Economics 24/06/2009: SMEs feeling the heat

Yesterday's business conditions survey from ISME paints a picture of dire operating conditions for Irish SMEs.

Q2 2009 survey results "confirm that smaller companies are still in the throes of economic despair with employment levels, investment and sales remaining extremely negative. Despite this harsh environment business optimism has improved for the second quarter running, albeit from historically low levels." The survey was based on 600 companies responses shows both that there is no 'green shoots' improvement and that expectations for 12 months ahead are not offering much hope of an upturn "with companies further readjusting downwards their employment and investment levels."

Business confidence "has improved since the previous quarter with a net 56% of companies less optimistic in comparison to a net 71% in the previous quarter. The most negative sector is Construction with a net 73% less optimistic, followed by Retail at 71%, Distribution (70%), Manufacturing (51%) and Services at 48%." In contrast, "74% of companies, up from 69% in the previous quarter, viewed the current business environment as being either ‘poor’ or ‘very poor’." Only 23% expect business conditions to improve over the next 12 months, up from 16% in Q1 2009. 66% of companies said viability of their businesses was under threat over the next 12 months, if present conditions remain.

Employment conditions continue to deteriorate dramatically:
"Nearly two thirds (62%), (56% in the previous quarter), of companies employing less than this time last year and only 6% employing more. These figures are the worst ever recorded and confirm that there has been no slowing down in job losses in the sector, with evidence suggesting that this trend is to continue over the next number of months. The Construction sector was worst affected with 83% of companies letting people go in comparison to 72% of Distributors, 61% of Retailers and Manufacturers, and 43% of Service firms."

Furthermore, "employment prospects remain bleak with 43% of companies anticipating letting people go over the next 12 months, with only 7% planning to increase employment numbers. Distribution companies are the most pessimistic with a net 52% expecting to let people go, in comparison to 40% in the Construction sector, 35% Retailers, 32% Manufacturers and 28% of service businesses."

Clearly distribution services are feeling the squeeze of higher excise duties, VAT and other consumption damaging taxes and retail sector collapse. Construction sector, despite having bled jobs at the fastest rate of all segments of Irish economy in the past still remains one of the focal points of jobs destruction. Ditto retailers. The spread between these sectors and services is narrow enough signifying that we are indeed heading for the second wave of layoffs in the higher wage sectors.

"Sales continue to fall off a cliff with a net 77% of companies reporting lower sales in comparison to a net 72% in the previous survey. To put this in context there has been an eight fold increase in the number of companies reporting reduced sales in comparison to the same period last year. Only 23% of companies expect to increase sales over the next 12 months. Not surprisingly profit levels are badly affected with a massive 73% of companies anticipating a reduction in net profits, while 61% expect revenues to decline over the next 12 months, down from 69% in the previous quarter."

A massive 81% of companies said their sales/order books are down in comparison to last year. But only 33% of companies reported that their stock levels are down for the year, in comparison to 24% in the previous quarter, suggesting that overcapacity is still plaguing this economy and putting more pressure ahead on employment levels.

Credit crunch is also getting worse: "26% of companies have orders, production capacity and markets unserviced for want of working capital."

And new orders are being pressured by existent orders cancellations (implying even more pressure on employment in the short term) as "54% of companies have encountered cancellation of orders in the last quarter." Interestingly (the level of detail supplied in the survey is remarkable), cancellations were from,

• Locally Based Multinationals 16%.
• Export Destinations 7%
• Local Indigenous Firms 77%
  

This means only one thing - domestic economy is still in a free fall and exporters are the last line of defense we have left. It is Stalingrad time for Brians & Mary and they are still in denial that the winter has arrived.

SMEs continue to reduce "investment in their businesses with 32% having done so in comparison to 30% in the previous quarter. 19% indicated they increased investment, down from 25% in the previous 3 months. Only 16% of companies anticipate an increase in investment over the next 12 months."

This puts to an end any arguments the Government might have had about aiding the investment cycle through 'knowledge' economy programmes and tax changes they 'introduced' in December 2008. It ain't working, folks.

Although our Government economists are keen on talking about deflation, "firms continue to experience inflationary pressures, with increases of 5% plus being reported for transport, energy, raw materials, Insurance and waste. However, there is evidence of reductions in wage costs and rents." So in the nutshell - the Government and its cronies in the unionised, state-controlled and priced sectors are still ripping-off consumers and producers, while ordinary workers are taking a pay hit.

Finally, "47% of companies apportion blame to the Government for the current economic crisis, with a significant number of SMEs concerned at the lack of direction being provided."

I don't have much to add to this one.

Economics 05/06/2009: PMI, Live Register & Why Brian Cowen is simply wrong on economy

So things are getting better, say Comrade ‘Surreal Economist’ Cowen. Translated into human language (any human language short of North Korean) this really means that we have a terrible crisis that is getting worse at a decreasing (for now) rate. What do I mean?

Exchequer returns were bad, but they were not worse than in April. Hmmm – it only took thousands of families drowned in fresh taxes to get us this far. And add to it a ‘slowdown’ in the rate of growth in expenditure. Mr Cowen calls this ‘the right policy that is supported by the majority of economists and the ESRI’. About the only part of this assessment that I would agree with is the one which separates ESRI from economists – being a nearly purely state-paid ‘group-think tank’, ESRI is not about economics, it is about kissing the… you know what.

