[article]Beware of Khrushchev's shoe -Irish economy

Maskhadov

Beware of Khrushchev’s shoe
05 March 2006 By David McWilliams

Forty-five years ago, Nikita Khrushchev, premier of the Soviet Union, took off his shoe and banged on the table at the UN General Assembly, boasting to the astounded dignitaries: ‘‘We will bury you.”

He was talking about economics.

Khrushchev was convinced, as was much of the rest of the world, that the Soviet Union would overtake the US, and the west in general. This confidence was based on the fact that, in the 1950s, the USSR had notched up double-digit growth rates and looked on course to overtake the west.

This did not happen. In fact, the USSR slowed down in the 1960s, stagnated in the 1970s and collapsed in the 1980s. Why did this happen?

The most compelling explanation is that the Soviet Union’s growth rates in the 1950s had been an illusion based on mobilising huge resources into the economy.

Peasants, women and German prisoners of war were forced to work in industry for the first time and were paid very low wages. So the Russians had more cheap workers than almost any other country.

This did propel the growth rate, but more by perspiration than inspiration.

When Russia started to run out of peasants, the growth rate started to fall. And, because it did not have the capital or money to reinvest, it could not build sophisticated machines to make the peasant workers more efficient.

By the mid-1980s, 20 years after Khrushchev’s antics, the Soviet empire was falling apart.

In the long term, money and people make economies grow. Combine them and it should do the trick. Some countries, like Germany today, have loads of money but not enough productive people and consequently, its growth rate has fallen.

In contrast, much of the Third World has loads of people and not enough money, with well-known tragic results.

Other countries, such as China and India, may be experiencing something like the USSR’s 1950s experiment, whereby huge swathes of previously idle labour are mobilised with apparently miraculous, but ultimately, illusory results. Time will tell.

What do these tales of growth and its illusions tell us in Ireland? They help us to understand why we sometimes get carried away with ourselves, talking about miracles, new paradigms and the like. In contrast, to the ‘new’ theories, there is usually a perfectly logical explanation for economic developments.

For example, in Ireland we are experiencing something like the Khrushchev illusion in reverse. Whereas Khrushchev was fooled by the masses, we are fooled by the money, particularly other people’s money.

The reason the economy is growing strongly, tax revenues are so buoyant, unemployment so low and house prices so high is because we are mobilising so much credit.

We are throwing money at the economy at a rate not seen in any other developed country in the past 40 years. Like the mobilised Russian peasants, the sheer volume of cash is tricking us into thinking that we are experiencing something permanent or, worse still, miraculous.

Let’s examine the figures. Private sector credit, which is how much we are all borrowing, stood at €240 billion at the end of 2005.Our total GDP was €135 billion. This means that borrowings are now running at 180 per cent of our income.

So for every €100 we earn, we are borrowing €180.This is the highest level in the world and, as it is growing at 30 per cent per annum (or about €55 billion), it is also growing the fastest.

Think about this for a moment. Borrowing will grow by €55 billion this year.

That figure is 42 per cent of our total national income. There is no historical precedent for this type of borrowing anywhere in the world at any stage in economic history. Ireland is truly in uncharted territory.

Now let’s project forward a year or two.

Given the level of borrowing, the incentive on the part of the banks to lend more and more and the maturing of the Special Savings Incentive Accounts (SSIAs), which will embolden borrowers further, it’s not unreasonable to suggest that total borrowing could rise to €80 billion for 2007.

This would bring the overall stock of debt in the economy to between €380 billion and €400 billion or something like 230 per cent of GDP. This implies that every 1 per cent increase in interest rates will cost us 2 per cent of GDP in extra servicing.

Which brings us nicely along to last week’s increase in the monthly cost of your mortgage, the second in a matter of months. Is this the last? Is it the second of many? Are we entering a new epoch of higher interest rates around the world?

In Europe, the feeling in financial markets is that rates will rise, but not by much.

In the US, there is a fear that it will ultimately have to raise interest rates if it is to continue to finance its large trade deficit.

For the first time in two decades, Japanese interest rates are on the way up.

