The emerging challenge to our competitiveness is making economic recovery ever more difficult, writes Jim O'Leary

THE YEAR just past began on a downbeat note. The expectation among forecasters was that economic growth would slow to 3 per cent, mostly because of a sharp downward adjustment in house-building. Even so, overall output was seen expanding strongly enough to generate a 1 per cent increase in employment and to prevent unemployment from rising by more than a notch or two. Granted, there was some variation around this view, but the variation was modest and consistent with a broad consensus that the economy would gently decelerate towards a soft landing.

What a difference a year makes. Never has the actuality been so hugely at odds with the expected. It is now estimated that the economy shrank by 2-2.5 per cent in 2008, employment contracted by as much as 2 per cent and the unemployment rate breached 8 per cent by year-end, 3.5 percentage points above its end-2007 level.

The pace at which things unravelled was alarming and the speed of deterioration set new records. The volume of retail sales, for example, fell in every month bar two in the period to October by which time it stood 7.3 per cent below its year-earlier level - the largest annual fall since 1984. The Live Register rose in every single month, and by a cumulative 107,000 in the 12 months to November, the biggest annual increase on record.

Nowhere was the speed of the unravelling as breathtaking as in the case of the public finances. The official projections at the time of the 2008 budget were that tax revenues would grow by 3 per cent and that the overall budget deficit would be just €1.8 billion or 1 per cent of GDP. As the year progressed it became clear these targets would be missed by ever-increasing margins. After the November exchequer statement the Department of Finance admitted that the tax shortfall would be at least €8 billion (more than 16 per cent), and the budget deficit would exceed €12 billion for the year, 6.5 per cent of GDP.

Why did the economy weaken so much more sharply than expected last year? To some extent it was due to the direct effect of a steeper than expected fall in house-building, but other factors played a far greater role. Chief among them was an unanticipated decline in consumer spending, due in part to the knock-on effects of the construction slump on sales of household goods, in part to the impact of falling asset prices and rising unemployment on consumer confidence, and in part to the dampening effect of falling employment on incomes.

Also, export growth was much more muted than had been forecast at the start of the year, reflecting the sharper than expected slowdown in the international economy. Another factor making for weaker than expected economic activity was the constricting influence of the credit crunch on non-residential investment, something not allowed for in initial forecasts.

Most commentators portray the Irish economy as having been subject to two major shocks in 2008: a domestic shock in the form of the collapse of the property and construction boom and an international shock in the form of global recession, itself the product of a meltdown in the global financial system. The effects of each of these shocks have a good deal further to play out in 2009.

The current weakness of demand, together with the large overhang of unsold stock, means that house-building will contract a good deal more before recovery in that sector becomes a realistic prospect. This will impart another big negative impulse to overall economic activity this year.

As for the international environment, available forecasts point to a continuation if not a deepening of recession. The expectation among professional forecasters is that GDP in our main trading partners will contract significantly further. Given the scale of fiscal and monetary stimulus that has been applied across the globe, there are grounds for hoping, if not a firm basis for expecting, that recovery might begin in the second half of the year.

Irish economic forecasts for 2009 reflect the continuation of these two malign sets of influences. House completions, which are estimated to have fallen to 48,000 in 2008, are forecast to register another steep drop, to 20,000 this year. Partly on this account, the prevailing view is that consumer spending will contract by 3-4 per cent.

Looking at the most recently published forecasts, the consensus is that exports will stagnate. As a result of all this, it has become commonplace to read projections of a fall of 4 per cent or more in overall output in the economy, a decline of at least that magnitude in total employment, a rise in the unemployment rate to 10 per cent in the course of the year and the resumption of net emigration.

As in previous years, this emerging consensus is likely to be wrong. However, deciding where the balance of risks lies is much more difficult than usual because we are in uncharted waters. For one thing, Irish households' balance sheets have never sustained as much damage as they have over the past 12 months, and there is no precedent for gauging what the response will be.

Another respect in which the current situation is without precedent relates to migration: this economy has never before faced into recession from a position where 10 per cent of the population is composed of immigrants, most of them of very recent vintage. How they react to the much harsher economic climate will have a bearing on the longevity and severity of the recession. A mass exodus may limit the rise in unemployment, but will also exacerbate weakness in the housing market and the retail sector.

There is another aspect of the present situation that is exceptionally problematical. It relates to competitiveness. Even before last year, the Irish economy had lost a great deal of competitiveness, a condition obscured (and to an extent caused) by the construction boom. But in 2008 this problem was greatly aggravated by the extraordinary collapse of sterling. Just before Christmas, sterling had fallen so low that the notional sterling/Irish pound exchange rate reached 1.21, a value 10 per cent above the level it reached during the ERM crisis of 1992-93.

On that occasion, as on previous occasions when an acute competitiveness problem required an urgent solution, the Irish authorities responded with a currency devaluation. Other small open economies that have in the past faced difficulties comparable to those we now face have also resorted to currency devaluations to pull them through. The examples that come most readily to mind, because in each case a serious banking crisis was part for the problem that needed resolving, are Finland and Sweden in the early 1990s. In both countries the big gains in international competitiveness brought about by sharp currency depreciations were a vitally important ingredient in economic recovery.

In our case the option to devalue is no longer available. Now, the only way in which we can restore lost competitiveness is by reducing our costs of production relative to our main trading partners. Given that our main trading partners are not inflating, this converts into the requirement that we cut our costs of production in absolute terms and, given the amount of ground we need to make up, the cut in costs that we need to effect is not small. I hesitate to put a precise figure on it, but it is almost certainly in double-digits in percentage terms.

Getting there will not be easy. It will add to the deflationary pressures bearing down on the economy in the short run - something that I don't think the existing forecasts for 2009 take cognisance of. On the other hand, if we don't get there, it will take an awful lot longer to pull the economy out of recession and the medium-term prospects for the economy will be a good deal bleaker.

Jim OLeary is a Senior Fellow of the Department of Economics, Finance and Accounting at NUI-Maynooth. He can be contacted at jim.oleary@nuim.ie