Ireland is facing unpleasant short-term future

One of the striking elements of the past half decade has been the way the public dialogue has become suffused with the language of economics.

Yet, the basic structure of the economy remains rather a mystery.

Perhaps the aggregate economy and its associated stocks and flows is simply too large for many people to grasp.

Compounding this is the fact that there are at least four measures of the economy. Three of these are equal — and yet each measure paints a very different picture.

We can measure the economy in one of three ways: Given that my spending is your income, we can measure the expenditure of various sectors; we can measure the income received by various sectors; or we can measure the output of the various sectors of the economy.

The first is the most common and gives a basic accounting measure. Income is equal to consumption plus investment plus net government spending plus net exports=. This gives us gross domestic product.

We can also take into account net income from abroad, which when taken away gives gross national product. In the Irish context, we have significant negative flows, making our GNP less than our GDP by some 20%.

So how have things evolved since 2000? One meme is that we have seen a massive expansion of government expenditure. We have, but perhaps not to the extent that many consider.

Government expenditure has risen by 97% over the period and has increased its share of GDP from just over 12% in 2000 to 16% now, down from 19% at peak.

The largest changes have been in investment. The decline in quarterly GDP since the peak at the end of 2007 has been just over €10bn. This equates almost exactly to the fall in investment, in turn driven by the unwinding of the credit driven housing bubble and its consequences. Quarterly consumption has fallen by €3bn while both exports and imports have risen.

It is in the interrelationships between these components, and in particular the relation of net government expenditure that the theoretical and policy battle between economic doctrines is being played out.

We have Keynesians of various stripes, who suggest that increasing net government spending increases the size of national income. Countervailing this are the austerians, the newest incarnation of what is also known as classical economists, who assert that increasing government spending crowds out private spending.

A key aspect of this argument revolves around the estimation of what is called the multiplier, the extent to which the data shows if government spending does lead to long-term increases.

The news for Ireland is not great for those who would wish for stimulus. Ideally we want the multiplier to be greater than one, so that increasing government spending by €1 will result in national income going up by a greater amount.

Ireland faces an additional problem in that it is an extremely open economy.

While much of the imported goods go to manufacturing and services for reexports, we also consume large quantities of imported goods. And we face the problem that there is no single multiplier (are we stimulating by capital spending or current spending?), it varies across the business cycle (with some evidence that it is higher in recessions, exacerbating the effects on national income of cutting government spending), and that it is closer to zero than one for highly indebted countries and open economies (we being both).

A further problem is that the evidence indicates that multipliers tend to be higher for countries in fixed rather than floating exchange regimes. Add to this the emerging evidence on how sovereign risk leads to a squeezing out of investment and we see that we face a most unpleasant short-term future.

* Brian Lucey is associate professor of finance in TCD