Taken together, it is fair to say that the era of low interest rates that has prevailed since the early 1990s is over. It might not be followed by a dramatic spike in the cost of borrowing, but let’s just say that your monthly repayments will not be going down from here.

So where does this leave us? The debt figures convey financial delinquency on a monumental scale, but, more worrying than that is the fact that probably about 80 per cent of all debt is borrowed for the construction sector. The construction sector acts as an amplifier of the initial credit throughout the economy.

By pushing up house prices, credit actually makes us feel richer, so we borrow and spend more. At least 20 per cent of this cash ends up with the government in the form of indirect taxes, so it spends more, amplifying the impact further.

Over 30 per cent of the price of a new house also ends up in government hands.

This process is called the ‘multiplier’ in textbook economics, and it explains the ramifications of an initial injection of cash into the system. As the construction sector employs a quarter of a million people, its boom is also a boom in wages and spending from this sector.

Logically, if there is a slowdown in borrowing - which is likely when a 1 per cent increase in interest rates causes a countrywide increase in servicing charges equivalent to 2 per cent of GDP - then house prices will also fall.

Any downturn in the construction sector from where we are now would have negative multiplier effects throughout the economy, which would be much more widespread in scope than just the sector itself. This process is called ‘negative contagion’, which is precisely the opposite of today’s situation. In negative contagion, the banks pull in their horns and nothing gets financed.

Now, let’s get back to Khrushchevian mirages. Is our growth rate the Irish equivalent of the USSR’s ‘miracle’ of the 1950s? Well, the major difference is that the Soviets threw cheap people at the economy, resulting in enviable, but short-lived, growth rates.

Today, we are throwing money at the economy: an increase in borrowing equal to 42 per cent of GDP this year achieved for us a growth rate of under 10 per cent.

Obviously, we are not spending our money well.

Of course, the workforce has expanded rapidly but, as the Economic and Social Research Institute pointed out last year, we are now using many more people and much more credit to generate much smaller increases in GDP than was the case a few years ago.

In short, we are reaching the Khrushchevian tipping point where the economic numbers are playing tricks on us.

Next time you hear someone boast of the great performance of the Irish economy, think of Nikita, his shoe, the UN, his dramatic fall from grace and his last days spent in forced exile.

www.davidmcwilliams.ie



http://www.thepost.ie/post/pages/p/wholestory.aspx-qqqt=DAVID%20MACWILLAMS-qqqs=commentandanalysis-qqqsectionid=3-qqqc=5.2.0.0-qqqn=1-qqqx=1.asp

So what does everyon think about the amount of credit in the irish economy. Personally I think it could all end in tears if we dont put an end to rising house prices. The rosey reports given on the irish economy couldnt well be based on a house of cards.

One thing Mc Williams didnt point out though. The Royal Dutch navy set sail to the far east on a massive amount of debt, money that the Netherlands simply didnt have. They didnt have a reserve and the whole thing was based on stock exchange and official I.O.Y (I owe you) documents.

At the time the amount of money taken out was astronomical and most Dutch people couldnt actually get their head around the large numbers. The Netherlands got on just fine with the increase in trade that they did and the same may be the case for Ireland.

Captain Trips

It's not so much I think there will be a collapse or something, but Ireland's double-digit property inflation rates and so on are like any other place - like Japan even.

It's not that Ireland is rich, it's that there is an easy line of credit that wasn't there 30 years ago. That is why previously banks loaned smaller multiples of salaries, but these days much more.

Furthermore, like the using of the cheap labour in the soviet era to boost productivity, it is like the emergence of the female in Ireland as a worker. So the emplyment numbers went way up as women went to college, etc., .

However, as that generation settles a abit, as in, the people from the start of the boom aged early 20s in the late 1990s, now deciding to say have one person at home or try to keep working to support an overpriced life, we will see the balancing out.

What cracks me up about people is that they think property prices will go up forever. I suppose they do in Bizarro World. If the banks stop doling out cash to anybody (e.g., 100% mortgages - good way to encourage people to stay in Ireland and not emigrate, eh?), then the property prices will readjuts downwards as it's all dependent on people having access to large credit.