Back to the ‘greening’ shoots of this week… Irish PMI figures came in with a slowdown in the rate of decline… same as with the Exchequer results… again – things are not getting better, they are getting worse, but worse at a slower pace. Now, services sectors in Ireland, per PMI, shrank for the consecutive 16^th month in May, as NCB’s PMI rose from 32.2 in April to 39.5 in May. If this is a glimmer of hope, it is a smile from the bottom of the ocean. Future expectations are up to 50.8 in May, which is good news, when compared to the reading of 46.6 in April, but what this means exactly, given that we are heading into summer doldrums is highly unclear. One brighter star at the bottom of the barrel was Technology, Media & Telecos (TMT) – most upbeat of all sectors. Apparently, contraction is over in the sector, per May data. I am sceptical here, since this sector just got a boost from political advertising spend, and it has contracted at an extremely fast pace in December 2008-February 2009. Furthermore, most of the spend for the TMT sector for 2009 has already been allocated, so the contraction might have overshot the target before, with a slight bounce to the low flat trend expected about now.

Manufacturing PMI came virtually with the same results as services PMI, delivering a rise to 39.4 in May from 36.1. In other words – still no expansion, or 16 straight months of contraction. Export component of PMI rose, but remains below expansion reading. “With the domestic economy so weak, look for the new export orders component of the PMI to breach the 50 mark before the headline PMI will follow suit”, NCB’s Brian Devine told The Guardian. I agree. So where does this leaves Mr Cowen’s ‘right’ policies? Oh, not far from the proverbial ‘hole’. If Mr Cowen’s policies were right, we should not be expecting our economy to be rescued by exports or in other words, if our policies were to work, they would have positive effect on domestic economy. Instead, Mr Cowen is now positioning himself to claim completely undue credit for any upturn in the global economy… after having spent last 10 months blaming the world for Irish economic troubles.

Going forward, my expectation is for a flat trend for both PMI reports with some volatility in months to come. Autumn 2009 can potentially yield another round of relatively shallow (compared to 2008) contractions, especially in services.

The real issue from now on will be what can we do with an army of unemployed, bankrupt families that is amassing in the country and how can we get out of the hole that Mr Cowen and his predecessor have forced us into.

Today’s Live Register data does not provide much of hope that the task will be easy. In May there was another 13,500 increase in numbers claiming benefits in May. It might have been the lowest monthly rise since September 2008, but we now have 402,100 on the Live Reg and we are still on track for reaching 500,000 before we can toast the New Year.

Dynamics are tough to gauge. May’s monthly rate of increase was 3.5%, down for the fourth consecutive month and the slowest pace of growth since May 2008. But there is no indication that we are not going to see another bout of accelerating growth in unemployment comes June and then September-October. One reason to note – males are still dominating the firing line (65% of all new additions to the LR in May), so at some point in time, there will be new entry by women. How do I know? Simple – since December, layoffs have been moving off the construction sector into other, more ‘gender balanced’ sectors. I many cases, employers there offered voluntary redundancies with rather generous pay-offs. Women were the most likely to take such for a number of reasons:

· Women are more willing to switch into part-time employment;

· Women are more likely to go into continued education than men;

· Women are more likely to undertake family work than men etc

So this means that there a many ‘hidden’ layoffs working their way through redundancy packages that will surface once money becomes extremely tight.

Just in case you still believe in Mr Cowen’s economic assessment, give the following fact a thought. It comes courtesy of the Ulster Bank economics team and I agree with them wholly:

“The Live Register estimate of the unemployment rate increased from 11.4% in April to 11.8% in May, a rate last seen in May 1996. Our unemployment rate forecast of 14% by the end of this year therefore continues to look realistic. While today’s figures were certainly a welcome improvement on preceding months, the numbers signing on will continue to rise in coming months, as job losses in the services sector, most notably in wholesale and retail and hotels and restaurants, in addition to layoffs in construction, are ongoing. We therefore continue to forecast that the unemployment rate will peak at 16% by the end of 2010, before falling back gradually when the economy starts to recover.”

So Brian’s policies are working, then… too bad he can’t even tell us which policies he has in mind…

Economics 2/06/2009: Innovation debate

My article in the Sunday Times last weekend has triggered some responses. The article is reproduced below.

Here is a link to at least one good reply, from DCU's President, Ferdinand von Prondzynski. In spirit of debate, I decided to address couple of points he raises in the post:

Ferdinand is right that I am arguing 'against' the current approach of promoting, disproportionately, the idea of lab-based innovation. But I think he is wrong in downplaying what I suggest as the way forward.

I am talking about the need to focus more on where the actual returns to innovation are. From business point of view, these returns are in 'soft' innovation - process innovation, managerial improvements, logistics, communications, etc. These have been neglected in academia and SFI has virtually no presence in these areas. Interstingly, Ferdinand actually appears to present these areas as being somewhat below the 'real' innovation, 'understood as investment in high value science and technology'.

I mention a Wal-Mart effect and the value-added accruing to marketing and sales as being more important than producing new patents and scientific papers. I am yet to see an argument that the former yields lower returns to the society and economy than the latter.

Ireland is a small player and holds little promise to deliver hard innovation on global scale. But it does offer a strong potential for delivering high value-added sales, international links etc. It cannot be a unique supplier of a significant number of competitively innovative products on a global scale, but it can be a platform for domiciling innovation of others. For that we have location, links to the EU and the US, and we have talent.

