Will 2008 be a bad year for the Irish economy?
HEAD 2 HEAD: YESAlan Ahearne says that with the end of the property boom denting consumer confidence, our economy is likely to fall into recession in 2008 NODanny McCoy says the slowdown in the market should help to create a better economic balance and a return to export-led growth.
Economic booms are often followed by busts. Businesses and households that over-extend during booms are forced to curtail spending sharply when conditions suddenly change. Nowhere is such behaviour more evident than in our housing market. The pace of new home-building over the past year far exceeded demand, resulting in an enormous overhang of unsold properties. Builders have responded to the glut in housing by shelving new projects.
Some commentators argue that the housing collapse represents a "healthy correction" in the market. There is some truth to that argument. But housing down-cycles have a nasty habit of spreading to other parts of the economy. Moreover, there is a serious risk that the housing adjustment will be accompanied by a combination of negative external shocks to the economy.
The Construction Industry Federation projects that house completions will drop at least 40 per cent next year, a figure that is consistent with recent readings from forward-looking indicators of building activity.
It follows from some simple arithmetic that our economy is likely to fall into recession in 2008. Since new homebuilding accounts for roughly 10 per cent of GDP, the slump in completions will subtract four percentage points from growth next year.
Unless the remaining 90 per cent of the economy grows at least 4½ per cent, GDP growth will turn negative. Over the past four years, GDP (excluding new homebuilding) rose about 4¾ per cent per year on average. A repeat performance next year looks increasingly improbable.
Consider the two largest categories of spending: personal consumption and exports. Consumer spending has been buoyant over recent years, boosted by strong growth in employment and after-tax incomes. But we are probably at a turning point. In a study of dozens of property cycles across 18 industrial countries since 1970, my former colleagues at the US Federal Reserve and I found that consumption typically weakens markedly during housing downturns, as unemployment rises and households tighten their belts.
Sure enough, retail sales have been sluggish since May and consumer confidence has tanked. Both the ESRI and Fás expect employment growth to come to a screeching halt next year and unemployment to rise. Tax cuts are a thing of the past. Wage moderation, though necessary to restore competitiveness, will further depress consumption.
The outlook for exports is also grim. The international credit crunch has increased significantly the risks of a downturn in the global economy. The US may already be in recession, while prospects for the UK economy have dimmed amid mounting evidence that the housing bubble there has burst.
The depressing effect on exports of slower growth abroad will be compounded by the recent rise in the value of the euro against both sterling and the dollar. Our competitiveness vis-à-vis other countries in the euro area has also deteriorated because inflation here has exceeded the euro-area average.
Other categories of spending look set to soften as well, or are too small relative to GDP to make much of a difference to the overall outcome. Growth in day-to-day Government expenditures will moderate, as outlined in the recent budget. Spending on the National Development Plan is budgeted to increase €1 billion next year compared with 2007. This will add about a half percentage point to growth, and therefore do little to fill the gap made by the housing slump.
Worryingly, the weakness in economic activity will feed back into the housing market. The expected sharp slowdown in immigration will further depress demand for housing.
How bad might things get? The answer depends in large part on how well prepared the business sector is for the coming economic storm. The concern is that what has happened in the housing market may be repeated to various degrees across other sectors in the economy.
Commercial property (such as offices and shopping centres) looks especially vulnerable. Many new retail units were probably built under the assumption that consumer demand would remain robust. If household spending under-performs in 2008, developers of commercial property may find that they have overbuilt.
Hopes that cuts in interest rates next year might boost construction have been dashed by the recent jump in euro-area inflation to well above the European Central Bank's target. In fact, interest rates are more likely to rise as lenders pass on to customers the ongoing elevated cost of borrowing on wholesale markets.
Business leaders who over the past couple of years heeded the warnings of the so-called "merchants of doom and gloom" should be in a reasonable position to ride out the storm.
But many business decisions were probably made on the expectation of continued sunny skies. In that case, the battering that our economy is about to take may be more intense and prolonged than almost anyone can conceive.