So as we see the ECB rates continue up, the mortgages look bigger, people will afford less.

DublinWriter

Good ol' Davey boy and his analagies.

How about "McWilliams' Hair"? Just like the Irish economy, it looks initially strong and shiney, but is it's really quite floppy, requires a lot of conditioner, and will eventually disappear.

redspider

I agree with David's main point that a lot of the Irish economy is based on credit. (The reasons for the collapse of the CCCP are more complex than what he's stated). I've been pointing it out for a while now as the credit figures just keep growing. It doesnt take an economist to show that the country is borrowing more than it can afford to pay, it is a bet on the future being as good as things are now with the same dynamics at play, low interest rates (ie: cheap money), bouyant inward investment (Damien Kiberd has an article in today's Sunday Times), the multi-national company effect, and cheap labour-source supply (eastern EU europeans, multitudes of Chinese "language" "students"), etc.

The problem with economies like ours is that a lot is based on confidence and the country is small. Therefore, people are willing to go crazy and invest in buy-to-lets, etc, and the place has gone property mad, a limited resource. We are borrowing like mad, not only on so-called asset-backed borrowings, but for expenditure like cars, holidays, etc, and we are building like crazy. This is a frenzy.

However, for the people involved in this they do not see it as a problem and times seem good. However, we all cant be property owners (home) and buy-to-letters (ie: renting), as that in effect is a bit like a pyramid scheme. ie: where its ok to buy something as we know that someone else will be there to buy it later for more and it will make money guaranteed (in real terms). That situation just cant go on forever.

But when will it stop is anybody's guess and how it will stop is another guess. It could slow gradually. But as you know there is a sort of blind craziness out there at the moment in terms of property. This is a nationwide gold rush. In fact Jan 2006 was the biggest borrowing month EVER !

In terms of the Dutch economy, are you referring to the south sea island shares bubble and all that? This did not end happily as many lost their shirts and houses in that bubble. The Dutch economy made a lot of money on natural resources (spices) which is a bit like the Oil-rich countries of today doing well, such as Saudi. However, it squandered some of that richness on bubbles, such as the south sea island one and the tulip bubble. The latter was where (I think David McWilliams may have even written a piece on it at one point) where the country went Tulip mad and fortunes were won (and more lost at the end) as the price collapsed. The tulip price in 1600 and something or 1700 and something or whenever it was has NOT recovered to those heighty levels since, even in nominal terms, never mind in real terms.

Economies are difficult to measure, organise, plan for, etc, and take on a mind of their own. Many countries have gone through booms and busts, and we are now going through a boom, and a large one at that, much of it driven on property speculation, flipping, etc, which is dangerous, as the actual cost of building a house in 2006 takes appoximately the same number of man-months as it did in 1986 and probably in 1966! If anything, houses themselves are being more efficiently built and basic introductory economics will tell you that the houses part themselves should be coming down in price. The land (which no-one is making any more apart from the the UAE and Hong Kong -the Dutch used to - hey, anyone want to start a polder somewhere in Ireland?) is of course going up in price as more money is chasing a limited supply which there is in certain areas, but even in Ireland there are 1000's of acres not being used. Ireland if anything has a surplus of land for its population. eg: Singapore has 3.5m people in an area half the size of Dublin county!

It took the Japanese decades to get over their 1980's property bubble and they are still suffering. They had to go through with things such as 100 year mortgages, much smaller housing units, Granny's, parents, and children living in the same house, etc.

Time will tell what we do, but at least we always have a safety valve in the Irish economy, as we can imigrate to US, UK, Australia, Europe, etc.

Of course the government could intervene in all this with a strong policy that would distribute growth in certain areas, create new towns, ensure a balance in growth, because at the moment, with everything Dublin, Dublin, Dublin we are createing a Tokyo effect. That one ended in tears, big time.

redspider

Maskhadov

I was on about the Dutch in the 1600's and middle ages heading off to the Far East. Borrowing isnt necessarily a problem as long as you know you can repay it. Our economy is ultimately pegged to the US economy and if it goes belly up the whole world will. Very unlikely.

