Beware of Khrushchev’s shoe

Forty-five years ago, Nikita Khrushchev, premier of the Soviet Union, took off his shoe and banged on the table at the UN General Assembly, boasting to the astounded dignitaries: ��We will bury you.�

He was talking about economics.

Khrushchev was convinced, as was much of the rest of the world, that the Soviet Union would overtake the US, and the west in general. This confidence was based on the fact that, in the 1950s, the USSR had notched up double-digit growth rates and looked on course to overtake the west.

This did not happen. In fact, the USSR slowed down in the 1960s, stagnated in the 1970s and collapsed in the 1980s. Why did this happen?

The most compelling explanation is that the Soviet Union�s growth rates in the 1950s had been an illusion based on mobilising huge resources into the economy.

Peasants, women and German prisoners of war were forced to work in industry for the first time and were paid very low wages. So the Russians had more cheap workers than almost any other country.

This did propel the growth rate, but more by perspiration than inspiration.

When Russia started to run out of peasants, the growth rate started to fall. And, because it did not have the capital or money to reinvest, it could not build sophisticated machines to make the peasant workers more efficient.

By the mid-1980s, 20 years after Khrushchev�s antics, the Soviet empire was falling apart.

In the long term, money and people make economies grow. Combine them and it should do the trick. Some countries, like Germany today, have loads of money but not enough productive people and consequently, its growth rate has fallen.

In contrast, much of the Third World has loads of people and not enough money, with well-known tragic results.

Other countries, such as China and India, may be experiencing something like the USSR�s 1950s experiment, whereby huge swathes of previously idle labour are mobilised with apparently miraculous, but ultimately, illusory results. Time will tell.

What do these tales of growth and its illusions tell us in Ireland? They help us to understand why we sometimes get carried away with ourselves, talking about miracles, new paradigms and the like. In contrast, to the �new� theories, there is usually a perfectly logical explanation for economic developments.

For example, in Ireland we are experiencing something like the Khrushchev illusion in reverse. Whereas Khrushchev was fooled by the masses, we are fooled by the money, particularly other people�s money.

The reason the economy is growing strongly, tax revenues are so buoyant, unemployment so low and house prices so high is because we are mobilising so much credit.

We are throwing money at the economy at a rate not seen in any other developed country in the past 40 years. Like the mobilised Russian peasants, the sheer volume of cash is tricking us into thinking that we are experiencing something permanent or, worse still, miraculous.

Let�s examine the figures. Private sector credit, which is how much we are all borrowing, stood at �240 billion at the end of 2005.Our total GDP was �135 billion. This means that borrowings are now running at 180 per cent of our income.

So for every �100 we earn, we are borrowing �180.This is the highest level in the world and, as it is growing at 30 per cent per annum (or about �55 billion), it is also growing the fastest.

Think about this for a moment. Borrowing will grow by �55 billion this year.

That figure is 42 per cent of our total national income. There is no historical precedent for this type of borrowing anywhere in the world at any stage in economic history. Ireland is truly in uncharted territory.

Now let�s project forward a year or two.

Given the level of borrowing, the incentive on the part of the banks to lend more and more and the maturing of the Special Savings Incentive Accounts (SSIAs), which will embolden borrowers further, it�s not unreasonable to suggest that total borrowing could rise to �80 billion for 2007.

This would bring the overall stock of debt in the economy to between �380 billion and �400 billion or something like 230 per cent of GDP. This implies that every 1 per cent increase in interest rates will cost us 2 per cent of GDP in extra servicing.

Which brings us nicely along to last week�s increase in the monthly cost of your mortgage, the second in a matter of months. Is this the last? Is it the second of many? Are we entering a new epoch of higher interest rates around the world?

In Europe, the feeling in financial markets is that rates will rise, but not by much.

In the US, there is a fear that it will ultimately have to raise interest rates if it is to continue to finance its large trade deficit.

For the first time in two decades, Japanese interest rates are on the way up.

Taken together, it is fair to say that the era of low interest rates that has prevailed since the early 1990s is over. It might not be followed by a dramatic spike in the cost of borrowing, but let�s just say that your monthly repayments will not be going down from here.

So where does this leave us? The debt figures convey financial delinquency on a monumental scale, but, more worrying than that is the fact that probably about 80 per cent of all debt is borrowed for the construction sector. The construction sector acts as an amplifier of the initial credit throughout the economy.

By pushing up house prices, credit actually makes us feel richer, so we borrow and spend more. At least 20 per cent of this cash ends up with the government in the form of indirect taxes, so it spends more, amplifying the impact further.

Over 30 per cent of the price of a new house also ends up in government hands.

This process is called the �multiplier� in textbook economics, and it explains the ramifications of an initial injection of cash into the system. As the construction sector employs a quarter of a million people, its boom is also a boom in wages and spending from this sector.

Logically, if there is a slowdown in borrowing – which is likely when a 1 per cent increase in interest rates causes a countrywide increase in servicing charges equivalent to 2 per cent of GDP – then house prices will also fall.

Any downturn in the construction sector from where we are now would have negative multiplier effects throughout the economy, which would be much more widespread in scope than just the sector itself. This process is called �negative contagion�, which is precisely the opposite of today�s situation. In negative contagion, the banks pull in their horns and nothing gets financed.

Now, let�s get back to Khrushchevian mirages. Is our growth rate the Irish equivalent of the USSR�s �miracle� of the 1950s? Well, the major difference is that the Soviets threw cheap people at the economy, resulting in enviable, but short-lived, growth rates.

Today, we are throwing money at the economy: an increase in borrowing equal to 42 per cent of GDP this year achieved for us a growth rate of under 10 per cent.

Obviously, we are not spending our money well.

Of course, the workforce has expanded rapidly but, as the Economic and Social Research Institute pointed out last year, we are now using many more people and much more credit to generate much smaller increases in GDP than was the case a few years ago.

In short, we are reaching the Khrushchevian tipping point where the economic numbers are playing tricks on us.

Next time you hear someone boast of the great performance of the Irish economy, think of Nikita, his shoe, the UN, his dramatic fall from grace and his last days spent in forced exile.