Economics:The recent turbulence on financial markets heralds the end of the second stage of the Irish boom, writes Paul Tansey

The era of unbridled optimism, easy credit and cheap money is over. The days of exceptional asset price inflation and credit-fuelled consumer spending have departed. Future economic progress, if it is to be achieved, will be hewn out of the hard rock of the real economy.

The first phase of the boom was built on the back of foreign direct investment.

During the 1990s, technologically sophisticated foreign firms cascaded into the State, turbo-charging growth both of industrial output and of exports. On the output side, production volumes in the modern - principally foreign-owned - segments of Irish industry quadrupled between 1995 and 2006.

In turn, this prodigious leap in output powered a tripling in Irish export volumes over the period.

Foreign industrial investment, output and exports together provided the launching pad for the first stage of the Irish boom.

The contribution of indigenous Irish industry verged on the trivial.

By 2006, the volume of industrial production outside the "modern" segment - broadly, indigenous industry - was just 30 per cent higher than in 1995.

The impetus to growth delivered by the foreign industries operating in Ireland began to wane as the new century dawned.

Between 2002 and 2006, the output of the modern segment of Irish-based industry increased by just 17 per cent. The export drive stalled in sympathy. Total export volumes also advanced by just 17 per cent between 2002 and 2006.

As the first foreign-induced phase of the boom began to stutter, the home team took to the pitch. The second stage of the boom was driven by the expansion of domestic demand.

Day-to-day purchases of consumers, investment spending by both the public and private sectors and the net current spending of Government are the three principal components of domestic demand. Between 2000 and 2006, the volume of domestic demand increased by one-third.

With export growth wilting after 2000, the sustained spending of households, both on consumer goods and services and on investments in new homes, maintained the economy's forward momentum.

This year, the consumer is keeping the economy afloat.

Aided by the release of SSIA savings and continuing employment expansion, both the Central Bank and the Economic and Social Research Institute are forecasting that consumer spending volumes will increase by 7 per cent or more in 2007.

However, the forces that propelled domestic demand in recent years will largely be dissipated by 2008.

Much weaker employment growth, high inflation, the rise in interest and mortgage rates, tighter credit and the absence of any further SSIA

windfalls will combine to constrain the growth in real consumer spending next year.

Three-quarters of investment spending in Ireland is accounted for by building and construction. With house building in reverse gear, the contribution of total domestic investment to economic growth during 2008 will be limited.

Little stimulation can be anticipated from Government consumption next year if the new administration adheres to its announced plans. The new Government has already stated its intention to almost halve the rate of current public spending growth in cash terms to about 7 per cent during 2008.

In sum, the domestic spending boom is set to run out of steam next year, with domestic demand volumes expected to show an increase of some 2.5 per cent in 2008.

While far from flat, real domestic spending growth of this magnitude would feel fairly thin after this year's forecast increase of 5 per cent in domestic demand volumes.

The bigger question then arises: if phase two of the boom is now nearing the end of its natural life, where do we go from here?

It is important at the outset not to expect too much of the future. The expansion path of the past 15 years will not be mirrored in the growth rates of the next decade and a half.

To date, the Irish boom has exhibited many of the characteristics of a "convergence" boom, though with bells and whistles provided by low corporation taxes and explosive rates of housing construction.

Spain is undergoing a broadly similar type of boom and for much the same reasons - economic and monetary integration with a group of initially much richer countries.

There is a difficulty, however: it is possible only to converge towards others in a union; it is as impossible economically as it is grammatically to converge past others. In other words, playing catch-up is a very different game than leaving the rest of the field behind.

Thus, over the long haul, with real convergence and economic maturity achieved, it would be expected that the Irish economy would grow in step with the euro zone.

Containing expectations is central to securing future prosperity. Unless a sustained effort is made to restore price and cost competitiveness, the economy's long-run future is bleak.

The Central Bank's latest quarterly bulletin notes that "relative labour cost competitiveness for the whole economy has deteriorated significantly since the beginning of the decade, and increases in unit labour costs for the non-traded sector will inevitably feed into higher costs for the traded sector".

The next stage of the economy's development requires switching resources from the non-traded to the traded sector, and from the domestic sector to the foreign sector. Put simply, it requires reigniting the engine of export growth - but the engine will not fire unless competitiveness is regained.

Foreign direct investment will flow past Ireland if it is seen as an expensive location relative to competing destinations.

Existing Irish enterprises will not be able to sell their goods and services on global markets if they cannot meet the prices set by those markets.

Restoring competitiveness cannot be achieved simply by capping wage growth. It also requires a tighter focus on raising productivity growth across the economy. Labour resources of high quality are available for the task.

The proportion of the population aged 25 to 34 years with a third-level education has risen from 27.1 per cent in 1999 to 40.2 per cent in 2006.

The central challenge for enterprises and for Government now is to manage, motivate and develop these enhanced labour resources in order to achieve a step change in the rate of productivity growth.

Our future hangs on it.