Yet, how many professors of biotech or computer sciences do we have? Dozens. How many professors of finance do we have? A handful. Our system of research and teaching assumes that there is no need for raising investment in innovation or in higher value-added activities because we became fully reliant on the State to provide such financing. We have virtually no indigenous R&D investment, with most of private sector R&D expenditure delivered by the MNCs.

Ferdinand might want to ask the following questions:

1. Can we build a thriving economy without any domestic biotech graduates? To me the answer is yes. Can we train a single biotech graduate without a system of funcitioning finance? To me the answer is no.
2. If you have limited resources to invest in two activities: activity A (lab coats) yielding X% return per annum, activity B (finance) yielding 2X% pa, with everything else being equal, which one would you choose? To me the answer is B. But hold on, B also offers better jobs security for people than A, more diversified markets on which the service can be sold, it is an activity that has remained with us for centuries, so it does not become obsolete. And it can be built in 5-10 years, unlike lab coats that might become outdated by the time we actually have them exiting out Universities.
   

So we have a chain of national economic development that should be going from: build a base for finance and business services first, then indulge in a luxury of producing lab coats. Not the other way around.

I am, of course, exaggerating somewhat, for lab coats are also important. SFI and our Government have made a choice - lab coats and nothing more. I am merely suggesting that we need more!

Are we a country that hosts MNCs and provides them with support labour, or are we a platform from which MNCs actually add value? If we are the former, we need to produce more hard science PhDs. If we are the latter, we need more specialists in marketing, sales, finance, etc. Value-added by the former - not much, once you adjust for the risk of failure and the scale of our R&D sector. Value-added by the latter - well, look at Switzerland, for example, or Luxemburg, or Austria. Hard R&D-intensive IT and Pharma sectors there account for at most 10% of GNP, finance and B2B services account for 30-50%.

Can we be like Switzerland? Yes, if we focus instead on business services, e.g financial services, and import talent for labs-based employment, we will still be able to produce innovative goods and services, but we are no longer running the risk of ending up with the indigenous specialists who are at risk of becoming redundant the minute technology trends shift. Ferdinand might point to the fact that Switzerland trains many hard science PhDs, but hey - they started doing so after centuries of investing in finance and business services.

Finally, there is another argument in favour of abandoning our senile concentration of 'innovation' on ICT and bio: it is a basic 'diversification of your investment' argument... lab-coats simply do not get this.



Sunday Times, May 31, 2009 (un-edited version)

Back in December 2008, Irish Government unveiled its response both to the current crisis and the longer-term growth challenges. The plan, bearing a lofty title Building Ireland's Smart Economy was an amalgamation of tired clichés. But it contained an even less palatable revelation: our Government has not a faintest idea as to where economic growth comes from. This plan – never implemented – would be the old news, if not for the insistence by our leaders that it remains the cornerstone of economic policy.

Economic growth happens when entrepreneurs and investors find new means to extract more value out of existent resources. This is not the same as our Government’s concept of the smart economy.

Instead, Government ideas are closer to Mao Tse Tung’s Great Leap Forward than to the intensive growth models. Mao believed, literally, that shoving more production inputs into economy was growth. Brian Cowen and his Cabinet believe that getting more PhDs and public capital into sciences-dominated sectors generates growth. Net result will be a waste of economic resources for several reasons.

Sustainable growth requires very little in terms of armies of science bureaucrats, people in lab coats and science campuses, and much more of the incentives for business competitiveness and productivity. Over the last 20 years, worldwide improvements in logistics and retailing (known collectively as the Wal-Mart Effect) have yielded several times greater contribution to economic growth than the so-called innovative sectors like bio-tech, nanoscience, clean energy technologies and other lab-based activities combined.

Ireland has missed the Wal-Mart Effect because of the Government’s economic illiteracy that wastes billions protecting inefficient domestic services from competition. Ditto for other crucially important business infrastructure: legal, accountancy, medical, media, energy, utilities and so on. We are languishing at the bottom of the world league in communications services (ranked 23^rd in 2008-2009 Global Information Technology Report) just as the Government policy papers and programmes promising to make Ireland the innovation wonderland by 2013 abound.

Studies in pharmaceutical economics show that the risk-adjusted returns to scientific R&D leading to the development of a blockbuster drug are only half as large as returns to marketing, sales and distribution. When value at risk assessment of pharmaceutical investment accounts for large research pipelines economic returns to companies like Elan (a tiny minnows in the world of global pharma) can be negative.

Our focus on science-based R&D is hopelessly out of synch with international trends. Five years ago, biotech, customiseable software, nanotechnologies, alternative fuels, energy storage and the rest of the fancy scientific stuff were the domain of smaller companies. Today, the big boys of global business – the likes of Pfizer and IBM – are firmly in the field and next to them indigenous Irish enterprises have little chance of succeeding in either attracting capital, or hiring the requisite talent, or capturing markets for their products.

Our real (as opposed to lofty policy-based) metrics reflect this. Last month Science Foundation Ireland claimed that it expects 30 local R&D-based start-ups and 40 revenue generating technology licenses to emerge over the next 5 years. This implies that billions spent on the ‘knowledge’ economy will be adding some 60-100 new jobs or less than half a license per Irish academic institution per annum. In almost 7 years of its existence, SFI supported creation on only 250 patents (1.7 per academic institution annually). Virtually none have any commercial value to date.

