Thursday, August 21, 2014

21/8/2014: Capital v Labour Taxes: Time to Scratch that Cabbage Head, Mr. Politico

Ireland, like majority of other small open economies, runs a tax regime that is punitive to highly skilled workers and benign to capital owners. This, as I explain in part here (, spells bad news for wealth distribution. It is simply a tax transfer from one form of capital (human capital) to other forms of capital (financial, IP and physical capital). Still, majority of small economies around the world continue to argue in favour of skinning alive their human capital and subsidising (in either relative or absolute terms) other forms of capital, based on a simple argument: in modern world, financial, IP and technological forms of capital are highly mobile (tax them and they will run for the border, goes the argument), even physical capital is mobile over the long run (tax it and investment will flow somewhere else), while labour is tied to its chair by the chains of visas, work permits etc (tax workers and they have nowhere to go).

Of course, in the real world, labour is mobile and highly skilled labour is highly mobile. That is something our outdated, outsmarted and out-of-touch political classes do not comprehend. But some academics do. Here's an example: Aghion, Philippe and Akcigit, Ufuk and Fernández-Villaverde, Jesús, paper, titled "Optimal Capital Versus Labor Taxation with Innovation-Led Growth" (May 31, 2013. PIER Working Paper No. 13-025. shows that in presence of mobile labour force, capital subsidies are suboptimal from the revenue point off view. And worse, the more innovation-driven is your growth (the more reliant it is on human capital and the more mobile that human capital is), the lower is efficiency of capital supports.

"Chamley (1986) and Judd (1985) showed that, in a standard neoclassical growth model with capital accumulation and infinitely lived agents, either taxing or subsidizing capital cannot be optimal in the steady state. In this paper, we introduce innovation-led growth into the Chamley-Judd framework, using a Schumpeterian growth model where productivity-enhancing innovations result from pro.t-motivated R&D investment."

Enough of mumbo-jumbo. "Our main result is that, for a given required trend of public expenditure, a zero tax/subsidy on capital becomes suboptimal. In particular, the higher the level of public expenditure and the income elasticity of labor supply, the less should capital income be subsidized and the more it should be taxed. Not taxing capital implies that labor must be taxed at a higher rate. This in turn has a detrimental effect on labor supply and therefore on the market size for innovation. At the same time, for a given labor supply, taxing capital also reduces innovation incentives, so that for low levels of public expenditure and/or labor supply elasticity it becomes optimal to subsidize capital income."

Of course, labour supply is even more income elastic when it is related to high quality human capital (that can be marketed internationally), and worse, when it is related to innovation (the one that is sought after by dozens of advanced economies bidding over each other to attract the right talent in).

Now, give it a thought:
* Irish tax system literally destroys returns to human capital through punitive levels of taxation of returns on high skills;
* Irish labour markets are open to migration (including emigration of highly skilled);
* Irish economy competes for high skills with scores of other similar economies; and
* Irish state is subsidising in relative terms returns to physical and financial capital, while our tax codes also subsidise IP returns.

Time to scratch that cabbage head, Mr. Politico?

21/8/2014: G20: Does it matter?

To many analysts and observers, in recent years, G20 has emerged as a broader and more inclusive alternative to the restricted club of advanced super-economies of G7 or G8 (see my earlier note on G8 here:

A new ECB paper by  Lo Duca, Marco and Stracca, Livio, titled "The Effect of G20 Summits on Global Financial Markets" (February 18, 2014, ECB Working Paper No. 1668: acknowledges that "In the wake of the global financial crisis, the G20 has become the most important forum of global governance and cooperation, largely replacing the once powerful G7."

All good so far but the question is: does G20 matter to the financial markets? Do summits and new announcements coming from G20 move the markets? "In this paper we run an event study to test whether G20 meetings at ministerial and Leaders level have had an impact on global financial markets. We focus on the period from 2007 to 2013, looking at equity returns, bond yields and measures of market risk such as implied volatility, skewness and kurtosis. Our main finding is that G20 summits have not had a strong, consistent and durable effect on any of the markets that we consider, suggesting that the information and decision content of G20 summits is of limited relevance for market participants."

Of course, the sample covers primarily the period of the Global Financial Crisis and the Great Recession, so one might think that G20 announcements might be swamped by other, more market-linked news. The problem with this is that during the crises, information - any information - acquires more significant value: (see box-out). So, no, the sample period is not at fault... 

21/8/2014: Consumption of Technology: Revolutions to Evolutions

Neat, although out of date by now, chart showing long-run evolution of consumer utilisation of technology:

Click on image to enlarge...

