12.95% by 2010 and 2011, compared to a similar allocation into other two countries.

Economics 22/8/10: Fundamentals of investing in IRL Inc - I

Few months ago, while speaking as a guest on RTE's Frontline, I confronted two of our 'surrender to Brussels' politicians with a suggestion that a country can do just fine outside the 'Yes, Commissioner' world of European convergence consensus. In return, one politician - from the opposition side of the Dail - rushed to conclude that when advocating greater sovereignty on economic policies I was talking about the UK. My reply was that I had in mind more the path of the country like Switzerland.

In the light of the ongoing sovereign crisis, and with all the talk about bond markets unwillingness to underwrite our economy, I decided to return to the same issue. Here are major comparatives in investment (bonds-related) fundamentals in Ireland vis-a-vis Switzerland and Luxembourg.

I do this in a series of 4 posts. The first one deals with current account dynamics, the second one will deal with Government finances, the third one will show comparatives for GDP, and the fourth one will conclude by making comparisons across other variables, such as inflation, population growth and labour markets.

All data is based on IMF's World Economic Outlook, updates for April and July 2010, which covers period from 1980-2015. Some additional forecasts (beyond 2015) were performed by myself, alongside some additional variables computations.

I chose the two countries for several reasons:

1. Both are core European countries;
2. One of these is outside the EU, another is inside the same tent as Ireland;
3. With a caveat concerning some of aggregate accounting issues with Luxembourg's data, all three have roughly similar economies characterized by: (a) no significant natural resources of their own, (b) small size of population and land mass, (c) heavy reliance on exports, (d) open nature of economies, (e) 'more Boston than Berlin' aspirations in tax policies, (f) being a bit of a thorn in the softer side of Brussels, and so on

So here are few charts and comments. In most cases, I take on the position of a rational investor in sovereign bonds, willing to hold these to maturity. In other words, what matters to me in most of these charts is the answer to the following question: "Given country A fundamentals compared to countries B and C, what is the likelihood that country A can generate sufficient net income to cover its debt obligations?"

Chart 1:
If our expected current account surplus of 2010 were to be used to pay down our debt, how long would it take? The answer to it is 'forever'. Our net surplus from trade and investments from the entire world was negative €4.03bn throughout the 2000s. In the 1990s, our average current account surplus was just €1.108bn, in 2010 our expected surplus in the only year when current account was positive in the 200s - the year 2010 - will be only €849mln. At the same time, our debt currently stands at €86.83bn and rising with interest bill on this well in excess of €4.56bn annually at latest 10 year bond auction yields. In other words, exporting our way out of the recession will not even cover our entire interest bill.

Here's an interesting observation. Irish Government thinks that exports will carry Ireland out of the recession. However, there is an argument to be made that value added in our exports is not really that impressive once the inputs costs are taken out.

Chart 2:If you were an investor thinking about Ireland's fundamentals, you wouldn't have much hope of getting a positive return on your investment, if net exports were your underlying security, except in the period 1992-2000.

This, one can argue, might be true of our manufacturing exports, where we import often expensive inputs and where transfer pricing (on inter-company sales) further contributes to lower net value added. But what about our services trade? Well, the current account data shows that during the last decade, when services trade really started to take off in Ireland, our net external balance was negative. So something is not adding up and I will take a look at this in the forthcoming posts.

But for now, we do have impressive exporters, yet our current account performance has been exceptionally weak, compared to Switzerland and Luxembourg - two countries that are equally as reliant on imported inputs as Ireland.

It is worth noting also that in the case of Switzerland, their exports composition includes significant pharma and high tech manufacturing exports as well. It just appears that they manage to do trade better...

In fact, a bet made on Ireland Inc based on its external economic performance back in 1980 would have been a disastrous one as Chart 3 below illustrates. An investor betting on our external balance would have 48.1 cents on every euro invested. Based on IMF forecasts, by 2015 this loss can be expected to widen to 48.9 cents. At the same time, identical bet on Luxembourg would have netted a gross return of over €5.11 by now, and a projected gain of €9.20 by 2015: a spread in return relative to Ireland of €5.59 by 2010 and €9.69 by 2015.

Chart 3:
The differences are even more dramatic when we look at comparison to Switzerland: a bet of €1.00 on Swiss external balance made in 1980 would have netted investor €8.145 by 2010 and is expected to yield €13.434 by 2015, implying the spread between investment in Ireland and Switzerland of €8.626 in 2010 and €13.923 in 2015.

