ECONOMICS:WHILE ALL forecasting exercises are conducted in a context of uncertainty, the background against which the latest Quarterly Economic Commentary(QEC) has been prepared was one of remarkable uncertainty

For this reason, we need to emphasise that the confidence with which we present the forecasts is a good deal lower than is usual. Having said that, it now seems clear that the economic difficulties facing Ireland will persist well into 2009.

Earlier in the year, many commentators such as the OECD were of the view that the US economy would pick up in the middle of 2009 and that the euro area would remain somewhat insulated from global economic difficulties.

Recent weeks have seen this view evaporate. A growing sense of pessimism has developed about the prospects for the global economy, with any hopes for a turnaround in 2009 largely extinguished. Against this background, we now foresee a second year of contraction in 2009.

While we have not produced forecasts for 2010 as part of the QEC exercise, we are mindful of a scenario presented in the ESRI's medium-term review in which a prolonged credit crunch means that Ireland does not return to trend growth until 2011.

Given this situation, it is inevitable that calls will be made on the Government to address the current difficulties and to implement policies to restore growth. A danger exists in this context, however, that the Government will take actions which are ill-advised and counter-productive.

Having sought to address the immediate problems in the financial sector, the Government's focus policy should now be on the more medium-term goal of ensuring that Ireland is well placed to participate in a global upturn.

The harsh reality facing the Government in the short-run is that there are few policy tools, if any, available to alleviate the current difficulties. The standard tool of short-run macro-demand management - ie a fiscal stimulus - is not an option due to the state of the public finances.

More focused, or micro, measures can generally only provide short-run, artificial boosts to certain sub-sectors. Of particular note here are measures to stimulate activity in the housing sector. These should be avoided so that a new equilibrium can be found in that market as quickly as possible.

Medium-term prospects can be seriously damaged by policy mistakes now, so the role of policy is still critical, even if it is limited in scope in the short-run.

With regard to the public finances, we argued in the last QEC that the 3 per cent deficit limit under the EU's Stability and Growth Pact (SGP) should not be viewed as a binding constraint in the short-run and that a more medium-term approach to restoring balance to the public finances should be taken.

We are still of this view, although the deterioration in the public finances since the last QEC means that a greater degree of fiscal restraint is now called for, even in the context of breaching the SGP limits.

We would now argue that the Government should aim to stabilise the general government deficit at 5.5 per cent of GDP in budget 2009. In making this recommendation, we are conscious of the need to balance two competing objectives.

On the one hand, it is desirable that the Government should not add to the problems confronting the economy by further weakening demand through spending cuts or through tax increases. On the other hand, it is also desirable that the public finances be brought back on to a sustainable path.

In recommending that the deficit be held broadly in line with the (projected) 2008 level, we are recommending a deflationary budget. However, we do so partly because of our uncertainty over when the economy will return to a period of economic growth.

Regardless of whatever action the Government takes in the coming weeks, we believe the possibility of higher taxes will have to be confronted in the near future as part of a structural review of Ireland's public finances.

Increased public spending was facilitated in recent years by property-related tax windfalls that have now dried up. Even when Ireland returns to its long-run growth path, it may well be the case that tax revenues are not sufficient to fund levels of public services which are (in some social sense) considered optimal.

In this way, the current tax shortfall would have to be viewed as a structural problem and not simply a cyclical problem which will be corrected once the economy experiences a return to trend growth.

At that time, the issue of the appropriate levels of taxation and public spending will have to be revisited.

Ide Kearney, Jean Goggin and Martin O'Brien (co-authors of the ESRI's Quarterly Economic Commentary) all contributed to this column.