Alan Ahearne is an economist at the JE Cairnes School of Business and Public Policy at NUI Galway.
Today is the traditional day to take stock. In that regard, the economy's stock is in good order with another year behind it of over 5 per cent growth in real output. However, this rate of economic growth is slowing substantially into the first half of 2008, primarily as a result of the significant slowdown in housing activity. Critically, other sectors of the economy should continue to perform strongly next year and, given the right circumstances both internationally and nationally, will take up some of the slack arising from the housing slowdown.
Despite the persistent uncertainty around the global financial credit crunch, the world economy should have another strong growth year in 2008 even if the US approaches stagnation. Of the 43 economies covered weekly by the Economist, all are forecast to grow in real terms next year with rates from a low of 1.5 per cent for Denmark to 9.9 per cent for China. The OECD actually expects the rate of growth in world trade to increase to 8 per cent next year from 7.1 per cent in 2007.
As a trading nation, this is a fertile ground for Irish growth to resume in a sustainable export-oriented manner as we rebalance away from an over-dependence on domestic demand growth factors.
Competitiveness and its restoration must be the over-riding domestic objective of 2008 for all social partners. As we square up to the new year, the competitiveness combination is a jab of cost containment with a punch of productivity improvement.
Regardless of what the international scenario may hold, this is the domestic imperative.
At this stage we have a reasonably good idea of what will happen to housing activity in 2008. We know from the pipeline data on housing starts that the number of new houses to be built next year will fall by at least one third. If the data on starts remains weak in the first quarter of 2008, then the fall-off in housing activity could be even greater. With residential construction now accounting for about 12 per cent of GNP, it is clear that the lower level of house completions will be a significant drag on growth. The rapid nature of the reduction in housing activity is welcome and will ultimately ensure that as output reverts to more sustainable levels, the risk of a severe correction in house prices can be avoided.
The Government's commitment to maintaining momentum in the capital investment programme through the National Development Plan will mean that increased activity in the non-residential construction sector will partly compensate for the housing slowdown. Overall, however, building and construction output in 2008 will contract. Just like the global credit crunch, the domestic correction in the residential housing market is a case of (In Macbeth's words): "If it were done when 'tis done, then 'twere well / It were done quickly." A key feature of the economy in 2007 has been the significant rebalancing which has taken place. The housing boom of the past decade led to an over-reliance on the sector for economic growth. The surge in both housing activity and prices contributed to inflationary pressures in the economy and ultimately led to a deterioration in competitiveness. With slowing housing activity levels, and an improving export performance, economic growth has been much better balanced.
The shift from the domestic sectors of the economy to the traded sectors as the main drivers of growth is likely to continue into 2008. Post-SSIA effects and the deterioration in consumer confidence will mean that consumer spending growth will soften. Nevertheless, strong demographic growth and the slight boost to real incomes delivered in the budget will mean that consumer spending growth will continue to outperform that in most other EU countries. Indeed the exceptionally strong demographics of recent years will underpin all sectors of the economy in the medium-term.
Exports of goods and services this year are set to grow at the highest rate since 2001. The strong industrial output performance has been reflected in a healthy increase in goods exports. Services exports continue to expand as Irish firms have been able to exploit the opportunities arising from the exceptionally high growth rates in world services trade. Maintaining this strong export performance in the coming years is essential if we are to preserve economic prosperity.
The slowdown in the domestic economy provides an opportunity to reduce inflationary and wage pressures. There is absolutely no justification for wages to continue growing at over double the average rate of wage growth in the euro zone. Productivity growth provides no justification for this.
The international and domestic economies face many challenges in 2008 but the possibility of a recession in Ireland is remote. The rate at which the economy will expand may be lower than in recent years but 2008 may provide the springboard for more sustainable growth into the future. And with the age-standardised mortality rate in Ireland having fallen by over 26 per cent in less than a decade there are more of us around to cheer the new year.
Danny McCoy is director of policy at Ibec, the Irish Business and Employers Confederation.