Wednesday 12 November 2008

A Challenging Economic Adjustment - Jim Power, Chief Economist Friends First

Economic Backdrop
The latest official growth data on the Irish economy do not make for pleasant reading. The data show that in the first quarter of 2008, GDP contracted by 1.5% compared to the first quarter of 2007, while GNP expanded by just 0.8%, which is the slowest annual growth rate since the first quarter of 2002. The key weakness is in construction activity, which declined by 18%, with the housing component down by 30%. Exports expanded by just 0.5% in the first quarter, which is the slowest growth rate since the third quarter of 2003. Consumer spending increased by 3.5%. This was stronger than expected, but largely reflected spending by Irish residents travelling abroad and spending on services such as health and education. Spending on goods was very weak.

In overall terms, the first quarter data do not suggest an economy in recession, but do suggest an economy that is slowing sharply, with housing the main contributor. It is clear however that the housing weakness is spreading to other areas of the economy. Subsequent evidence would suggest that the economy actually went into technical recession in the second quarter, which is defined as two successive quarters of negative growth,

The main contributor to the slowdown in the economy is the adjustment that is occurring in the housing market. The boom in the housing market in recent years has been a key driver of employment in the economy, tax revenues, consumer confidence, consumer spending, the Irish equity market performance and overall economic activity. Given the key contribution made by the housing sector to economic activity in recent years a housing market adjustment was always going to be a painful experience for the economy and that is turning out to be the case.

However, the pressures arising from the housing adjustment are being exacerbated by rising food and oil prices, the contraction in credit availability as a result of the sub-prime crisis, the sharp slowdown in the US and UK economies, and adverse exchange rate movements.

A decline of 10,000 in the number of houses built knocks up to 1% off economic growth. This sharp slowdown in house building was inevitable at some point, as house building had reached unsustainable levels in recent years. However, the adjustment to more normal housing market conditions is exacting a heavy price, and in particular is having a very negative impact on unemployment, tax revenues, consumer sentiment, and economic activity in general. Furthermore, the sharp hosing adjustment has caused a dramatic crash in the Irish equity market.

It is clear that the housing adjustment is not yet over. Prices are likely to fall further over the coming months and building activity will remain very weak and will continue to act as a drag on economic activity well into 2009.

The Economic Outlook
2008 is certainly turning out to be a challenging year for the Irish economy. Unemployment is rising, consumer spending is weakening, house prices are still falling and house building activity remains very weak. Given the domestic housing market adjustment and the more difficult external environment as a result of the sub-prime crisis, it is looking likely that 2009 will also be a challenging year.

The key message for Ireland at the moment is that while the economy is currently in a challenging situation due to the ending of the residential house building boom and the more difficult external environment, the future is still bright provided policy makers do the right things in terms of policy making.

The return to more normal levels of house building and the reversal in house prices is a positive development because the trends that were emerging were clearly unsustainable. The construction sector will continue to make an important contribution to growth, with public and private sector non-residential activity set to remain reasonably strong. The ESRI estimates that the annual average housing requirement out to 2015 will be 48,000 houses per annum. However, following house completions of around 48,000 this year, completions could fall to 35,000 in 2009.

Consumer spending is slowing, but this too is desirable and easily understandable after five years of aggressive borrowing and spending.

High level manufacturing activities and service exports will become increasingly important drivers of the economy in the medium-term, while there will have to be limitations placed on the contribution from the public sector in a tighter fiscal environment.

To emerge from the current difficulties it is clear that the housing adjustment will have to run its course, oil prices will have to fall and the external economic cycle will have to improve. Most of these developments will happen, but not before 2010 at the earliest. Most importantly, the global credit crisis will have to end and it appears at this stage that global credit availability will not return to more normal conditions until the second half of 2009.

From a Government perspective it is important not to panic and instead try to take a longer-term strategic perspective. In this context, cutbacks in wasteful spending are now essential. This should primarily focus on the day-to-day spending across all sectors. Over the past 5 years current spending has been allowed escalate out of control and the taxpayer has not got very much in return. This needs to change.

In relation to capital spending, continued delivery of the National Development Plan is essential, but there will have to be some prioritisation. Delivery of the physical infrastructure in areas such as road, rail and airports is essential, as is investment in the hopelessly inadequate IT infrastructure. Focused investment in education and training is also the only response to the jobs that are migrating to low cost locations. Postponing some of the ‘nice to have’ but not essential’ elements of the NDP would be warranted.

Government has been one of the biggest contributors to the escalating cost of living and business costs since the beginning of the decade. Much of this has been driven by the inability to control public sector pay. The new wage negotiations will need to deliver serious wage restraint, particularly in the public sector, as market forces will look after wage growth in the private sector.

In relation to revenue raising measures, increasing general taxes in an economic slowdown would be tantamount to economic suicide. However, looking closely at BIK on employer provided parking would be a decent revenue raiser and would also bring greater equity.

In summary, Government must not now panic. Control of current spending, investment in the quality of the labour force, control of state service costs, public sector pay restraint, and delivery of the essential elements of the NDP, would represent the best contribution the Government could make to the longer-term prosperity of the economy. Populist policies in the run up to next year’s local elections must be avoided at all costs.

The following growth outlook is suggested, but is heavily predicated on an improved external economic environment and a freeing up of global credit conditions in the second half of 2009. If these do not materialise, the slowdown in the Irish economy will be more pronounced and of longer duration.

House Completions
F= forecast