All along, our state policies have ignored more productive avenues for growth: international finance, business services and market access platforms. While successful in delivering serious presence of Dublin for international back-office and domiciling operations, to-date we have failed to foster the emergence of Irish front-office activities. Yet, if back-office accounts for roughly 5-10% of the total value added in financial services, front-office (you’ve guessed it: sales, marketing, research and management) account for the rest.

Although employee value-added in Irish internationally traded financial services is some 70% greater than in the IT sector, no innovation policy recognises this. International financial services can be even more R&D and knowledge-intensive than the lab-coat sectors. Strangely, you can get tax breaks for developing new financial software – with a risk-adjusted return of ca10% per annum, but you will be paying exorbitant transactions and income taxes on research- and knowledge-reliant financial management activities.

There are even more bizarre twists in Irish policy. Irish Governments – from time immemorial – have preferred simplistic numerical targets to quality analysis and cost-benefit assessment. Thus, we now have a patently absurd goal of doubling the numbers of PhDs in Ireland by 2013 without any regard to the quality of these researchers. We have no stated goals as to the international rankings we would like to achieve for our numerous third level institutions generously financed by taxpayers. Only four out of our 7 universities and 14 ITs (TCD, UCD, UCC and UCG) have serious chances to either retain their position in the top 200 rankings or reach such position in the foreseeable future. Not a single Government department or public body is expressing any concern about this lack of competitiveness.

[Note: I do recognize (hat tip to Ferdinand von Prondzynski) that by latest rankings, DCU is actually ahead of UCG, so the list should have read TCD, UCD, UCC/UCG and DCU, per my belief that UCG can be competitive if and only if it merges with UCC]

Even more disconcerting is the total lack of foresight as to the employment prospects for our new PhDs. In the US some 50-55% of PhDs are employed by taxpayers. In Europe, the number is even larger – around 70%. In Finland – long regarded to be inspiration for Ireland’s knowledge economy – only 15% of PhDs are employed in the private sector. Majority of Irish PhDs go on to take up post-doctoral grants financed by the Government. They are, in effect, employees of the state with no academic positions and little hope of gaining one in the future. How many will find employment commensurable with their stated qualification once their grants run out in 2-3 years time?

Irish policy structures are simply unsuited to the emergence of entrepreneurial and productivity-enhancing culture necessary to sustain real long-term investment in knowledge-intensive enterprises. Most of our civil service is based on anti-entrepreneurial centrally planned system. Majority of our public service employees lack requisite knowledge of the private sector and the comparable aptitude to understand the present economy, let alone to accurately foresee its future needs. This is reflected in education and research policies, economic analysis documentation and in the structure of taxation.

Instead of providing incentives for business-related innovation, our taxation system penalizes investments in human capital with punitive rates of taxation. Returns to investment in property or physical capital in Ireland imply marginal tax rates of 0-25%. The same investment undertaken in education faces a marginal tax rate in excess of 50%. Chart above shows the relative taxation burdens associated with human capital and property between 1998 and today. As Ireland embarked on the path of building ‘knowledge economy’, tax on human capital as a share of overall tax revenue rose from roughly 63% in 2006 to 80% this year.

High income and consumption taxes are directly linked to the fact that three quarters of the EU nationals who obtain higher degrees in the US never return back. Are we setting ourselves up for the future brain drain from Ireland as well?

In years ahead Ireland stands a chance of either becoming a booming 21^st century economy or a laggard to the increasingly geriatric Eurozone. This choice will be based on our ability to deliver real entrepreneurship and skills infrastructure. More than a breeding programme for PhDs, this will require reforming taxation system to incentivise commercially viable knowledge, risk-taking and skills acquisition. It will also require support of a top-to-bottom reshaping and scaling down of our public sector and focusing the state priorities on delivering real improvements in simple things like communications and early education.

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…

Economics 22/05/2009: Tumbleweed Brain?

Imagine a high desert scene outside Los Angeles - vast expanse of nothingness, sandy patch of a road and a massive, prickly and menacingly fast advancing tumbleweed rolling at you, kicking up dust of sand every time it bumps over a rock or a hillock. Thus, the picture of devastation complete, the sense of stable equilibrium achieved, the landscape is all but a sign of devastation.

Would you call it an image of hope?

Well, Brian Cowen does.

Today reports claim that Mr Cowen told FF gathering that the Government had taken necessary decisions to ensure the Irish economy could bounce back next year. So what can go wrong? Jobless and about to lose your home? Pay-up to the Revenue and shut up, for FF has taken the necessary decisions. We are but the roadkill for Cowen and Co on the road to his recovery.

Mr Cowen also decided that the high cover achieved in the last auction for 5-year bonds was a sign of investors regaining confidence in Ireland Inc.

This blog has long argued that the demand for Irish bonds is similar to a Ponzi pyramid due to Irish banks rolling over Government debt to the ECB and monetizing it. Yesterday's Irish Times editorial finally bowed to the facts and agreed. Last week, Michael Somers of NTMA has "pointed out that 85 per cent of Ireland’s debt is held abroad but that in recent bond sales, Irish banks were significant buyers of Government debt" to be used as collateral to borrow from the ECB. This was not, he said, “a genuine end investor result". How much did the latest bond auction success depend on investment by Irish banks which have already received some €7 billion from the Government to help secure their survival? The NTMA should ease investor concerns and set out the details," said the Irish Times.