21/8/2014: Euro Area Construction Sector Activity: H1 2014

Euro area production in construction sector series are out for Q2 2014 (excluding a number of countries) and here is the latest data (you can see press release here:

First, EU28, EA18 compared to UK (non-euro) and Switzerland (non-EU):

Takeaways from the above:

  • The latest euro area index performance (+3.47% y/y) is weak (this is seasonally-adjusted data) and q/q the index has fallen 0.56%. EU28 data is even worse: y/y up 2.90% and q/q it is down 0.57%.
Next: Euro area Big 4:

Again, key takeaways

  • Germany: y/y activity is down 0.33% and q/q it is down massive 5.75%
  • Spanish construction activity posted large 26.01% y/y rise and a q/q increase of 7.04%.
  • French construction activity shrunk 0.78% y/y and was down 0.69% q/q
  • Italy is yet to report Q2 2014 data, but in Q1 2014, country construction activity was down 5.51% y/y and down 2.56% q/q.
Euro 'periphery' remains the weak point of the sector activity in level terms, but improving and outperforming EA18 in growth terms:

Key takeaways:

  • Having noted Spanish and Italian construction sectors performance above, Ireland's Q1 2014 activity was up 7.68% y/y and up 2.10% q/q
  • Greece is a mixed bag: Q1 2014 activity was up 2.66% y/y but down 6.56% q/q
  • Q2 2014 data for Portugal posted an 10.0% decrease in activity y/y and a rise of 0.77% in q/q terms.
Now, to summarise the problem, here is the rate of decline in Q1-Q2 2014 compared to pre-crisis peak:

Key takeaways:

  • All 'peripheral' euro area economies remain deeply below water in terms of their construction sector activity in H1 2014.
  • No euro area  advanced economy has regained pre-crisis levels of activity. 
The above hold even if we replace pre-crisis peak with 2000-2004 quarterly average:

21/8/2014: Shanghai Academic Rankings 2014: Ireland

Earlier this week, I promised to update historical track record of Irish Universities performance in Shanghai Academic Ranking of World Universities. The latest (2014) results are here:

Summary of all Irish Universities rankings by 'neighbourhood':

Top-ranked TCD:

Second best-ranked UCD:

Third best-ranked UCC:

Historical evolution of Irish rankings:

Draw your own conclusions...

21/8/2014: Thomas Piketty: Powerful Questions, Questionable Answers

This is an unedited version of my article for the Village magazine, August-September 2014

Thomas Piketty's "Capital in the Twenty First Century" (Harvard University Press, 2014) has ignited both public and professional debates around economic theory of income and wealth distribution not seen since the days of the Interwar period a century ago when applied Marxism collided with the laissez faire economics.

To give the credit due to the author and his book, this attention is deserved.

Like Marx's opus, Pikkety's volume is sizeable enough to provoke an instantaneous submission of the readers to its perceived academic (meticulously factual and theoretically all-encompassing) virtues. Like "Das Kapital", "Capital in the Twenty First Century" is impenetrable to anyone unequipped with an advanced degree in political economy and understanding of economic theory. Like Marx's tome, Piketty's work is an attempted herald of a New Revolution; the one that, in the end, boils down to exactly the same Revolution that Marx foresaw: the dis-endowed against the endowed. Like Marxist debates of the 1930s, Piketty’s thesis comes at the time of a major upheaval and crisis.

Thus, Piketty's work is destined to stay with us for a long, long time. Looming at the horizon line, its thesis of the coming age of chaos rising from the chain reactions of growing wealth inequality will be fuelling activists' imagination for decades into the future.

Yet, perhaps to the surprise of the majority of non-specialists, the book has, within a month of its publication, faded into the background in the world of economics. The reason for this is the book’s comprehensive ambition at creating a unified theory of future economic development renders it an easy target for criticism, challenge and, ultimately, negation.

Before diving deeper into Piketty's work, let me state three facts.

Firstly, I admire Piketty for his audacity to challenge the orthodoxy of macroeconomics and tackle a broad-ranging set of targets. 99.9 percent of economics literature explores the minutiae of some empirical or theoretical cul-de-sac in a specific sub-division of a sub-field of economics. Piketty falls into the 0.1 percent of economists who pursue the big picture.

Secondly, witness to the vitriol with which Piketty’s book was greeted in the economic policy circles, I have defended his work in the media and on my blog.

Lastly, having read Piketty's academic publications and working papers in the past, I found his book to be inferior to his academic publications. "Capital in the Twenty First Century" is too long and stylistically un-engaging to be worth returning to it in the future.

The last fact means that you should read Piketty's thesis and be aware of his core evidence, as well as the growing evidence of its shortcomings.  The best means for acquiring this information is by reading Piketty's articles and interviews, as well as taking in the debates surrounding his book. But you should not buy "Capital in the Twenty First Century", unless you are endowed with a desperate propensity to impress your image of a couch intellectual onto the receptive minds of your friends and colleagues. In the latter case you should avail of Flann O'Brien's gentlemanly service that can get the tome thumbed, marked and annotated for you with scientifically-sounding marginalia.

Core Theses

Piketty's core thesis is based on what he defines to be the 'fundamental laws' of Capitalism. Both of these laws stem directly from his view that the economic inputs can be grouped into only two categories: capital (something that can be bought and sold, and thus accumulated without a bound) and labour (something that cannot be sold, although it does collect wage returns, and cannot be accumulated without bounds). Incidentally, beyond undergraduate economics, this division remains valid only in the literature pre-dating the 1980s.

Piketty’s First Law states that capital's share of income is a ratio of income from capital (or return to capital times the quantum or stock of capital) divided by the national income (for example, GDP).

As anyone with a basic knowledge of economics would know, this is not a law, but an accounting identity. Furthermore, any undergraduate student of economics would spot a glaring problem with the above definition: it applies to all forms of capital, including the ones that Piketty omits.

