Keynote Speech at the Trinity Economics Forum , in the Long Room Hub, in Trinity College, Dublin on Saturday 15 February at 4.15pm
I propose to speak here today in a personal capacity, and not on behalf of any organisation with which I am privileged to be associated.
The recent economic crisis has been good for economists. They are in demand as members of panels of all kinds, to explain what went wrong.
But it has not been so good for the science of economics, in the sense that so few people with economic training foresaw either the scale, or the timing, of the collapse.
WHY DID THE SCIENCE OF ECONOMICS NOT FORESEE THE CRISIS, AND OFFER PREVENTATIVE SUGGESTIONS?
It is possible to argue that foreseeing the timing of the collapse was a lot to ask. Sometimes a random event can occur, which will set off a chain of events that will topple an economic set up that was already unstable, and it is difficult to know which random event will be the one to have that effect, or to predict when it will happen. Obviously the sooner it happens the better, because a lesser adjustment will then be necessary.
But it is less easy to understand why the bulk of the economics profession worldwide, did not grasp the fact that the scale of the imbalances in the world had grown so great, that the gradual “soft landing” , that most seemed to have assumed would happen, was inherently unlikely. Virtually all the major international bodies expected a soft landing.
Given that everyone knew that paper money itself is based on confidence and trust (the paper itself is worth nothing), and that most money in use is actually bank credit, and that few banks anywhere are strong enough to resist a sustained bank run, it is hard to see how so many economists could have assumed that unsustainable positions could be unwound slowly, over a long period, without somebody panicking at some stage, and thereby precipitating a bank run.
Yet, that seems to have been the general assumption.
WHY WERE BALANCE OF PAYMENTS, AND HOUSE PRICE, DATA IGNORED?
In Ireland’s case, there was published data which showed clearly to all who could read that, although we were part of a single currency which we had no power to devalue, we were running a large balance of payments deficit. In other words we were spending more abroad than we were selling. Ireland had a very large balance of payments deficit in 2005, 5690m euros, and been running a deficit in every year since 2000. Meanwhile, new house prices had risen by 64% since 2000, whereas consumer prices (excluding mortgages) had only risen by 18%. These figures were known at the time. Economists and others believed, mistakenly, that the balance of payments did not matter in a currency union, and the potential danger of private sector imbalances was ignored
Some Irish economists, and non economists, may have sensed that there was something radically wrong here, but the consensus remained that the position would unwind slowly and relatively painlessly.
But HOW was it supposed to unwind?
How were exports supposed to accelerate and catch up with imports, which was the only way the balance of payments could correct itself without a domestic recession being used to curb imports?
How were incomes of households in Ireland supposed to catch up with house prices, without a fall in house prices which would undermine the basis on which people were contracting mortgages, and without thereby creating a banking crisis(which is what happened)?
What economic strategy or projection was there for such a major increase in incomes in Ireland? What economic strategy was there for an increase in exports sufficient to overtake imports and eliminate the balance of payments gap? Given that we were buying the imports on credit, surely this raised questions about our banking system?
I have no doubt that some economists were asking these questions, but they were not being heard.
Why is this?
BUSY OPTIMISTS HAD NEITHER THE TIME, NOR INCLINATION, TO HEED THE WARNING SIGNS
One reason is that people did not take the time to listen. They were too busy, busy making money, meeting their quarterly targets, winning votes, or doing all the other things that make up a modern crowded life. Most people did not have, or did not make, the time to think things out.
Furthermore, I believe any economist who sounded a warning was not being heard, because of a good trait of human nature, which serves us well in normal times, namely optimism. If humans were not optimists, they would not have taken the risks which, after much trial and error, brought about advances in technology from the earliest times, from the domestication of wild animals to the invention of the world wide web.
But lack of time, and optimism, were also present in other countries which did not have property bubbles, countries like Canada, and Germany.
There may thus be other factors to look at, principally the recent economic history of Ireland.
BLINDED BY RECENT SUCCESS, THE SOURCE OF WHICH WAS NOT FULLY UNDERSTOOD
We had been blinded by success, a success we did not fully understand.
In Ireland’s case, we had had, from 1994 to 2000, a surge in economic growth, which was based on solid technological advance, and improved cost competitiveness and productivity.
