Economic Indicators: Part 1 (GDP, Inflation & Exchange Rates)
In my experience as a public speaker, trainer and media guest, I find that a lot of people are confused by economic indicators, or find it difficult to relate these indicators to one another. I recently published two articles about economic indicators in the Sunday Business Post and thought the readers of my blog might be interested as well…
This article is the first part and was published on Sunday 22nd April, 2012.
What exactly is a recession?
Since 2007, Ireland has seen a very harsh, deep recession with contracting consumption, investment and government expenditure. A recession is defined as “two consecutive quarters of economic decline in terms of GDP”.
Contracting consumption is due to the fact that many people’s wages were cut and also a very significant number of people lost their jobs. As a result, the less money people had, the less money they could afford to spend. In addition, people knew that there were years of austerity ahead, as indicated by the Memorandum of Understanding. This anxiety about the coming years motivated the Irish nation to save more and spend less. This was clearly evident in the double digit personal savings ratio reported by Central Bank figures.
Next, investment on the part of Irish households and businesses collapsed. In the case of the former, the number of new house builds fell from 80,000 in 2005 to below 5,000 today, according to the Department of the Environment, Heritage and Local Government. As for businesses, declining GDP, a contraction in domestic demand and several years of government budgeting that focused heavily on cutting back instead of expanding meant they strategically chose not to pursue opportunities that would require using their own reserves as well as borrowing. The net result is that investment, as a percentage of GDP, has fallen to an all time low: below 10% in 2011 versus 27% in 2007, according to the CSO.
Government expenditure also took a lot of strain. The Exchequer has come under pressure from two different fronts. Firstly, due to rising unemployment (which impacts PAYE & PRSI), lower personal consumption (which affects VAT) and a fall in investment taxes (e.g. stamp duty and Capital Gains Tax), taxation revenue fell drastically, requiring the introduction of new measures like the Household Charge. On the other hand, the demands on the government’s social welfare budget expanded in line with higher numbers on the Live Register.
As a direct result, their deficit ballooned to the highest in Europe and major steps had to be taken to try to control this figure. This manifested in several ways – cut on capital spending, levies on public service wages, introduction of the Universal Social Charge, etc. Due to the fact that the government as an entity was spending less in the economy, this also had a compounding downward effect on GDP.
One bright spot: Irish exports
However, throughout the recession, exports were the one brightly shining light. According to the Irish Exporters Association, in 2011 “because of the rapid international trade expansion in the first half of the year, exports for the full year increased by just under 5% to €171 billion which represents a very substantial increase of €8 billion in the year.” This very tangible boon in the economy was strong enough to turn the direction of our GDP around. 2011 was the first year since 2007 in which GDP was higher than the previous year.
In fact, our GDP increased by 0.7% last year and according to Department of Finance forecasts, this figure is expected to strengthen and build from 1.3% in 2012 to 3% in 2015. This is a positive development for the country as the more that we are earning (via income) or producing (via output), the more that can be funnelled back into the economy and compounded by the Multiplier Effect.
The mixed blessing of deflation
Given the fact it wasn’t just Ireland that faced weak economic activity, but the whole Eurozone, the ECB dropped interest rates to boost investment. As a result, variable mortgage repayments fell and therefore, the cost of repaying a mortgage fell.
Due to the recession, domestic demand fell significantly in Ireland over the last few years; retailers had to fight much harder for their portion of a shrinking market. One of the ways in which they did this was by dropping their prices and this fed into the inflation figures in the form of “deflation”. This is the first time the CSO recorded negative inflation in decades! For example, in 2009, the Consumer Price Index fell by 4.5% and in 2010, the price of a sample basket of goods contracted by another 1%.
The thing to consider here is that if all prices are steadily declining, then consumers may postpone buying goods and services, expecting them to cost less a week later and less again a month later. This causes a knock-on effect of lowering consumer demand, thus negatively affecting employment and growth (e.g. house prices at present in Ireland).
Likewise, a company might postpone investing and the economy (and its respective GDP) would suffer. However, the Irish consumer has had to face cost increases along the way via higher energy prices and the 0.5% increase in VAT announced in the last Budget.
On balance, inflation is now positive again, with 2011 recording a 2.6% increase in the CPI. It’s interesting to note now that the increases in absolute terms are much larger than the decreases. For example, in the latest inflation report, the CSO reported that “The most notable changes in the year were increases in Education (+9.4%), Housing, Water, Electricity, Gas & Other Fuels (+5.8%), Transport (+4.8%) and Miscellaneous Goods & Services (+3.2%). There were decreases in Furnishings, Household Equipment & Routine Household Maintenance (-2.0%) and Recreation & Culture (-0.9%).”
According to the Department of Finance, this is set to continue with inflation fluctuating between 1.4% – 1.9% over the coming five years. Yet, our rate of inflation is among the lowest in Europe; only Malta has lower levels of inflation than we do. Hungary (who are also engaged in an IMF programme), Estonia (who joined the euro in 2011) and the United Kingdom (who have printed vast amounts of money over recent years i.e. quantitative easing), on the other hand, are at the top end of the inflation scale. This bodes well for the future of Ireland as businesses seeking to expand internationally will see that prices in Ireland are rising at a slow rate and this could add to our attractiveness as a foreign direct investment location.
What it means for Ireland to be an open economy
Ireland is a very open economy – this means that we engage in a very large amount of international trade annually. According to 2010 figures, we exported 16% of our goods to the UK, 43% to the Eurozone, 24% to the US and 17% to the rest of the world. It is easy to see that, as a result, we are very dependent upon the exchange rate of the euro against other currencies as 57% of our trade takes place outside the Eurozone.
Let’s take a look at the U.S., our largest currency bloc trading partner. The exchange rate of one euro is currently $1.32. This is a floating exchange rate: these two currencies fluctuate in value and the equilibrium rate is decided by the market forces of supply and demand. The currency finds its own equilibrium on the markets without government intervention. Markets are underpinned by the forces of supply and demand, reflecting the state of the underlying economy.
However, businesses trading internationally or people who want to go on holidays abroad also find it very difficult to plan ahead. Let’s say that I need to buy $10,000 worth of goods next month. At the current exchange rate, it would cost me €7575. However, if the euro weakened (this means that it costs more euros to buy the same amount of dollars) to the point where we could only buy $1.10 with a euro as opposed to $1,32, it would cost me €9090 to buy the same goods for $10,000. That’s a difference of €1515! While an importer would be unhappy with the above devaluation of the euro, an exporter would be delighted! In essence, if they were selling $10,000 worth of goods, when they convert it back into euros in their bank account, they would now have an extra €1515! Alternatively, they could pass on this extra revenue in the form of a price reduction, which would boost demand for our exports. This would would be a welcome injection to the Circular Flow of Income and our National Income. Further, this bolsters confidence and disposable income increases, driving consumption higher.
The health of Irish businesses affects public finances
Of course, the finances of the Irish government would also be affected. For example, due to the increased spending within the economy and the potential rise in employment, the government would take in additional direct and indirect tax revenue. In addition, due to greater profits, the government receives more corporation tax. This has the impact of reducing the need for the government to borrow. Also, there will be a reduction in the numbers on social welfare due to the increase in employment. As a result, current government expenditure would fall (e.g. social welfare payments) and so would the need for the state to borrow.
Stay tuned for Part 2 next week: I will talk about the national debt, the banking crisis and the 2010 Census, and the lessons they contain. Sign up to The Positive Economist newsletter to receive updates by email when a new blog post is published!
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