Prof. John FitzGerald says borrowing by households was funded directly through mortgages from the domestic financial system. In turn, the financial system was not able to raise adequate funds domestically and, instead, the net foreign liabilities of the banking system rose rapidly in the period to 2007. This very rapid rise in the banking system’s net foreign liability, shown in Figure B, would not have been possible if Ireland had not been a member of EMU. If the borrowing by the banking system had been in a foreign currency the dramatic increase in foreign currency risk would have been passed on to domestic borrowers as higher interest rates and this, in turn, would have choked off the boom in the housing market. (The boom would probably have been choked off prematurely around the turn of the century.) Because the government sector will fund its borrowing through sales of bonds abroad this will cover the balance of payments deficit. In fact the government’s deficit will tend to pump some liquidity into the economy. With the personal sector no longer a net borrower the banking system will find itself not having to borrow abroad (net) to fund household sector activities in 2009. Moving into 2010, the household sector could even become a net lender. This could even see some repayment by the banks of their net foreign borrowing.

Irish  Economy: The ESRI (Economic and Social Research Institute) in a grim assessment of the Irish economy, forecasts up to 117,000 job losses in 2009. In the 1980's, 1985 was the worst year for job losses, at 24,000.

The unemployment rate is forecast to average 9.4 per cent in 2009, up from 6.9 per cent this year. Net outward migration of 50,000 for the year to April next is forecast.

Dr Alan Barrett said a 3.5 per cent pay rise due next September "appears unaffordable" for the Government, adding that the possibility of pay cuts in the public sector should at least be considered.

The ESRI says the general government deficit (GGD) will rise to 10.2 per cent, up from 6.9 per cent this year. The economy, as measured by gross national product, will contract by 4.6 per cent in 2009 after a 2.6 per cent slump in 2008.

The ESRI says a rise in public borrowing to €18.2 billion from €13 billion in 2008 has potential to impede recovery prospects.

The debt/GDP ratio is projected to rise to 47.5 per cent, almost twice the end of 2007 level.

Inflation is forecast to fall to -2 per cent.

The Institute says many of Ireland’s trading partners are now in recession and are expected to record falls in output volumes in 2009. For example, the OECD expects the US to contract by 0.9 per cent in 2009 and the Euro Area to contract by 0.6 per cent. Prospects for the UK are even worse, with a fall in GDP of 1.1 per cent expected in 2009. As a result of these anticipated outcomes, The ESRI expects Ireland’s exports to fall by 0.4 per cent next year.

If the global recession is deeper than the ESRI anticipates, the outlook for the Irish economy will be even gloomier.

The Winter 2008 Quarterly Economic Commentary, says that one year ago the Institute was forecasting a growth rate of 2.3 per cent in GNP for 2008. Its latest estimates suggest it will now contract by 2.6 per cent. Within a short twelve months the forecasts have switched from downturn to prolonged recession.

"We now expect the economy to remain in recession throughout 2009, with both consumption and investment weak throughout the year. We do pencil in the possibility that there will be a small upturn in exports towards the latter half of 2009, if there is a recovery in world growth and world trade at that stage. Nevertheless, this recovery is not sufficient to lead to an increase in volume exports in 2009.

Our forecasts imply a very rapid rise in the unemployment rate, to average 9.4 per cent in 2009. On a quarterly basis this is consistent with an unemployment rate of 10.2 per cent in the fourth quarter of 2009. With rising unemployment and falling output the public finances move into significant deficit, with a general government borrowing requirement of over 10 per cent of GDP in 2009. This implies an increase in the government’s net debt position from 12 per cent of GDP in 2007 to 34 per cent in 2009," the QEC says.

The QEC says that between 1998 and 2006 total expenditure as a percentage of GDP was relatively stable at between 31 and 32 per cent of GDP. It rose by over one percentage point in 2007, most of which was due to an acceleration in capital spending. However, this figure jumps dramatically in 2008 and 2009, because GDP falls by a cumulative 6.4 per cent (2.6 per cent in 2008 and 3.9 per cent in 2009) and total expenditure rises by a cumulative 16 per cent (10.9 per cent in 2008 and 4.5 per cent in 2009). Together with the collapse of windfall property taxes, this has created a yawning gap between expenditures and revenues.

