Wednesday, April 20, 2011

A “Demand-Side Recession”

This has been some criticism recently of the revised elements in the Memorandum of Understanding which forms the basis of the EU/IMF deal.  The details can be read from this DoF statement.  One frequent criticism levelled against the programme is that it offers “supply-side” solutions to what is a “demand-side” problem.  This is most visible if we consider the elements included under the heading ‘structural reforms’.

Structural Reforms

Product and Labour Market Reforms

  • We are adopting policies to lower costs in sheltered sectors, thus boosting purchasing power and underpinning further competitiveness gains.
  • The Government is due to consider a potential programme of asset disposals based on the Programme for Government and the Review Group on State Assets and Liabilities. The Government will discuss its plans with the European Commission, the IMF and the ECB when it has finalised its response to the Review.
  • We are committed to create conditions conducive to job creation through the Jobs Initiative, which will be announced in May.
  • The reversal of the cut in the minimum wage will be reversed with the effect on business costs being offset by a reduction in employers' PRSI.
  • The review of the EROs/REAs and other measures to increase competition in sheltered sectors of the economy (these measures are not conditional on each other but are part of a comprehensive package designed to make work pay and improve the competitiveness of the economy).

No other structural reforms are listed.  Here is a thoughtful post on some of these changes from UL’s Stephen Kinsella - Will cutting GP and lawyer fees help Ireland?  I too would have concerns about the effectiveness of this list and would largely agree with the conclusion.

The core issues are not supply-side rigidities such as expensive lawyers and doctors and overpaid low-skilled workers. The core issue is the collapse in domestic demand.

Ireland's problem is demand deficiency caused by a collapse in asset prices, expansion in debt, and a fiscal imbalance caused by improper taxation policies during the boom.

Supply-side measures, while useful, won't solve, or even buttress, the problems of our economy, because they aren't the cause of the problem. We should remember this when listening to prognostications from our well meaning EU colleagues.

Although there is a “demand deficiency” I am not sure that demand-side solutions will necessarily work.  If we look at the contribution of the domestic and traded sectors to overall GDP growth we can see the domestic demand story stacks up.

Contributions to Real GDP Growth1

It is pretty obvious that the domestic economy that has been the source of the collapse with falls in ten of the past 12 quarters.  On the other hand net exports has made a positive contribution to growth in eight of the 12 quarters.

As we have done before we can break the fall in domestic demand into it’s constituent parts of consumption, investment and government expenditure.

Contributions to Real GDP Growth

Although a negative pull of consumption is seen up to Q1 2009 for the past two years two factors have dominated the growth rates.  Net exports has made a positive contribution to growth and investment has made the dominant negative contribution to growth.  Here is the same data presented in a different fashion.

Changes in GDP Components

Private consumption has contributed to the fall in GDP but consumption has been unchanged over the past two years.  In real terms consumption in 2010 was 1.2% lower in 2010 than in was in 2009 (because of price falls the nominal change was –2.5%).  However as a result of the falls that occurred in 2008 and 2009, consumption in 2010 was 9.5% below the level seen in 2007 in real terms (the nominal drop is an eye-watering 12.8%).  There is no doubt that a fall in private consumption has been a key component of the downturn but most of this occurred more than two years ago.

On the other hand investment has been falling continually over the entire period.  Although investment makes up a much smaller proportion of GDP than consumption, it has made a much larger contribution to the collapse of GDP.  Since 2007, consumption in constant prices has fallen from €96 billion to €87 billion.  Over the same time investment in constant prices has fallen from €46 billion to €20 billion.  Consumption has fallen €9 billion.  Investment has fallen €26 billion.

One would expect that the fall in consumption is the result of a fall in income, but as we have seen that is not necessarily the case.

Household Expenditure

In 2009 net household disposable income fell by about 2%.  At the same time, consumption expenditure fell by over four times that rate.  Demand as measured by ability to pay still existed, it was demand as measured by willingness to pay that fell.  We don’t know what happened to disposable income in 2010 but we know that the decline in consumption eased.  The impact of the tax increases in last December’s Budget are likely to further tighten income. 

