Y=C+I+G+(X-M)

This is an expanded and linked version of my column in the Irish Examiner of Saturday 23 June 2012.

One of the striking elements of the last half decade has been the way in which the public dialog has become suffused with the language, if not completely the understanding of economics. We are all now experts on bond spreads, credit default swaps, the ECB, IMF and the troika. Yet, it remains the case that there is a persistent impression, at least in this writers mind, that the basic structure of the economy remains rather a mystery. Perhaps it is that to the majority of people the magnitude of the aggregate economy and its associated stocks and flows is simply too large. Compounding this is the fact that there are at least four measures of the economy. Three of these are in principle, and in measurement to the extent of human accuracy, equal but give a very different picture of the economy.

We can measure the economy in one of three ways: given that my spending is your income, we can measure the expenditure of various sectors , we can measure the income received by various sectors (rents, wages, profits and income from self employment) or we can measure the output of the various sectors of the economy. The first is the most common and gives a basic accounting measure : income is equal to consumption plus investment plus net government spending plus net exports (Y=C+I+G+(X-M)). This gives us Gross Domestic Product. We can also take into account net income from abroad, which when taken away gives gross national product. In the Irish context we have significant negative flows ,these mainly being the outflows of multinational companies domes filed here making our GNP less than our GDP by some 20%. In most countries these two aggregates are nearly equal, and the Irish situation is unusual. These measures are not ideological or theoretical but are basic accounting identities. An understanding of these is essential to anyone who wants to fully understand the rise and fall of the economy. The CSO databank provides a clear and simple way to drill into these aggregates. The site is well worth investigating.

So how have things evolved since 2000? One popular meme is that we have seen a massive expansion of government expenditure. Well, we have seen an increase but perhaps not to the extent that many consider. Government expenditure has risen by 97% over the period. While that headline figure seems very stark, it is perhaps more instructive to examine the share of government. Measured this way the government has increased its share of GDP from just over 12% in 2000 to 16% now, a significant fall from a 19% share at peak. The largest changes have been in investment. The decline in quarterly GDP since the peak in end 2007 has been just over 10b. This equates almost exactly to the fall in investment, which in turn is largely driven by the unwinding of the credit driven housing bubble and its consequences. Quarterly consumption has fallen by 3b while both exports and imports have risen. It is worth noting that, as it should be when acting as a stabiliser, government spending is much less volatile than that of many other aggregates.

It is in the interrelationships between these components, and in particular the relation of net government expenditure that the theoretical and policy battle between economic doctrines is being played out. At one pole we have Keynesians of various stripes, who suggest that increasing net government spending increases the size of national income. The most notable here is Krugman of course. Countervailing this is the argument from austerians, the newest incarnation of what is also known as classical economists, who assert that increasing government spending crowds out private spending. This debate was first formulated in the mid C19 by David Ricardo, the MP at the time for Portarlington, and in its modern form suggests that increases in economic activity via debt financed government expenditure will be off set by increased savings as economic agents know they will have to pay increased interest charges on this debt . It was revitilized and reinvigorated in the 1980s by Robert Barro. We might note in passing that it is in the view if many indicative of a rather unhealthy state for a aoi-disant scientific discipline to remain mired in what is essentially a two centuries old argument. macroeconomic theory in particular has, many would argue, become sterile and proved itself unable to cope with the political economy aspects of the EU crisis or the massive rise in financial complexity preceding. Economics, macro especially, needs to undergo what Kuhn called a paradigm shift and to incorporate much more explicitly finance and behavioural aspects of human behaviour if it is to move forward. A key aspect of the argument about the role of government revolves the estimation in practice of what is called the multiplier, which is the extent to which the data show whether government spending does lead to long-term increases in economic output.

The news for Ireland is not great for those such as I whose natural inclination would be to wish for a government led stimulus. Ideally we want the multipler to be greater than one, so that increasing government spending by one euro wwill result in national income going up by a greater amount. Irish estimates (see p 48) of the aggregate multiplier tend to be at or below 0.5. Ireland faces an additional problem in that it is an extremely open economy. While much of the imported goods go to manufacturing and services for reexports, we also consume large quantitites of imported goods. And we face the problem that there is no one multiplier (are we stimulating by capital spending or current spending), it varies across the business cycle (with some evidence that it is higher in recessions, exacerbating the effects on national income of cutting government spending) and that it is closer to zero than one for highly indebted countries and open economies (we being both) . A further problem is that the evidence indicates that multipliers tend to be higher for countries in fixed rather than floating exchange regimes, suggesting that the cheery panacea of “ditching the euro” would in all probability result in further reduction of the ability of a government to gain economic traction Add to this the emerging evidence on how sovereign risk leads to a squeezing out of investment and we see that we face a most unpleasant short-term future. Cutting expenditure on government, capital or current, is appalling economics in a recession the more so when it is in a European environment of coordinated austerity. It is however, unavoidable given that we cannot borrow, but the indications are that this will exacerbate and deepen the recession. In the short term that might be balm to the legions that seem to consider all government spending bad but in the long-term a shrinking economy hurts all. Kneejerk cries for “ditching croke park”, slashing public sector wages, are never accompanied by a sober analysis of the downstream economic consequences of same but are instead trotted out liturgically and with the fervour of cargo cultists worshipping a bamboo and coconut mockup of a DC3. But increasing expenditure, even if we were able to, would not in itself refloat the ship of state, as much of the stimulus would be lost. Ireland in other words needs to rely on both exports (in a world and a Europe of competitive austerity) and domestic demand and investment in an environment of broken banks and stagnant consumer sentiment. Which means that we face years of stagnancy, regardless of what way we proceed.

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One thought on “Y=C+I+G+(X-M)

  1. Pingback: Revisiting the Croke Park Agreement on Public Sector Pay | Brian M. Lucey

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