The Causes of the Irish Depression

Economic consultant and formerly chief international economist with Citibank in London

The latest Organisation for Economic Cooperation and Development (OECD) predictions for the Irish economy are for zero Gross Domestic Product (GDP) growth in 2011. This would mark a fourth consecutive year of recession. It is widely accepted that the GDP data themselves are inflated-multinationals, many of whom have little or no economic activity here, book profits and sales in this jurisdiction simply to avail of the ultra-low corporate tax rate of 12.5 per cent, the lowest in the OECD. Taking the measure of domestic economic activity, OECD forecasts show that, aside from net exports, the economy will contract again in both 2011 and 2012.

Usually, economists reserve the term ‘depression’ for a total economic contraction of 20 per cent or more. In terms of total domestic demand (the spending of individuals, government, and businesses) the economy is already in a depression, and the OECD forecasts that the real decline in total domestic demand will be over 26 per cent by 2012.

This is an Irish depression. It is possible that it is the most severe economic crisis in the history of the state.

Explanations of the Crisis

Both the Fianna Fáil and Fine Gael-Labour governments have set out to severely curb the spending of the public sector. A glance at any of the leading newspapers or other media demonstrates that there is an overwhelming consensus that public spending must be cut. Implicitly, and often explicitly, an unsustainable level of public spending is held to be the cause of the current crisis.

That this nonsense has such traction in the public debate tells us more about the society in which that debate is being conducted than about the economy itself. Prior to the crisis, the level of public spending was 36.7 per cent of GDP in 2007, nearly 10 percentage points lower than the euro area average of 46 per cent.1

To understand the Irish crisis, it is necessary to identify the specific combination of those global features that apply to the Irish economy and society.

It is frequently argued that this is a false measure of spending as it includes the inflated export sector. Like so much of the debate, this assumes the Irish economy is unique in having a sizeable trade surplus. This is not correct. If we adjust for the Gross National Product (GNP) measure, Irish public spending was 40.6 per cent in 2007. But other countries, such as Germany and the Netherlands, also have sizeable external sectors. On the GNP measure, their public spending in 2007 was 47.1 per cent and 50 per cent respectively. Neither feels constrained to take the axe to public services in the way that has been done by successive Dublin governments.

Outside of government and the supporters of ‘austerity’ measures, the principal explanation of the crisis finds its origins in the huge losses of the private banks that have now been socialised by the Dublin government. Alongside this, there is the flow of cheap money from Europe, widespread greed, lack of regulation, and a system of cronyism and corruption (principally by Fianna Fáil and the developers). One of the more lucid exponents of this argument is Fintan O’Toole.

While all of these undoubtedly occurred and are part of the story, none of them are new, and, excepting different names for some of the principal actors, none of them are unique to this society. The crisis was a global one. To understand the Irish crisis, it is necessary to identify the specific combination of those global features that apply to the Irish economy and society.

Chicken or Egg?

The explanation of the global crisis is not dissimilar to the homegrown one for the slump in Ireland. That is, under-regulated banks got out of control, lending to people who could not afford to repay and repackaging the loans for those who did not understand. When this game came to an end, they stopped lending and caused the Great Recession.

There is, too, a left variant of this argument, which is that the cause of the bank lending frenzy was ‘financialisation,’ that is, the dominance of financial capital, which has turned all commodities into financial instruments because capital is unable to identify sufficiently profitable investments in non-financial, productive capacity. The leading exponents of this view are the French Marxists Dumenil and Levy.

It was the fall in profits and the decline in investment that followed that produced falling asset prices.

Again, while many of these symptoms are correctly identified, they do not amount to an explanation of the crisis. Why did the crisis of the banking system become a crisis of the economy, when other agencies, including governments, can mobilise huge resources? More profoundly, what caused the banks’ game of pass the parcel of derivative instruments to come to an end? Who, or what, called time on the party?