I think it is time we ask a hard question about our bond market revolving door to the ECB. Is it true that:

• as Brian Lenihan takes our taxes, we are hit once; then
  
• as Brian Lenihan issues bonds, we are hit again with the debt to be repaid in the future; and
• as the banks buy these bonds and go to the ECB to borrow against them, we are saddled with the banks-held debt that will have to be repaid to the ECB at some point in time and which is, in the end, our - taxpayers - liability too? so that
• the entire scheme requires continuous borrowing to sustain itself...
  

And what is all of this Ponzi pyramid used for? To finance early retirements of the civil servants and to pay their increments? This, indeed, is what Mr Cowen calls 'the necessary decisions'.

Cowen also stated that "we have a way out that is working". Remember the brilliant German movie Downfall about the last days of the Third Reich? (See a reminder/spoof here). Say no more... our unbeloved leader is in a state of delusion that is equivalent to awaiting the arrival of a miracle weapon (which does not exist) as the real enemy tanks are crushing your city.

What plan does Mr Cowen have? Brian Cowen claimed that economic recovery will be based on 4 pillars:

1. Banking crisis resolution;
2. Public finances gap closure via revenue increases and spending cuts;
3. Jobs protection; and
4. Investing in the unemployed to return them to work.
   

Brian Cowen has produced not a single policy to address any of the four pillars. Not a single one.

The entire country now is aware that NAMA cannot be made to work. Brian Cowen is in denial of this.

The entire country knows that he has not cut public spending (his own Government Budget shows increasing public current expenditure in every year through 2013). Brian Cowen is in denial of this.

The entire country knows that his Government is drawing blood out of taxpayers to raise revenue and that it is not working. Brian Cowen is in denial of this.

The entire country sees jobs being lost in thousands week, after week, as Brian Cowen and his Government choke enterprises, workers, investors and entrepreneurs with higher and higher taxes and charges. Brian Cowen is in denial of this.

The entire country knows that it was Brian Cowen as Minister for Finance who raised our social welfare rates to such a level that no programme that FAS can run will ever turn former construction workers off the welfare. The entire country knows that FAS should be renamed FARCE because it is one of the most wasteful and least productive Government organizations. Brian Cowen is in denial of this.

It is my sincere hope that his own party colleagues stop listening to the man for two reasons:

1. Brian Cowen no longer speaks for the people, about the people and with the people; and
2. No one listens to Brian Cowen anymore.

Brian Cowen is in denial of reality.

Economics 14/05/09: Economy bottoming out?

Per Davy note today: "pace of decline of activity has slowed: January-February was the worst point of the recession. All available indicators suggest that the Irish recession is past the most acute point. It is becoming clear that January-February was the most intense phase."

This statement is conditional on two assumptions - not explicitly identified -

1. Irish fiscal position remains sustainable underpinned by relatively easy borrowing, despite the demand for new and massive volume of funding under NAMA; and
2. Global economic stabilization is going to spill-over into Irish growth.
   

"Consumer confidence bottomed last summer," says Davy. I would not be impressed by this statement too much. Consumer confidence can be volatile. Underlying fundamentals are still weak and even assuming consumer confidence is on an upward trend (I am yet to see this happening), consumer spending might not resume, as jobs losses fear and taxation increases expectations are still there. It will take a NAMA-induced budgetary hit on households after-tax income to send confidence tumbling down to historic lows, but this is on the books for H2 2009 anyway.

"Core" retail sales are rising says Davy note. Hmmm, rising? Latest data for retail sales ex motor (core) we have shows that in February 2009 core sales rose 1.3% after contracting 1.1% in January and rising 1.1% in December after falling 2.3% in November... A saw-like pattern at the very best. If Davy want to stake their claim on February numbers, why not call for the 'bottoming out' in December?

"Survey indicators for services, manufacturing and construction have improved". Now, don't tell that to PMI survey administrators at Markit and NCB...

"Unemployment claimants are increasing more slowly". I am stunned to see Davy economics team actually looking at month-to-month dynamics for something so rich in lags and various degrees of severity by unemployment type as unemployment figures. Presuming they are referring to the Live Register data, what we do know is the following:

• the pace of overall increases in Live Register data have slowed down from a destructively high level in January-February 2009;
• this does not tell us anything about a trend, but can either signal a temporary bounce or indeed a reversal in trend;
• I prefer the former explanation to the latter because I can clearly see a new wave of layoffs rising - construction sector jobs destruction is by now complete. But financial services and business services jobs and retail sector workers are probably going to see rising rate of layoffs. If I were working for Davy, I would explained to the 'masters ordering the music' for this note that laying off a financial services worker is 6-8 times more expensive for the economy than laying off a low-skilled construction worker. I would also explain that the probability of a laid off construction worker leaving this country is probably 10-15 times greater than the probability of a laid off Financial or Business Services worker going elsewhere. I would further add that our banks have issued much larger and more stretched mortgages to the latter, not the former and thus their impairments on mortgages side is, guess what, much more adversely impacted by the next wave of layoffs than by the former one.
  

"Meanwhile, the fact that Irish exports outperformed during the collapse in global trade late last year and in early 2009 received little attention". I agree with this statement. The problem is can we hold on to this performance and also, how much of the good news is driven by the resilient and competent MNCs and how much is driven by the lower value-added domestic exporters? One only needs to look at the combination of sectors with rising imports (inputs) and exports (outputs) to see where the answer to this question lies.

