Will 2008 be a bad year for the Irish economy?
YES:
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.
