Forecasters, if not economies, are beginning to recover their equilibrium. Last autumn, not only was the economy in free fall but forecasters' forecasts were falling daily. But since the spring, our understanding of what has happened in the world economy has improved. Here, as policy has begun to tackle our problems, a path to recovery has become clearer. We have reached a stable level of pessimism.
Last May, with colleagues, we published a paper 'Recovery Scenarios for Ireland' where we suggested that the Irish economy had a future. While this analysis indicated that because of the legacy effects of the burst property market bubble, a recovery in Ireland would lag behind developments elsewhere in the EU – once a European recovery actually began, growth would eventually follow in Ireland.
There are now reliable signs that the EU economy has turned the corner and that 2010 will see a return to real growth. For Ireland, the effects of past policy mistakes linger on and it will be 2011 before a robust recovery is likely. While the most obvious fall-out from the burst bubble is the collection of severely damaged Irish banks, a more serious long term problem is the loss of competitiveness caused by the building boom.
To get the resources the building sector needed during its period of excess, it had to rob resources from elsewhere in the economy. This was done by bidding up prices, wages and costs. While the boom lasted, to get the resources it needed the building sector outbid firms that were exporting. The effect of the rapidly rising costs, especially wages, was that firms that depended on export markets were closing even in the good times. Because of the general buoyancy in the economy these losses went unnoticed.
However, once the world economy collapsed and the domestic property bubble burst, exporting firms found their markets contracting and their cost base too high, resulting in a flood of job losses. This has compounded the effects of the huge job losses in the building-related sector of the economy.
To return the economy to full employment in the next decade, a substitute will have to be found for the unsustainable jobs lost in building. These new jobs will have to be created by firms developing and expanding into new markets abroad. However, as of today, this is a very difficult task given Ireland's very high cost base.
If the awful unemployment problem is to be solved by the middle of the next decade through nurturing new jobs, Ireland will have to price itself back into its European markets. This could be done by holding wage rates unchanged for quite a number of years as wages rise slowly in our competitors. Such an approach would eventually work but competitiveness would only gradually be regained.
Alternatively, the lead given by the public sector pay cut of 7% could be followed in the private sector, preparing the economy for a more rapid lift off from 2010 onwards.
A second major problem is the massive deficit in the public finances. After a few false starts, the government began to tackle the massive borrowing with the April budget. In that budget they indicated they also planned to implement a very tough budget for next year to move the public finances towards a sustainable path. While there is much discussion as to how much of the tough medicine should be in the form of a further increase in taxation and how much through a cut in current expenditure, what is crucial is that the medicine is actually administered in December.
One of the reasons why this economy will lag behind the rest of the Euro area next year is the huge uncertainty affecting households and companies in Ireland. Until individuals feel reasonably certain about their jobs and future incomes, it is very difficult to see them deciding to increase their consumption, buy a new car or invest in a house. Thus the longer the necessary budgetary reform is postponed the longer this uncertainty will last and the greater the delay in returning to normal levels of consumption and investment.
Assuming that the necessary fiscal medicine is taken in December, with a world recovery the Irish economy should return to reasonable growth in 2011. If, in addition, Ireland prices itself back into its markets, this recovery could be quite robust. Under these circumstances the additional doses of fiscal discipline planned by the Department of Finance for 2011 and 2012 might be avoided. Even more important, the recovery could generate substantial numbers of new jobs, returning the economy to near full employment by the middle of the next decade. Failure to implement the necessary changes this year will only prolong the misery of the huge numbers now on the dole queues.
Dr John FitzGerald is an economist and research professor at the ESRI