Having told us the half-baked story of the 'green shoots' Davy forecast the economy will bottom in Q1-Q2 2010. Now, this is puzzling. If we are seeing reductions in the rates of decline in some series today, while other are, according to Davy recording an outright improvement, what will be happening to the economy between Q3 2009 and Q2 2010? Bouncing at the bottom? No - Davy say that it will bottom out in Q1-Q2 2010. So things will be deteriorating then through Q4 2009. But hold on a second. The same Davy note also says - in its title - that "Ireland is probably past the worst of the recession"...

Anyone to spot a blatant contradiction here?

Well, Davy didn't:

"Consumer spending may trough in six to nine months due to the savings ratio peak and slower income declines" - so we are not past the worst yet in terms of consumer spending?

"The risks to our forecasts are evenly balanced: the economy may hit the floor sooner if we are too pessimistic about the fragile recovery in the global economy, but a double-dip recession is possible if the reaction of households to the recent Budget is negative". So again, under both scenarios, we are not past the worst point yet.

And as a side bar - how far detached from the reality do you have to be to presume that the household reaction to the recent Budget can be anything but negative?

I am simply amazed at the lack of consistency or basic logic in the Davy's arguments! But enough on this - there is an article of mine coming out on Sunday on the issue of 'green shoots'... so until then the topic shall rest.

But here is a good analysis of 'green shoots' theory for the global economy that folks in Davy might want to read.

A quintessence of Lenihan's economics

Hat tip to Linda - here is a descriptor of the logic of 'shared pain' policies that ask us all - ordinary me and you, a lavishly paid Secretary General of Department of Somethingness, a patrician head of some Quango in charge of Everythingness etc - to make sacrifices in the name of the country - to go that extra step beyond our already up-to-my-ears-in-work existence...

So what makes 100%? What does it mean to give MORE than 100%?
If: A B C D E F G H I J K L M N O P Q R S T U V W X Y Z
is represented as:1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26.

Then:
H-A -R -D-W-O -R -K 8+1+18+4+23+15+18+11 = 98%
and
K -N -O -W-L -E-D-G-E 11+14+15+23+12+5+4+7+5 = 96%
and
A-T -T -I -T -U -D-E 1+20+20+9+20+21+4+5 = 100%

But
B -U -L -L -S -H-I -T 2+21+12+12+19+8+9+20 = 103%
and
A-S -S -K -I -S-S -I -N-G 1+19+19+11+9+19+19+9+14+7 = 118%

So, one can conclude with mathematical certainty, that
While Hard Work and Knowledge will get you close, and Attitude will get you there, its the Bullshit and Ass Kissing that will put you over the top - all the way to Brian Lenihan's national sacrifice economics...

Mini-Budget 2009: A 'Fail' Grade

To summarize, mini-Budget failed to deliver the substantial public expenditure savings promised. As a result of destroying private wealth and failing to cut public sector waste, instead of reducing the Gen Government Deficit to 10.75% of GDP as claimed in the Budget (Table 5), Minister Lenihan has left a Deficit of -12.5% to -13.0% of GDP in 2009. Details below.

The mini-Budget 2009 Part 1 is in and the Government has done exactly what I've expected it to do - soaked the 'rich'. This time around, the 'rich' are no longer those with incomes in excess of €100K pa, but those with a pay of €30K pa. We are now in the 1980s economic management mode, full stop.

Microeconomic Impact: Households

• The heaviest hit are the ordinary income earners and savers: Income levies up, thresholds down. Impact: reduce incentives for work at the lower end of wage spectrum and generate more unemployment through adverse consumption and investment effects. Before this budget, it would have taken a person on welfare living in Dublin ca €35-37,000 in annual pre-tax wages to induce a move into job market. Now, the figure has risen to over €40,000. PRSI ceiling is up a whooping 44.2% to €75K pa. This is jobs creation Lenihan-style;
• DIRT is up from 23% to 25% and levies on non-life and life insurance are up. CGT and CAT are up from 22% to 25%. The CGT is a tax stripping off the savers/investors protection against past inflation, so Mr Lenihan is simply clawing back what was left to the investors after his predecessors generated a rampant inflation. This is savings and investment incentives Lenihan-style;
• Mortgage interest relief is cut and will be eliminated going forward (Budget 2010) - I hope people in negative equity losing their jobs will simply send their mortgage bills to Mr Lenihan. Let him pay it;
  
• Interest reliefs on investment properties and land development are down. The rich folks who bought a small apartment to rent it out in place of their pension (yes, those filthy-rich Celtic Tiger cubs who saved and worked hard to afford such 'luxury' as a pension investment) are getting Lenihan-styled treatment too.These measures, adopted amidst a wholesale collapse in the housing sector, are equivalent to applying heavy blood-letting to a patient with already dangerously low blood pressure.

Microeconomic Impact: Businesses

• Providing no measures to support jobs creation or entrepreneurship, Lenihan managed to mention only his Government's already discredited programme for 'knowledge and green' economy creation from December 2008 as a road map for what the Government intends to do to stimulate growth;
• No banks measures announced or budgeted for, implying that an expected budgetary cost of ca €4-5bn in 2009 due to potential demand for new banks funds is simply not factored into our expenditures. Neither are there any costings or provisions for the 'bad' bank;
• No credit finance resolutions, PRSI cuts for employers, minimum wage reductions etc;
• CAT and CGT taxes up, income of consumers down, insurance levies up... Lenihan-styled treatment for business support is so dramatic that it is clear we have a Government that only knows how to introduce pro-business and pro-growth policies for their own cronies.

