David McWilliams has stirred up the long grass and has a few leg bites as a result. This is from irisheconomy.ie which should be required reading for politicians.

More on sectoral financial balances

This post was written by Alan Matthews

David McWilliams discusses the Irish version of the ‘Gavyn Davies’ sector financial balances graph in the Irish Independent today. He makes two points. The first is to highlight the restoration of the foreign sector balance in recent years, which he interprets as meaning that, absent the banking crisis, the government would not have needed to seek EU/IMF funding given the availability of sufficient domestic savings to fund the government deficit.

His second point is that the chart shows that austerity will not work because, if the private sector keeps saving, then either the government deficit remains high (as a result of a further contraction of the economy) or there is a build up in the current account surplus on the balance of payments, which he also sees as undesirable because it means that “we will export capital to the rest of the world for them to use, while projects in Ireland are starved of capital”.

While the first point may be true in the sense that the state would not have faced the downgrade on its sovereign debt in the absence of the banking crisis, I think the second conclusion is wrong.

To help the discussion, I reproduce the chart here which I had earlier created in a comment on Brendan Walsh’s post below. Two caveats are in order. First, although in principle the financial balances are equal to the net borrowing or lending of each sector as shown in the institutional non-financial accounts, there is a sizeable discrepancy due to errors and omissions. More important, these figures only show the flow of funds for any year, and need to be complemented by the balance sheet figures showing the stock of financial assets and liabilities held by each sector if we are to assess these flows correctly.

The stock figures (not shown here) show how private sector debt increased in an unsustainable fashion and that the private sector now needs to deleverage, i.e. to reduce its liabilities relative to its income. The government is currently unable to borrow because of the size of the bank liablities, but even if this constraint were not there there are dangers in allowing the public debt to build up with the consequent knock-on debt service costs. So if the government deficit is to be reduced given high private savings without causing a further serious contraction in the economy, we need the foreign sector balance to take up the slack. In other words, given the various objectives which macro policy must keep in mind, exporting more to pay off our foreign creditors is the least painful way of resolving the various dilemmas that now face the Irish economy.

This entry was posted on Wednesday, December 29th, 2010 at 8:32 am and is filed under Economic PerformanceFiscal Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, ortrackback from your own site.

  1. Brendan Walsh Says:
    December 29th, 2010 at 9:04 amAlan
    David McWilliams’ second point is, of course, daft and you are right to correct him.
    As far as I can see from the online version of the Indo there is no acknowledgement of the source of his erudite analysis.
  2. Paul Hunt Says:
    December 29th, 2010 at 9:44 am@Alan Matthews,

    Your effort to counter the fantasy of the ‘crock of gold at the end of the rainbow that will solve all our problems’ is indeed welcome. But I fear you may be preaching to the converted on this board. And, as I am sure you are well aware, adversarial rebuttal of patent nonsense is not generally given sufficient houseroom or currency on this island of saints and scholars.

  3. Alan Matthews Says:
    December 29th, 2010 at 9:48 am@Brendan
    David had asked me if he might use the figure so there was no problem with that.
  4. Rory O’Farrell Says:
    December 29th, 2010 at 10:34 amI don’t think his second point is completely daft, though I don’t see how it follows from the graph.

    There are some infrastructural investments the government could do that would improve our ability to export, like fixing the water pipes. This would help sustain industry (which needs water) boosting exports and reduce imports of San Pellegrino. Also, as a percentage of GDP these imbalances would be smaller due to a growing economy. Of course, this line of reasoning has little to do with the graph.

  1. Alan Matthews Says:
    December 29th, 2010 at 2:50 pm@JR, BW
    The CSO institutional accounts show the gross accumulation of financial assets as well as the gross assumption of liabilities by each sector, so you can check how the change in the private sector net financial balance is derived (the CSO Excel spreadsheet is here http://www.cso.ie/releasespublications/documents/economy/2009/isafin2008-2009.xls).

    However, while these trends may be interesting in themselves, they are not relevant to interpreting the financial balances graph, which is based on the identify that the sum of the three balances (private, government and foreign) must equal zero. It is this zero constraint which, together with some assumption about causality, makes the graph a potentially useful way to interpret and project the economy. If there is a private sector surplus (however derived), then this must be reflected in either a government deficit or a current account + capital transfers surplus. Of course, the graph tells us nothing about the level of GDP at which this identity is reached. Its really a consistency check in thinking about how the economy might evolve in future.

  1. Michael Hennigan – Finfacts Says:
    December 29th, 2010 at 4:28 pmDavid McWilliams

    Do you want a financial equivalent of the Famine, where a country with plenty of money collapses for want of credit? Do you want a situation where we export our young, educated people rather than spend money we have here on investing in them?

    David McWilliams appears to appeal to both the desperate unemployed and the privileged who have been guaranteed security of employment by the State despite the benefits they have compared with most private sector workers. With the limitations of space, ‘cost’-free choices are presented and the solutions are usually set out without any downsides.

    Journalists are usually ill-equipped to challenge the claims.

    In Oct, Japan was the second biggest holder of US Treasuries at $877.4bn compared with China’s $906.8bn and Ireland’s $41.4bn.

    Japan has a gross public debt of over 200% of GDP and as with Ireland, it just can’t conveniently seize private cash holdings. US companies have $1.8trn in cash or cash equivalents on their balance sheets which could help Uncle Sam.