Obviously, the earlier analysis is sensitive to the time frame for investment chosen (Chart 4).

Chart 4:
Suppose a bet €1.00 was made on Ireland Inc based on its external economic performance back in 1995. An investor betting on our external balance would have grossed 0.393 cents on every euro invested by today and can be expected to gross a loss of 1 cent by 2015. An identical bet on Luxembourg would have netted a gross return of 11.23 cents by now, and a projected gain of 13.305 cents by 2015. The differences are slightly less dramatic when we look at comparison to Switzerland: a bet of €1.00 on Swiss external balance made in 1995 would have netted investor 9.54 cents by 2010 and is expected to yield 11.88 cents by 2015. Oh, and there wouldn't be any risk of getting these returns expropriated by the Government tax policy changes.

(Second post to follow)

Economics 5/7/2010: Future of our cities

This is an unedited version of my current article in Business & Finance Magazine:

Global recovery, no matter how tenuous, is poised to present a new set of challenges and opportunities for smaller open economies, such as Ireland. These challenges relate to the changing nature of economic growth and competition worldwide.

Starting with the early 2000s, there is a new ‘brain-and-creativity’ economic growth paradigm that is emerging across more dynamic globally-integrated economies. In this new paradigm, cities and larger urban-centred regions are increasingly competing for highly mobile and diversified human capital, and creativity and innovation capabilities associated with it. This trend represents a far wider change than the much-talked-about ‘knowledge’ economy. In fact, according to our research at the IBM’s Institute for Business Value, it represents a re-orientation of the core sources for future growth away from the traditional ‘bricks-and-mortar’ economy based on physical capital (e.g. buildings and equipment) and financial capital, and toward human capital or talent-intensive growth.

Last month, Dublin-based IBM’s Global Centre for Economic Development that forms a part of the Institute for Business Value (IBV) published a study titled Smarter Cities for Smarter Growth: How cities can optimise their systems for the talent-based economy. Co-authored by Susanne Dirks, Dr Mary Keeling and myself, the study looked at the changing nature of competitiveness that cities and larger urban areas around the world will be facing over the next 10-20 years.

It offers important policy and investment priorities insights not only for world’s leading cities, such as New York, London, Tokyo, Shanghai, but also for smaller open economies, such as Ireland.

The core insight from the study is that creativity, knowledge and skills, together with technological innovation are becoming the key drivers of economic growth and activity.

For example, the share of overall economic value added attributable to creativity, knowledge and skills-intensive sectors of the economy (e.g. internationally traded and other higher value-added services, design and innovation-centred manufacturing, etc) is expected to increase by 8.2% over the current decade.

Cities are natural hubs for this growth for two reasons.

Globally, leading cities have GDP shares of their national economies that are up to 5 times higher than their share of national populations. Top 100 cities worldwide accounted for roughly 25% of the world’s GDP in 2005. By 2008 this had increased to over 30%. As charts 1 and 2 in my earlier post (here) on cities weights in domestic economies illustrate, Dublin clearly falls within this category of cities that represent a leadership flank in their respective domestic economies.

Second, cities, and greater urban areas, are at the forefront of global competition in higher value-added, and creativity and knowledge-intensive sectors. Between 1999 and 2007, skills and knowledge intensities of some 350 urban economies comprising OECD member states have increased dramatically.

In 1999 average urban area in the OECD had 25% of its population holding third level degrees or higher. By 2007 this number increased to 29%. Over the same time, the degree of skills and knowledge utilization in urban economies also increased. Modern services – a sector that is at the forefront of the new economic paradigm – saw its share of overall employment rise from 34% to 38% in 8 years to 2007. With these changes, income per capita rose from the average USD27,400 to USD36,050, expressed in constant dollar terms.

A similar dynamic took place in Ireland, where Greater Dublin region, inclusive of commuter belt, saw its proportion of the workforce with tertiary or higher education rise from 25% to 39% between 1999 and 2007. Contrary to most of the commentary on Irish development model, the Greater Dublin area has moved from being average in terms of skills presence in the OECD at the cusp of the new Millennium, to above average by 2007. Over this period, the share of modern services in total regional output rose from 34% to 38% in Dublin, while per capita income rose from USD31,900 to USD46,300.

Our data analysis clearly shows that urban income per capita has been strongly positively correlated with rising importance of skills, innovation and knowledge in the economy. Our forecasts also indicate that this trend is going to strengthen over time. For example, there is a rapid change in the relationship between technological innovation and talent contribution to productivity that is emerging across all industries. Instead of technological innovation serving as a strong substitute for labour, it is becoming a supportive enabler for people and their skills. This relationship is forecast to strengthen by over 70% by the end of this decade in modern sectors and is set to become positive for the first time in over 40 years in traditional sectors as well.

