Consumer confidence has been eroded by rising unemployment, writes Paul Tansey, Economics Editor

WITH THE Economic and Social Research Institute (ESRI) forecasting today that the Irish economy will shrink in size this year by 0.4 per cent, the Irish boom has finally hit the rocks of recession.

The recession has not been triggered by the global economic slowdown or even by the surge in world prices for energy and food. Its origins are closer to home. The recession is the result of a fall in domestic demand.

Last year, domestic demand - which embraces fixed investment, consumer spending and the day-to-day spending of government - increased by 3 per cent in volume terms. This year, the ESRI anticipates that it will fall by 2.6 per cent when adjusted for inflation.

With a helping hand from a resurgent export drive last year, the 3 per cent growth in real domestic demand was transformed into a real growth rate in Gross National Product (GNP) of 4.5 per cent.

However, in 2008, even the continuing strong performance forecast from net exports cannot offset the sizeable slide in real domestic spending. Hence, this year's recession is home grown.

The origins of this recession can be traced to the construction sector, and particularly its housing segment. The housing boom saw annual housing completions peak at 88,000 in 2006, an unsustainable level of output. Housing completions declined to 78,000 in 2007. Now, the ESRI has cut its forecast for housing completions to 40,000 in 2008 and just 30,000 in 2009. It has also halved its forecast for the volume growth in other building to 6 per cent this year.

As a result, the ESRI now anticipates that the volume of total building and construction output will fall by 21.6 per cent this year, as shown in Table 1. With the construction sector accounting for more than one-sixth of total domestic demand, this forecast fall in building output subtracts some 3.75 percentage points from home demand in 2008. This contraction in construction is thus the proximate cause of the fall in domestic demand and hence it is the principal agent of the forecast recession.

But while the recessionary virus originated in the construction sector, it has now infected consumer spending, the largest component of domestic demand. Rising unemployment, much of it stemming directly from the building sector, has prompted fears of job losses elsewhere in the economy. As a result, consumer confidence has been eroded and households have reined in their spending. At the same time, national employment growth is now at a standstill and this has removed the principal stimulus to real consumer spending growth. With price increases accelerating past pay rises, those at work have little in the way of additional real income with which to finance additional consumer purchases.

The combination of these forces has caused the ESRI to revise downwards its forecast for real consumer spending growth to 1 per cent this year from 3 per cent just three months ago.

As a result, the power of consumer spending growth to brake the fall in domestic demand occasioned by the collapse of construction investment has been significantly reduced.

The impact of increases in the quantum of consumer spending and current public spending, together with some additions to investment in plant and machinery, effectively contain the fall in the forecast volume of domestic demand this year to 2.6 per cent.

While net exports are forecast to deliver the equivalent of 2.2 percentage points to the national growth rate this year, this is insufficient to offset the downward drag caused by the fall in domestic demand.

As a result, real GNP is forecast to fall by 0.4 per cent this year, the first decline in Irish GNP since 1983.

Thus ends the first chapter in the story of this recession.