The ability of a bank to lend is dependent on its net assets. If an asset (say, a bundle of mortgage-backed loans) purchased for $100 million is now worth $99 million, then the bank will curtail its lending because its asset base is depleted. If the asset is now worth $90 million and it has net assets of less than $10 million, then the bank will be insolvent. On a vastly larger scale, this is what happened to Lehman Brothers, Anglo Irish Bank, and the rest.

But the loans themselves did not go bad. Mortgage defaults have risen only during and after the economic crisis, not before the financial crash. Instead, it was the value of the financial assets that fell. This is because investment in them and their counterparts in the real economy, such as construction, dried up. The reason that investment declined was because profits were falling, as no sensible business will increase investment while profits are falling.

It was the fall in profits and the decline in investment that followed that produced falling asset prices. Falling asset prices led to the banking collapse. But this was only the most spectacular, because most vulnerable, portion of capitalism, which was in a generalised profits and investment-driven crisis.

Finance and Investment

There is an official explanation for the financial aspect of the crisis from the St. Louis Federal Reserve Bank in the US. It has an entire website devoted to the topic: ‘The Financial Crisis – A Timeline of Events and Policy Actions.’ It states that the crisis began on 27 February 2007 when the Federal Home Loan Corporation (Freddie Mac) announced that it would no longer buy the most risky sub-prime mortgages and mortgage-related securities. Lehman Brothers filed for bankruptcy along the way on 15 September 2008, by which time most of the major economies had already gone into recession from early 2008.

The construction sector in the real economy was already in trouble long before the crisis became apparent in the financial sector.

But, why did Freddie Mac stop investing in financial assets in early 2007? — because real investment in the construction sector was already falling. In 2006, US real investment in construction fell by 1.7 per cent, having slowed to a halt in 2005. That is, the construction sector in the real economy was already in trouble long before the crisis became apparent in the financial sector.

Investment is determined by the anticipated rate of return – if it falls, investment will contract. But the rate of return is not determined by the sale price alone. According to the US Census Bureau, the median price of new homes in 2006 was $235,000, up from $222,000 in 2005.

Instead, economists from Adam Smith onwards have recognised the fact that there is an inherent instability within capitalism, which is that at the level of the economy as a whole an increase in investment tends to decrease the profits. ‘The increase of stock, which raises wages, tends to lower profits,’ Smith says in The Wealth of Nations. Quite pointlessly, some of the most severe criticism of Marx arises from his identification of the law of the tendency of the profit rate to fall, even though less precise formulations were commonplace to all classical economists. It is only the modern ‘neo-classical’ economists who have substituted observation and analysis with blind faith in the equilibrium of the markets.

Falling Profits

The rate of return is a ratio. To assess the rate of return (or profit rate) it is necessary first to take the sale price minus the cost price of inputs to establish the profit level, and then to divide that by the level of capital employed. For the economy as a whole, the required data are the level of capital employed and the level of profits.

The level of capital employed can be gauged from the capital stock. However, in mainstream economics what is reported as the profit rate is actually the profit margin, the ratio of sale price to input costs. Instead, it is necessary to use a proxy for profits, which is the gross operating surplus. Since all value is created by labour (Smith, again, prefiguring Marx) then profits are primarily the surplus of the gross value added minus labour costs, which is represented by gross operating surplus (GOS). GOS only approximates to profits, however, because it also includes the self-employed income of the plumber, dentist, barrister, and so on. However, since the composition of GOS is unaltered over time, it provides a reasonable proxy for the trend in the level of profits.

If we take the US economy, data from the US Bureau of Economic Analysis shows that the capital stock was $28.485 trillion in 2000 while the GOS was $3.576 trillion, giving a profit rate of 12.6 per cent. In 2007, the capital stock had risen to $45.541 trillion, but the GOS had risen to only $5.138 trillion-the profit rate had therefore fallen to 11.3 per cent.