Microeconomic Impact: Public Sector
The only clear winners in the Budget were public sector workers. They face no unemployment prospect, no imposition of any new levies or charges, no cuts in salaries or indeed no changes to their atavistic, inherently unproductive, working practices.

Yet, they can retire earlier with a tax-free lumps sum guaranteed. And no actuarial reduction for shorter work-life, implying that the cost of the Rolls-Royce pensions to all of us has just risen by a factor of at least 1/3! Happy times skinning the taxpayers to pay the fat cats of the public sector elites? Lenihan-styled sharing of pain.

Pat McArdle of the Ulster Bank in an excellent late-night note on the Budget said: "Our main quibble with the Budget is with the split of the burden between tax and spending. ...contrary to the recommendation of practically every economist in the country, they opted for a 55% to 45% split in favour of taxes".

This is correct. On the morning of the Budget day, Mr Lenihan told the nation that not a single economic adviser was suggesting that the Budget impact should fall onto expenditure side. Clearly, he was either incapable of listening or simpy arrogantly ignorant.

Adding insult to the injury, Lenihan also ensured that majority of cuts were to befall the already heavily hit middle classes. Microecnomically speaking, Minister Lenihan has just dug the private sector grave a few feet deeper. It was at 6ft before he walked into the Dail chamber. It was at 10ft once he finished his speech.

Macroeconomic Impact: When Figures Don't Add Up
In Macroeconomic terms, we are no longer living in Ireland. We are living in Cuba where numbers are fudged, forecasts are semi-transparent and the state knows better than the workers as to what we deserve to keep in terms of the fruits of our labour. Mr Lenihan has torn up any sort of social contract that could have existed between the vast majority of Irish people and this Government.

All data is from DofF Macroeconomic & Fiscal Framework 2009-2013 document.
More realistic assessment of the GDP collapse in 2009 is being met with a relatively optimistic assumption that GDP contraction will be only 2.9% in 2010. Even more lunatic is the assumption that Ireland will return to a trend growth of ca 4% in 2012-2013. So my assumptions are: -8-8.5% fall in GDP in 2009, -3.5-4% fall in 2010, +1% growth in 2011, +2% in 2012 and +2.2% in 2013. This will be reflected in my estimate of the balance sheet below.

Another thing clearly not understood by the Government is the relationship between income, excise and import duties. Imagine a person putting together a party for few friends. She had before the Budget €100 to spend on, say, booze. Now she has €90. Her VAT, excise, import duties on €100 of spend would have been ca €66. Now she goes off to Northern Ireland with her €90. Does the Government lose €66? No. It also looses other (complimentary) goods shopping revenue. Say that the cost of party-related goods is €250 worth of purchases at 21% VAT, 10% duties. Total cost of a €10 generated by Lenihan in income tax levies is a loss of over €140 in revenue. Good job, Brian. Your overpaid economic policy advisers couldn't see this coming?

Notice investment figures in the table above? Other sources of GDP growth? Well, DofF did apply a haircut on its projections in January 2009 update, but these corrections are seriously optimistic on 2011-2013 tail of the estimates. This again warrants more conservative estimates.
Judging by the inflation figures estimates, the DofF believes that the era of today's low interest rates is simply a permanent feature of the next 5-year horizon. Again, this is too optimistic and should it change will imply much deeper economic slowdown in 2010-2013 period.

Now to the estimates Table below summarizes the estimated impact of the measures.
Per DofF estimates, the Exchequer deficit drops, post mini-Budget-1, by ca €2.7bn in 2009 or 2% of GDP. This is rather optimistic. In reality, this estimation is done on a simple linear basis, assuming no further deterioration in receipts and a linear 1-to-1 response in tax revenue to tax measures. This also assumes the macro-fundamentals as outlined in the Table 2 discussed earlier.

Now, building in some of my outlook on the budget side and GDP growth side, Table below reproduces DofF Table 5 and adds two scenarios (with assumptions listed): From the above table, we compute the General Government Deficit (the figure that is the main benchmark for fiscal performance) as in the following Table:
This speaks volumes. The Government promised in January 2009 the EU Commission to deliver 9.5% deficit in 2009. It has subsequently reneged on this commitment, producing an estimated Gen Gov Deficit of 10.75% today. However, stress-testing the DofF often unrealistic assumptions provides for the potential deficit of 12.5-13.0% for this year.

But there is a tricky question to be asked. Has Lenihan actually gone too far on the tax increases side? Note that the estimated gross impact of the overall budgetary measures is €3.3bn for the remaining 8 months of 2009, implying an annual effect of €4.95bn in fiscal re-balancing. This is ca 2.9% of GDP - a sizable chunk of the economy. From that figure, per Table 5 above, the implied net loss to the economy from the Government measure (estimated originally at -1% of GDP) should be closer to 1.5-1.7%. This in turn implies that instead of an 7.7% contraction in GDP, the DofF should have been using a 9.2-9.4% contraction. In today's note, Ulster Bank economics team provides a revised estimate of GDP fall for 2009 at 9.5% for exactly this reason.
Mr Lenihan and his advisers simply missed the point that if you take money out of people's pockets, you are cutting growth in the economy. Of course, our Ministers, their senior civil servants and advisers would not be expected to know this, given they lead such sheltered life of privilege.

