Trouble in store after free-spending during boom years

Some difficult choices await the next Government. The current economic debate centres on how bad things really are and when they are going to get better, but the Economic and Social Research Institute (ESRI) has flagged a much more fundamental problem coming down the track.

For the record, the ESRI yesterday reaffirmed its view - which is shared by the Central Bank - that an economic recovery will take place in the second half of next year and that the economy will start to grow at around 5 per cent from then onwards. The return to economic growth will solve the immediate problem facing whoever wins next year's election, but will not save them from having to make political choices that have been put off during the years of sustained "above trend" growth.

The massive tax buoyancy of the past few years has allowed the Government to let spending run ahead and to cut income taxes substantially at the same time. This win-win trend came to an abrupt halt this year when economic growth faltered. Both the ESRI and the Central Bank were at one yesterday in warning that a political choice will now have to made on whether the Republic will be closer to the US model, with low taxes and low Government spending, or the European model, with higher taxes and higher Government spending - the "Boston or Berlin" debate.

The problem would have been apparent this year if Mr Charlie McCreevy, the Minister for Finance, had not found £1.5 billion (€1.9 billion) in various State piggy banks to balance his Budget.

To fail to make a clear choice now would be a recipe for disaster, believes Mr Danny McCoy of the ESRI, chief author of its Quarterly Economic Commentary, published yesterday. "The underlying deterioration in the public finance position does point to the need to make choices with regard to higher current expenditure and increased taxation, either through higher rates or expanded bases," he said.

According to the ESRI figures, Government expenditure grew by 17.8 per cent last year, while revenue increased by only 4.5 per cent. The predictions for next year, based on the Budget, are for expenditure to grow by 10.4 per cent and revenues by 10.6 per cent, after the once-off measures announced in the Budget.

The trend is not sustainable in an economy that will be growing at a maximum of 5 per cent for the foreseeable future, argues the ESRI. Making this decision is a matter for another day and another government. It also presupposes that the economy recovers in the middle of next year and this, in turn, requires an early end to the US slump.

The ESRI is more bullish about the US economy than most commentators - predicting the US economy will grow by just under 2 per cent next year. They take comfort from the fact that since the second World War, US recessions have lasted on average 11 months. The present downturn is nine months old, suggesting a pick-up in March.

There are also some signs of a tentative corporate recovery, with some corporations indicating that inventory and other problems are being overcome.

The US authorities are "convinced and very convincing" that their fiscal response will be effective, according to Mr Michael Casey, the assistant director general of the Central Bank. Historically, there tends to be a 12-18 month lag between interest rate cuts and their impact on the economy, according to the ESRI, which further supports the idea of a US recovery in the second half of the year, given that US interest rates have been cut aggressively since the start of the year.

In order to ensure Ireland benefits quickly from the US recovery, it is important that the economy's competitiveness is safeguarded. One of the main threats to competitiveness, labour costs, is receding with rising unemployment, but the risk of an appreciation of the euro is on the rise.

The fall of the euro from $1.17 at its launch to current levels of 90 US cents has allowed Ireland to remain competitive relative to the US, despite rising costs of labour. But with the ESRI now forecasting a return to parity by the middle of next year, some of these gains will undoubtedly be lost.

A return to parity could wipe out all the gains in competitiveness made since 1998, according to research published by the Central Bank yesterday. Unlike the ESRI, the Central Bank does not make any predictions about either interest rates or exchange rates in its forecasts.

This is because it is involved in setting European interest rates and thus, indirectly, the value of the euro, through its membership of the European Central Bank. Instead, it uses current levels in its forecast of 3.5 per cent GNP growth next year, and the ESRI's 2.1 per cent growth is mostly due to its assumption that the euro will appreciate and that interest rates will rise towards the second half of the year.

Bad and all as this scenario is, it will get a lot worse if the US recovery is delayed, both bodies have warned. If the slump is not short-lived, then the consequences of the mismatch between revenue and expenditure flagged by the ESRI will become much more serious, according to Mr McCoy yesterday. Mr Casey was even more blunt, warning that unemployment could spike above 6 per cent, "which would not be good".