Medicine is built on tragedy. It is littered with stories that might have been avoided had the physician seen the signs the patient’s body was giving off. Proceeding error by fatal error, doctors have learned what to do when patients show up with certain symptoms, and what not to do.
The patient’s history matters a lot—where they came from, what they were doing, how they were doing it—before they got sick. There are tests to be done to see how damaged the body is. The patient’s body gives off signs, and the doctors, schooled in the recorded tragedies that have gone before them, interpret those signs. Perhaps the blood pressure is too low; perhaps there are not enough white cells, perhaps the patient is vitamin deficient. The signs all add up to a diagnosis. Correct diagnosis leads to effective treatment and, hopefully, to the patient’s recovery.
In economics, like medicine, history matters. Diagnosis matters, because effective diagnosis may lead to effective treatment. Sadly economists don’t have the precision of scientific measurement. We have quarterly data at best for the economy as a whole. But there are still clear signs economies, like bodies, give off during times of stress and distress. We can, and we should, be able to diagnose these properly, and at least try to do something about it.
Economist Richard Koo has written about Japan’s history during the 1990s, when Japan went from economic wunderkind to basket case. Koo found that the Japanese authorities had misdiagnosed their economy’s problem. The Japanese initially thought their recession was a plain old-fashioned one, and pumped in money to help restore demand. That didn’t work, so they tried cutting back on spending, which made things worse by causing a sustained fall in the price level. Asset prices fell 87% from their peak. Their banks were ‘zombie banks’, unable to lend but unable to die. Monetary policy was useless, as people didn’t want to borrow, even at near zero nominal rates. The political machinery in Japan took a decade—a lost decade—to realize the solution: prolonged fiscal injections from a positive trade balance, followed by debt reduction. Koo diagnosed Japan’s illness as a ‘balance sheet recession’. Balance sheet recessions happen after asset price collapses. The economy stalls because households and firms start saving like crazy to pay down debt and buttress themselves against the coming hard times. The treatment prescribed when you’re in a balance sheet recession is to spend from a trade surplus, not to cut spending. Throughout the lost decade, the IMF and World Bank were telling the Japanese authorities to cut spending. They were wrong.
This post looks at the evidence that Ireland is suffering from a balance sheet recession.
First, there has certainly been an asset price collapse. The residential property price index shows a 40-50% drop in residential asset prices to date, with downward momentum. Commercial property prices ar 60% off peak, as Namawinelake has documented.
Second, there has been a huge debt buildup in private and government sectors.
Third, domestic demand has collapsed. Ireland’s domestic output has fallen by 4.3% in the last quarter. Annualized, and in real terms, gross national product was down about 0.9 percent. Private consumption has fallen, again. Gross national product is now 15.4% below its peak level.
Fourth, the savings ratio has exploded as households and firms save and pay down debt. The chart below shows the net savings ratio for Ireland, Estonia, and Germany. See the difference? Ireland and Estonia are both saving like mad. Click the images to enlarge them.
Household (and non-profit institutions serving households) net saving ratio. Source: OECD Economic Outlook June 2011.
Fifth, private sector credit has shrunk since 2007. The chart below shows the number of outstanding loans in Ireland since 2003, indexed to January 2007. We can clearly see the post-boom decline.
Outstanding loans, Jan 2007=100. Source: Central Bank
Sixth, exactly as in Japan, Ireland’s zombie banks have soaked up immense amounts of capital without contributing to a meaningful economic recovery. After unemployment, (see this very useful post from Seamus Coffey for more on unemployment at the moment), debt is the biggest problem Ireland has.
Ireland’s general debt to gross national product ratio has exploded. In the figure below I plot the ratio of general government debt to gross national product. I also show the forecasted effects on the debt ratio if there is 0%, 1%, and 2% growth in gross national product. Here I'm taking the NTMA’s forecasted figures of government debt as my starting point. I also include a measure of debt sustainability from Rogoff and Reinhart (that straight line). Below a debt to gross national product ratio of 90%, debt levels seem to be sustainable. After 90%, states tend to get themselves into trouble.
General government gross consolidated debt (GGD) divided by gross national product (GNP) at constant prices, with forecasted values for 2012-2015. Source: CSO, NTMA & Author's calculations.
Finally, it is a fact that each successive austerity package has made things worse in Ireland, not better, exactly as in Japan.
To recap. The signs for Ireland are: debt buildup following an asset bubble, sluggish demand, private sector deleveraging, increases in savings rates, slumps in consumption and investment, and zombie banks all over the shop. This may be a balance sheet recession, we need more evidence. The solution to a balance sheet recession isn’t austerity. It’s fiscal expansion followed by debt resolution. We are doing the opposite.
Hi Stephen,
Just to say on Irish commercial real estate (CRE) that the two established indices in the State (Jones Lang LaSalle and SCSI/IPD) indicate that we are 60% off peak though no doubt there are individual cases where we are more down than that.
Development land, which is distinct from what we term CRE is down 75-90%+ from peak. Remember that field in Athlone that had lost 98% of its value and was essentially back to agricultural land value? Well now, sites in Dublin are also off 90% from peak, but that can still mean paying €1m+ per acre in some places.
Hi Stephen,
Sorry, should have started off by thanking you for timely, informative and highly readable article on debt. Your article answers many of the debt questions constantly asked, though rarely - if ever - answered so clearly. Thank you.
Jadgip, high praise indeed coming from you! I've updated the figures in the blog post. The 50% figure was from Ronan Lyons' recent work on the overall economy, but you're right, it's better to stick with established sources.
It may be a matter for the next article but not expanding at all on the words 'fiscal expansion' left me unsatisfied. My dictionary has 'fiscal' as 'of or relating to government revenue, esp. taxes'. What would fiscal expansion mean in your proposition?
Is fiscal expansion about spending government income on public works, infrastructure (broadband to rail, trams and buses), schools, R&D etc.? Wouldn't that be lovely. How weird that prospect seems, to spend those amounts on those good things at this time. Could it possibly be done? Or have I got the wrong end of a monetary stick?
Richard Koo's talk at the INET conference was very convincing, and your application to Ireland sounds pretty reasonable if you ask me. I just wanted to caveat the statement you make about the 90% debt threshold assigned to Reinhart and Rogoff. I'm not sure that is a fair representation of what they say about 'sustainable' debt.
It is not - in my reading - that a Debt/GDP ratio in excess of 90% is a hard line. It's more the case that where governments have gotten into trouble they tend to have a debt/GDP ratio higher than 90%; but all countries with a 90%+debt ratio will not get into trouble, and indeed countries with less are not safe. I'm just worried about arriving at a new 'gold standard' of Debt/GDP ratios like we had with the EU requirement to have a certain (and arbitrary) ratio as a 'safe' state of affairs. Government's can be fine above 90 and default below - there's a lot of other stuff going on - like a balance sheet recession 😉