Ireland's 'austerity' is working - for profits

By Michael Burke

The Central Statistical Office (CSO) has produced its latest institutional sector accounts for the Irish economy in 2011. The title would suggest they are among the driest economic data possible - from a long list. In fact they are among the most important data available because they reveal the sources of income for all the main sectors, or classes, operating in Irish society.

This situation in Ireland is not unique and it actually represents a specific combination of general trends that apply in all the capitalist economies. The CSO has simply set these out with unusual clarity.

The chart below shows the profits of non-financial firms operating in the Irish economy (Figure 1), as well as the profit share, that is profits as a proportion of total Gross Value Added (GVA). GVA is the same as GDP, except the effects of subsidies and taxes on production are excluded.

Figure 1



The profit share has been rising since 2008. This is when ‘austerity’ policies were first adopted in Ireland. This is not coincidental. Clearly the purpose of policy is not to foster economic growth. GDP data in Ireland is highly distorted by the activities of overseas multinational corporations operating in
 Ireland who falsely book activity in order to avail themselves of ultra-low corporate tax rates.

Domestic demand (primarily personal consumption, government spending and investment) has fallen continuously for 4½ years and is now 25.6% below its peak in 2007.

The stated aim of policy is to reduce the government budget deficit. However as the separate National Income and Expenditure Accounts for 2011 show from 2008 to 2011 government current receipts have fallen by €6.3bn while current expenditure has risen by just €0.5bn, a total increase in the deficit of a little over €6.8bn despite all the fierce ‘austerity’ measures (Table 21). The current budget deficit is that part of the public sector accounts which ‘austerity’ is supposed to be addressing, yet the deficit on this measure has risen from 2.2% of GDP over that time to 6.7%. Yet this policy will be maintained even though its stated objective is not being achieved.

In fact the total public sector deficit has only stabilized because the government has cut its own investment over the same period, by nearly 60%. This has exacerbated the total decline in investment (Gross Fixed Capital Formation) which has fallen at the same rate. The decline in GFCF significantly exceeds the fall in GDP. Investment has fallen by €23.6bn in the recession, compared to a fall of €14.6bn in GDP.

This hoarding of capital - a refusal to invest - is the source of the recession. A government committed to boosting the profits of the private sector would reduce benefits and pay in the public sector in order to lower private sector wages. This is what mainstream economists refer to as a ‘demonstration effect’ . At the same time the government would reduce its own investments, say in schools, hospitals, housing or transport in order to facilitate private sector investment at a later date. This is the content of current policy.

Investment has declined throughout the crisis, even after profits have begun to recover. The chart below shows the level of investment of non-financial corporations versus GVA, and the relationship between the two which the CSO calls the investment rate.

Figure 2


But another way of expressing the investment rate is as a proportion of total profits. The chart below shows non-financial firms’ profits versus the level of investment. Profits have risen from their low-point of just over €39bn in 2009 to €46.3bn in 2011, close to the peak in 2007. At the same time the level of investment has fallen by €9.4bn (all expressed in nominal terms, not taking inflation into account).

Figure 3


To put this in perspective firms operating in Ireland formerly invested about one-third of their profits before the crisis. Even this investment rate was very low by international standards. In 2011 the investment rate on this measure was that about one-seventh of all profits were invested. This is also below non-financial firms rate of capital consumption, which was €8bn in 2011. They are producing profits but not forming any new capital.

Yet this cause of the crisis points to its own resolution. A €15bn increase in investment would restore all the output lost in the recession. A larger increase would be required to restore the entire loss of investment. The alternative is to allow firms to continue to hoard capital, with all the consequent damage to the economy, living standards and jobs that entails. At some point in the future they are likely to resume investment even on current trends. But that would required an increase in the profit rate and, with the economy stagnating, that could only arise if living standards and wages are driven even lower.

The importance of the debate on the IMF's 'multipliers'

By Michael Burke

It is unusual for ‘academic’ research published by the IMF to find its way into popular media. But this has happened to the latest World Economic Outlook where the IMF deals briefly with the issue of ‘multipliers’ that is, the economic impact of changes in government spending.

