Sunday, September 26, 2010

Iceland and Ireland: economic comparisons

I must admit that I enjoy reading the economic columns of David McWilliams. Whereas I do not generally agree with him with respect to the fine detail implications of his proposals, he invariably however manages to make interesting suggestions assisting valuable reflection.

In this morning’s Sunday Business Post article, he addresses the present situation in Iceland, where apparently interest rates on long term bonds have now fallen below corresponding recent – and still rising – rates in Ireland.

And given that a short time ago Iceland was looked on as the undisputed financial basket case of Europe, this indeed is a disturbing revelation.

One has to admire the resilience of the Icelanders in dealing with their problems. Though they did require IMF assistance, they refused to bail out their banks with the losses therefore falling on depositors and lenders (rather than as in Ireland on the shareholders). Also in allowing depreciation of their currency, they have thereby managed to substantially reduce costs giving them a more competitive edge in trade.
Probably most importantly – as McWilliams emphasises – they have based their revival on the success of locally traded goods and services. So rather than relying on the rest of the World, the Icelanders are looking firstly to themselves to resolve their issues.

McWilliams – perhaps unsurprisingly – then uses Iceland as a blueprint for what we should be doing. In particular he believes that we should transfer the mounting costs of our bank debts (especially in Anglo Irish) on to the bondholders and then concentrate on increasing domestic trade as the prime means of achieving economic recovery.

However what McWilliams’s article fails to address is the fact that the Irish economy in many ways differs from that of Iceland.

Though geographically we are both islands of roughly the same size on the periphery of Europe, the Icelandic economy is much smaller than that of Ireland being less than 1/10th the size. Therefore though relatively their banking debts were greater per head of population than in Ireland they have less impact on the overall international financial system.

Secondly, not alone is Iceland not a member of the Eurozone, it is not even a member of the EU. In fact their present status is pretty much akin to that of Ireland at the time of the 2nd World War. Because of the isolationist stance then pursued by Fianna Fail under DeValera, Ireland was able to come through that period without any great damage to its economy. However since those times, there has been a fundamental change in policy direction. So from an economy that looked decidedly inwards we are now one of the most open in the world.

So when one looks at the percentage of the total value of exports in Ireland (relative to GDP) it comes to about 90% (with the corresponding percentage of imports only slightly less).

What McWilliams does not also relate is the uncomfortable fact that over 90% of the value of our current exports in goods and services is directly related to the activities of the multinational companies that have invested here in Ireland (mostly from the US).
So unfortunately the big difference in this regard from that of Iceland is that we do not at present have a sufficiently viable domestic economy with which to spark recovery!

Whereas the Icelanders can rely on their fishing industry, the tourism sector and the enormous potential of geo-thermal activity for producing energy, the fact is that we are deeply dependent on the multinational sector. Indeed the one bright recent indicator here amidst all of the doom and gloom has related to the buoyancy of exports (which again highlights the importance of the multinationals).

Likewise McWilliams ignores the important fact – that unlike Iceland – we are members of the Eurozone. What this means in effect is that we simply do not have the luxury of making fully independent decisions as economic policy in Ireland ultimately has a bearing on the potential viability of the Euro.

Therefore the most important reality regarding our present situation is the extent to which we have mortgaged our economic independence to the whims of international sentiment both in Europe and elsewhere.

I would agree however with McWilliams that recovery will ultimately come from domestic – and not international – initiatives. However in the meantime we have an extremely uncomfortable transition period where we will have to rely on the international community (and be held hostage in many ways to its transient opinions) while gradually trying to wean ourselves from such dependence.

There are other examples which McWilliams might have quoted – but which would not have suited his argument – regarding the best approach here in Ireland in the short run.

For example Latvia is suffering an even greater economic meltdown than Ireland in in recent years with the origins of its problems very similar i.e. an enormous property bubble. However though having a separate currency, they did not use devaluation of the lats to attempt a recovery. Rather it resorted to a much more dramatic form of internal devaluation than we have attempted in Ireland. So for example in the public sector, salaries have been cut by up to 30% with welfare payments also suffering.
So in dramatically cutting costs, it is hoping to significantly improve competitiveness and use this as the main means of economic recovery. Also in showing such discipline at a time of acute crisis with respect to the value of its currency, it is attempting to quickly attain membership of the Euro (which it would see as affording greater protection in any future crisis).

So in the examples of Iceland and Latvia we see two separate accounts of how small countries in Europe are attempting to deal with a severe economic crisis.

And what explains this difference is the nature of the two economies in question!

Iceland for its part sees itself as largely self sufficient and therefore entitled to follow a go-it-alone strategy. However Latvia by contrast has a high level of interdependence with neighbouring Baltic and Scandinavian economies and sees its future in cementing ever closer ties with the EU.

When we look at Ireland these problems of interdependence with Europe and the Euro currency are further complicated by a massive reliance on US foreign investment.

So the go-it alone strategy that presently suits Iceland would seem particularly inappropriate at this time.

I would of course agree with McWilliams that we need to greatly increase self reliance which is the best long-term solution. However this will not be achieved overnight.
What is obvious to me during recent debates is the extent that we are in denial regarding the need to reduce costs (which presently on average are way in excess of the EU average). So whatever way you look at it addressing this issue in the short-term will inevitably mean significant internal deflation and a big drop in general living standards.

A large part of the present lack of confidence on the bond markets is due to the fact that investors doubt whether we have the appetite to apply the necessary painful measures.
Though this problem has been greatly aggravated by rising bank debts and an uncertain political climate, a firm commitment on all sides to follow through with the necessary competitive adjustment (possibly with both EU and IMF assistance) would eventually reassure the markets.

And here is another point that McWilliams glides over. Whereas in certain circumstances the cancellation of debt obligations can swiftly aid economic recovery, a long term price could also apply. So if the same economy that previously cancelled debts was to get into further difficulty bond holders would have greater reason to fear for their investments thus raising interest rates.
On the contrary if a country has a reputation for always attempting to honour debts (despite domestic problems) this would cause less risk for bondholders thus lowering interest rates in the long-term.
However having said this the performance of the Government - especially in recent months - has been unsure and hesitant which has only compounded the growing fears of the markets. Thus it is becoming increasingly difficult to convince them of our ability to properly manage the crisis.

Now there are wider issues about the very viability of the Euro for small economies in Europe, and on this score I would share many of the same opinions as McWilliams.

Unfortunately in the short-term we have to work within that system and achieve a compromise as between what is presently workable in terms of our own interests and that of the wider Eurozone. This leads to a range of possible policy choices all of which are uncertain as to their effects. Which of these might prove the best option is not obvious; all are likely to be very painful!

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