Although the outlook is good for 2006, the Irish economy is too reliant on external factors to have confidence in the medium term, writes Jim O'Leary
I've said it before in the columns of this newspaper: 2000 marked a watershed for the Irish economy. In that year the pace and pattern of economic growth fundamentally changed and the Celtic Tiger gave way to what might be more aptly called the Celtic Beaver.
Between 1993 and 2000, the Irish economy expanded at an extraordinarily rapid pace, with GDP growing by 9 per cent and overall employment rising by 5 per cent per annum. The locomotive for that growth was trade with the rest of the world. Export volumes increased by 17 per cent a year, accompanied by a major expansion of manufacturing and internationally traded services. That expansion was based in large part on huge inflows of foreign direct investment, but was also fuelled by improvements in the cost competitiveness of Irish producers.
In the period since 2000, economy-wide output and employment have continued to expand impressively, albeit at rates a good deal slower than in the preceding years. However, the most marked differences vis-a-vis the earlier period do not relate to the pace of growth but to its composition. Since 2000, exports have grown very sluggishly, manufacturing output growth has decelerated sharply and industrial employment has declined. By contrast, output and employment growth in construction have accelerated and the building industry has become the new engine of growth, accounting for not far short of half the total increase in private sector non-farm employment over the last five years.
There are other important differences between the two periods. One relates to the sources of labour supply. In the years before 2000, the vast bulk of the increase in the labour force was due to domestic factors: rising female participation rates and an excess of young people reaching working age over older people reaching retirement. Since 2000, as the domestic labour supply has become less plentiful, an increasing proportion of the annual increase in the labour force has been due to immigration. In 2005, some 40,000 of the 100,000 expansion of the labour force was due to net inward migration.
According to forecasters, 2006 will bring a continuation of the pace and pattern of economic activity characteristic of the Beaver period. Overall growth rates of output and employment, at about 5 per cent and 3 per cent respectively, are expected to remain impressive. Export growth is expected to remain sluggish, with industrial output and employment continuing to stagnate. Once again, it is expected that the most dynamic sectors will be domestic: construction and consumer spending. Migration is expected to continue to be a major source of labour supply growth. It is set to be another good year for households, which will benefit again from expanding employment opportunities and healthy growth in real disposable incomes. And also for firms, at least those serving the domestic market, which will benefit once more from buoyant demand.
Irish people obviously take pleasure in the prospect of another year of strong economic performance, as indeed they take pride in the country's extraordinary economic record of the past 12-15 years. The pleasure and pride are understandable, but complacency is not appropriate. For all that our economic achievements of recent times reflect creditably on the wisdom of our policy choices as well as our genius, enterprise and energy, they also reflect the influence of events and processes that are outside our control.
In this regard, it is worth noting that, for all the differences between the periods either side of the 2000 watershed, Ireland's impressive economic performance in both periods has been greatly facilitated by external developments. Between 1993 and 2000, the external events from which Ireland benefited enormously were: (i) exchange rate movements, which for the most part boosted the competitiveness of Irish producers, and (ii) those global developments that spawned large inflows of foreign direct investment into sectors such as electronics, pharmaceuticals and software.
Since 2000, the external factors that have wielded a critically important influence have been: (i) the historically low level to which interest rates have been reduced by the European Central Bank, and (ii) the accession of the central and eastern European countries to membership of the EU in 2004, a development that has opened up an important new source of labour supply for Ireland.
The point here is that the very external factors that exert a powerfully positive influence in one period can easily turn around. Thus, exchange rate movements, which provided a strong stimulus to the economy in the Celtic Tiger period, have in more recent years acted to reduce the competitiveness of Irish producers and so have helped to curtail exports.
We have been fortunate that, as the influence of the exchange rate moved from positive to negative, interest rates were reduced to historically low levels, providing a major stimulus to the construction industry. We have also been fortunate that the sectors in question have been able to respond to that with the help of substantial inflows of immigrant labour.
However, interest rates are now at abnormally low levels. There can be little doubt that they will be raised in 2006 and beyond. The outstanding question is by how much. Moreover, the wave of inward migration that has occurred over the last couple of years has been extraordinary in scale and it is hard to see it being sustained at its recent rate. Indeed it might be instructive for us to consider what would be the consequences if immigration came to an end. For example, how many new houses would we need in these circumstances compared with the 80,000 a year we are now building?
Without any negative shocks the outlook for the Irish economy in 2006 is favourable. But the current pattern of growth leaves the economy highly vulnerable to developments that are largely outside our control and at least one of which - rising interest rates - is quite predictable. Moreover, the current pattern of growth has resulted in those sectors of the economy that are vital to sustaining living standards in the long run (manufacturing industry and internationally traded services) having the life squeezed out of them as they try to compete for scarce resources.
Optimism about the short term may be soundly-based, but it is becoming increasingly difficult to extend that optimism to the medium term.
Jim O'Leary is an economist and lecturer at NUI Maynooth