The short article has caused an usually high level of commentary among economists and commentators because the data suggests that the multipliers are perhaps more than double the level generally implied by official research and forecasts. Nobel Laureate Paul Krugman has commented that the research shows that, ‘the reason for the worsening outlook is that policy makers have gotten the basic economics wrong’. In Britain Chris Giles economic editor of the Financial Times has led a counter-attack by questioning the validity of the research. A string of other commentators have joined the debate on both sides, including a Greek finance minister.

The key point in the IMF research is that the multipliers are much higher than previously thought by leading bodies such as the IMF, OECD and others. ‘The main finding, based on data for 28 economies, is that the multipliers used in generating [IMF] growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2….’ Whereas the IMF’s (and others) own forecasts implied a multiplier of 0.5, the actual multipliers may be in the range of 0.9 to 1.7.

It is useful to assess why this seemingly arcane debate has created such controversy and why that is taking place currently.

Importance of the controversy

Because of the division of labour all changes in production have a wider impact on the economy. Increased output of one sector necessarily requires increased inputs either of labour, or of capital, or of production goods or raw materials, or some combination of all factors. This is not necessarily true of changes in incomes (which might be saved) or even expenditure (which might be met from existing stocks).

There can be no single multiplier effect. The size of the impact of changes in government spending must depend on firstly on the type of change in government spending. At the same time, even where an increase or decrease in government spending has a very large impact in terms of altering output in other sectors, the impact is not infinite. The size of the impact is itself constrained by the existing capacity of the economy. Therefore the largest multiplier effect can be found where government spending requires the greatest degree of inputs from other sectors (that is, where the division of labour is at its highest level) and which increases the productive capacity of the economy as a whole.

As a result, the overwhelmingly majority of research finds that the greatest multiplier is attached to direct increases in government investment. These are usually held to be much higher than inducements to private sector investment (which may simply be saved and from which profits must be deducted). They are also higher than the multipliers attached to consumption (which does not increase the productive capacity of the economy).

In Table 1 below the Office for Budget Responsibility’s (OBR) own estimates of the different multipliers are set out. These were first published in June 2010 and have not been altered. They are characteristic of thinking among most policymakers.

Table 1


The OBR has not altered these estimates even though in its latest publication its estimates show GDP will have grown by 3.6 per cent over 3 years compared to their forecast of 7.8 per cent. In addition, the OBR concedes that an assumed average multiplier of 1.3 would fully explain the shortfall in growth compared to its own forecasts. 1.3 is in the middle of the IMF’s 0.9 to 1.7 range.

It is the insistence on unchanged estimates of the multipliers which is most significant, rather than the OBR’s own very poor forecasting record. In particular there is virtually a religious Golden Rule in (semi-) official literature which places the upper limit on all multipliers at 1. A multiplier lower than 1 implies that GDP will be reduced by less than the total change in government spending. Implicitly, the private sector will always respond in the opposite direction, increasing its spending when government reduces its spending, and vice versa.

This is the crux to the whole debate on multipliers. If government spending ‘crowds out’ private spending then it should be avoided as detrimental to total economic activity. At the same time, it is claimed that ‘austerity’ measures will not prove damaging as they will be offset by increased private sector activity. This false logic explains why the OBR forecast a 20.3% rise in business in the last two years while the actual increase has been 2.5%.

It is also extremely rare that the literature acknowledges the multi-year impact of the multipliers. Very little private investment achieves its return within 12 month. The same is true of government investment. The full yield on investment in transport takes place over the life of the railway or bridge, investment in education is returned over the working life of the pupil, and so on.

Essentially, the insistence on 1 as the ceiling for fiscal multipliers and confining them to a single year is to minimise the role of the state in the economy and its capacity to determine the trajectory for the economy as a whole, in both directions.

Timing of the controversy

This is not the first time IMF research has estimated the multipliers at very high levels. Daniel Leigh, one of the co-authors of the latest piece has previously written in a chapter of the IMF World Economic Outlook (‘Will it Hurt?’) that the 5-year multiplier of a cut in government investment when interest rates are close to zero and main trading partners are also cutting is 6.

This finding was almost exactly mirrored in an IMF Working Paper (‘Effects of Fiscal Stimulus in Structural Models’ ) which used its own econometric model and those of six other institutions including the OECD, the US Federal Reserve Bank, the EU Commission, and others. The key finding was that the 5-year impact of an increase in government investment has a multiplier of 5 or more.