This brings us to the first major problem with Piketty's core thesis: capital itself is neither homogeneous, nor yields a deterministic and singular rate of return. Instead, capital takes various forms. There is financial capital - the one to which the rate of return is measured in form of equity returns, bond returns, financial portfolio returns and so on. There is also intellectual capital that can be traded. This generates financial returns to the holders/investors, but also yields productivity gains to its users, including workers. There is human capital - which generates (alongside other inputs into production) returns to labour (wages and performance-related bonuses), but also returns to entrepreneurship, creativity of employees and so on. There is managerial and technological know-how that can be invested in and transferred or sold, albeit imperfectly, in so far as it often attaches to labour and skills.

To measure income share of all of these forms of capital, one simply needs to divide income from the specific form of capital by total income. Ditto for labour's share and for any other input share. This is neither Piketty's discovery, nor a law of Capitalism.

The problem is that in many cases we cannot easily measure returns to the more complex forms of capital. And a further problem is that returns to one form of capital are linked to returns to other forms of capital. A good example here is urban land. Return to this form of capital is strongly determined by the returns to human capital that can be deployed on this land, as well as by know-how and technology that attaches to economic activity that can take place on it.

Piketty's second fundamental law is a theoretical proposition derived from the mainstream macroeconomic theory. The author claims that the ratio of the stock of capital to income will be equal to the ratio of the savings rate to the sum of growth the growth rates in technology and population. Together with the first law this implies that income share of capital equals to the ratio of the product of the return on capital and savings rate to the combined growth rate in technology and population.

Piketty's main thesis is that over time, as growth rates in technology and population fall, capital's share of income will rise resulting is a sharp rise in inequality.

The core corollary of this is Piketty's call for a global tax on capital (or wealth) coupled with a massive rise in the income tax on super-earners. These measures, in his view, can ameliorate the increase in the income share of capital triggered by slower growth.

Mythology of the Piketty’s ‘Laws’

There are numerous and significant problems with Piketty's analysis and even more problems with conjectures he draws out of data.

Although Piketty presents numerous factual arguments describing the rise and fall and the rise again in income and wealth inequalities, his factual arguments are tangential to his theoretical proposition. Per Krusell (Stockholm University) and Tony Smith (Yale University) pointed out that "Piketty’s forecast does not rest primarily on an extrapolation of recent trends that he has uncovered in the data..."

Krussell and Smith go on to show that Piketty’s second 'fundamental law' relies not on data, but on an assumption that the ‘net’ saving rate is constant and positive over time. This means that capital stock rises by an amount that is a constant fraction of national income.

Now, suppose that Piketty is correct. And suppose that the growth rates in population and technological progress fall to near-zero. Piketty’s assumption then implies that ever greater share of economy’s output will have to be used to maintain capital stock. This will crowd out investments in education, health or new technologies. Eventually capital formation will have to consume the entire GDP. This has never been observed in the past and cannot be true in the future.

Now, personally, I do believe we are staring into the prospect of diminished rates of growth in the advanced economies. But I also believe that savings follow growth over the long run, implying that, the gross investment - investment including replacement of capital depreciation and amortisation - is relatively constant as a ratio to national income. At times of structurally slow growth, therefore, savings are also low.

This belief is supported by historical evidence and contradicts Piketty's conjecture. Furthermore, this evidence is supported by data from individual consumers’ behaviour. In cyclical recessions, households do engage in increased savings, known as precautionary savings. But this phenomena is short-lived and does not contribute to increased investment. Over time, slower growth in income equals lower rates of savings.

Piketty’s Tax Fallacy

Aside from the above, Piketty's suggestion that a wealth tax can stem the rise of inequality is illogical.

Wealth taxes tend to decrease the quantity of capital, thus raising the scarcity and the quality of it. The result - higher returns to capital in the long run that will at least in part neuter the wealth tax effects on stock of capital. More scarce goods tend to command higher prices.

The problem with wealth inequality rests with the distortionary nature of taxation, not with tax levels per se.

To see this, take three forms of capital: financial assets, intellectual property and human capital.

Tax rates on financial assets normally run close to zero, due to availability of various off-shore schemes for tax optimisation for those well-off enough to afford legal and financial engineering services required to attain such rates. Each 1 percentage point in return to financial assets held by a wealthy Irish owner attracts a tax of under 10 percent (inclusive of costs of tax optimisation). For the mere mortals, capital gains rates run also well below income tax rates. In Ireland today, the headline rate is 30%. Intellectual property is facing an effectively near-zero tax rate.

Whereby professional or institutional investors in traditional capital collect roughly 85-90 cents on each euro of gains, intellectual property investors collect closer to 90 cents and retail investors pocket around 70 cents. On the other hand, human capital returns are taxed at an upper marginal tax. Thus a professional consultant will collect around 45 cents on each euro returned to her from added investment in education and skills upgrading.

The result of this asymmetric treatment of returns from various forms of capital is that households simply have no surplus income left to invest and accumulate wealth. Instead, wealth accumulates in the hands of those who can afford living off rents and start their lives with inherited capital.

