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News : Irish Last Updated: Dec 19th, 2007 - 13:17:15


Irish Economy: Medium-Term Review: 2005-2012 - ESRI says aura of invincibility coupled with considerable risks
By Finfacts Team
Dec 16, 2005, 08:16

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The ESRI (Economic and Social Research Institute) publishes its latest Medium-Term Review of the Irish economy today. This Review is published every second year, providing a comprehensive analysis of the prospects for the Irish economy over a seven-year time horizon.

Some of the main findings of this Medium Term Review include:

Services are the activity of the future: The market services sector will play a gradually increasing role in raising output and employment. In the medium-term, less output and employment growth will come from the manufacturing sector with the market services sector continuing to grow in importance.

While the economy has the potential to continue growing quite rapidly, there are significant dangers on the horizon: If there are no unpleasant surprises the economy could grow at just under 5 per cent a year out to 2010. However, the US economy is currently on an unsustainable growth path with ever-rising deficits. If and when the US economy switches to a more sustainable path this could result in a slowdown in growth elsewhere, including in Ireland. While this is unlikely to happen within the next two years, thereafter there is the risk that Ireland could find itself experiencing a rate of growth below its long-term potential.


The very high level of dependence on the building and construction sector leaves the economy vulnerable to shocks: The building and construction sector’s need for an ever-increasing share of national resources has been a source of inflationary pressure. This has had adverse consequences for other economic sectors. As the economy evolves over the coming decade the building and construction sector is likely to fall in importance.

Key priorities for policy are:

» Development policy needs to adjust to take account of the changing roles of manufacturing and services.
» Managing the exposure of the economy to external shocks and also to its exposure to sudden changes affecting building and construction.
» Tackling the infrastructural constraint on growth remains urgent.

Introduction

Professor John FitzGerald, Director of the ESRI, with Ide Kearney & Adele Bergin at the launch of the Medium Term Review 2005-2012
A
fter a decade of generally high growth and low unemployment there is a growing feeling among households and companies that the Irish economy is invincible. Even the short slowdown of 2001-03 did not lead to an appreciable rise in unemployment and, as a consequence, it did not significantly dent confidence in the future. Today investment in housing is running at an unprecedented rate, fuelling growth elsewhere in the economy. The unemployment rate is bouncing around close to the full-employment level, and Ireland is seen to be the most attractive labour market in Europe for many of the mobile young population.

The pattern of behaviour by households reflects a high degree of certainty about the future. The level of gross (and net) household debt is rising rapidly; households have confidence that they will be able to service this in the future. Many companies also appear to be sanguine about the future. This is reflected in very substantial increases in employment. While some firms, especially in the tradable manufacturing sector, are facing difficulties, their woes are masked by the feeling of bonhomie elsewhere in the business sector, especially in all those businesses that depend on the building sector for their success.

As discussed later in this Review, the fundamental factors driving the Irish economy remain favourable. The economy faces a very fortunate set of demographic circumstances over the next fifteen years. Together these circumstances will conspire to give Ireland one of the lowest rates of economic dependency in the OECD area. The benefits of past investment in education will also continue to produce a significant boost to productivity for some time to come. In addition, the economy, including the labour market, shows considerable flexibility. The limited impact of the recent economic slowdown on the unemployment rate was indicative of this flexibility. Also the very elastic labour supply through migration means that the labour market is fast to react to changes in demand.

While the underlying structure of the economy is evolving in a manner that should be favourable to future growth, there are considerable dangers in the current situation. In particular, the extremely high level of dependence on the continuing success of the building industry is a serious cause for concern. This is compounded by the certainty with which many in the household sector view the future prospects for growth.

These internal risks to future prosperity must be seen against the background of the global economic imbalances that, if anything, are growing in magnitude. A key part of the story of this Review is the future evolution of these global imbalances. In the more favourable, High Growth scenario, teased out in detail in Chapters 3 and 5, we assume that the US economy will continue growing at a rapid pace indefinitely in spite of a gradual worsening in its external and government deficits. We continue this scenario out for the next decade and, if realised, it would provide a very favourable backdrop for the Irish economy. However, it is not possible for the US to continue forever on this path and the results of this scenario suggest that other domestic factors, in particular the gradual loss of competitiveness, could in any event bring the period of high growth to an end.

When looking beyond 2010 we feel that an alternative Low Growth scenario is more realistic. This scenario, discussed in detail in Chapters 3 and 6, assumes that the US economy begins a gradual adjustment to a more sustainable growth path from 2007 onwards. This adjustment process would be painful for the US and for the rest of the world in the short term. We do not attempt to predict when this adjustment will actually occur. It could begin as early as 2007 or it could be postponed until well into the next decade. With the global imbalances increasing year by year the adjustment process is likely to be more painful the longer it is delayed. In addition, in the Low Growth scenario we assume that the adjustment process is fairly gradual and spread over a number of years. In practice, if it is to occur, the adjustment may be more of a short sharp shock. This could portend a much more unpleasant environment for the Irish economy in the year it happened, but the more rapid restoration of the world to a sustainable growth path could prove beneficial in the longer term.