    Overseas residents hold more deposits in Irish banks than domestic residents and the crock of gold which McWilliams sees is in the control of the likes of Pfizer, Microsoft and Google and is used for lending to other foreign affiliates.

    As for the household savings rate, it dipped to 3.9% of disposable income in 2007, the year of the SSIA maturities and recovered to 12.3% in 2009, according to the CSO. McWilliams says the savings rate is more than 16%.

    In Jan 2007, The New York Times reported that Irish consumer spending in Ireland was less than 50% of gross domestic product, low by European standards, according to Dan McLaughlin, chief economist at Bank of Ireland. According to the Central Statistics Office, the country had a household savings rate of 11.9% of income in 2003, compared with 2.1% in the United States and 11.1% in France.

    Part of the increase in the rate in 2009 reflects the dip in disposable income but it did remain above the 2007 level of €87bn.

    McWilliams refers to “a wild swing of 21% of GDP in less than two years” using his savings rate figures; “such a swing is unprecedented in the western world and mirrors exactly what happened in Japan in the 1990s.”

    However, the facts show that the current savings rate is back to an Irish and European norm.

    The chart also tells us that austerity will not work, because if the private sector keeps saving, austerity will only lead to less and less spending in total, which will cause the budget targets to be missed — as happened in Japan — and public debt will rise unnecessarily.

    So there is no need for ECB or the IMF support; all we need do is seize funds held at the IFSC!

    The devil can cite Scripture for his purpose and Irish data in particular needs interpretation.

    Irish households remain among the wealthiest in the European Union; Ireland’s stock of direct investment overseas is valued at €190bn. The stock of FDI assets here in Ireland is at €170bn.

    The Irish side of the equation is impressive on paper, like much else when it comes to international-related data.

JohnTheOptimist Says:
December 29th, 2010 at 8:16 pm

As usual, Brian Woods II is spot-on in all his comments about the significance of the balance-of-payments surplus, and in his statement that all these points were being made by himself, myself, and economists like John Fitzgerald, many months ago. It is high time that he was promoted to Brian Woods I. I won’t make the points that I was going to make when I logged on, as I’d just be repeating what Brian Woods II has said. So, I’ll make another point.

Contrary to most media commentary, the move into balance-of-payments surplus is occurring primarily because of a large increase in exports, rather than a fall in imports. Imports are running about 5 per cent higher in volume in 2010 than in 2009. However, exports are running about 10 per cent higher in volume in 2010 than in 2009. This is on top of exports having held up remarkably well in 2008 and 2009, falling by only 2 to 3 per cent, compared with 20 to 25 per cent in most EU countries. In addiition, the trend is accelerating. It looks as though exports will be about 15 per higher in volume in the second half of 2010 than in the second half of 2009. In other words, we are now in a full-scale export boom.

The question needs to be asked. Why did our official economic forecasters fail to predict this and does it matter that they failed to predict it? In September 2009, the Department of Finance and the Central Bank were both forecasting that Ireland’s exports would fall by around 2 per cent in 2010. Even by budget day in December 2009, the Stability Programme (link below), published by the Department of Finance, contained the following statement:

“There is likely to be a lag between global recovery and an improved export performance in Ireland, given the deterioration in competitiveness. This suggests that export growth will be a modest 0.4 per cent next year.”


So, even as late as December 2009, the Department of Finance was predicting that exports would only rise by 0.4 per cent in volume in 2010, a year in which global trade was forecast to rise by about 20 times that amount, implying a large fall in market share. Even this was an upward revision from its forecast a few months earlier of a 2 per cent fall. There is a saying in the IT world: ‘garbage-in, garbage-out’. Clearly, their forecast of a miserly 0.4 per cent growth in exports in 2010 was ‘garbage-out’. I’d suggest that greatly exaggerated claims of loss of competitiveness’ was the ‘garbage-in’.

I am not being wise after the event. I posted repeatedly on this site at the time (so much so that a prominent academic economist called me a pollyanna) that these pessimistic forecasts for export growth in 2010 were nonsense. I argued that the supposed loss of competitiveness was greatly exaggerated. I predicted on this site in December 2009 that exports would rise by approximately 8 to 10 per cent in volume in 2010. Even my ‘pollyanna’ forecast now looks like it was too pessimistic. The only prominent media economist that I am aware of, who also argued that the ‘loss of competitiveness’ was being exaggerated by other economists, and who forecast a large increase in exports in 2010, was Ronnie O’Toole. He did so several times on this very site. He has now been triumphantly vindicated. In contrast, in early 2010, McWilliams was repeatedly writing in his media columns that exports were collapsing and that only a withdrawal from the Euro and a massive devaluation of around 30 per cent could save them.

Does any of this matter? Yes, of course it does. Investors read these forecasts and conclude that a Euro exit and massive devaluation are more than probable. The Department of Finance forecast implied a very large fall in Ireland’s market share of exports. McWilliams’ forecast implied a total collapse in Ireland’s market share of exports. In these circumstances, why shouldn’t investors conclude that a Euro exit and massive devaluation are more than probable, and demand an interest rate premium as insurance? Which is exactly what happened.

The Department of Finance and the Central Bank should both apologise for their poor and damaging forecasts, while McWilliams should be held up to ridicule for being the publicity-seeking clown that he is, which I am glad