For cities this transformation means new model of development and growth – a model focused primarily on the need to build a diversified, highly skilled and creative workforce capable of developing and absorbing technological, managerial and creative innovation.

Change in demand for skills in EU27
Net increases in excess of demographic factors, millions of jobs
Source: CDEFOP, 2009 and 2010, and IBV analysis

Forecasts show that demand for talent, creativity and skills is expected to accelerate dramatically over the next 10-20 years (Chart above). In the EU27 alone, growth in demand for higher skilled workers is expected to double from 10.1 million in 2007 to 20.1 million in 2020, according to the European Commission. At the same time, demand for low skilled workers is expected to contract by 28.3 million by 2020 having fallen by 8.5 million in 2007.

While pressures of rising demand for skills will be acute, the supply side – represented by demographics and higher education capacity – is going to be strained to deliver sufficient inflow of new skilled knowledge and creativity-enabled workers. Assuming current demographic trends, demand for international students in the OECD will be expected to rise from 6% of total third level student population in the mid-1990s to 30% by 2020, based on our forecasts.

Cities are increasingly competing for internationally mobile and highly diversified workers of the future. For example, between the 1990s and 2020 net international migration flows of highly skilled workers will more than triple from 29.5 million to 98.6 million, according to our forecasts. Majority of these flows will continue to be attracted to Western European and North American economies. However, in a departure from the previous decade, next ten years will see acceleration in the net demand for highly skilled international migrants from the emerging economies of Asia Pacific, India and Latin America. These developments imply that previously taken for granted inflows of talent to the advanced economies are now wide open to competition.

The entire notion of competitiveness will be reshaped by the new growth paradigm. Our research shows that in the near future cities will have to focus their attention on attracting, retaining, creating and enabling people with diversified and high quality skills and knowledge, capable of generating and absorbing creative and technological innovation.

Highly-skilled individual’s location decisions are directly influenced by the quality of core services provided by the cities. And these decisions, in turn, increasingly influence location of FDI. In 2008, according to data for OECD, 69 percent of companies have identified availability of the high quality human capital as a major determinant of their decision to invest in a specific economy. Urban centres will need to change the nature of their core services away from focusing on standardized services aimed at the homogenized populations, toward services that are more citizen-centric: tailored and individualized, green and lean in line with the demands of the internationally mobile highly-skilled employees.

Our research has identified four core services areas that will need to be prioritized for investment with the greatest expected impact on highly skilled, knowledge, creativity and innovation-enabled workers. These are Government Services and Education, Public Safety, Health and Transport.

Given the constraints on fiscal spending, faced by many Governments around the world, including the Irish Exchequer, such investments will have to deliver optimal gains in quality of life while demanding minimal public outlays. Based on our analysis of the best practices around the world, this can be achieved by deploying advanced technologies to understand, predict and intelligently respond to services systems behaviour and demand.

For example, cities like Singapore, Tokyo, Amsterdam, London and Stockholm have been able to successfully leverage real-world data generated by their public transport providers. This allowed not only to optimize the existent city services, but to simultaneously increase both capacity and demand for public transport. Several cities worldwide are currently building new modes of public transport that attempt to seamlessly integrate the concept of mass public transit across various modes of transport while delivering extensive customization of routes and modes.

In Singapore, creation of a seamless, smarter national transport fare system has resulted in $40 million annual savings from reduced congestion on expressways alone, as well as gains in workforce productivity equivalent to more than 5 million man-hours. Singapore’s Land Transport Authority can now optimize routes, schedules and fares based on the insights from the 20 million trip-related transactions generated each day. As the result, usage of mass public transport increased by 14.4% between 1996 and 2007.

Congestion negatively impacts on the quality of life in a city by decreasing personal and business productivity. It also imposes negative externalities on the overall quality of life. The cost of congestion ranges between 1.8% of GDP in Kuala Lumpar to a massive 4.1% in Dublin.

Smarter transport systems can integrate traffic, weather, business and traveller information to provide real time services to users to create more efficient and user-friendly services. A number of cities in Japan are now moving to new models of delivering public transport that aim to bring greater degree of routes flexibility, on-demand capacity and more organic links between daily demand changes, external factors, such as weather and seasonality of demand, and the supply of public transport.