Turning to the specific features of the global crisis in Ireland, the tendency of the profit rate to fall provides the key to unlocking the Irish crisis.

While construction spending was the first category of investment to decline, total US real investment fell by 1.4 per cent in 2007. In fact, the total level of profits had stagnated in 2007, unchanged from 2006. From the perspective of profit maximisation, there was no reason to increase investment in 2007.

The Irish Crisis

Turning to the specific features of the global crisis in Ireland, the tendency of the profit rate to fall provides the key to unlocking the Irish crisis. In 2000, the stock of capital in this economy was €221.3 billion according to Central Statistics Office data, while the GOS was €51.4 billion according to the OECD. This approximates to a profit rate of 23.3 per cent, which was a considerably higher profit rate than available at that time in the US. This arose from a number of factors, not least of which being the activities of the US multinationals previously mentioned. In addition, the taxation of corporations is very much lower in this jurisdiction, an infamously low tax rate of 12.5 per cent, compared to 30 per cent for the US. Finally, the Irish economy is also a highly exploitative one, in which nearly 50 per cent of gross value added is claimed by capital – this is common across the crisis-hit countries (in the EU, only Greece has a higher rate of exploitation).

The capital stock rose to €482.7 billion in 2007, while the GOS rose to €87.3 billion, giving an approximate profit rate of 18.1 per cent. This decline in the profit rate in the Irish economy is shown in the chart below.

[Source: CSO, OECD, author’s calculations]

The upturn in the profit rate in 2009 (which belies any idea that the economy is ‘broke’) was a function of a number of factors. In the first instance, the stock of capital was depleted, both through the consumption of capital and through its scrapping as firms went bankrupt. The capital stock fell by 4.2 per cent in 2008 and by 12.5 per cent in 2009. Secondly, wages were reduced sharply, OECD figures showing that the compensation of employees fell by 8.4 per cent in 2009.

This is the classic recipe to restore profitability: disinvestment and a reduction in wages. In the modern era, the other ingredients are low taxes for corporations and privatisations. Irish taxes cannot go much lower, so the specific features have been disinvestment and an attack on wages (including the social wage). Privatisations will follow.

It is repeatedly claimed that the aim of government and now EU-IMF policy is to reduce the public sector deficit. In that light, the policy has been a failure, even on its own terms. When the recession began in 2008, the public sector deficit amounted to 7.3 per cent of GDP. Now, after six different ‘fiscal adjustment’ packages, Eurostat forecast the deficit will be 10.5 per cent of GDP in 2011. However, if the actual purpose of policy is to restore the profit rate, then policy must be counted as a partial but significant success.

The Investment Strike

Across the OECD, the decline in investment (gross fixed capital formation) accounts for 99 per cent of the total loss in output during the recession. In the Irish economy, investment has fallen throughout the recession and is now €27.6 billion lower than prior to the recession. Since GDP has fallen by €27.7 billion, the entire slump is driven by the collapse in investment. Although other categories have also fallen, notably personal consumption (minus €10.8 billion), this has been offset by other factors, notably rising net exports.

In the Irish economy, investment has fallen throughout the recession and is now €27.6 billion lower than prior to the recession.

Therefore, the private sector’s investment strike is responsible for the Irish depression. In fact, the decline in gross fixed capital formation began a year earlier than the recession itself and has fallen by 65 per cent or €32.5 billion, far in excess of the total decline in output. There can be no possibility of a sustained economic recovery without an increase in investment.

One of the abiding myths of the Irish slump is that this is all about construction and that all citizens are culpable for the madness of the real estate boom. The decline in construction investment has certainly led the way in the slump, down 64 per cent in the period 2006 to 2010. But this is a generalised investment strike by capital, as investment in equipment has fallen by 46 per cent. This has been abetted and reinforced by the decline in government investment, down 29 per cent from 2008 to 2010.

