Wednesday, 10 June 2009

Irish economy notes #1 - is it a "small open economy"

One of my favourite pastimes is to exist in a state of self induced angst about the lack of any apparent comprehension by anyone of the nature and behaviour of the Irish economy. Well, at least anyone in any position to exert policy influence.

Egotistical and self absorbed, most probably. But the feeling is real I promise.
For the last number of years events have provided ample opportunity to wallow in this strange mixture of self delusion and rage. We all know what that was; the "Property Bubble". Of course it is a bubble now (it was the "Celtic Tiger" then) after the event, as bubbles invariably have to be.

So now I need a new focus for my angst and believe me I don't find them hard to come by. I though I would kick off with another "self evident truth", that sits up there with "Celtic Tiger" and that is the claim that Ireland is a small open economy.
My bollocks it is.

Let's start with what exactly we mean when we use the phrase small open, or even simply open, economy. Most non-economist (and probably a lot of trained economists) would invariably answer that it is an economy that trade a lot, or something like that; a lot of exports. At that point one would point to the national accounts of Ireland for handy proof that the market value of exports from Ireland are indeed large relative to total output - exports are approximately 80% of GDP. Grand so, as they say on the Emerald Isle.

Except this is a bit of a trap. You see there is at least two distinctly different ways in which external trade (exports and imports) can originate and occur. I would say that one of those is not an example of an "open economy" in the true sense - something I will expand on later.

What are these two different types of trade? The first is one when imports occur and are used and transformed into others stuff of use and value to other people, either domestically or abroad. For example, you import some coal to generate electricity to run a factory that produces washing machines. What I am trying to identify here is the amount of "value added" that occurs in transforming the imported commodity into something else; that this value is added withing the country and hence the income that accrues to that added value is income to that economy. If a lot of these washing machines etc. are exported and a lot of stuff is imported to help make them, this would be an example of an "open economy".

Let's look at the second type of trade. You import some coal and stick in on a train and ship it to a neighbouring country. Why would you do that? Well, maybe that neighbour is landlocked. A tiny amount of value is added as the commodity is imported into the country and then exported. There are many examples of such activity. Hong Kong is the classic. Goods come in from China and get shipped out around the world. Similarly it act as an import hub also. There are examples closer to home for Ireland, Belgium is one. Now this is something I would suggest is not an open economy, but a "re-exporter".
So that is the distinction and so what? Well, it is important to understand what is going on in the economy at any time and it is important to understand before you propose any economic policy. And here is the reason:

If there is a downturn in global trade (a global recession like now), the an open economy will suffer. The exports represent a large amount of value added, or income to that country. In terms of national accounts aggregates, exports will fall, but imports will not fall a great deal. OK, global recession is bad for an open economy.

But what about the re-exporter? If there is less demand for exports, this has less affect on income (because those exports represent less value added). In national accounts terms, exports will fall a lot, but imports will fall almost as much in direct response. Eagle eyed observers will note that the important factor here will be the proportion of value added compared with the scale of trade. Ireland has exports which are probably twice as large (scale adjusted) compared with other industrialised countries, but the value added is probably only a quarter.

So far so good. But so what? Well here are some of the relevant implications of this:

The Irish economy is not overly susceptible to global recession (government finance are, but that is a story for another day). In fact it is less exposed to a dip in foreign demand. So when a member of Government claims that Ireland's woes are due to "global recession", they are stretching the truth to say the least.

Another important implication is that domestic demand is relatively important. Low interest rates (perhaps lower than they should be) that help fuel a consumption and borrowing boom will inflate the economy. An "open" economy would import a lot more, effectively utilising the productive capacity of other countries to meet demand. However, as I suggest, Ireland is not an open economy in the true sense, but a re-exporter. A surge in domestic demand will not naturally divert massively into imports as in the case of a truly open economy. And ignorance of this is one source of the massive failings of the last 15 years of Irish economic policy

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