To make things worse, Peketty also calls for raising dramatically upper marginal tax rate - to hit the high earners. This too is directly contradictory to the objectives he claims to pursue.

Upper marginal income tax rate hits those who live off the wealth of the businesses they built and skills they acquired. Capital gains tax hits those who either dispose of the businesses they built or sell capital they accumulated or inherited. Two of these groups of earners are collecting on value added they created. One is collecting on what others created for them. Treating them all with one brush will simply reduce future rates of growth and/or reduce rates of return on non-capital income. In other words, Piketty's income tax policy proposal will lead to higher wealth and income inequality in the long run under his own model.

The solution to this dilemma is not to tax all capital more, but to equalise the rates of taxation on all capital: physical, financial, technological and human. And focus on what Jacob Hacker of Yale University calls 'pre-distribution' of labour income. The latter requires simultaneously addressing three determinants of market wages: education and skills (increasing skills of the low income segments of population), focused enterprise policy (supporting demand for these skills) and improved mobility and efficiency of the labour markets (increasing returns to skills and human capital).

The Economic ‘Bad’ of Inequality

Piketty's work deserves huge credit for bringing to the fore of the economics debate legitimate concerns with inequality. However, here too the book is open to criticism for being based on occasionally thin evidence.

"Capital in the Twenty First Century" is premised on the assumption that wealth inequality is tearing societies apart, leading to violent conflicts and breakdowns of the civic and state institutions. There is very little evidence to support this assertion amongst the advanced economies. Extreme inequality, measured in absolute terms, can be exceptionally dangerous. So much is true. But relative inequality to-date has not been a major flashing point for revolutions whenever such inequality is anchored in some meritocratic foundations for wealth distribution. All of the recent disturbances in the advanced economies have referenced income and wealth inequality if one were to listen to activists involved in these events. But all have been linked to either public policies relating to income and opportunities available to the less well-off groups or to diminished growth rates in the local economies.

More importantly, current research shows that individual perceptions of relative income and wealth inequality strongly depend on which reference group one selects for benchmarking against.

For example, Daniel Sacks, Betsey Stevenson and Justin Wolfers paper "The New Stylized Facts About Income and Subjective Well-Being (published by CESIfo in 2013) find that there is little evidence to support theories of relative income. In simple terms, if you are concerned with inequality, you should focus on increasing the rates of growth in the economy, not depressing the rates of return on capital.

Another study, by Maria Dahlin, Arie Kapteyn and Caroline Tassot, titled "Who are the Joneses?" (CESR, June 2014) shows that individuals are "much more likely to compare their income to the incomes of their family and friends, their coworkers and people their age than to people living in the same street, town, …or in the world." We reference our own wellbeing against wellbeing of those close to us socially. In this case, Piketty's policy prescription should call for taxing rich people with greater familial networks at a higher rate than those with fewer familial ties. Which, of course, is absurd.

The World is Non-Marxian

Perhaps the greatest error in Piketty's logic is the failure to account for other forms of capital – an error exactly identical to that committed by Marx.

I named these forms of capital above in the discussion of Piketty’s two Fundamental Laws. Ricardo Hausmann from Harvard ("Piketty’s Missing Knowhow", Project Syndicate) shows that Piketty's argument completely falls apart at the national accounts level in the case of advanced and emerging economies. Furthermore, his argument dovetails with my view that hiking upper marginal tax rates to combat income and wealth inequality is simply counterproductive.

Piketty's assumption that the rate of return to capital is following a historically constant trend of 4-5 percent per annum is also questionable. Dani Rodrik of Princeton University reminds us that the return to capital is likely to decline if the economy becomes too rich in capital relative to labor and other resources and the rate of innovation slows down. So if innovation were to fall, as Piketty assumes, rate of return to capital is likely to decline in line with diminished economic growth. This decline is going to be further accelerated by the rise in the quantum of capital accumulated prior to the economic slowdown.

Lastly, since capital is non-homogenous, even constant average return can conceal wide variations in returns to various forms of capital. For example: agricultural land vs industrial property, private equity vs listed shares and so on – all command different and over-time varying returns. Imposing a uniform tax on all wealth will raise cost of investing in more productive and less certain (thus 'pricier') capital associated with new technologies and new industries. In turn, this will only reduce mobility of wealth in the society, increasing, not lowering long-run wealth inequality and supporting currently endowed elites at the expense of any challengers.

Truth is, Marxian world of the epic confrontation between labour and capital has been surpassed by reality. Today, we live in a highly complex, more dynamic and less homogenous economy. This does not mean that the burdens of rising income and wealth inequality should be ignored. But it does mean that policy responses to these challenges must be based on more complex, behaviourally and macroeconomically-anchored analysis.

Piketty’s "Capital in the Twenty First Century", spectacularly succeeded in raising to prominence the debate about income and wealth distributions. But it also failed in delivering both the analytical frameworks and policy responses to these twin challenges.

Tax and reallocation measures - whether through aid or charity, force of compulsion or financial repression - are neither sufficient to restore balance between returns to physical capital, technology and human capital, nor conducive to delivering continued growth of human-centric economic systems. Instead, there is a dire need for direct, markets-based repricing of the sources of value added in the society. This repricing must recognise the simple fact of nature: people add value to capital, not the other way around, and people with skills and productive attitudes to work do so more than those without both or either.

