Not really Taylored to suit

Setting interest rates involves a balancing act between "price stability" and "economic growth". In an influential 1993 paper "Discretion Versus Policy Rules in Practice" Stanford professor John Taylor proposed the following rule for setting the central bank interest rate:

Interest Rate = Inflation + 2.0 + 0.5 (Inflation − 2.0)

+ 0.5 (GDP gap).

The interest rate is the policy rate set by the monetary authority or central bank. Inflation is a measure of domestic price changes and the GDP gap is the percentage by which real GDP deviates from an estimate of its natural level.

According to this rule, the policy interest rate equals 4 percent when inflation is 2 percent and GDP is at its natural level. The first constant of 2 percent in the equation can be interpreted as an estimate of the natural rate of interest, and the second constant of 2 percent subtracted from inflation can be interpreted as the inflation target.

For each percentage point that inflation rises above 2 percent, the interest rate rises by 0.5 percent. For each percentage point that real GDP rises above its natural level, the rate rises by 0.5 percent. If inflation falls below 2 percent or GDP moves below its natural level, the interest rate falls accordingly.

In 1999 Ireland handed control of our monetary policy to the ECB meaning that our interest rate is set in Frankfurt rather than Dublin. What would we see if we compare the eurozone interest rate as set by the ECB to the predicted rate of the Taylor rule if we applied it to crude Irish data for the past decade?

In the following graph inflation is measured using the Harmonised Index of Consumer Prices (HICP) as used by the ECB and the GDP gap is measured as the difference between the Non Accelerating Inflation Rate of Unemployment (NAIRU) as produced by the OCED and the actual unemployment rate. All data are quarterly.

The result is pretty clear. For the last ten years interest rates have been too low in Ireland. The predicted rate from the Taylor rule has been an average of three and a half percent higher than the rate applied by the ECB. The rule suggests that rates should never have been set below four percent and that during the "peak" of the boom they could have been as high as 12 percent. The interest rates set by the ECB were too low and no doubt contributed to the overheating of the economy and in particular the property sector.

It is also interesting to note that the Taylor rule suggests that the appropriate interest rate using the current figures is negative three and a half percent. In fact if we take the medium term forecasts produced by the ESRI that suggest HICP inflation of negative one percent and unemployment of 17 percent for 2009 then the interest rate suggested by the Taylor rule is around negative 10 percent!

In the absence of monetary autonomy can we substitute one of the remaining policy instruments in our control? A General Government Deficit (GGD) of 12% of GDP would seem to fit but our huge deficit is a result of excessive expenditure funded by the now departed construction boom rather than a planned attempt to counter the economic downturn.

The GGD is now a policy target rather than an instrument. Thinking back to 1979 suggests that this is deja vu all over again! What odds on three general elections in the next 24 months?

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Presentation on Irish Economy

Business Planning Seminar

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Health Care Systems

Here's a quick run through the Dutch system which is getting some strong airplay in Ireland at the moment. (Mainly in English but with some segments in Dutch that have difficult to read subtitles.)



Here's a bit on the Singapore system which should be getting more coverage. (All in English!)





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This looks familiar

Consider the following as the foundation for economic turnaround

• low corporate and income taxes
• highly educated and skilled workforce
• low wages
• macroeconomic stability
• excellent infrastructure
• free trade access to European markets

Should we tell them how it's going for us now? Tweet

Not a Budget to savour but we'll save for the next one

Tuesday's budget from Minister Brian Lenihan was definately not a budget for people to savour. The problem is whether it will become a budget that will further lead people to save for the rainy day. It seems in Ireland that we are going to try and tax and save our way out of the recession.

For 2008 the Central Bank reports (Note to Central Bank: your website is appalling!) that there was an increase in precautionary savings of about 2.5% of household disposable income. Along with changes in the labour market this accounts for the substantial drop in retail sales we have seen recently.

In January 2008 Irish households had €26.6 billion saved in accounts with a maturity of less than 2 years. By January 2009 the amount saved in these accounts had risen by almost €10 billion to €36.3 billion. That is €10 billion that might have been spent and added to the circular flow had times being better. What the government wouldn't give for the multiplier effects and their share of that €10 billion had it been spent on consumer goods and services.

It is also worth noting that in April of last year there was €125 billion outstanding in residential mortgages. The most recent figures for February put this at €115 billion. This reduction in debt is a form of savings and that's another €10 billion taken out of the economy. Of course the key driver of this financial indicator is the impact of new mortgage balances. The creation of new mortgages has ground to a standstill so the drop in this number need not necessarily suggest increased rates of repayment but again it is an indication of consumer slow down.

It is likely that continued deterioration in the labour market will lead to further increases in precauationary savings. This is one of the features of a recession that just at a time when we want households to spend more they actually save more.

The Budget is also likely to increase uncertainty and in turn peoples' urge to save rather than spend. Spending will naturally be reduced following the increases in the income levies and PRSI and the reductions in mortgage interest relief and the early childcare supplement. The full year effect of the tax measures introduced is estimated to raise an additional €3.6 billion. Remember that in two years tax revenue has fallen from €47 billion to just over €30 billion. This budget narrowed about 25% of that fall. There's still 75% to go!

Obviously the gap can also be narrowed by expenditure cuts. However the Minister only announced full years cuts amounting t0 €1.2 billion. The government predicts that this year current expenditure will come in at €46.3 billion. It should be noted that current expenditure in 2008 was €44.7 billion. So even with the announced "cuts" the government is increasing expenditure rather than reducing it.

The government is indicating that order can be restored to the public finances through tax increases rather than expenditure cuts. Over the next two years they have indicated they will be seeking to raise an additional €4.6 billion in taxes while cutting current expenditure by €3 billion. The government is clearly of the view (optimistic opinion?) that an upturn in the global and domestic economies will bring back the bouyancy in tax revenues that will allow it to solve the crisis in the public finance without any actual reform of the problems that got us into this mess in the first place.

It is likely that people who live in the real economy will not be as confident. People are likely to save more as they fear the additional pain that is coming down the track. This will be because of continuing deterioation in labour market conditions and also what they see the government planning over the next few years. In the Budget the Minister announced that the next Budget day we will see the following:

• the complete abolition of the early childcare supplement
• the taxation (or means testing) of child benefit
• the introduction of a carbon tax
• the introduction of a form of property tax

These are is to be considered along with likely additional increases in income and consumption taxes. To prepare for this people are going to further cut their expenditure and try to increase their savings. This is only going to add to the government's woes as more money is stowed away and economic activity (retails sales, jobs and tax revenue) will continue tracking downward. All that we will be increasing are our savings as the forecast for the rainy day just got a whole lot gloomier.

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