Escaping, if lucky, dangers outlined by ESRI

 

'Like a clockwork mouse that was fully wound up in the late 1990s, the Irish economy is gradually running down. Its potential to grow is less today than five years ago, and it will be slower still in the next decade."

That's the ESRI's verdict on our medium-term economic prospects. "But", it adds comfortingly, "for the years immediately ahead this would represent an unusually robust prospect compared to most of our EU neighbours."

If achieved, the institute's projected "high growth" rate of almost 5 per cent a year to 2012 would indeed be "robust". But this depends in part on further significant growth in manufacturing, where the ESRI expects high-tech output to grow at almost 8 per cent a year until about 2010. However, I have some doubts about the scale of this projected industrial growth, for up to October last there had been no sign of any recovery in the volume of manufacturing output or of exports, both of which have been stagnant throughout the past two years.

If these figures are correct - and it has to be said that attempts to measure the purchasing power of different countries' output are always uncertain - the ESRI's growth projections would suggest that - leaving aside the special case of tiny Luxembourg - Ireland, together with Britain, could by 2012 have the highest purchasing power per head in the EU. That's the good news. But the ESRI has several serious qualifications of its own about this "high growth" projection.

First of all, the institute is clear that rapid economic growth cannot be sustained much beyond the end of the present decade, and in the meantime its continuance at a rate of almost 5 per cent a year will, it believes, put a strain on our economy's resources, and might create inflationary pressures.

Second, the achievement of a 5 per cent annual growth rate in the years immediately ahead is in any event conditional on neither of two events happening within the next five to seven years. These two events that we need to be spared are, first, an already overdue correction of the huge US external payments deficit; and, second, a "hard landing" to our own phenomenal construction boom.

Our very open economy, to which we owe our economic success to date, leaves us vulnerable to external shocks: more so than any of our EU partners because of the exceptional scale of US investment here and, in particular, the high proportion of our corporate tax revenue that derives from or is connected to these investments.

(The ESRI warns about the potential strategic danger of our becoming too dependent on the low corporate tax rate, which "is becoming less effective due to enhanced competition from countries such as Estonia". In particular, it points out that this is especially the case because changes in tax legislation in other jurisdictions, which currently operate to favour the sheltering of profits in Ireland, "could have a sudden and large impact on the Irish economy". Our 12.5 per cent corporate tax now yields €6 billion a year - which is over half as much as the €11 billion of personal income tax paid by well over 1¾ million of our population.)

The ESRI also points out that the "continuing preservation of the status quo [in respect of corporate taxation] may involve increasing costs in terms of Irish political capital within the EU" - a point I first made here as long ago as 1997.

Because of the scale of the US budget deficit, together with the almost total collapse of net private savings in the US, that country has become hugely dependent on foreign investment for the financing of its enormous external payments deficit. And, as Alan Greenspan, then Federal Reserve chairman, pointed out a year ago, "deficits that cumulate to ever-increasing external debt, cannot persist indefinitely. At some point investors will balk at further financing."

No one knows when that day will come. The ESRI believes it might be postponed for a number of years, in which event our economy could continue to expand quite rapidly until the end of this decade or shortly afterwards. This is the scenario set out in its "high growth" projection, although it also points out that the longer the US crisis is postponed, the worse will be its eventual impact on our and other economies.

When and if the crisis does eventually happen, the ESRI foresees a devaluation of the euro/dollar rate to around €1.50 - which would hit severely not only the one-fifth of Irish exports that go to the United States, but also high-tech Irish exports to other countries, the economies of which would be hit by such an event.

Even if our housing construction boom was to continue unabated until such a US crisis eventually occurs, a decline in output and employment in foreign-owned high-tech industries would probably then hit housing construction in this country. The ESRI estimates that such a "double whammy" could push unemployment back up from its present 4-5 per cent level to above 10 per cent, with an additional serious impact on wage levels.

These dangers have led the ESRI to recommend that the Government stop using public policy to artificially boost output in this already over-stretched housing sector, so as to reduce the scale of a possible "hard landing" for housing construction. In the recent Budget the Minister for Finance announced plans to terminate a range of tax reliefs for various construction projects, but he excluded housing from this list.

His statement in the Budget speech that "we should not do anything that disrupts unnecessarily an industry that is such an important driver of jobs", suggests that political fears about the impact of the kind of precautionary action in relation to housing recommended by the ESRI is still being allowed to take precedence over the desirability of acting now to minimise the risk of a possible hard landing for the housing construction sector. Of course, the gamble of refraining from action at this stage may pay off, but if it doesn't the Government will be open to serious criticism for having disregarded what could turn out to have been wise advice.

The impact upon our public finances of the kind of crisis envisaged could, the institute says, increase our budget deficit and borrowing rate by as much as 3.5 percentage points. This suggests a need to maintain some overall budgetary surplus in the years ahead, so as to make it possible in such a crisis to avoid the need for tax increases or damaging spending cuts, and perhaps also to accelerate other infrastructural investment to limit the scale of unemployment in the construction sector, whilst still keeping within the EU borrowing rate limit of 3 per cent of GNP.

Unfortunately, in the recent Budget the Government planned instead for an overall budget deficit of almost 1 per cent in the years 2007 and 2008 - which could leave us very vulnerable in the event of such an emergency arising.

All that having been said, we may, with a bit of luck, escape the dangers outlined by the ESRI above, at least during the next five to seven years and thus succeed in becoming, with Britain, one of the two wealthiest countries in the EU by 2015-2020.