ANALYSIS:Even if credit crunch is prolonged, growth will rebound to 5.5% by 2011, writes Paul Tansey,Economics Editor
THE ECONOMIC and Social Research Institute (ESRI) shone a little light into everybody's life this week with its forecast that the economy would surmount its difficulties and rebound to relatively strong growth from 2010.
The model that the ESRI has developed to forecast the future essentially sees Ireland as highly integrated into the global economy. The Republic's growth prospects are largely shaped by the prospective performance of our major trading partners.
Robust growth in the US, the UK and the euro zone spill over into enhanced demand for Irish exports for as long as Irish goods and services remain price competitive on international markets.
Exports remain the largest source of business in the economy. In 2007, they comprised 47 per cent of final demand for Irish output, whereas consumer spending - the biggest component of domestic spending - accounted for just 29 per cent.
With consumers financially exhausted by the spending spree of recent years, growth depends increasingly on the pace of export growth, which in turn depends on the twin forces of market expansion in the economies of Ireland's major trading partners and trends in price competitiveness.
The ESRI's central forecast sees the economy facing difficult conditions this year and next before rebounding strongly with a growth rate of 5.1 per cent in 2010. Thereafter, real growth in Gross National Product (GNP) is forecast to average 3.8 per cent annually between 2010 and 2015 (Table 1).
The economic growth rebound is based on a projected revival of fortunes in Ireland's major trading partners from 2010 onwards. In other words, a short-lived global credit crunch is the crucial assumption underpinning the ESRI's benchmark forecast. With no deep-seated hangover effects, growth in the major advanced western economies returns to trend by 2010.
On the price competitiveness front, the outlook is less benign. By March this year, Ireland's real exchange rate had appreciated by 27.5 per cent since euro entry in 1999. In recent years, almost all of the deterioration in price competitiveness has been caused by the strengthening of the euro against sterling and the US dollar.
The ESRI envisages little relief on the exchange rate front in the years to 2015. It anticipates that the euro's exchange rate against the US dollar - currently $1.54 - will average $1.50 over the next two years before sliding gently back to $1.41 by 2013.
Against sterling, where the exchange rate now stands at £0.79, the euro is forecast to stabilise to around £0.77 for most of the period to 2015. In other words, Ireland will have to learn to live with competitive pressures imposed by a relatively high exchange rate if it is to prosper.
The medium-term review proffers little advice on how this competitiveness challenge is to be addressed, but assumes much slower real wage growth until 2015 than in the past decade.
Real wages - money wages less the consumption deflator - increased at an annual average rate of 2.6 per cent over the decade to 2005, even before tax cuts kicked in. For the years 2010 to 2015, the ESRI projects real wage growth of 1.5 per cent annually, reflecting, in part, the impact of higher unemployment rates.
This deceleration will be particularly difficult to achieve in the face of the institute's concurrent forecast that productivity growth will be at 2.5 per cent annually over the period. The ESRI demonstrates the sensitivity of economic performance to competitive losses in its "wasted opportunity" scenario. Where wages are assumed to drift 10 per cent above the levels projected in the central forecast by 2025, then at that point, the level of real GNP would be 10 per cent lower and the level of employment would be almost 8 per cent lower than in its central forecast. Competitive losses would force the economy on to a permanently flatter growth trajectory, clipping 0.7 percentage points off the annual real GNP growth rate.
Finally, the ESRI forecast assumes a reasonably swift end to the global credit crunch, with the major economies returning close to trend growth in 2010/2011. But if the credit crunch were to persist to the end of 2010, driven by a severe liquidity crisis in the US, this would impart a severe deflationary shock to the advanced western industrial countries.
The extent of Ireland's integration into the global economy would ensure these deflationary shocks were quickly transmitted to the domestic economy. Their impact, summarised in Table 2, would send the economy into a tailspin. The Republic would subside into recession in 2009, real wages would decline and the level of employment would fall in 2008 and 2009. Unemployment would rise, peaking at 9 per cent in 2010.
Moreover, the public finances would be stretched to breaking point. At unchanged tax and expenditure levels, the ESRI simulation shows that exchequer borrowing swells to 6 per cent of GNP in 2009 and, in the absence of remedial action, remains close to that level through 2011. Public borrowing at this rate could not be sustained and attempts at correction would inflict more economic pain.
However, the remarkable feature of this scenario is the extent to which the economy revives once the credit squeeze eases. GNP growth would rebound to 5.5 per cent in 2011 as the economy returned quickly to its medium-term growth trajectory.
Even in such times of simulated trouble, the ESRI maintains its faith in the economy's resilience and flexibility. We should hope that their faith is rewarded.