The other key point is that instead of all this money being government borrowing its individual borrowing so its unlikely that everyone in the country will default on the debt at the same time.

The biggest problem I have with house prices in this country is the amount of green space there currently is in Dublin (just take a look on Google Maps/Earth). Its incredible. Also the amount of Semi- D's you see in Dublin is another scandal. No wonder there is a shortage of property.

Until the government start tackling things from this angle we will continue to face sky high costs. The only other thing that could possiblily help the economy is unified with the north. It would help ease demand and reduce house prices.

Captain Trips

Maskhadov wrote:

I was on about the Dutch in the 1600's and middle ages heading off to the Far East. Borrowing isnt necessarily a problem as long as you know you can repay it. Our economy is ultimately pegged to the US economy and if it goes belly up the whole world will. Very unlikely.

Nonsense.

Ireland's major export trading partners: UK 28.5%, US 13.9%, Germany 7.5%, China 5.7%

Ireland's major import trading partners: US 19.7%, UK 16.0%, Belgium 14.7%, Germany 7.7%


US is one factor of many, as we are in a totally different situation than 40 years ago. Back then, the dominance of the US didn't do us much good, did it? However, we have had steady increases in standard of living and quality of life and reduced emigration since our trading partners went beyond the US.

The other key point is that instead of all this money being government borrowing its individual borrowing so its unlikely that everyone in the country will default on the debt at the same time.

No, more money is being borrowed by developers and the like. You could afford an extra 200 a month on your mortgage because it's your home, but the multimillion euro developments are based on profit percentages at the sales, and the banks are loaning ****loads of cash to them, just like Japan in the 1980s.

Until the government start tackling things from this angle we will continue to face sky high costs. The only other thing that could possiblily help the economy is unified with the north. It would help ease demand and reduce house prices.

But they have been, and have been given large tax incentives to developers and we will end up with apartments for everybody and their pet cat. I would think unifying with the north would be catastrophic as we have benefitted from moving away from the Anglosaxon countries immensely, and it would be suicide to go back that way.

Maskhadov

I was on about all those US multinationals in Ireland. The whole IT economy is built around them.

There was an article in either the indo or irish times today saying that the irish economy could continue to invest in infastructure, health, pensions and still wipe its national debt to zero in the next 10 years. Mixed signals but personal debt is still better than national debt.

I agree about moving away from the inferior anglo saxon model.

ronbyrne2005

Maskhadov wrote:

Mixed signals but personal debt is still better than national debt.

the government can borrow at a much lower rate than the public can so i dont see a problem raising national debt for productive purposes or for short term tax cuts and other fiscal stimulis if theres an economic slowdown.

Peace

Maskhadov wrote:

The biggest problem I have with house prices in this country is the amount of green space there currently is in Dublin (just take a look on Google Maps/Earth). Its incredible. Also the amount of Semi- D's you see in Dublin is another scandal. No wonder there is a shortage of property.

Until the government start tackling things from this angle we will continue to face sky high costs. The only other thing that could possiblily help the economy is unified with the north. It would help ease demand and reduce house prices.

Seriously, is dublin the only place in Ireland we can build houses?

Maskhadov

Peace wrote:

Seriously, is dublin the only place in Ireland we can build houses?

Going by the amount of low rise and green areas - thats a no.

Government failure to introduce compulsory orders to buy up large areas of Semi-D's and have the private sector re development them into medium densisty and in some appropriate locations HIGH QUALITY high density is one of the biggest reasons why house prices are riduclously high in the capital.

It could well reck the economy.

Victor

davidmcwilliams.ie wrote:

Let’s examine the figures. Private sector credit, which is how much we are all borrowing, stood at €240 billion at the end of 2005.Our total GDP was €135 billion. This means that borrowings are now running at 180 per cent of our income.

So for every €100 we earn, we are borrowing €180.This is the highest level in the world and, as it is growing at 30 per cent per annum (or about €55 billion), it is also growing the fastest.

He's mixing his numbers here. For every €100 we earn, we have total borrowings of €180, not that we are borrowing €180 per year or per €100 earned.