There is a need for closing tax incentives that favour physical capital over human capital, and there is a need for rebalancing our tax system to allow for greater rewards to flow to those creating new value in the economy. But there is also a need for the state systems to stop treating workers as captives for tax purposes, whilst capital remains highly mobile and tax efficient.

21/8/2014: Economy in a 'Not me, but maybe you?..' recovery

This is an unedited version of my column for the Village Magazine, June-July 2014 (date of filing: May 24, 2014)

There has been a uniformly singular analysis of the fallout from the European and local elections last week, the leitmotif of which is the view that the voters have vented their frustration and disappointment with the policies the coalition government. Majority of these policies, relate to the economy. Going into elections, candidate after candidate insisted on recounting the successes of the Fine Gael and Labour in reversing the pains of economic crisis: tens of thousands of jobs created, economy stabilised, property markets and investment on the upside and households finally facing into the prospect of tax cuts in the Budget 2015. Save for the contracting pharma sector – suffering from ills of the patent cliff unrelated to Ireland and the Government – things are getting brighter by the minute.

The voters bought none of these claims. Still, the question remains unanswered: has the economic decline been reversed during the years of coalition management?

It is a difficult question to tackle. So let us try and face up to the core facts with a measure of cold statistics.

In very broad terms, the economy can be broken into private consumption, Government consumption, private investment, public investment, and net exports (exports less imports) of goods and services. Everything, excluding net exports, taken together is known as the Final Domestic Demand. Adding to the demand net exports provides for the Gross Domestic Product. Adding to GDP inflows of payments on Irish investments abroad net of outflows of payments on foreign investments in Ireland gives the Gross National Product.

In the economy severely distorted by MNCs tax arbitrage and where foreign companies account for the entire trade surplus (the positive measure of net exports), the Domestic Demand is the measure of economic activity that most accurately measures what takes place in the country. It excludes the pharma sector and the ICT services exporters who are pushing massive accounting revenues and profits into our national balancesheet.

The simple statistical fact is that final domestic demand rose in Q4 2013 by EUR630 million compared to Q4 2012, although for the full year 2013 it was down EUR366 million, once we adjust for inflation. This means that 2013 was the sixth consecutive year of declines in domestic demand, but it also means that toward the year end things started to look a little sunnier.

Looking at the composition of our demand, both public and private consumption fell in 2013. These declines were moderated by a rise in gross domestic capital formation (or in more simple terms, investment), which rose EUR710 million year-on-year. Much of this ‘upside’ was Nama and IDA attracting foreign investors to Dublin. In other words, it had little to do with our real economy.

While on the topic of property investments: house prices and commercial real estate valuations did rise through 2013 in Dublin and trended down in the rest of the country. But since the on-set of 2014, things have gone slightly off the rails. National property prices index peaked at 70.0 in December 2013 and have slipped to 69.1 by March 2014. In Dublin, this decline was even more pronounced - from the local peak of 68.5 at the end of 2013 to 67.2 in February and March 2014. Building and construction activity picked up in 2013, with index of activity by value of construction up from 94.3 in Q4 2012 to 105.4 in Q4 2013 and volume up from 95.7 to 106.2 over the same period.

Here's the kicker, however: much of the above growth related to completions of already started projects and retrofits. Planning permissions for new construction, stripping out alterations, conversions and renovations fell year on year in Q4 2013 and were down over the full year. The pipeline of building permissions into the near future looks dire.

In contrast, contribution of industry, excluding building and construction to GDP was down EUR1.1 billion in 2013. Overall, of the five broad sectors of the economy contributing to our GDP, three posted decreases in activity compared to 2012 and two recorded increases.

Here's an interesting comparative. As Chart 1 below clearly shows, since the current Government came to power in Q1 2011, our real GDP in constant factor cost terms grew on average by less than 0.76% per annum. In the recovery of the 1990s this rate of growth was around 14 times faster. Agriculture, Forestry and Fishing; Industry; Distribution, Transport Software and Communication; and Public Administration and Defence – four out of five broad sectors of the economy are down over 3 years of Government tenure. Only Other Services (including Rent) sector was up. No prizes for guessing which sector is dominated by internet giants pumping tens of billions of revenues and profits earned elsewhere around the world into Ireland to be recycled to tax havens.

Things are even worse when we consider domestic economy excluding external trade. Personal Expenditure on Consumer Goods and Services shrunk 3% in the tenure of this Coalition, falling at an annual rate of 1%, Net Expenditure by Central and Local Government on Current Goods and Services is down at an annual rate of decline of 2.4%, while Gross Domestic Fixed Capital Formation fell at an average annual rate of almost 2.3%.

So by all metrics, save the one that covers Google & Co, the Coalition record to-date is hardly impressive.

Which leads us to another question: what is there to look forward to in the economy between now and the next general election?

Assuming the current Coalition remains in power through its term, there are some positive signs on the led-grey economic horizon. The data on these positives is not exactly convincing, but still, some signs are better than none.