Since the latest IMF research is shorter, no more prominent and modestly focuses on 1-year outcomes compared to previously published research, the unusual controversy it has generated must be due to other factors. Almost simultaneously, writing in the Financial Times, ex-US Treasury Secretary and current Harvard Professor Larry Summers highlighted ‘deep differences of opinion.....between the ‘orthodox view’ [which supports austerity]....and the ‘demand support view’ [which pushes for steps o increase demand in the short run]’ (‘The world is stuck in a vicious cycle’).

The deep split within mainstream economics and the controversy over the IMF research are associated with the same trends. Countries which have adopted the ‘orthodox view’ have generally experienced sharp slowdowns and renewed deterioration in government finances. Other countries, such as the US and Germany, which have ‘supported demand’ have experienced mild but slowing recoveries. In the US this has required the maintenance of large budget deficits. While the latter policy has clearly been more effective in restoring growth it is not sustainable over the medium-term. There is little official enthusiasm in either Germany or the US for further measures to support demand. In effect both ‘austerity’ and ‘demand support’ are running out of road.

Across the OECD government spending rose during the crisis in 2009 and 2010. But this was already being reversed by 2011. Belgium, Denmark, Greece and Slovenia were the only counties where total government spending rose as a proportion of GDP in 2011. In every other OECD economy where it was recorded, government spending fell, as was the case in the OECD as a whole. Despite government investment producing the biggest impact on the economy, all the OECD economies cut investment in 2011. The solitary exception was Denmark, where government investment rose fractionally.

The well-known efficacy of increased government investment has not prevented it from being cut in all the major economies. SEB has previously shown that the cut in government investment entirely accounts for the latest recession in Britain. Evidently, even though government investment would restore growth or even improve government finances it cannot be countenanced as it would interfere with the prerogatives of the private sector.

Conclusion

The debate on the size of the multipliers is effectively debate about the role of the state in determining economic activity. The official literature tends to minimise both the scope and the timescale of the impact of changes in government spending. The latest controversy arises because in their different ways both ‘austerity’ and ‘demand-support’ policies are failing.

The alternative is government-led investment. But this has been cut in all the major OECD economies in order to facilitate an increase in the profits of the private sector. The opposite policy is required, one which increases government investment in order to boost growth, jobs and the productive capacity of the economy.

Lloyds Bank Can Fund Investment

By Michael Burke

A number of media reports suggest there is a dispute between the management of Lloyds Bank and its regulators at the Bank of England and the Financial Services Authority (FSA). The dispute centres on Lloyds’ estimated profits, which one set of City analysts forecasts will be £800 million. Management wants to use the profits to pay out dividends to shareholders. The regulators argue that prospective losses at the bank in future years mean that the profits should be retained, and used to bolster the bank’s capital.

Lloyds Bank is 43% owned by the state following the bail-out in 2009. In common with all deposit taking banks operating in Britain, it can only function because of government guarantees. It also benefits from liquidity provision and Quantitative Easing. Without these Lloyds Bank would collapse. The government is also the major shareholder and therefore has the capacity to determine the policies of the bank.

The attempted payout to shareholders is not the first instance in which bailed out Lloyds has used taxpayers’ funds to benefit either capital or the rich. Over the 3 years to 2011 Lloyds has paid out £1.385 billion in bonuses. It made a big fanfare of clawing back just £2 million in bonuses to former executives.

SEB has previously shown that the driving force behind the recession is the refusal of firms to invest. Capital is being hoarded rather than invested. Non-financial corporations alone currently have £391 billion on deposit at banks that report to the Bank of England. Retaining capital for prudential reasons is clearly preferable to wasting it on shareholders who have little inclination to invest and will simply increase those deposits. But Lloyds Bank adding to the cash hoard and then waiting for its existing loan books to deteriorate under the impact of the economic slump is hardly much preferable.

Instead, new investment would provide a return on investment for state-owned Lloyds and so reduce the risk of another bailout. The regulators could insist that profits cannot be used for either bonuses or shareholder dividends. An instruction from the government as the major shareholder to invest the profits in productive investment, say housing, high-speed broadband or rail would have a number of positive effects. It would boost economic growth and provide jobs. The effect of that would be to reduce the government deficit, without a penny of increased government borrowing.

