Why the ESRI has got it wrong

Should governments cut spending rapidly this year and next if the economy is still on its knees?

This debate is raging, not just in Ireland, but around the world. Broadly speaking, the EU and the European Central Bank (ECB) want to cut back government spending quickly, while the Americans are more cautious, wishing to make sure that the economy is strong enough before they start cutting.

All this comes against a background of the world economy turning out to be more fragile than expected and a real worry in the US that there will be a double dip recession.

The data from the US is not reassuring right now – particularly from the housing market, which has been a good leading indicator of how strong any recovery is likely to be.

The latest in a long stream of increasingly powerful signs that the US housing market is plunging headlong into a double dip came in data published last Tuesday. It showed that housing starts in June fell to a seasonally adjusted annual rate of 549,000 units, including both single-family homes (the great majority) and multiunit buildings.

This was 5 per cent below the level for May, of 578,000 starts – which itself had originally been reported as 593,000, but was revised down with the publication of the June data.

The all-time record low in this series – which stretches all the way back to 1959 – was in April 2009,when 477,000 units were started. So, although there has been a recovery from the trough, it has been a very minor one when you consider that the peak, in January 2006,was 2.3million units.

After a ‘dead-cat bounce’ last spring and summer, the direction has been sideways for the last year.

Now, housing starts are clearly heading downwards again. This renewed slump led Ben Bernanke, chairman of the US Federal Reserve, to admit candidly this week that the outlook for the future was ‘‘unusually uncertain’’. That is banker-speak for ‘‘what we have done so far to solve the problem does not seem to be working’’.

It is refreshing to hear a man in power admit he is not sure which way things are going.

This honesty is not a weakness; it is a strength. It also informs the US position when they question whether it is prudent to cut back state spending right away.

Contrast this humility from the Americans with what was on display in Ireland this week.

Here, where practically every mainstream economist got this boom/ bust cycle totally wrong, many, completely unabashed, are still confidently doling out advice and long-range economic forecasts, despite the fact that the future is extremely uncertain.

In Ireland, the Economic and Social Research Institute (ESRI) has a pretty patchy forecasting record, particularly in recent years.

Yet last week, based on its long-range forecasts, the ESRI was telling the government to ‘‘front-load’’ expenditure cuts.

In a week when the Department of Finance took a hammering for its competence in economics, let’s look at the ESRI, another public sector institution.

In December 2005 (less than five years ago) it produced a long-range forecast similar to the one it produced this week – which was supposed to tell us where we would be now, in 2010.According to its ‘‘worst case scenario’’, Irish GDP would be €196,876 million; in fact, it is €166,345 million.

At worst, our debt-to-GDP ratio would be 16 per cent; it is now66 per cent.

It forecast that the 2010 budget deficit would be, at worst, 0.3 per cent GDP; it is, in fact,14.3 per cent of GDP.

So, to use the vernacular, the ESRI, writing in December 2005 hadn’t a rashers what they were taking about.

Remember, I’ve used their worst case scenario here.

The ‘‘high growth scenario’’ in 2005 said that GDP would be at €208,718 million, the debt/GDP ratio would be 15 per cent and unemployment in 2010 would be 123,000.

The point here is not to have a go at the ESRI – we all make mistakes – but to show that trusting an institution like that, which hasn’t exactly covered itself in glory, might not be the cleverest thing to do.

So when the policy advice from the ESRI is to ‘‘front-load’’ expenditure cuts in December in order to impress the financial market, I am a bit sceptical – particularly as the ESRI itself said the reason its forecasts were so wrong was it that it didn’t have any expertise in credit, banking and financial markets. If it has no expertise, how can it make pronouncements on the likely reaction of the financial markets to anything?

It would seem more logical to adopt the US approach: throw our hands up and say we don’t really know what is going to happen next.

What we do know is that if the government can invest now in productive assets such as people or infrastructure, which will generate a return on investment greater than the rate of interest, this is likely to put us in a stronger position to emerge from even a double-dip slump.

As a response to the Irish people deciding to save more (which is what is happening), privatising the state assets that make most money and cutting back on social services seem a little odd.

It is made all the odder by the fact that we are a tiny part of a monetary union, and the only real benefit of our membership is that we can borrow to invest in productive assets. (By all means, sell state assets, but do so towards the top of the cycle when the state can get a good price for them, rather than now when it will definitely be a fire sale benefiting buyers, not sellers.)

The downside of the monetary union is that it makes the recovery much harder, because you can’t devalue to regain competitiveness. In political terms, it also biases economic policy towards evolutionary progress, when something revolutionary might be necessary.

The upside is that it allows you more time to transform the place.

This is what the Americans are doing: playing for time.

This is what Paul Krugman, a Nobel prize winner for economics, was getting at when he took the ESRI to task this week, writing that the institute was doling out policy advice based on assertion, rather than persuasive analysis. It seems that in Ireland, some of the strongest supporters of the euro are advocating policies more appropriate for a country with an independent currency.

Small countries with independent currencies always run the risk that the markets will close down on them, so they must react quickly. In the EMU, the opposite applies because the small country is simply the weakest link in a chain.

It looks like the ERSI – because it doesn’t have (as it admits itself) the expertise in financial markets – doesn’t understand that the euro gives us time.

This is the real lesson from Greece’s bailout.

There are many good reasons to reform the public sector; an immediate threat from the bond market isn’t one of them.

The front-loaded cuts idea seems based on a strange ideology, whereby one very well-paid public sector institute contends that we must close down other public sector institutes. Pots and kettles come to mind.