If the above estimates were to reflect this adjustment, we have: 2009 GDP of €168.2bn;General Government Deficit of 11% for DofF estimates, and 12.7-13.25% for my scenarios. I will do more detailed analysis for 2010-2013 horizon in a separate post, but it is now clear that the Government has not achieved its main objective of an orderly fiscal consolidation to 9.25% deficit. Neither has it achieved an objective of supporting the economy through the downturn.

Conclusions
Today's Budget delivered a nuclear strike to the heart of the private sector economy in Ireland. It furthermore underscored the Government commitment to providing jobs and pay protection for public sector workers regardless of the cost to the rest of this economy. We are in the 1980s scenario facing years of run-away, unsustainably high public spending and no improvements in public sector productivity amidst severe contraction in demand and investment at home and from abroad.

Minister Lenihan has promised to go on a road show selling Ireland Inc. I wish him good luck and I wish his audiences a keen eye to see through the fog of demagoguery this Government has produced in place of sensible economic policies. If they do, their response to Mr Lenihan's approaches is likely to be "Thank you, Minister. We don't need to invest in the economy that taxes producers, savers and consumers to protect public sector waste. Thank you and good by."
From an investment case point of view - they will be right.

PS: As the first fall-out from the Budget, Moody's downgraded Irish banks (here)... More to come.

OECD report blasts Irish policies

Now, that the FT busted out the OECD report released today, I can do the same. I gave it a quick preview in this yesterday's post (here) so now let's get down to the details.

Here is what I said about it's findings yesterday:
"...compared to other developed countries around the world, Ireland finds itself as:

• the worst economically governed in the world;
• in deepest trouble when it comes to housing markets declines to date;
• the country that is applying all the wrong (uniquely Irish) remedies to its fiscal problems; and
• the country that is least well positioned to come out of this recession any time soon."

In effect, OECD's report, that does not focus on Ireland alone, provides a somber assessment of Irish Government policies, exposing their complete and total failure in addressing the crisis to date. And here are the actual details per each point.

Point 1: The worst economic governance in the world:
Table 3.4:
So per the above numbers:

• Ireland has the fastest rising debt in the OECD;
  
• Ireland has the worst primary imbalances in the OECD. The US is catching up in 2010 projections, though the cumulative impact of primary imbalances over 2008-2010 will still remain the highest in Ireland (by over 1% point). Furthermore, the US imbalances are sourced from rapid fiscal spending expansion - wasteful, but nonetheless stimulative, while Irish primary imbalances arise from over bloated current expenditure - the purest form of public sector waste of all;
• Ireland has the highest fiscal gap in the OECD in both 2008 outrun and 2010 projections.

Next, move up to Figure 3.3 (below) which shows that we have blown fiscal spending policies not on healthcare or long-term care provisions, but on something else.
Ireland is managing to achieve the third highest projected spending rises through 2050 of all OECD states (after catch-up Korea and Greece), but lions share of that is being consumed by growth in pensions exposure. Why? How else do you think are we supposed to pay for Rolls-Royce pensions provisions in the public sector?

Point 2: Ireland is applying the uniquely wrong measures to addressing our fiscal and economic problems:
This is a point that links to point 1 above, so let us deal with it now. Table 3.2 below gives the data on different measures and their incidences and impact on the sectors of economy as adopted by various OECD governments.
Ireland clearly stands out here as:

• The only OECD country that, unconstrained by the IMF austerity measures, is facing a rising burden of the state (positive net effect of fiscal austerity for 2008-2010 period);
• One of only three OECD countries (Italy and Mexico being in our company) that is raising taxes (and here we are facing tax increases that are 12 times more severe than Italy and over 4 times more severe than Mexico, before the April 7 Mini-Budget hammers us even more);
• One of only two countries (Iceland being another country, but it is constrained by the IMF conditions) to raise individual taxes (our tax increases are twice those of Iceland). What is even more insulting is that our individual tax increases are by far the biggest source of fiscal burden of all other fiscal policies Messr Cowen and Lenihan are willing to adopt;
• One of only 3 countries (the IMF-constrained Hungary, and Italy being the other two) that is raising consumption taxes, with increased consumption tax burden being 5 times greater in Ireland than in Italy;
• A country with the heaviest burden of fiscal policies on households - with combined effect of individual, social security and consumption tax increases of +3.7% - 12 times the rate of tax burden increases in Italy and almost 4 times the rate of total household tax burden increases in Iceland and Hungary;
• Our fiscal expenditure measures are second worst only to IMF-constrained Iceland.
  

Figure 3.2 below illustrates, although one has to remember that Israel scores next to us because it actually has rising tax revenue and is facing the unwinding of some of the exceptional spending that occurs during military campaigns.
Another interesting aspect of the OECD findings relates to the sources of our fiscal imbalances. Figure 3.1 shows these:
Notice that according to the OECD chart, the cyclical component of the debt increases for 2008-2010 is only roughly 26% of the entire debt levels. The ESRI (see here) says it should be around 50%. I estimated (here) that it should be around 21% (here).

Point 3: The scope for recovery:
According to the OECD "On this basis, the countries with most scope for fiscal manoeuvre would appear to be Germany, Canada, Australia, Netherlands, Switzerland, Korea and some of the Nordic countries. Conversely, countries where the scope for fiscal stimulus is very limited would include Japan, Italy, Greece, Iceland and Ireland." We are in a good company here, indeed.

Point 4: Housing troubles:
Finally, Table 1.2 below illustrates my housing crisis point.
Yes, no comment needed here.