In this Review we have only considered two alternative scenarios for the world economy in detail. Obviously there is an infinite set of possibilities, some of which might produce a less painful resolution to the problem of international imbalances. However, it is equally true that things could be more difficult than we envisage in this Review and in Chapter 6 we consider how problems in the building and construction sector could interact with an unfavourable external environment to produce a serious domestic slowdown.

While our forecasting record (see Appendix 1) has been acceptable, the one certainty is that the world will not turn out exactly as it is modelled in any of our scenarios. The purpose of this Review is primarily to provide an explanation of the factors driving the Irish economy and to explore a range of possible future economic outturns. This range of possibilities highlights the uncertain world in which policy-makers must operate. Their objective in forming economic policy should be to choose a strategy that will be robust in the face of a wide range of possibilities. It is also important to adopt policies that may reduce or eliminate the danger of some future shocks. To the extent that the range of forecasts in this Review helps policy-makers hone their policies to avoid future shocks, the actual economic outturn could be enhanced (and the forecasts rendered obsolete).

When Odysseus undertook his long voyage home from Troy he encountered many dangers. Not least were the distractions that the Lotus-eaters provided for his crew. The lure of good times with the Lotus-eaters nearly derailed the voyage and tough measures had to be taken by Odysseus to get the crew back on board. Today, one of the key issues for policy-makers is how to tackle the dangerous imbalances that are building up in the economy at a time when euphoria in the household sector is possibly clouding the judgement of individual households. Trying to get households and companies to focus on future dangers at a time when the economy is thriving is always difficult. However, the nature and dimensions of the risks that the economy is likely to face over the coming decade does underline the importance of commencing this task.

In Chapter 2, we bring together the results of recent work on the changing structure of the Irish economy, in an effort to develop our understanding of the mechanisms underpinning recent trends. As will be seen in that Chapter, services are playing an ever increasing role in the economy, both in terms of domestic consumption patterns and exports. Given the historic concentration on manufacturing in the policy arena and in discourse on the drivers of economic growth, this shift will be critical from a number of perspectives. In Chapter 2, we also return to some more traditional themes such as the role of human capital and immigration. While these themes have been discussed before, the work presented in Chapter 2 places developments in these areas in the broader context of Ireland’s recent economic experience.

Turning next to the international context, a number of uncertainties exist which could have potentially large impacts on the Irish economy. Foremost among these are the on-going large imbalances in the US economy, in particular the deficit on the current account of the balance of payments. The US balance of payments deficit has been growing in recent years and has now reached over 6 per cent of GDP. This situation is unsustainable in the long run and at some stage the US economy will have to adjust to return it to a sustainable path. As the adjustment could involve a large dollar depreciation and/or a dramatic cutback in US consumption, the implications for the Irish economy could be significant.

In Chapter 3, using the NiGEM1 model of the world economy, we quantify by how much US private and public consumption might have to fall in order to bring the US economy to a point where the balance of payments deficit is sustainable. The results are used in the rest of this Review when we quantify the possible impact on the Irish economy of a US adjustment. As will be seen, the estimated impact is large and provides one of the key findings of this Review. We also look at the German economy to assess the prospects for recovery based on improved consumer sentiment as this, along with investment, appears to be the missing link in the potential German (and hence euro-zone) recovery.

In Chapter 4, we provide a broad overview of our forecasts before going into greater detail in Chapters 5 and 6. Chapter 5 contains the High Growth forecast. In a sense, the crucial assumption that underlies this forecast is that no adjustment occurs in the US in response to its imbalances until after 2012. We have opted to present this as our detailed forecast to 2012 based on a belief that adjustment in the US is unlikely to occur in the immediate future. We are less certain as to whether or not an adjustment will occur after 2008/9. However, a working assumption is needed and so we have opted for the no-adjustment story as the baseline. In the absence of a US adjustment, the picture that emerges of the Irish economy in the medium term is one of continued economic growth averaging over 4.5 per cent per annum out to 2010.

In Chapter 6, we alter the crucial "no-adjustment" assumption and estimate the impact on Ireland of an adjustment in US private and public consumption commencing in 2007. This Chapter presents details of our Low Growth scenario. This adjustment could begin in any year from 2007 onwards. The later it occurs the bigger the adjustment that is likely to be necessary. In modelling the adjustment in this way we do not imply that this is when and how we necessarily see adjustment occurring. Rather our goal is to quantify the impact of an adjustment and to examine the implications for Ireland. As noted already, the impact is large and so a core conclusion of this Review is that the on-going US imbalances pose a substantial threat to Ireland’s economy.

Chapter 6 also includes an analysis of what would happen if the world slowdown, consequent on the US adjustment scenario, triggered a major fall in domestic housing prices. This scenario shows just how vulnerable the Irish economy now is to any downturn that has a major impact on the building industry. In this scenario where housing prices and output drop very substantially, the unemployment rate rises dramatically to over 10 per cent of the labour force towards the end of the decade.

In Chapter 7, we discuss the implications of these scenarios for public policy over the coming decade. While there are dangers for future development, prudent policy could minimise these risks and help ensure that the Irish economy realises its considerable potential.

Medium-Term Review: 2005-2012, No. 10


© Copyright 2007 by Finfacts.com

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