In fact this surge was the result of improvements that had been made long before, but that was not widely understood, and we thus drew the wrong conclusions from our growth performance in the 1994 to 2000 period. Our growth in the 1994 to 2000 period was, in good measure, a one off harvesting of the fruits of previous investment, a harvest that had been artificially delayed by extraneous events.
Ireland had been held back relative to the rest of Europe in the post war decades, by poor education, by protectionism, by over dependence on one market and a few products, and by a neglect of technology. Up to 1970, we were a long distance from the “productivity frontier”, which could be assumed to be the levels of productivity being achieved in the United States.
In the 1966 to 1973 period, these defects were put right. And in a sense, the Celtic Tiger should have happened in the mid 1970s, rather than in the mid 1990’s. Remember there was a big return of emigrants to Ireland in the 1970’s, many of whom were children, which was a good sign for the future.
But the Celtic tiger was then postponed by external developments.
In1974, we were hit by the oil crisis, which dramatically worsened our balance of payments and public finances.
In the 1980s, we were hit by the huge hike in interest rates, initiated by Paul Volcker of the Federal Reserve, to squeeze inflation out of the system. This rise in interest rates caused a crisis in the public finances of Ireland in 1981, because we had exposed ourselves needlessly, by unwise government borrowing in the late 1970’s.
Then, in the early 1990’s, when we should have been recovering quickly, we were hit by renewed higher interest rates. This arose from currency exchange rate instability in Europe.
There was another factor at work, demography.
Ireland’s birth rate had been very high in the 1970’s and peaked in 1980. So we had a disproportionately large number of children in the country in the 1980’s. These children were too young to earn anything, and had to be provided for by a relatively small working population.
By the mid 1990s, some of these young people were entering the workforce, and furthermore women were taking up paid work much more than before, where previously they had worked outside the paid economy, at home. As a result of the combination of these two changes, the workforce in Ireland in the 1990s, was almost twice, what it had been in the 1980’s.
THE GROWTH RATES OF THE 1994-2000 PERIOD WERE A ONE OFF
So the exceptional growth rates, in the 1994-2000 period, were a form of one off, catching up.
Once external constraints, like artificially high oil prices and interest rates, were removed, and the working population increased, all was set for a surge forward in economic activity. But this also meant that we came much closer to the global “productivity frontier”, beyond which further advance is only possible through profound technological advances.
Looking at how we responded to the crisis, in the period from 2008 to date, it is important to stress that the fundamental structural advantages of the Irish economy, the base of high tech industry and services, and the flexibility of our work force, were preserved.
Indeed competitiveness was improved quickly, and the success in negotiating pay reductions and economies in the public sector was remarkable. Some progress was made in reducing private debt , which had reached around 220% of gross disposable income in 2010.
On the other hand, Government debt rose from 40% of GDP in 2008 to 125% today. While some of this was due to the cost of recapitalising banks, the bulk of the increase in debt was due to borrowing to bridge the gap that had suddenly grown between previously inflated spending levels, and presently depleted revenues.
ESCAPING THE DEBT TRAP..WHEN NOMINAL GROWTH RATES EXCEED THE RATE OF INTEREST
Responsible finance is neither a left wing nor a right wing idea. It is common sense.
To escape from the debt situation we are in, we need to reach a point where our nominal GDP is rising faster than the rate of interest we are paying.
The Department of Finance says that our nominal GDP growth rate this year is 2.8%, whereas our interest rate is 4 %, and our deficit to be met by Government borrowing will be at 4.8% of GDP.
But by 2018, they expect our nominal GDP growth rate will be in 5.4%, as against an interest rate of 4.4%, and that we will have a budget surplus of 0.5% of GDP. Thus, we should, in 2018, be in a position where our Debt/GDP ratio will be falling, rather than rising.
Obviously, if the Department has over estimated our like nominal growth rate, or if we fail to meet the targets for reduced borrowing, that happy outcome will not happen. We are not in complete control of any of these variables.
The one we have most control over is our gap between spending and revenue, but even that can be affected by international trade and interest rate conditions, which can increase spending or reduce revenues.
Interest rates could be raised above the expected level, as they were in the early 1980’s, if either Central Bankers start worrying about rising inflationary expectations, or if lenders are hit by a sovereign default somewhere else, either in the euro zone or otherwise. This could become a problem when we have to roll over existing fixed rate borrowings. Conversely, if deflation sets in, the real value of our debts would start to rise, even though we had not increased them in nominal terms.
