Pay, taxation and public spending must all be adjusted if we are to stem our seeming slide into economic doom, writes Patrick Honohan
THE REVERSAL in the fortunes of the economy may seem to have come very suddenly. But ever since about 2000, it has been increasingly evident the character of the Irish boom had changed. Before then, the economy was catching up by a process of competing in the world and living within our means.
But the momentum of that catch-up period, combined with the sharp fall in interest rates as we joined the euro zone, triggered a wholly unsustainable boom in house prices and housing construction.
Economists have long foreseen an abrupt end to the residential construction boom, though the timing of the bust was not clear. They pointed out house prices had soared well beyond what could be considered an equilibrium level: only the belief that prices would continue to rise could justify the levels they had reached.
This has been a classic house-price bubble. Sure enough, as soon as prices began to falter in the spring of 2007, the demand for new house construction began to drop steadily, making a fall in construction-related employment inevitable.
The decline of the construction sector has had gradually accumulating knock-on effects.
A lot of attention has been focused on the consequences for the banks. This is not surprising, given the degree to which they have concentrated on lending for construction and home ownership over the past decade, borrowing huge sums from abroad to finance it.
Even though they do not appear to have indulged in the radically unsound practices of US mortgage lenders exposed in the subprime crisis, the Irish banks have seen their share prices marked down very sharply from their peak levels of early 2007. This reflects market expectations of a much-reduced stream of profits in the years ahead.
Of course, wider international developments have not helped either. The surge in the price of oil, the marked slowdown of the US economy - a major export destination - and the soaring international value of the euro have all added to the gloom.
What needs to be done? Some dimensions of the necessary adjustment are inevitable and will occur of their own accord. These include house prices, which could easily fall another 25 per cent in real terms over the next couple of years. There will be much less residential construction and employment.
But that is not all. The artificial construction boom lulled us into a false sense of security on three other fronts.
First, there is wages. There may be a tendency to think that the social partnership model has faithfully delivered wage moderation assuring labour competitiveness. This was the case between 1986 and 2000 - by which stage Irish labour was supercompetitive - but during the construction boom phase, since 2000, the steady deterioration in labour competitiveness which proved so damaging in the 1970s and early 1980s has resumed. This was fuelled by the demand spillover from construction and, in turn, contributed to the opening up of what is now a sizeable current account international payments deficit. This loss of competitiveness must be arrested, if not reversed, for the growth in unemployment to be halted.
The second area is taxation. Stamp duty and other revenue from the construction boom was so great that governments could reduce other tax rates and boost allowances. Arguably, tax reductions have overshot what was sustainable. A gradual and modest upward adjustment will be needed in the medium run if necessary public services are to be financed.
The third area is public expenditure. Revenue from the unsustainable construction boom made governments complacent about spending growth. This manifested itself in an upward drift in public-sector pay rates - above what would be needed to retain and attract the needed staff - and in the adoption of some hugely costly initiatives such as decentralisation. Correcting these excesses, rather than cutting back on core public service provision, is what is now needed.
Fortunately, there is no need for abrupt and drastic action in the public accounts. Government debt is low and the euro zone Stability and Growth Pact wisely exempts an economy in or near recession from the famous 3 per cent borrowing limit. The rebalancing of the economy should not be so precipitate as to contribute to a collapse in demand in the short run.
What is needed now is a reprogramming - on a medium-term, multiyear basis -of spending and taxation plans. We also need a realistic reassessment by the social partners of wages, if the rise in unemployment is to be stemmed and if needed public services are to remain affordable.
The total tax take as a percentage of gross domestic product will fall unless rates are adjusted: the Government should very carefully consider how much of that fall to allow, bearing in mind the implications for delivery of needed public services.
We have almost forgotten the basics of good government housekeeping. A root-and-branch multiyear public finance planning exercise is now required. It is not clear that the Government's recent spending cuts reflect such an exercise.
The Government is right to point to the need for adjustment.
But the adjustment should be balanced and focused on reversing recent excesses. It should not threaten core public services and should not be so abrupt as to contribute to the downturn in demand.
A return to moderate pay settlements will be especially helpful in restoring both the demand for labour (by limiting the growth in unemployment) and helping public spending achieve better value for money.
Patrick Honohan is professor of international financial economics and development at Trinity College Dublin