Little as they matter in current environment with no established economy-wide trend and a lot of volatility, the Purchasing Manager Indices for Manufacturing and Services continue to move deep in the growth territory. Investment remains sluggish, with credit in the economy continuing to shrink and cost of loans continuing to rise gradually. But non-traditional sources of funding are showing signs of growth: investment funds, private equity and even some direct peer-to-peer lending.

As banks shift defaulting mortgages into 'restructured' portfolios of loans, numbers of new mortgages approvals, although volatile, are on a gentle upward slope. However, average value of mortgages approved continues to trend down.

Retail sales are faring much worse: value of retail sales in Q1 2014 remained static on Q4 2013 and is up only 0.6% y/y. Volume is up 0.2% q/q and is now 2.6% above Q1 2013 levels. Which means that deflation is still cutting into retail sector earnings, and with this trend, new hiring is still off the agenda of Irish retailers. However, encouragingly, retail sales have finally started to move in line with consumer confidence in recent months, although gains in retail sales still severely lag behind the confidence indicator, as the chart below shows.

Meanwhile, on the exports side, external demand for Irish goods and services might be improving at last, although you won't be able to tell this from the hard data, for now. The growth in global demand is yet to translate into indigenous exports growth for a number of reasons. Chiefly, growth in global trade volumes has shifted toward trade between middle income and emerging economies, away from advanced economies. This pattern of trade dis-favours Ireland. MNCs based here predominantly service the US and Europe, with the rest of the world being supplied from other countries. Our own exporters are having hard time getting a strong foothold in the merging markets. In 12 years since 2002, Irish exports to markets outside the EU and North America stagnated, as a share of our total exports at a miserably low 15-17%, as the chart below illustrates.

Growing our indigenous exports will require serious rebalancing of our sales and marketing efforts toward the markets outside our familiar geographies. The good news is that we have a ready base for such a push. Our competitive advantages are in the sectors where proximity to MNCs resulted in Irish indigenous startups gaining experience, intellectual property and access to early stage supply contracts, e.g. auxiliary services in international finance, ICT and biotech. The challenge, however, is to continue generating exports-oriented startups, while forcing more indigenously firms to export. The former requires financing and business development supports that are very scarce on the ground, especially for companies not clients of the Enterprise Ireland. The latter is a challenge no one has been able to tackle to-date.

Majority of companies operating in the Irish economy are engaged in reselling foreign goods and services without any serious value added to them. In order to push these firms into exporting, they need to identify potential ways for adding value to imported goods and services and then identify the markets and the path for entering these markets, where this value-added can generate sales. Parallel to this, Irish firms are facing an uphill battle to increase productivity of their capital and workforce to make certain that any value added is not consumed by the internal inefficiencies. While during the crisis, Irish economy regained some share of its competitiveness lost during the Celtic Garfield years of 2001-2008, these gains were achieved predominantly through two channels: productivity growth due to on-shoring of large-scale ICT services providers (Google, Amazon, etc), and due to massive jobs destruction in less-productive sectors, such as construction and retail, and other domestic services. Which, incidentally, shows that our Government’s claims of competitiveness gains are barely scratching the surface in terms of revealing the underlying trends in this economy. Stripping out the MNCs with their tax arbitrage, Irish economy is more competitive today than it was in 2004-2006 only because we are no longer employing builders and not adding more convenience shops to every street corner of every town. This is hardly a form of productivity gains that can make our products more competitive on supermarkets’ shelves in Canada or our services supplied to an Indonesian investment bank.

The final drag on the prospects for exports-led growth relates to skill sets required. These skills rest predominantly outside the current vast pool of the unemployed. Despite the claims of 70,000 new jobs created by the Government, data from CSO shows that in Q1 2014, there were only 49,500 fewer unemployed in Ireland than in Q1 2010, of which 14,314 came from higher numbers in state training programmes, such as JobBridge. Meanwhile, numbers of those in unemployment for over 1 year – the period commonly associated with long-term losses in skills and employability – declined by only 20,800 in 3 years of the current Coalition rule. If in Q1 2011 when this Government came to power, 57.5% of all unemployed were jobless for longer than 12 months, in Q1 2014 this proportion rose to 60.5%. Demographically, numbers of older workers (age 45 and older) without jobs rose by 5,900 during the tenure of the Coalition, and number of older workers out of jobs for more than 12 months is now up by 7,000.

While the Government has been successful in reversing the trend in rising unemployment, the progress to-date has been relatively weak compared to the enormous task at hand. Irish economy has been creating new jobs that suit skills and career progression of the younger workers – jobs that require excellent command of foreign languages, coding, technical services that cannot be easily taught to those of older age. Majority of new jobs being created are at the earlier stage of careers, meaning that they are basically of no use to mortgaged and indebted middle-age households with children and ageing parents. In addition, these starter-level jobs are not likely to improve pensions prospects for those currently unemployed, especially those of age above 45, when savings for retirement must be ramped up aggressively.

All of the above problems as well as opportunities are closely interlinked and reach across all groups and segments of our society and all sectors of our real economy. They require not just a policy response, but a coherent, long-term and comprehensive strategy. So far, such a strategy remains wanting. The Coalition might deserve credit for doing the hard thing over the last three years, but it still an open question whether it deserves the credit for doing the right thing.