Nominal growth can be raised in two ways, by inflation, or by real increases in output.
Inflation, which would also reduce the real value of our debts, seems unlikely.
So we will have to rely on real output increases, which we can either sell abroad as exports, or sell to ourselves.
Some see a boost to domestic demand as part of the solution, but that would be counterproductive if it meant that we stopped reducing our very high household debts, or increased salaries and wages in a way that diminished our ability to compete on export markets. We rely on export performance to bring in the money that will enable us to get our debts under control. Much of any “stimulus” to domestic demand would seep away into imports very quickly. We would be stimulating someone else’s economy.
In the longer term, we are also bound by a Treaty, approved in a referendum by the Irish people, to reduce our debt/GDP ratio at a steady pace, down to 60% of GDP, from its present level of 124%.
COMMITTED BY TREATY TO HAVING BUDGET SURPLUSES, WHILE ALSO COPING WITH UPWARD SPENDING PRESSURES
This will mean running primary budget surpluses year after year. A primary surplus is a surplus of revenue over all expenditure, except debt service. This will not be an easy sell in an ageing society, where demands for more spending, especially on health, will be very strong.
It is important to reflect on the present inbuilt tendency of Government spending to rise, even when no policy decision to raise it, is taken.
As Brendan Howlin TD, Minister for Public Expenditure , pointed out in his budget speech recently, with no policy change since 2008, the number of people of pensionable age increased by 13.5%,the number of medical card holders by 40%, and the numbers in schools and universities by 8%.
This year alone, Social Welfare pension costs will increase by 190m euros and public service pension costs by 77 million. Meanwhile next year, some of the Haddington road pay savings will expire, when the agreement itself expires.
So even if there are no tax cuts, and no new spending ideas, keeping spending down to the level required to meet the deficit targets will be hard work.
Indeed it will be important that election manifestos are compatible with the Treaty obligations we have undertaken. One suggestion is that Election Manifestoes should be costed in advance by the Fiscal Advisory Council.
IN IRELAND’S INTEREST TO ENSURE ALL EURO STATES RESPECT THE TREATY
Matching the pressures of national politics, with mutual Treaty obligations to control debt for the sake of our shared currency, will be a challenge in every democracy in euro zone, including in countries like Germany, France and Italy, which have a lower long term growth potential than we do.
Indeed it will be in our interest that others are seen to respect their Treaty obligations too, because doubts about the viability of sovereign borrowing in any euro zone country could have an immediate knock on effect on the interest we would pay on our sovereign borrowing, and that could throw our plans off course.
Our future is, of course, inextricably linked up with the future of the euro, and thus of the European Union. Worries about the future of the euro have diminished, but have not disappeared.
The fragility of the EU lies in the extent to which, as new items have come on the agenda, for which inadequate provision has been made in existing Treaties , power has gravitated back to the big member states at the expense of the common EU interest, as expressed through the Commission, Council of Ministers, and Parliament. Power has been renationalised, and that suits big states, not small ones.
Ireland’s rejection of previous EU Treaties has, entirely unintentionally and indirectly, contributed to this process, by making EU leaders reluctant to propose Treaty amendments that might restore more initiative to the traditional EU decision making process, which works better for small countries. .
THE NEED FOR INTEGRATED DEMOCRACY IN EUROPE
Economists understand the power of incentives.
In the European Council, where the real power now lies, no member has a strong political incentive to put the collective interests of Europe, before the interests of his/her own country.
Even the Commission, because of its method of appointment, has an incentive to consult the interests of the big states first.
That is why I believe, if the EU is to succeed, it needs some form of supranational democracy, that will create a political mandate, derived from all the people of Europe, that will be large enough to take precedence over even the biggest state. Improving scrutiny of EU policies in 28 national parliaments is not enough.
I believe that either the President of the Commission, or the President of the European Council, should be directly elected by the people of Europe.
If something radical like that is not done, I fear that the EU and the euro will continue to be blamed for the consequences of failures of national policies, failures that will have only a slight connection with the euro. If that happens, the permissive consent of citizens, which allows the EU to exist and grow, will disappear.
That would be an economic and political disaster, for the EU and its neighbours, far greater than the crash of 2008.
UNDUE INCREASES IN THE GAP BETWEEN WINNERS AND LOSERS CAN UNDERMINE THE SYSTEM
The issue of growing inequality in some western economies is different from the issue of whether or not we should live within our means. Yet they are often confused in public debate by people who want to be popular, and dodge the true implications what they are demanding.