The Government says in its Building Ireland's Smart Economy: A Framework for Sustainable Economic Renewal plan, published on Thursday, Dec18, that "over the period of the next few years, it is estimated that the interest costs on the national debt will more than double, accounting for 11% of tax revenue by 2011 as compared to 5% in 2007. This means that more and more of our day-to-day resources are simply being raised to pay interest costs as opposed to paying for services. So the taxpayer could end up paying more and getting less. This is not acceptable. Furthermore, the state of our public finances is a key factor in the cost of borrowing on international markets."

With the economy facing a relatively prolonged recession with rising unemployment and falling consumption it is inevitable that the public balance will deteriorate. However, the ESRI says policy choices made at the beginning of the decade which led to a structural reduction in the taxation take in the economy were effectively masked by the windfall exchequer gains generated by the property bubble in the middle of the decade. This meant that structural expenditure increases were funded out of an unsustainable revenue trajectory. The consequence of these imbalances for the economy during the current recession is that the borrowing requirement is rising too rapidly to allow for any form of pro-cyclical fiscal policy. Instead over the short-term the key priority of the authorities must be to control the growth of public spending.

The ESRI's Summary of its main findings include:

• The forecasts in this Commentary illustrate how the Irish economy is in the midst of a contraction that is large by both historic and international comparisons. For 2009, we expect GNP to fall by 4.6 per cent in volume terms. Coming after an anticipated contraction of 2.6 per cent in 2008, the accumulated fall in output is dramatic.

• The volume of consumption is expected to fall by 3.6 per cent in 2009. The fall in investment is expected to be larger still. We are forecasting a fall of 19.3 per cent in investment volume in 2009.

• We now expect that average employment will fall by 117,000 in 2009. A fall in employment of that size will be consistent with net outward migration of 50,000, the unemployment rate averaging 9.4 per cent and participation falling by 1.3 per centage points.

• On the public finances, we expect the General Government Deficit to be 6.9 per cent of GDP in 2008 and 10.2 per cent in 2009. We expect that the general government debt will reach 47.5 per cent of GDP in 2009, up from 24.8 per cent in 2007.

• We expect HICP inflation to average 0.5 per cent in 2009. With interest rates falling rapidly, we expect CPI inflation to be negative, at -2 per cent. For the economy as a whole, we expect zero wage growth in 2009. As wages in the public sector will show an increase during 2009 as a result of an increase granted in September 2008, implicit in our forecasts is a wage fall in the private sector in 2009.

• In our General Assessment, we argue that the focus of policy should be on ensuring that Ireland is as well placed as possible to participate in the global upturn. As part of this strategy, we need to ensure that the public finances do not become a constraint on growth, as they did in the 1980s. With this in mind, we would stress yet again the importance of ensuring quality in all public spending, whether current or capital. We would also re-iterate a point that was made in the last Commentary, namely, the likelihood in the medium-term of a need for tax increases as a result of the erosion in the tax base in recent years.

• We also argue that the deterioration in the public finances will make it difficult for the government to pay the 3.5 per cent increase in September due under the pay agreement. We argue that the social partners need to come together and to reassess the most recent pay deals in the light of rapidly changing circumstances. The possibility of pay cuts in the public sector should at least be considered in this context as pay cuts may well be considered preferable to cuts in services. As well as protecting services levels, the pay adjustment approach could well yield expenditure savings more rapidly than an approach based solely on job cuts through natural wastage, early retirements and redundancy schemes.

• New research reported on in the Commentary on the public/private wage differential suggests that there is a significant pay advantage for those working in the public sector and that this may have increased in recent years. Taking account of factors such as the education and experience of employees in both sectors, the public sector wage advantage appears to be over 20 per cent. Given this, it seems highly unlikely that any wage reductions in the public sector would, in general, lead to any significant challenges in terms of retaining or recruiting staff.

Download Executive Summary (pdf)