Sunday, August 17, 2014

17/8/2014: The Globalization Paradox and Land-linked Taxation

Couple of years ago, I wrote extensively on the efficiency of land-value or site-value taxes in raising public investment funding and alleviating the adverse impact of private rents accruing to landowners from public investment (see for example here: and more extensive version: I have also covered the advantages offered by land-value taxation in the context of stabilising macroeconomic and tax environments and addressing key risks to these environments (

A new paper by Schwerhoff, Gregor and Edenhofer, Ottmar, titled "The Globalization Paradox Revisited" (July 22, 2014, CESifo Working Paper Series No. 4878. makes a similar argument, but within the context of the land linked taxes efficiency in alleviating a different problem. Note, emphasis in italics is mine.

Per authors: "According to the Globalization Paradox, globalization limits the freedom of choice for national governments. Capital mobility in particular induces tax competition, thus putting downward pressure on capital taxes. However, while capital mobility introduces the inefficiency of tax competition, it makes the allocation of capital more efficient. Whether national welfare and tax-financed public good provision increase or decrease through capital mobility depends on country characteristics. These characteristics include the relative capital endowment, the availability of taxes on fixed factors such as land and the preference for the public good. We compare the two second best settings of a closed economy and an economy with capital mobility to show that the relative capital endowment determines whether the net effect of capital mobility is positive. Fixed factor taxes have the potential to improve welfare by defusing the globalization trilemma through a reduction in the need for capital taxation."

17/8/2014: Disruptive Innovation, Experimentation and Entrepreneurship

Last week I highlighted several studies relating to human capital and entrepreneurship. Here, continuing with the theme, couple more.

First, a paper by Acemoglu, Daron and Akcigit, Ufuk and Celik, Murat Alp, titled "Young, Restless and Creative: Openness to Disruption and Creative Innovations" (February 1, 2014, MIT Department of Economics Working Paper No. 14-07: Per authors: the study argues that "openness to new, unconventional and disruptive ideas has a first-order impact on creative innovations" where such innovations are defined as those "that break new ground in terms of knowledge creation". The problem, of course, is not that this is something new - if anything, this is trivial - but that we (as society and managerial systems, firms, enterprise ownership structures etc) have a very hard time managing disruptive innovation to achieve 'openness' to the ideas and the generators of such ideas that deliver true disruption.

"After presenting a motivating model focusing on the choice between incremental and radical innovation, and on how managers of different ages and human capital are sorted across different types of firms, we provide cross-country, firm-level and patent-level evidence consistent with this pattern. Our measures of creative innovations proxy for innovation quality (average number of citations per patent) and creativity (fraction of superstar innovators, the likelihood of a very high number of citations, and generality of patents). Our main proxy for openness to disruption is manager age. This variable is based on the idea that only companies or societies open to such disruption will allow the young to rise up within the hierarchy. Using this proxy at the country, firm or patent level, we present robust evidence that openness to disruption is associated with more creative innovations."

All of the above is fine. All is neat and well-argued and empirically backed. But, now, try and tell your average HR manager that the firm they work for should hire someone who breaks consensus and bends rules of logic, thinking and creativity?.. Or try telling them that standard CV/interview/test metrics they employ make hiring disruptive talent actually impossible, let alone difficult… And try telling them that majority of people graduating with 'right' degrees and offering 'right' references and credentials are actually deeply conformist, rather than disruptively innovative…

The second paper of interest is by Kerr, William R. and Nanda, Ramana and Rhodes-Kropf, Matthew, titled "Entrepreneurship as Experimentation" (July 28, 2014, Journal of Economic Perspectives: argues that "…entrepreneurship is about experimentation: the probabilities of success are low, extremely skewed and unknowable until an investment is made." The most interesting bit in the above is the unknowable nature of the probability of success ex ante actual investment. This really cuts across the entire notion of angel financing…

"At a macro level experimentation by new firms underlies the Schumpeterian notion of creative destruction. However, at a micro level investment and continuation decisions are not always made in a competitive Darwinian contest. Instead, a few investors make decisions that are impacted by incentive, agency and coordination problems, often before a new idea even has a chance to compete in a market."

Another interesting issue is that the authors "contend that costs and constraints on the ability to experiment alter the type of organizational form surrounding innovation and influence when innovation is more likely to occur. These factors not only govern how much experimentation is undertaken in the economy, but also the trajectory of experimentation, with potentially very deep economic consequences."

The reason why it is go interest from my point of view is nine years ago, I tried to formulate some of these exact fundamentals in relationship between ability to take risks, experiment, innovate and the macro-economic policy environments in the paper available here:

Saturday, August 16, 2014

16/8/2014: Three Charts of Euro Area's Abysmal Growth Performance

Few charts to summarise the continued problems with growth in euro area and the 'peripheral' states:

First, consider changes in real GDP on pre-crisis peak:

Next, the weakest link in the euro area: Italy. This is really woeful - since hitting absolute lows, Italian economy continued to decline, steadily and with little sign of improvement.

The above also shows the miserable state of the euro area as a whole.

Another chart, to show changes on crisis-period absolute lows:

Note: the first 2 charts reference index to 2005=100, the last one references index to Q4 2006=100.

