The Medium-Term Review (MTR) has become one of the most influential of the Economic and Social Research Institute's (ESRI) research reports. Its influence derives as much from the way it frames and addresses economic policy issues as from the forecasts it sets out.
Medium-term forecasts are not designed to anticipate turning points in the economy - that's the job of short-term forecasting. Medium-term forecasts plot the economy's potential growth rate over a five- to 10-year timeframe.
This may be reduced to plotting the future course of two sets of variables: the labour force and labour productivity. The former indicates by how much employment might be increased and the latter shows how much of an increase might be expected in output per person employed.
In economies with a more-or-less fixed labour supply, this exercise is relatively tractable as it reduces forecasting to labour productivity growth, which tends to be quite stable over the medium term.
However, in economies characterised by labour supply that is highly responsive to changes in economic conditions, medium-term forecasting can be hazardous. Therefore, most of the error in the ESRI's forecasts of the late 1990s (on average they underestimated gross national product (GNP) growth by about three percentage points between 1994 and 2001) can be attributed to an underestimation of the responsiveness of labour supply. It was not alone in this regard.
The performance of the Irish economy during the 1990s greatly exceeded everyone's estimates of what was likely (and pretty well everyone's judgement as to what was possible).
The benchmark forecast set out in the ESRI's latest MTR (GNP growth of 3 per cent next year followed by average annual growth of 5.3 per cent over the balance of the decade) represents its estimate of the economy's potential. It is an estimate of what is possible. As such, it prompts two sets of questions.
The first is: how robust is that assessment - to what extent is it an overestimate /underestimate of the economy's potential? The second is: what conditions have to be present for that potential to be realised?
As far as the ESRI's estimate of potential growth is concerned, it is based on projected annual average labour force growth of 2 per cent and projected labour productivity growth of 3.2 per cent each year. The latter is well above the average of our main trading partners. It is also above Ireland's long-term historical average (2.5 per cent between 1975 and 2000), and not much lower than the exceptional 3.9 per cent achieved between 1995 and 2000. It would be hard to argue that it errs on the side of caution.
A similar judgement attaches to the 2 per cent labour force growth projection, based as it is on the assumptions of significant increases in female participation rates and of continued substantial net immigration.
The ESRI's estimate of potential growth carries little evident scope for surprises on the upside, although the MTR explores (with a distinctly sceptical tone) one such possibility - that immigration might be materially stronger than provided for in the benchmark forecast.
What this means is that, if the future turns out to be significantly different from the benchmark forecast, it is far more likely to be more downbeat than upbeat. The risks to the benchmark are more heavily weighted towards slower growth than faster growth, either because the economy underachieves its potential or because the ESRI's estimate of potential is too high.
The economy may fail to achieve its potential because of a continuing unfavourable external environment. The international economy may not recover as quickly or as strongly as expected, with obvious implications for Ireland's export markets and foreign direct investment.
Or it might occur because of a further sharp appreciation of the euro against the dollar and sterling (a scenario explicitly modelled by the ESRI and with pretty grim results. Ireland's unemployment rate rises to 9 per cent by 2006 in response to a €1 = $1.40 exchange rate).
Alternatively, the economy may not realise its potential for reasons that have a domestic origin, reasons that are captured by the word "competitiveness".
The ESRI's analysis highlights two dimensions in particular: wage inflation and infrastructural bottlenecks. Both require urgent remedial attention if the economy's potential growth is to be realised, and the remedies are very much a matter of Government policy.
As far as wage inflation is concerned, the Government needs to get things under control by linking public sector pay clearly and decisively to productivity. Failure to do so will mean tax increases and the further erosion of already damaged competitiveness in the private sector.
As for infrastructure, the yawning deficit between what is needed and what exists has not been perceptibly reduced - even after almost four years of the much-vaunted National Development Plan. It's time for a ruthless recasting of priorities, even if that means sacrificing current consumption and ministerial pet projects, and perhaps adopting a more flexible approach to Government borrowing.
Failure to close the infrastructure gap will fatally undermine Ireland's attractiveness as a business location. The ESRI is right in suggesting that this prospect should dominate Government thinking about future pension liabilities.
Economic potential is not self-realising. Our relatively recent past is testimony to that. The 1980s saw this economy fall far short of its potential, largely because of avoidable policy errors. Let's hope the latest report from the ESRI helps to avert another similar episode.
Jim O'Leary lectures in economics at NUI-Maynooth.
