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David Mc Williams: Simple rules of economics say we must spend, not cut

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On Monday the opposition parties finally visited the oracle on Merrion Street. Things are bad. So bad that even Michael Noonan couldn't summon a suitable analogy to describe the situation.

This is the same man who on Budget Night was capable of the immortal put down "Wasn't Pol Pot radical?" when individualisation was being breathlessly and flatteringly described as "radical".

He is again focusing on the budget but this time he could only muster: "The figure of adjustment published already in the Government plans was €7.5 billion. With lower growth rates projected, the level of adjustment is going to be significantly higher than that."

It may lack Noonanesque flourish, but let's look at that statement for a minute. Growth in the economy is expected to be lower than previously forecast, and yet the solution proposed is to cut more. In economic terms, this option is madness verging on criminal negligence.

At the core of macroeconomics is an idea called the "automatic stabiliser". This could be described as economic ballast. When the people save money, the government should compensate by spending it and vice versa.

A recession like the one we are experiencing happens because people start, quite suddenly, saving much more of their income. This recession in Ireland is a balance sheet recession -- a recession which occurs in response to the implosion of the national private balance sheet. We have a load of debt on one side of the balance sheet and a load of assets (property) on the other, which are falling in value.

In order to get their houses in order, people are saving and trying to pay down debt. This means that they are taking money out of circulation and saving it rather than spending it.

This is easy to see when looking at the figures. At end December 2006, household savings were €77bn; GNP for 2006 was €153bn. This meant that national savings equaled 50.3pc of GNP.

By the end of June 2010, household savings had jumped to €85bn and GNP for the 12 months to June 2010 had fallen to €135.5bn. This means that household savings are now 62.7pc of GNP.

Taken together, these two developments mean that household savings as a percentage of GNP surged by an enormous 24.5pc in three and a half years. (It is important to note that while the level of savings increased by only €8bn, or 9.5pc, much of the increase in the ratio has come about because of the fall in GNP across that period.)

In 2006, as you'd expect from the 'automatic stabiliser' way of looking at the economy, when the people were spending, the government was saving -- running a small €2.26bn budget surplus which was 1.5pc of GNP. Today the budget deficit is 17pc of GNP. So the swing from government saving to spending has been a full 19.5pc of GNP.

Taking a bit of altitude, we can see that the budget position is doing exactly as expected. This is the way the modern economy operates. It is not the end of the world that the budget deficit has ballooned. I am not making light of what needs to be done, but we need to see some context. Put simply, there is still lots of money in the economy, but people are scared stiff of spending it.

Any big budgetary strategy should be aware of this.

When you draw back and look at policy, it is not hard to conclude that there is a basic failure of economic understanding at the centre of the 'slash and burn' policy.

The first thing is that there is a difference between the individual and the economy. If there wasn't, economics would be accountancy.

If an individual is living beyond his means, then yes, cut back on spending. But a country is not an individual. An individual's income comes from an external source (an employer, customers or the dole) but a country's income comes from itself mainly. Because of this, when a country cuts spending, it ends up cutting its own income.

This might sound like a contradiction, but it can be explained by another simple bit of economics called the multiplier.

In a normal functioning economy, when people have money they spend it. The people they give it to when they spend, also spend it, and so on. The money is shunted on throughout the economy.

When you cut, the opposite occurs. The more we cut, the more the economy will shrink because there is in tandem with the cuts a credit crunch -- the banks are bust and interest rates are going up, not down.

Ireland is in a bind when it comes to stimulus. We cannot print money to increase the amount of money in the economy. We cannot borrow more from the markets because they, rightly, see our economy as a risk.

So what can we do? We can make sure that the money that is in the economy is used wisely and not wasted on savings or banks, or, indeed, saving banks.

It is time to think a bit. Here is a possible alternative plan to achieve stimulus so that the economy doesn't unnecessarily contract in the next two years and so that unemployment doesn't unnecessarily rise.

Currently there are €107bn of outstanding mortgages in Ireland. Allowing for an average outstanding term of 25 years and an interest rate of 4.5pc, that means that mortgage payments per month in the economy are approximately €600m per month. Or €7.2bn per year. There is a stimulus sitting right there.

Why not freeze all mortgage payments for two years? Nobody makes any payment on their mortgage until November 2012. If we assume a conservative multiplier of only 1.4, Ireland would get €20bn worth of stimulus without upsetting our EU leaders' rules at all.

Probably a function of how we are all thinking at the moment, but I bet your first question is 'What about the banks?' Well first, we own the banks, so they will do what they are told. The financial regulator has been very generous with bending the rules to allow defunct institutions like Anglo to continue in whatever half-life it currently inhabits, so I'm sure he would be willing to allow Irish banks to carry mortgage debt for two years without forcing them to take write-downs on it. After all, a policy like that would be in the interest of the country, rather than just the interest of banks.

Of course, the bondholders would still want to be paid. And they would be, they just might have to join in the two-year waiting game. Which would be better for them? Get a haircut now, or wait a few years and get paid.

The effect on the economy should be fairly rapid, as the increased spending would lead to inflation. Right now, for Ireland, some inflation would be a good thing. True, some people would choose to save the money, but targeted incentives to bring forward spending could be also applied.

We need to come up with suggestions, which limit the downturn and ease the burden on ordinary people. Isn't this what sovereignty is all about? The financial markets would be the first to support us, because they want Ireland to grow.

As the economy grows, the risk diminishes. In contrast, the more we become a large debt-servicing agency with falling revenue, the riskier we become and the more likely the austerity drive will hit the buffers.

David Mc Williams will host Ireland's first economics festival in Kilkenny from Nov 11 to 14. Details at: www.kilkenomics.com

Irish Independent