Of course, public transport is just one area of services where the Greater Dublin area and other cities in Ireland will be facing significant competition. Health, education, government services and public safety are also important determinants of the quality of life in the city and thus city’s ability to attract, create, retain and enable the workforce of the future. And we have quite a distance to travel in these terms. If in 2007 Dublin ranked 20^th in the world in terms of overall quality of living the city delivers to its citizens, this year it has slipped to the 26^th place. These rankings do not reflect even poorer quality of services delivered in the commuter belt of the Greater Dublin area.

The core conclusion that emerged from our report is that cities that adopt a pro-active approach to investment in citizen-centric services will position themselves to thrive in the new age of human capital-intensive growth. Those that continue to invest in traditional infrastructure designed for mass population are set to struggle.

Economics 09/12/2009: Budget 2010 - first shot at numbers

I will be blogging on the Budget 2010 over the next few days, but here is the main point:

The Budget did not deliver a significant adjustment to our structural deficit.

1. Claimed adjustments to the deficit totaling €3,090 million on current expenditure side and €961 million on capital side. These are gross figures which imply that we can expect net adjustments of ca €2,600 and €800 million each to the total deficit reduction of no more than €3,400.
2. Per table below, the Exchequer deficit will likely stand at €21,400 million in 2010 and not anywhere near the projected deficit of €17,760 million.
3. Stabilization of deficit is not happening on a significant downside, but in a marginal fashion, which is simply not good enough.

The main conclusion here is that the Budget has not gone far enough in reducing the structural deficit. There is another €10-12 billion worth of cuts looming for 2011-2012. It would be dangerous to assume that this can be corrected for through re-jigging tax system in 2011 as Minister Lenihan appears to imply.

At this junction, I simply cannot see how the Budget delivered anything more than a breathing period for Ireland before we resume our slide toward Greece. 12.4% deficit before we factor in demand for capital from Irish banks is just not enough. Full stop.

The Minister is now talking about €3 billion cut in 2011, then €5 billion cut in 2012-2013. This implies that from next year's standing position we are looking at a deficit of well over €9-13 billion in 2014. Assuming economy grows at a robust 2.5% every year from 2011 through 2014, this would imply a deficit of 4.9-7% of GDP - way long of the SGP-required 3%. If economy grows at even briskier pace of 3% per annum over the same period, the resultant deficit will be around 4.8-6.9%. Again, not much of a fit for our promises to the EU...

Economics 01/12/2009: A real breakthrough of Mr Cowen

So per latest reports, the nation is saved. Facing a systemic deficit of €14bn per annum, the leaders of the Social Partnership have been contemplating a dramatic reduction in the cost of Government business. The dramatic news from the Government buildings, suggested a pay cut for public sector workers of 5% gross, or less than 3% net, delivering something to the tune of €836mln in gross savings (as claimed by the unions). Which, of course, will be clawed back to less than €600mln through automatic stabilizers (taxes on earnings paid through taxes and so on - per reported estimates by the DofF). For a moment, it all looked like our Taoiseach Brian Cowen reigned over the business-as-usual at the Partnership Table.

Credit for derailing this 'savings' deal goes to the public outcry, the media, a handful of backbenchers, the Department of Finance and also to Brian Lenihan - all of whom have managed to restore our policy back to senses. The numbers bandied around by the unions' heads were simply not adding up.

For a moment - it all looked like:
As one fellow economist described the 'New Deal' to me: “a Dora the Explorer bandaid on a shark bite”. Optimist he is – more like a prehistoric shark bite, judging by its gaping size.

Now recall, Brian Lenihan has promised three things to the nation and the EU:

1. cut €4bn in deficit this year and the same next;
2. no new taxes (except for carbon tax and, may be, higher taxes on the so-called 'rich');
3. cut €1.3bn in public sector spending
   

As long as the talks with the Partners are dragging on, this is becoming an impossible trinity of policy objectives. Will Joseph Brodsky's ending for his Elegy serve as a perfect descriptor of the Government's real legacy in the history of Ireland?

... And it says on the plinth
'commander in chief'. But it reads 'in grief', or 'in brief'
or 'in going under'.

Oh, and one last thingy - if you think that €600mln in 'savings' ever had a chance of materialising, think of public sector workers taking a 14-day holiday who will have an option to do agency work to replace their own jobs... earning a nice tidy premium...