Thursday, August 14, 2014

14/8/2014: Recessions and the Cost of Job Loss

Long-term unemployment has serious consequences in terms of

  1. Reducing life-time earnings, including post-unemployment spell earnings;
  2. Increasing life-time probability of future unemployment spells; and
  3. Carrying severe costs in terms of reduced health, quality of life, mental health and social wellbeing.

This far we know. We also know that:

  • Long-term unemployment effects start kicking in at around 3-6 months spell, rather than conventionally-measured 12 months spell
  • Long-term unemployment is a problem most commonly associated with recessions; and
  • Recessions-linked unemployment impacts those who have held the job prior to unemployment spell and those who are just starting their careers, with the latter suffering more significant effects of unemployment than the former.

A recent (December 2011) study by Davis, Steven J. and von Wachter, Till, titled "Recessions and the Cost of Job Loss" (NBER Working Paper No. w17638: looks are the evidence on "the cumulative earnings losses associated with job displacement, drawing on longitudinal Social Security records for U.S. workers from 1974 to 2008."

The findings are striking:

  • "In present value terms, men lose an average of 1.4 years of pre-displacement earnings if displaced in mass-layoff events that occur when the national unemployment rate is below 6 percent." So when national unemployment rate is close to frictional (or voluntary or alternatively when employment is close to full-employment rate - in the U.S. case around 5 percent), losing one job in large-scale unemployment generating event is bad. 
  • But, "they lose a staggering 2.8 years of pre-displacement earnings if displaced when the unemployment rate exceeds 8 percent." So rate of losses doubles for a 50% rise in unemployment.
  • The authors also "…characterize how present value earnings losses due to job displacement vary with business cycle conditions at the time of displacement. For men with 3 or more years of prior tenure who lose jobs in mass-layoff events  at larger firms, job displacement reduces the present value of future earnings by 12 percent in an  average year. The present value losses are high in all years, but they rise steeply with the  unemployment rate in the year of displacement. Present value losses for displacements that occur in recessions are nearly twice as large as for displacements in expansions. The entire  future path of earnings losses is much higher for displacements that occur in recessions. In short,  the present value earnings losses associated with job displacement are very large, and they are highly sensitive to labor market conditions at the time of displacement." Now, do tell me how on earth can we expect our pensions systems to be solvent in the future, following the Great Recession, given they were already insolvent prior to the crisis and given the effects of jobs losses on future earnings are so devastating?!

The authors "also document large cyclical movements in the incidence of job loss and job displacement and present evidence on how worker anxieties about job loss, wage cuts and job opportunities respond to contemporaneous economic conditions." Specifically they find that "…the available evidence indicates that cyclical fluctuations in worker perceptions and anxieties track actual labor market conditions rather closely, and that they respond quickly to deteriorations in the economic outlook. Gallup data, in particular, show a tremendous increase in worker anxieties about labor market prospects after the peak of the financial crisis in 2008 and 2009. They also show a recent return to the same high levels of anxiety. These data suggest that fears about job loss and other negative labor market outcomes are themselves a significant and costly aspect of economic downturns for a broad segment of the population. These findings also imply that workers are well aware of and concerned about the costly nature of job loss, especially in recessions."

Here's a chart to illustrate the empirical dynamics of earnings losses due to job loss.

14/8/2014: The Yugo Area Economy

Much has been already said about the disastrous GDP data for Q2 2014 posted today by the Eurostat.

Here is to add to the pile... Starting with the Eurostat grotesque or pathetic - or as I put it EUrwellian - language headlining zero growth as 'stable' performance:

Link here:

I covered slowdown in the industrial production in the EU here:

And as far as leading economic indicators go, today's miss on expectations is largely driven by the fact that said expectations for positive growth were based on superficially-optimistic data: PMIs, investors' surveys and asset markets performance (see here:

But here's a much more worrying bit: there is preciously little in the data to be surprised about. Euro area has been sick - when it comes to growth - not for a quarter, nor for a year, not even for a decade. Here is a chart showing average annualised rates of growth over longer periods of time:

In no period (and I computed the above series for every 12 month period average from 1 year through 15 years) did the euro area average longer-term growth reached above 1% per annum.

The main point of this can be best seen by removing the extreme underperformance during the peak of the crisis and taking a trend, as shown in the chart below:

 As the red line clearly shows:

  • Over the last 12 months, as dismal as its performance has been, growth in the euro area has outperformed its long term trend.
  • Long-term trend growth in the euro area should be where it is: near/below zero.
There is a structural or a very-long-run recession/stagnation in the euro area and it coincides with two other factors:
  1. Low cost of credit over the last 15 years, and
  2. Low inflation over the lats 15 years

We are all sick and tired of hearing the words 'structural reforms', but it is painfully clear at this stage that the entire history of the euro area to-date is that of sustained weakness. The ECB has now firmly run out of any conventional tools for dealing with it. And this brings us back to where Jean Claude Trichet left us some years ago, before the crisis hit in 2008: the simple truth about Europe is that it has no real drivers for growth. Forget q/q starts-and-fails of the engine, this diesel can't take you to a grocery store, with kids on board or without...

Time to call it what it is: the Yugo Area Economy...