The McIlroy effect

This is Ireland 2014.

In certain parts of the economy, money is no object, yet in other large swathes of the country, many people haven’t a bean.

Events in the past few months have exacerbated this divide because the single biggest divider of wealth in this country, the housing market in Dublin, is taking off. With house prices booming in south Dublin, the already rich are getting wealthier. In other parts of the country, house prices have hardly budged and the residents are stuck, in many cases, in negative equity.

When house prices move in Dublin, this generates a wealth effect. People feel richer not because they have actually got any richer, but because they “feel” richer. Their notional balance sheet – the difference between assets and liabilities – has improved.

But this only is the case for the lucky ones who are already wealthy and whose perceived income is affected by asset values.

Meanwhile, the vast majority – those people who depend on wages for their income – don’t feel any richer. In fact, the evidence over the past few years is that their income has been eroded. We can see this from the first chart, which shows that real wages in Ireland – that is wages minus inflation – have fallen substantially.

If fact, real wages have fallen and not recovered, even as the GNP figure has risen rapidly. GNP is the figure that is used by economists to measure income in the domestic economy. It is often reported that if GNP is rising, a person’s income is rising. But this is not always the case. Look at the chart and you see something else happening, which is that wages are flat-lining while income rises.

How could this be?

The implication is that profits in the economy, or the return to capital rather than labour must be rising rapidly and this is indeed true. Therefore, the people who own capital in the country are doing well, but those who only have their labour to sell are not.

Given that the greatest source of private capital and wealth in Ireland is a person’s house, any increase in this asset drives consumer sentiment and therefore, retail sales.

We can see this very clearly from chart 2. This shows the extraordinary correlation between house prices and consumer sentiment and also reveals how important the house price recovery is for domestic spending.

So where do we go from here ?

My feeling is that Ireland is on the cusp of a massive surge in wages and a fall in profits and when this happens, the trauma of the past seven years will begin to ease.

To understand this thinking, I will ask you to take a bit of altitude from the day-to-day, blow-by-blow reportage on the economy and consider how economic cycles work.

The first thing to appreciate is that in recessions, profits don’t fall, they rise! This seems counter-intuitive, but it’s true. In fact, recessions are actually caused by a surge in profits. This might seem odd, but this is how the economy works. Marx made the point that capitalism was a constant struggle between workers and capitalists. He was – and still is – right.

When something is sold, either the returns go to workers in the form of wages, or capitalists in the form of profits. When more of the returns go to wages, people have more money in their back pockets and more work. They then spend this cash and this is how the economy grows, purchase by purchase. If more of the economic output goes to profits, these retained profits are saved normally and don’t recirculate in the economy because they are normally owned by a small percentage of the population. Therefore, when there is a surge in profits in the economy, there is too little spending and the economy shrinks. This is how recessions can get prolonged.

In contrast, when there is a boom, the rate of unemployment falls dramatically as it did in the years 2000-2007 in Ireland and this drove up the share of wages in GNP and drove consumer spending, pushing up the growth rate further. Ironically, the boom was the period when companies in Ireland made least profit, not most profit. This point is rarely appreciated.

The bust occurs because companies try to increase their margins by letting go workers and squeezing wages. This process drives down spending and up savings, thereby suppressing activity.

We are now at an inflexion point where wages are lowest and profits are highest and a small minority whose wealth is dependent on profits and capital are much richer than the rest of society. This will now change as the pendulum swings back towards wages and employment and away from profits and capital.

Does this mean that Ireland is about to experience a significant rise in wages over the course of the next few years?

Yes I believe that will happen, not because I have any insider knowledge, but because this is how economies behave and this is how humans behave. Expect the trade unions and workers very soon to demand their share of the pie. Does that mean industrial relations issues? Why of course.

There’s more chance of Rory McIlroy getting back with Caroline Wozniacki, than Ireland not having labour disputes in the period ahead.