The Deficit

In any market economy, part of the normal functioning of the different sectors of society is that private individuals save some portion of their income. Via the mediation of the banks, these savings are the basis of investment by the corporate sector. Ignoring for the time being the overseas sector as a source of savings, the government can aim for a surplus or deficit on the public sector accounts through the combination of taxation and spending policies it adopts. However, this usual pattern breaks down when the corporate sector no longer is a net borrower but is a net saver, when it refuses to invest. As the personal sector remains a net saver, one sector of the economy must become a net borrower. The Irish corporate sector is a net saver, running down its stock of capital and refusing to invest, even though profits have not just stabilised but are rising once more. In fact, this is a key factor in most recessions in the majority of countries over time: the falling rate of profit leads to an investment strike.

One of the abiding myths of the Irish slump is that this is all about construction and that all citizens are culpable for the madness of the real estate boom.

As a result, the government has no option but to run a deficit – not all sectors of the economy can simultaneously be savers; one, at least, must be a borrower. Raising taxes on individuals (VAT hikes, pension levies, etc.) and cutting the pay of the public sector constitute an attempt to seize a portion of their incomes so as to reduce their savings and increase those of the government. There is no such compulsion on the corporate sector, the actual source of the crisis. (The drive towards an ‘export-led recovery’ is an attempt to increase the claim on the savings of the overseas sector-however, it is being encouraged not by increasing investment but by lowering wages).

The Origins of the Crisis

The features of the Irish crisis examined so far conform to an international pattern that was initiated in the US but affected nearly all the crisis-hit countries in a similar way (with some important exceptions). However, there are two important features of the current crisis that are unique to Ireland.

The first is that only in Ireland has there been a blanket state guarantee to the creditors of the failed banking system. The costs associated with this alone may capsize the state into default. Second, only the Dublin government moved straight to an attack on living standards as a response to the crisis – most other countries did the opposite initially, providing some sort of fiscal stimulus as a means to prevent disaster.

These were unique responses to the crisis, prompted by the weakness of Irish capitalism not its strength. While the economy is a highly exploitative one, this does not and could not compensate for its weakness relative to its international competitors – there are literally only a handful of Irish companies that compete internationally. IBEC’s claim that wages need to fall for reasons of competitiveness are a grim irony, since most IBEC members have never received an export order in their existence.

Ireland is a unique economy, so much so that the bulk of this article has been referring to only 80 per cent of it, leaving aside the 20 per cent that remains a colony of Britain. The singular response of the Dublin governments to the crisis is related to that fact and the post-colonial settlement that still pertains on the southern side of the border.

While the economy is a highly exploitative one, this does not and could not compensate for its weakness relative to its international competitors – there are literally only a handful of Irish companies that compete internationally.

Instead of initiating a thorough reorganisation of society after achieving partial independence in order to advance the interests of its population, the state has been dominated throughout its short history by a class that sees its role more as representing the interests of foreign capital and its local allies. This began with large farmers who produced for the British market. More recently, when this class tried to strike out on its own, it has been as speculators in banking and property, with capital borrowed from abroad that they can no longer repay and is now being tied around the neck of the rest of the population. Correctly speaking, it is a comprador bourgeoisie.

Technically, resolving the debt crisis involves the simple matter of retransferring those debts back to their private, speculative source. Resolving the economic crisis is equally simple at a technical level: rather than seizing the incomes of ordinary workers and the poor (which undermines the economy still further), the state could seize the idle capital of the corporations and break the investment strike. But, in order to do that, the citizens of the whole island would come up against a series of entrenched forces that derive their authority from the partition settlement.

Notes

1 All data, unless otherwise stated, from European Commission, Directorate General for Economic and Financial Affairs, European Economic Forecast, spring 2011, (see the Statistical Annex), available at http://ec.europa.eu/economy_finance/eu/forecasts/2011_spring_forecast_en.htm.



CURRENT ISSUE

The Citizen, Issue 4
September 2011

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