Our economy is going backwards. Latest figures from the CSO reveal that the economy has shrunk since last summer.

We are now contracting at a pace last seen in 2009, when the wheels really began to come off. The Irish economy has contracted now for three quarters in a row.

Throughout recent recorded history, recessions last on average ten months. This recession is completely different, both in terms of its scope and its depth. We are seeing a massive double-dip recession led by a depressed local economy, which is compounded by the delayed effects of austerity in Europe.

Domestic consumption is cratering. According to the figures, in January to March of this year, consumption fell by 3 per cent. This is the largest fall in the whole recession – even including 2009 and 2010. Investment, too, is down 7 per cent and even exports, usually the bright point on the Irish economic landscape, were down 3 per cent in the first few months of the year.

Traditional economics tells us that, in a recession, as unemployment rises, wages fall. And as wages fall, the cost of labour falls. When you go back to Karl Marx (not a bad launch point), you will know that in any economy, there is the return to capital and the return to labour. If one goes up, the other goes down and vice-versa

The return to labour is wages. If wages are falling, then the implication is that the return on investment – profit – must be rising.

Thus, the way the economy rights itself is that wages fall and profits rise. As profits rise, the return to investment rises. Eventually, investors will come to see that they have a ‘one-off’ opportunity to invest their capital and get more for each euro invested than was previously the case. This should trigger an increase in investment and the economic cycle kicks off again.

So why is this not happening now anywhere in Europe, let alone Ireland?

The most obvious answer is debt. There is simply too much debt, which is strangling investment opportunities.
Take Ireland, for example. Many small businesses are starved of capital and are offering investors double-digit returns for working capital. Many small businesses are surviving due to the dexterous management of this cashflow, deploying a bit here and there to keep all the balls up in the air.

We know from the US that in the past few years it is these small, young businesses that create jobs. Indeed, large companies are net job destroyers, so these cash-strapped small businesses hold the key to the future.

So why are they not getting the capital, if the return on capital is rising? The reason is that the capital is trapped in the banking system and it is not being released into the economy. Now, maybe the new capital might come from outside the country in time. Foreigners may well decide that Irish businesses are worth backing, but it seems fair to suggest that foreigners will only buy trophy assets, rather than recapitalise the entire economy. Providing working capital is still the job of local capital, and it is not working.

Maybe one way of attracting capital out of the banks in the next few years is for this coming budget to be truly pro-small business. Maybe the government could think of giving a tax holiday to local investors investing in local companies.
Such a tax holiday could apply to the investor’s income or property tax. These are just obvious ideas. At the moment, there is over €90 billion in deposits in the banking system. Getting even a fraction of this money into the local economy could work wonders.

Without such initiatives, we end up with an economy with plenty of potential working capital, but no actual working capital. This explains how the return of capital can remain in double-digits without investors taking up these opportunities.
The problem with small companies offering double-digit returns to real investors is that they can’t do this indefinitely. With inflation running at a few per cent, the company that offers double-digit returns on capital goes bust quickly or becomes dependent on expensive capital, and it can’t grow because so much of the turnover is going to pay the investor.

The company that is offering such returns is only doing it because it is desperate and, unless it gets working capital, it will shut down.

Thus double-digit returns are an opportunity, but also a sign that things may actually slump further from here because it is not a sustainable business model.

The other mechanism whereby the recovery becomes a self-reinforcing mechanism is through wages. In normal recessions, wages will fall as the number of people looking for a job increases. But this is not happening because, naturally, trade unions will move to protect their members.

Instead of wages falling, as classical economics suggests, we see in Europe that companies don’t cut wages; instead they let people go. As this process tends to follow the ‘last in, first out’ pattern, it disproportionately affects younger workers.

Obviously, the people in work want to keep their jobs and conditions, even if the people out of work would be prepared to do the same job for less. This tends to lead to the insider/outsider dilemma, where the workforce is pitted against each other.

Those on the inside – with jobs – have different interests to those on the outside without jobs. The upshot is that people who lose their jobs can’t get back into the workforce and the rate of long-term unemployment rises, as we have seen to an alarming extent in Ireland. All this causes demand to fall.

The implication of both these big forces in the credit markets and in the labour market is that the economy gets stuck. Businesses not only don’t have enough credit, they don’t have enough customers.

If the government cuts spending in this context, the money the government is not spending has to be spent by someone else, otherwise the economy will have to contract.

In the case of Ireland, our government still hopes that foreigners will take up the slack, offsetting the reduction in government spending by buying Irish goods in huge volumes. The plan was that this foreign demand would be seen in surging exports.

Unfortunately, this is not happening. Export figures are actually falling, most probably reflecting austerity policies abroad.
Therefore, national income is falling, unemployment remains far too high and thousands are leaving the country. It is difficult to see how this is all going to turn around and the more the economy contracts, the more the initial debt burden becomes unsustainable.

The economy needs a lower debt burden, a more competitive exchange rate and policies that either liberate the potential capital in the deposit base, or a slow down in government cuts and tax increases.

None of these appears on the cards, implying that last week’s atrocious figures may become a trend.

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