We need to look at the factors that are driving inequality, because if the outcomes of economic policy create unduly wide divergences between winners and losers, the whole system will be undermined.
Taxation is one factor that can aggravate inequality, but in Ireland we already have a relatively progressive tax system. We are also beginning to tax property, which is only fair. We have to remember that people can move residence to avoid unduly progressive taxes. Some high earners, coming here from abroad, bring jobs for others into the country, and we would like them to stay here.
It is arguable that quantitative easing, by boosting share prices, has added to inequality, because only the better off tend to have a lot of shares and financial instruments and are thus in a position to benefit from the increase in their nominal value
It is also arguable that systems of executive compensation, which reward short term gains in share prices, encourage business managements to favour the buying back of shares over investment, add to inequality, and depress long term growth. Pay systems that reward short term results are particularly noxious in the financial sector.
The celebrity factor has also added to income inequality, because all sorts of businesses, like football clubs, recognise the importance of holding on the celebrity managers or players, as a means of boosting stock prices, match attendances, or TV revenues.
Given that we live in a globalised world, it is difficult for one country to deal with these issues on its own, without provoking a flight of capital and talent to other countries. Imagine what would happen to the success rate of football clubs in a country that decided unilaterally to cap the pay rates of players in the interests of equality!
To address some of the causes of the growth of inequality, international understandings will be necessary. The OECD and the EU are the venues in which some of the causes can be tackled, but it will not be easy.
STRUCTURING THE ECONOMY TO PROMOTE GROWTH
I will turn, finally, to the things we might do to boost economic growth.
As far as I can see, this is not an area in which economists have reached a final consensus.
The prevailing view is that the best way to promote growth is to encourage labour and capital to move freely from one activity to another, so as to find the activities with the highest rate of return. High legal costs, restrictions on entry to professions, state monopolies of particular activities, and big barriers to redundancy of workers, all work against freedom to allocate resources efficiently, and thereby inhibit growth. In Ireland’s case we still have high legal costs, and a problem of monopoly pricing in the energy sector.
But it is also possible that markets can be TOO efficient, at least in a short term sense. For example, banks were too efficient in lending money here during the boom!
Returns to pension funds have declined, notwithstanding the additional sophistication of the independent fund managers used by the funds. UK pension funds earned a 5% return on capital between 1963 and 1999. But between 2000 and 2009, they earned only 1.1% return. That’s not financially sustainable. Why did this happen? Low interest rates promoted by Central Banks are part of the problem.
Incentives to unduly rapid turnover of investments are blamed by some for this decline in the return on investments by pension funds. To remedy this, suggestions for reform of the incentive structure of fund managers have been made. Worries have been expressed about bonuses earned from artificially rapid turnover in shares held on behalf of pension funds, and about “momentum trading,” where an attempt is made to make gains by anticipating the momentum of the market, rather than by focussing on underlying returns.
I do not feel able to judge these matters, or to say what, if anything, we should do about them in this jurisdiction, but the fundamental point I would make is that capitalism works best when it is subject to good, clear and simple rules, which strike the right balance between promoting lively competition in the here and now, the taking a long term view of investments that will yield the best returns over time.
The international financial service sector is part of Ireland’s export success story. Exports of services now make up 52% of all Irish exports, with financial services, software and business services making up the bulk of this. Opportunities are enormous.
The global middle class, the class that saves for a private pension, is set to treble by 2040. This is a major market opportunity for the Irish Funds Industry.
The urban population of the world is set to increase by 75% by 2050. This will require huge infrastructural investment in roads, water treatment, electricity, and other forms on infrastructure. As a centre of excellence in both finance, and sustainable technology, this is also an opportunity for Ireland, and particularly for the Green IFSC.
The International Financial Services industry needs to make a big investment in IT and social media. For example, Ireland is getting a leading position in IT through the design, by Intel in Ireland, of the Quark X 1000 chip.
If a country is able to host the designers of big technological breakthroughs like this, it is breaking through the “productivity frontier”, to which I referred earlier. Again this is an opportunity for Ireland to connect its financial service expertise with its IT expertise, and it’s hosting of firms like Google, Facebook, and Paypal.
This is, I believe, the key to promoting economic growth….making new connections. Economic growth is about a state of mind, in individuals and in society. About failing, and still trying again.