The above gap was money that was saved and more than likely used to pay down debt.  The savings rate has shot up to near 12%.  It is more probable more accurate to say that we have a “debt problem” rather than a “demand problem”, though the two are obviously related.  Consumption has fallen because the demand has shifted from buying goods and services to paying down debt.  This pattern is likely to continue.

Finally, as we said above, the biggest source of the decline in domestic demand is investment and it is pretty evident that we do not want to go back to the way things were.  Here is what has driven the change in the contribution of investment to GDP growth.

Investment Contributions to Growth

Building houses drove the boom and not building them has driven the recession.  It is likely that investment is undershooting, but the fall in investment from building 90,000 houses a year at the peak is a necessary one.  The fall of this “excess demand” is an adjustment that has to be made.  The task is now to find the replacement.


  1. This is true and is a European objective ala the competitiveness pact however there is some merit to supply side responses to a demand side recession given the constraints on fiscal policy faced by the government. Namely an export driven recovery as the goal capitalising on external demand. In addition it is highly likely that the fiscal multiplier is small or at least less than one rendering our constrained fiscal policy ineffective.

  2. Excellent post Seamus. When you write "Consumption has fallen because the demand has shifted from consumption to paying down debt."

    Do you have a Koo-style balance sheet recession (or some kind of debt-induced lack of sustained growth) in mind?

    If so, Koo's prescription is to keep domestic demand buoyant, almost exactly the opposite of what we're doing here:

  3. Hi Stephen,

    Thanks for the link. That was some presentation. Some serious graphs in there.

    We seen to be hitting a lot of bases of what Koo has described as a "balance sheet recession". Maybe he will add Irish data in an updated version!

    I think it could be illuminating because we are going through a different sort of balance sheet recession than the Japanese one described by Koo. In Ireland it is household balance sheets that are a mess and if 'Exhibit 16' was repeated for Ireland all the action would be in the household and government sectors rather than the corporate sector.

    From 2007 to 2009 the net lending/borrowing position of the household sector has gone from (€16 billion) to €9 billion. This €27 billion reversal has fed through somewhat to consumption but mostly to the collapse in investment.

    Over the same time the net lending/borrowing position of the government has gone from €0 to (€24 billion). The corporate sector has moved from borrowing €1 billion to a surplus is €3 billion.

    This move to deficit in the government sector almost fully offsets the move to surplus in the household sector. It is this move that has kept household disposable income from exhibiting serious falls up to now (tax revenue is down and transfer payments are up).

    Of course, these changes were not very planned and the structure of them may be questioned (and of course some of the money borrowed in 2009 went into Anglo!).

    I'd like to think there was some perfect way of keeping "domestic demand buoyant" but I'm struggling. We're almost entirely dependent on households to generate the demand but for those with money, debt repayment is high on the agenda. The government doesn't really contribute to demand (G is only 17% of GDP) as about half of government expenditure is actually transfer payments. See here.

    Can that government support domestic demand in a way that doesn't see people simply save the money used? That is a question that has exercised us for a long, long time and I'm sure there will be plenty of more economists who will make a career out if it.

    It'd be great to say that fiscal policy can stimulate to economy but nearly two-thirds of government expenditure is giving people money (pay, pensions and transfers). How do we get them to spend it?

    Targetted schemes offer some potential but we have a penchant for universal payments in this country. I think a redesign of universal payments like child benefit, mortgage interest relief and pensions offers some potential and we wouldn't have to spend any extra money. I'm not holding my breath though.

    Capital expenditure is one clear avenue that could be taken, but the low-lying fruit of an "austerity" programme is capital expenditure. The capital budget has been decimated. There is scope here to support domestic demand through capital expenditure and capital spending is the one that actually justifies borrowing!

  4. Quite an interesting blog entry Seamus. I hadn't visited your blog before. I was referred to it by a link on Mr. Kinsella's blog today. All the best. BOH.