The new recession is directly made in Downing Street

By Michael Burke

The final release for UK GDP in the 2^nd quarter of 2012 showed a small upward revision to recorded growth. But this still showed a contraction of 0.4% of GDP for a third consecutive decline. Real GDP is now 1% below the level recorded in the 3^rd quarter of 2011.

Previously SEB has shown that the driving force behind the recession has been the decline in investment (Gross Fixed Capital Formation, GFCF). That remains the case. In aggregate real GDP has declined by £60bn since the peak level of activity in 2008. Investment has contracted by £50bn.

Only the decline in household consumption comes close to making such a negative impact on GDP, falling by £42bn. In contrast the other main categories of GDP have risen. Government current spending has risen by £13bn while net exports have risen by £14bn. The latter is overwhelmingly due to the slump in import demand as exports have risen by less than £3bn over the period. GDP and its main components are shown in Chart 1 below.

Chart 1

The private sector was the source of this decline in investment, as the Labour Budget of 2009/2010 temporarily increased public investment. The incoming Coalition immediately brought that to a halt. What is now striking is that the decline in investment is now led by the contraction in public investment. In fact the whole of the ‘double-dip recession’ of three consecutive quarters of falling GDP is accounted for by the sharp fall in public investment.

This is shown in chart 2 below. This is the same format as the previous chart but it covers the time period from when the Coalition came into office. In addition it separates the two sources of investment, public and private. The data for these are taken from Schedule F of the latest  quarterly national accounts.

Chart 2

Over the period of the Tory led-coalition’s time in office the economy has contracted by £5.6bn. But the main driving force is no longer the investment strike of the private sector. It is the sharp contraction in public investment which has fallen by £11.2bn, almost twice the fall in GDP. Private investment has actually increased by £4bn over the same period.

It is noteworthy that household spending has also fallen by an amount greater than the fall in GDP, down by £8.6bn and reflects the effects of ‘austerity’, the cuts in welfare and other payments, the public sector wage freeze and the decline in real wages because of high inflation. Off-setting these to some extent have been the rise in government current spending and the increase in net exports.

In a very direct sense the latest contraction in the British economy is a function of government policy.

It is a recession made in Downing Street.

Improving Yields and Destroying the Environment

By Michael Burke

A short but very interesting item was recently broadcast on Radio 4’s Today programme. A recording of the programme can be replayed here where a summary is also available.

The report highlighted a disaster in the production of corn, wheat and soya beans in the US. This was not because of the widespread recent drought, but an additional man-made disaster which may have longer-lasting impact.

In effect, large US farmers have been encouraged to adopt genetically modified strains of the seed varieties for these different crops. The specific form of GM was resistance to extremely powerful weedkiller, which was then used exhaustively.

But giant ragweeds have developed resistance to that weedkiller just as many campaigners had suggested. Now 2,4-D a new chemical will be deployed that last saw widespread use in the rice fields and jungles of South-East Asia as part of Agent Orange. Formerly, it had been used as in Vietnam part of the campaign to destroy foliage and crops. Now, it will be used in the US to destroy all vegetable life including weeds, except for the seeds once more genetically modified to withstand it.

It seems almost incredible, but the response of vast agrichemical companies like Dow and Monsanto is to develop even more highly resistant seed strains. At the same time, at US insistence, consumers are not allowed to know whether they are purchasing goods made of GM products.

This intensification of both the efforts to increase yields at all costs and the hoodwinking and fraud perpetrated on consumers are likely to intensify in the current crisis. The crisis is characterised by a slump in investment. In effect, firms stop investing when they cannot be sure of making a profit. As a result, measures to increase productivity and schemes that amount to reckless fraud or endangerment (of consumers or the environment) are likely to increase in an effort to increase profits.

Marx put it this way, “If the rate of profit falls, on the one hand we see exertions by capital, in that the individual capitalist drives down the individual value of his own particular commodities below their average social value, by using better methods, etc, and thus makes a surplus profit at the given price; on the other hand we have swindling and general promotion of swindling, through desperate attempts in the way of new methods of production, new capital investment and new adventures, to secure some kind of extra profit, which will be independent of the general average and superior to it”.

Mass unemployment and lower pay are key consequences of the current refusal to invest, but so too are the growth in reckless schemes involving swindling and environmental depredation.