ANALYSIS:The loss of jobs caused by the sharp contraction in the over-heated construction industry is the clearest indication that recession and emigration are on the way back - buckle up for a roller-coaster ride, write Ide Kearneyand John Fitzgerald.
AS THE ESRI's Quarterly Economic Commentary, published today, makes clear, in 2008 the Irish economy will experience its first recession since 1983 - a bleak prospect. With unemployment on the rise, net emigration is likely to resume in 2009 and the public deficit will breach the 3 per cent deficit limit under the Stability and Growth Pact.
However, if handled correctly the economy should still bounce back in 2010 and beyond.
The recession will be driven primarily by domestic problems.
In early 2007, the housing market began to slow and the effects of this have now spread more generally to personal consumption, which could grow by as little as 1 per cent in real terms in 2008.
This is a dramatic slowdown from the last three years when consumption growth averaged over 6 per cent. Tax revenues are falling, unemployment is rising and consumer sentiment is at an all-time low.
Growth prospects for our major trading partners over the short term are poor, driven in part by the ongoing credit crisis and compounded by uncertainty around commodity prices.
Despite this, the economy's current problems are not primarily due to these difficulties abroad.
For some considerable time the overblown size of the building and construction sector was the elephant in the room - it is finally making its presence felt.
The major contraction in the size of the building sector was inevitable.
The problem is that the growth of new jobs to replace it in the rest of the economy will take some time.
The rapid decline in the housing market is creating serious difficulties for the exchequer, which has become accustomed in recent years to the windfall revenue arising from the housing boom. Likewise, it will lead to significant job losses.
With numbers unemployed set to increase sharply in 2008, it is likely that there will be a return to net emigration next year.
More than any other indicator, this could signal to the wider public the severity of the current recession.
The huge cost of the excessive housing boom is now being laid bare.
The euro area economies, a few of which also have domestic housing market difficulties, are not facing such a dramatic decline; we could have been like them if our boom years had been less extreme.
Yet there are some positive signs.
In spite of a serious loss of competitiveness in recent years, trade in 2007 made its largest contribution to the overall growth rate since 2002 and net exports will add significantly to activity again this year.
It is this resilience that gives promise of better things to come after 2010.The growth in exports, and hence output, is predominantly in business and financial services.
The move to services and away from manufacturing reflects a change in Ireland's comparative advantage in the global economy.
Much of manufacturing is facing difficult times.
The loss of competitiveness has accentuated these difficulties, which were reinforced by the excessive growth in the building sector squeezing resources out of the rest of the economy.
Over the coming two or three years, as the building sector contracts, the economy needs to price its way back into a competitive position to allow new activities in the manufacturing and services sector of the economy to grow, providing a full recovery in 2010 or 2011.
The problem is that when firms have to cut employment this happens very rapidly, as is the case today, while it may take a few years to grow the new firms providing the employment of the future.
Fiscal policy, which is broadly neutral today, is appropriate and it should remain unchanged next year, even if the deficit breaches the EU guidelines. This will still involve tight control of public expenditure and no tax giveaways. It also requires that public expenditure is properly managed. Only if things prove even worse than expected, giving rise to the prospect of an even bigger deficit (over 4 per cent), would fiscal policy have to be tightened next year.
For the future it is important that we learn the lessons of the past. As assumed in the ESRI Medium-Term Review, published last month, fiscal policy will need to be tightened in 2010 once economic recovery gets under way to ensure that the likely high level of Government borrowing is only a temporary phenomenon.
The Review assumed that this tightening would be achieved through an increase in taxation, though it could also be achieved by cuts in expenditure. Fiscal policy in the future should seek to ensure that the economy does not grow more rapidly than is sustainable over the longer term, as it did in the recent past.
This should be implemented through growing a surplus in good times, while allowing a more relaxed approach when times are difficult. Had such a policy been adopted since 2000, things would be significantly better today.
While the costs of the current recession will be serious - higher unemployment and a likely return to emigration - if the flexibility of the labour market sees Ireland pricing itself back into major markets, it is probable that the economy will make up for "lost time" after 2010 with a return to steady growth somewhat above the average for our EU neighbours.
Ide Kearney is a consultant with the ESRI and is based in the Netherlands; formerly, she was an economist with the research department of the Central Bank. John FitzGerald is programme co-ordinator of macroeconomics research at the ESRI and is manager of the macro-economics and resource economics division. He is also responsible for the Energy Policy Research Centre.