Slowdown poses tough political choices

ECONOMICS: Remove our rapid economic growth and two incompatible sets of expectations - better public services and low tax rates - are set to collide

It's almost seven months since I put together a set of forecasts for the Irish economy. At that time I was talking in terms of GDP growth of 6.5 per cent in 2001 (after 11.5 per cent the previous year) and 5.4 per cent in 2002. The 2001 figure could yet prove correct. After all, GDP rose at an annual average rate of 11 per cent in the first half of the year, implying that economic activity would need to have contracted very sharply (though not implausibly sharply) in the second half to produce an annual average increase of much less than 6.5 per cent for the full year.

My 2002 forecast of last July is an entirely different matter, however. To be honest, looking back on it now makes me flinch. The reason, as my former colleagues at Davy Stockbrokers have been pointing out, is that in order for annual average GDP growth of 5-6 per cent this year, the economy would have to rebound very soon and with unusually strong momentum.

The available evidence, such as it is, does not provide much support for such an expectation. The exporting sector of the economy lost a lot of steam during 2001, with exports declining at an annualised rate of 12 per cent in the closing months of the year. Leading indicators suggest the position may be close to stabilising at this stage but indications that the worst is over should not be taken as evidence that the boom times are about to roll again.

Respondents to the latest IBEC-ESRI survey, for example, expect exports to be flat in the months ahead, while NCB's purchasing managers' index was still below the critical 50 threshold in January.

Of course, exports aren't everything, although in an economy where they weigh in at the equivalent of 95 per cent of GDP, they amount to rather more than the proverbial hill of beans. Some people are apt to point out that domestic demand continues to be very buoyant. Well, I'm not so sure that's what the data to hand are saying.

Take construction, for example. It's actually very difficult to put together a satisfactory picture of what is going on in that sector because of a paucity of reliable data. But what we can say is that construction employment (at least, among firms with five or more employees) increased at an annual average rate of close to 8 per cent from 1995 to 2000, but was running almost 2 per cent below its year-earlier level by the end of 2001.

Then there's consumer spending. Here there is evidence of continuing buoyancy. The latest published data show core retail sales (sales excluding garages and filling stations) growing at about 5 per cent year on year in volume terms. That's not bad, but it's some way off the 8-9 per cent pace of 1999 and 2000 and, as such, indicates a distinct downward gearshift on the part of consumers.

Moreover, my guess is that the slowdown in consumer spending growth evident in these numbers does not fully reflect the softening in labour market conditions that is under way.

The principal reason for this judgment is that the softening in labour market conditions has not run its course.

Labour market conditions typically lag behind economic activity, and it is likely to be some months yet before the unemployment rate and the rate of wage inflation have fully adjusted to the recent weakness in output.

When they have, household income growth will be tamer than of late and household savings rates will probably edge higher.

Furthermore, the chances are that unemployment will continue to drift upwards beyond that point. In this connection, it is worth pointing out that, the question of lags aside, GDP probably needs to increase by 5-6 per cent in order to prevent unemployment rising, given the growth of productivity and of the labour force. I wouldn't be betting heavily on that sort of output growth showing up for some time.

The Government's budgetary arithmetic has been a conspicuous casualty of the economic slowdown that has occurred to date. The fact that last year's Budget surplus was €2.5 billion below target, and that this year's target was saved from being a deficit only by large-scale recourse to accounting sleight-of-hand, shows how heavily geared to growth the public finances are.

All of this is a reminder of an obvious point. Remove the rapid economic growth of the Celtic Tiger era and the resultant tax buoyancy, and either the rate of increase in public spending must be reined back quite sharply or some of the reduction in tax rates of recent years reversed.

Two incompatible sets of expectations are on a collision course here: the expectation that the scope and quality of public services will be greatly expanded and the expectation that tax rates will be reduced further or, at worst, maintained at current levels.

The resolution of this conflict is likely to set a challenging agenda for policy-makers in the period ahead. In particular, it presents a fundamental challenge for the Republic's much-vaunted social partnership model, based, as that model has been, on a combination of large tax cuts and public spending increases.

Is it too much to hope that these challenges might set the agenda for the forthcoming election?

Jim O'Leary lectures in economics at NUI Maynooth