In Ireland since the second World War, major deficits on the current account of the balance of payments have generally been associated with periods of economic crisis. This occurred both during the slump of the mid-1950s and during the 1980s recession. Thus the current account of the balance of payments was in the past an important danger signal, suggesting that the economy was out of kilter.
With the advent of Economic and Monetary Union (EMU) in 1999, there was a belief among many economists that the current account of the balance of payments no longer mattered, that it would no longer be necessary to ensure that exports were broadly in line with imports. These economists assumed that, under EMU, it would be easy to finance a current account deficit through foreign borrowing, given the absence of exchange rate risk. In future, they believed, things would be different.
However, other more perceptive economists, such as Olivier Blanchard, the recently retired chief economist of the International Monetary Fund (IMF), believed that this was an erroneous and dangerous conclusion. Unfortunately, his worries proved well founded. In the period 2002-2008 the best indicator that countries were getting into difficulties was the appearance of a substantial current account deficit, where imports were exceeding exports by an increasing amount. But this danger signal was ignored.
The reason the current account deficit proved an important indicator of danger for an economy was that, even without exchange rate risk, borrowing large sums abroad to fund a current account deficit still involved risks for both lenders and borrowers which were not initially priced in by the markets. Once the dangers began to manifest themselves, the cost of borrowing mushroomed, as happened in Ireland and other countries that got into difficulties.
Borrowing from abroad needs to be matched by a future flow of foreign earnings to enable the debt be repaid, otherwise it is unsustainable. EMU did not change this fundamental problem. So borrowing from abroad to fund consumption, or to fund investment in housing that won’t produce any flow of future foreign earnings, was unsustainable. Ireland’s property bubble was largely financed from short-term borrowing abroad, but it didn’t generate any export earnings to pay off the debt incurred. If the growing balance of payments deficit in Ireland had all been due to major investment by multinationals in new businesses, there would have been no risk to the Irish economy.
Last month the Central Statistics Office published new revised figures for Ireland’s current account of the balance of payments. As expected, these new data incorporated a major revision to fully cover the operation of aircraft-leasing companies in Ireland. The effect of this change was to include the purchase of aircraft by these firms in Ireland’s imports. As the balance of payments figures had previously included the leasing income of these firms as an export, while omitting the import of aircraft, it underestimated the deficit. The result of the revision was a substantial increase in the current account deficit, providing a more realistic picture of the state of the Irish economy.
Before and after revision
Figure 1 shows the current account of the balance of payments as a share of gross national product (GNP), both before and after the recent revision. In the revised figures, rather than a significant surplus in 2014, as suggested by the unrevised data, there was actually a very small deficit – exports, broadly defined, were slightly lower than imports.
The revisions particularly affect the years after 2008. They suggest that there was a much slower turnaround in the current account than had previously been understood. If we had had the correct figures in 2010 and 2011, it would not have changed the policy prescription. However, the steepness of the hill to be climbed to recovery would have been better understood.
The revised figures have important implications for policy today. If the current account surplus had been as large as previously believed, this would have suggested significant room to stimulate domestic demand, even though this would have increased imports. However, the revised figures indicate that there is not much scope for such action. Instead, the necessary expansion in investment should be funded out of domestic savings.
There remains the problem that we are probably not investing enough, especially in housing and infrastructure. This is reflected in Figure 2, which shows investment, excluding aircraft, as a share of GNP. In a normal economy that is growing, there is usually an investment-to-output ratio of at least 20 per cent. Currently, as shown, the ratio is well below that. One result of the investment shortfall is growing pressure in the markets for housing and office space.
As we can’t go back to a situation where banks borrow abroad to fund mortgages, much of the future investment in housing will have to be funded from domestic savings. However, there is some scope for commercial foreign investment in the rental sector, which could earn a return to fund itself, and help ease some of the current supply pressures.
Continued growth in Irish export earnings will be needed to pay for a necessary increase in investment, particularly to ease the housing shortage. While we are currently benefiting from benign movements in exchange rates vis-a-vis the dollar and the pound, it will be essential to maintain competitiveness in the coming years in order to generate the growth in foreign earnings we need, and to guard against future adverse movement in key exchange rates.