Thursday, January 3, 2019

“Living away beyond our means”

The concept of an economy living beyond its means does not have a uniform definition.  However, there are outturns in the national accounts that can reflect it.  Once such event is when Net National Saving turns negative.

Net National Saving is a measure which shows the difference between national income and the amount necessary to fund current expenditure on consumption and the investment needed just to maintain the capital stock. This is spending that does not bring long-term living standard benefits and is primarily to maintain living standards as they are now.

[There are a number of things that could be considered exceptions to this, one of which is current expenditure on education.  Although counted as consumption of goods and services it could be argued that this current expenditure leads to long-term benefits but for our purposes here we will treat it as current spending as we are looking to see whether we can afford it – the main cost being included being teacher salaries which is government consumption.] 

If national income is not sufficient to fund consumption of goods and services and cover depreciation of the capital stock an economy could be said to be living beyond its means.  There have been two instances in the past 50 years when this has happened in Ireland: 1980-81 and 2009-2012 (n.b. the series break in 1995).

Net National Savings 1970-2017

In both instances significant adjustment was required.  The differing pace of that adjustment can be seen through the improvement in the net national saving ratio after coming out of negative territory; gradual and prolonged in the 1980s; steep and rapid in the recent instance.  Net National Savings was the starting point for a recent presentation I gave on Ireland’s national income (slides, text).

Should we be looking at Net National Saving as a sign of macroeconomic imbalances? No. By the time this particular canary has fallen off its perch the damage has been done.  Ireland’s problems were in train well before Net National Saving turned negative in both 1980 and 2009.  Net National Saving might be useful if you want to go on television to talk about “living away beyond our means” but a red flag is needed to try and help prevent things getting as far as that in the first place.

That red flag might be the current account of the balance of payments.

BoP Current Account 1970-2017

It can be seen that the two instances of Net National Saving turning negative (the shaded regions) were preceded by significant deteriorations of the current account of the balance of payments.  Prior to the 1980 the current account deteriorated from a relatively small deficit of 1.6 per cent of Gross National Income in 1975 to a deficit of 6.4 per cent of GNI in 1978 and to one of 12.2 per cent in 1979. 

Before 2009, the modified current account deteriorated from a surplus of around 1 per cent of modified gross national income in 2003 to a deficit of 5.0 per cent of GNI* in 2006 and further again to a deficit of 7.5 per cent of GNI* in 2008.

Net National Saving doesn’t signal the problem as imbalances are building up because the unsustainable income isn’t picked up by it until the tide goes out.  As long as some sector can inject the money into the circular flow it will appear as income in the national accounts.  Credit can be the source of this injection.  The government did the borrowing in the late 1970s with the private sector doing so in the run-up to 2008.  And the spending driven by this increase in debt showed up in the deterioration of the current account – or at least it does now.

One major issue with the current account in the run up to 2008 was that the scale of the deterioration was not fully identified at the time.  Here are the first estimates of the changes in the current account from the publication archive and the latest estimates for 2000 to 2008:

BoP Current 2000-2008 First Estimate versus Latest

There are likely a range of measurement and methodological reasons for the differences but it can be clearly seen that from 2004 to 2007 the latest estimate shows significantly larger deteriorations than the real time data.  And if we look back at the first full-year estimates for 2006 published in March 2007, which did show a current account deficit, but the first sentence of the release points to the “continuing the trend of reducing deficits during 2006.”

When it comes to assessing imbalances both measurement and interpretation matter.  There are plenty of reasons why the CSO’s modified current account balance is important.  It looks fine at the moment with a surplus of just over 1 per cent of GNI* showing for 2017.

But it is not the be all and end all.  For example, there would be no red flag from the current account if the unsustainable income that makes net national saving appear comfortably positive also shows up current account of the balance of payments.  Corporation Tax receipts from US MNCs could fit that bill. The link between CT receipts and the current account is something we may come back to but, for the moment at least, the scale of the potential imbalances seem much smaller than those of the late 1970s and mid-2000s.

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