Economics 25/09/2009: Don't believe 'our recovery plan' drivel

I like some of our brokers guys and gals, I really do – they are intelligent, ambitious, outwardly mobile in their outlook and hard working. They often spot the rat, although usually warn of its existence only privately. But the current Nama and Lisbon ‘debates’ are just too much for them to bear without assuming the usual 'hand in the sand' positions.

First Davy strategist was telling us all that everyone criticizing Nama is a ranting lunatic (at the very best) or a deceitful manipulator (at its worst). I obliged to reply here.

Now, Bloxham folks lined up to spout nonsense as well. Here is an example from today’s morning note: “A Yes vote [in Lisbon Referendum] would be seen as positive [one assumes by the markets] and would keep recovery plans on track ahead of the critical NAMA vote…”

I don’t give a damn how Bloxham modeled their assertion on the markets' assessment of an outcome of the Lisbon vote. The Wall Street Journal disagreed with them. Studies performed on sovereign default spreads in the Eurozone and bond spreads are inconclusive one way or the other. But one thing is certain when it comes to spotting a lie in their statement: an assertion that either Lisbon or Nama or both can ‘keep [Irish] recovery plans on track’.

This is a first class bullshit.

One minor point why this statement makes absolutely no sense is that the 'distance' between the Lisbon vote and Nama vote is going to take place within a couple of weeks there after, around October 14-16. If Irish economy is so critically sick that a difference of two weeks can push it off the track, I wonder if Lisbon vote would be of any priority for our stock brokers at all.

Now to a bigger lie in the above statement:

In order to keep plans on track, one must first have a plan. Or at least and inkling of one. A handful of morsels of thought saying: we want to do A to achieve B… and a short list of actions to be taken to get there. This is a starting point for any logical ‘keeping on track’. And, guess what, unless you are smoking the same stuff folks at Bloxham are, there are no plans. Let me repeat: there is no plan for an Irish economic recovery.

Fiscal crisis: this is Government’s own backyard, so we should expect that at the very least here the Cabinet has done some homework on getting a plan for recovery started. Nope. McCarthy Report and Taxation Commission Report – two key pieces of policy strategy are now largely binned by the Government. It is clear that there is no will in our Triumvirate to do anything serious about the expenditure side of the fiscal crisis. Even Bloxham guys would probably agree that in the current conditions there isn't anything new they can do on tax side of things either - short of turning us all into serfs. The fiscal stabilization ‘plan’ presented officially by DofF following the Supplementary Budget 2009 was a re-hashing of the exactly identical ‘plan’ from January 2009 which was rehashing the ‘plan’ from October 2008 Budget. All three were not realistic in their assumptions and expectations and all three had not a single year of declining nominal current public expenditure between 2008 and 2013.

Economic crisis (domestic economy): this Government produced only one strategy document on domestic economy. Don’t call it a policy document, for it is too vague and lofty to be a policy. Their vision of the future of Ireland Inc was, and remains, in a nutshell, a combination of lab coats with Petri dishes in hands growing thoughts and knowledge in the foreground and windmills spinning out green energy in the background. The ESB is in existence too, with new sparkling headquarters and, one assumes, smokestacks belching CO2 to offset green energy from the windmills. If Bloxham folks think this drivel passes for a plan, good luck to them. Domestic consumption is being killed off by reckless tax increases. Domestic investment is being kept below the water line by absurd taxes on capital, charges on capital-intensive activities and depressed savings of the households. Households are prevented by the Government from de-leveraging and will be facing increasing costs of mortgages and credit post-Nama due to banks hiking up charges and margins.

Economic crisis (external economy): apart from IDA’s advertising campaign launched last week by our unfortunate choice of a Tanaiste, there is no plan for improving competitiveness of Ireland Inc vis-à-vis foreign investors and domestic exporters. There are no reforms in the pipeline to help improve their operating costs, capital costs, costs of electricity, gas, water supply, costs of currency risks on sterling and dollar side, costs of labour, health & safety, costs of buying out trade unions into agreement not to derail investment and production, costs of state-controlled and regulated transportation, energy, communications, etc services.

Financial crisis: half-thought through idea of Nama is unlikely to do anything significant to improve flow of credit in this economy – I wrote on many occasions about the risk of capital being transferred out of the country and about banks’ incentives to pay down inter-bank lenders, plus about potentially zombie banks and development markets, dormant / dead property market and other potential downsides to Nama, so no need to repeat this here.

So, my dear friends at Bloxham, what is the exact ‘plan for recovery’ that we will 'keep on track' if we vote Yes to Lisbon and/or Yes to Nama? Name one, please…