ECONOMICS:The non-housing sector must be in robust shape if growth is still expected in the economy overall
IRELAND IS already experiencing a growth recession. The pace at which the economy is growing is receding rapidly. Over the past year, the State's leading forecasters have cut in half their expectations for Irish economic growth in 2008.
A year ago, the Central Bank was projecting that the economy would expand in real terms by 4 per cent this year. In its latest Quarterly Bulletin, published a week ago, the bank pared back its forecast for real growth in gross national product (GNP) to 1.9 per cent.
Similarly, the Economic and Social Research Institute (ESRI), in its Spring 2007 Quarterly Economic Commentary, was looking forward to a real GNP growth rate of 3.9 per cent in 2008. This spring, the ESRI has pulled back its growth forecast for 2008 to just 1.6 per cent.
Forecasts change because the facts change. Economic forecasters are not clairvoyants. They can only base their projections on the information available when they are constructing their forecasts. As Maynard Keynes put it, when challenged over his frequent shifts of direction, "When the facts change, I change my mind. What do you do?"
The facts that have changed in the Irish economy over the past year relate principally to housing. The continuous cutbacks in growth forecasts for the Irish economy reflect, in the main, the ongoing deceleration in house-building activity.
During the building boom the growth in housing investment speeded up the pace of economic expansion; now the housing slump is subtracting from economic growth. House-building peaked in Ireland in 2006, when 88,000 units were completed. In that year, residential investment accounted for 13.3 per cent of gross domestic product (GDP) and 15.6 per cent of GNP in Ireland. These were truly remarkable - and wholly unsustainable - residential investment ratios.
In its recently-published World Economic Outlook, the International Monetary Fund (IMF) calculates that, among advanced economies, residential investment averages 6.5 per cent of GDP*. Thus, the Irish ratio of housing investment to GDP, at 13.3 per cent in 2006, was more than twice as high as the average for advanced economies.
Moreover, the Irish ratio had risen rapidly since the turn of the century. Residential investment increased its share of GDP from 7.8 per cent in 2000 to 13.3 per cent by 2006.
This steep incline in housing investment, particularly after 2002, quickened the domestic boom and levered up the national growth rate. The expansion in the volume of residential investment accounted for more than one-third of all growth in real GNP recorded in the three years ending 2005. Annual increases in the volume of housing investment directly added an average of 1.7 percentage points to the real GNP growth rate in each of the three years 2003-2005.
But now the housing boot is on the other foot. Where residential investment speeded economic activity in the first half of the decade, it is now subtracting from growth. The housing bubble has burst rather more quickly than forecasters had anticipated, hence the continuous downward revisions in the forecasts for the national growth rate over the past 12 months. Housing investment stuttered during 2007, with the annual number of completions declining by 10,000 to 78,000. Now, both the ESRI and the Central Bank foresee a fall in housing completions to 50,000 this year and even the attainment of these projected levels of activity is by no means a sure bet.
Using the ESRI spring forecasts, a decline of this magnitude in residential investment subtracts 3.8 percentage points from the prospective growth rate in real GNP during 2008. As a direct result of the forecast fall in residential investment this year, the prospective real GNP growth rate for this year is knocked back from 5.4 per cent to 1.6 per cent.
Two inferences can be drawn from these results. First, the growth recession is all the fault of the collapse in residential investment. It is the housing sector that is dragging down economic performance. Second, the rest of the economy must be in robust shape if it is withstanding the body blow inflicted by a major housing slump and still managing to grow at all.
On the basis of recent forecasts, the rest of the economy is set to put in a solid performance this year. The volume of consumer purchases - which account for more than half of all spending in the domestic economy - is projected to grow by 3 per cent and more.
The 2008 Budget was highly expansionary, so real government spending is injecting extra demand into the economy. Net exports - exports less imports - are again making a perceptible contribution to economic growth.
It is but a short step to concluding that, once the shake-out in the housing sector is completed, the economy will rebound and recapture the high ground. It will all be over by Christmas.
This may prove to be an excessively sanguine view, as it was in August 1914. The IMF notes that residential investment tends to lead the business cycle. An initial slump in housing triggers a subsequent economic stumble. For the housing sector is not hermetically sealed from the rest of the economy. The negative effects of a steep housing downturn spill over into other sectors, most crucially in the Irish case, into the financial sector.
Finally, outside the housing sphere, the economy's future performance is threatened both by the weakening of economic activity levels in the country's two major foreign markets - Britain and the US - and by the jolt to competitiveness caused by the continuing strengthening of the euro. It has passed almost unnoticed that Ireland's real exchange rate - the trade-weighted exchange rate adjusted for excessive Irish inflation - has now appreciated by almost 25 per cent since entry to the euro. The effects of such competitive losses can take quite a time to crystallise.
Against this background, a growth recession may be the best option on offer.
* The Housing Sector and the Economic Cycle, IMF, April 2008, Chapter 3.
