The Irish economy will almost certainly undergo a severe downturn over the next year or two. The exact scale of job losses - or indeed falls in house prices - is almost impossible to predict. But if the Economic & Social Research Institute's (ESRI) slowdown forecast is even close to accurate, many tens of thousands of people will be affected.

A doubling of the unemployment rate to around 7 per cent by 2003 or sooner would be extraordinarily bad news. When combined with a likely decline in consumer spending and a fall in confidence generally within the economy, the net result would be particularly severe.

Almost solely because of the events of September 11th, the ESRI - in its Medium-Term Review 2001-2007, published today - is predicting growth in gross national product (GNP) at around 2 per cent in 2002, which could be more than 3 percentage points lower than would otherwise be the case. This is a far greater impact than on any other OECD economy, according to ESRI research professor, Mr John Fitzgerald, and is a demonstration of how open, and therefore how vulnerable, the Irish economy is.

Similar falls in growth resulted from the Gulf War and the reunification of Germany in 1989 to 1990, when the figure fell from 7 per cent to 2 per cent.

The Central Bank, in its Autumn Bulletin published yesterday, is far more optimistic, with a forecast for 3.5 per cent growth in GNP next year and a much smaller rise in unemployment to 4.5 per cent.

Most of the reason for this is the different assumptions about the exchange rate. The ESRI has assumed that the dollar will fall rapidly, whereas the Central Bank is obliged to forecast on the basis of unchanged exchange rates. In addition, the ESRI was more negative about the outlook for consumer spending.

Privately, however, central bankers admit that the ESRI forecast may not be very wide of the mark if the dollar weakens rapidly.

But the exact scale of the downturn is impossible to predict accurately. The ESRI had worked on a benign benchmark forecast as well as a slowdown scenario.

Events of September 11th have made the slowdown the most likely outcome. But Mr FitzGerald was keen to point out that the organisation's latest review was most concerned with the medium term and that its forecasts for that timescale had not changed significantly, with growth of around 5 per cent on average between 2000 and 2005 still expected.

He pointed out that there was little that could be done by way of mitigation in the short run, saying it was a bit like bringing a child with flu to the doctor. There was nothing the doctor could prescribe and the child would get better of his/her own accord.

That is small consolation to those who have recently lost jobs or who are worried about their future prospects.

But Mr FitzGerald was also adamant that the good times were not over for good. By the middle of the decade, employment, house prices and growth should be back to where they would otherwise have been were it not for the events of September 11th.

"It will be a short, sharp shock but it is a temporary setback, not the end," he said at a press briefing yesterday.

This may offer some comfort to policymakers looking at the longer term but will do little for those worried about next year, or, indeed, re-election.

And even a medium-term rebound in the State's economic prospects is subject to a number of conditions. Inevitably, there is the external environment where currency levels, oil prices and US growth will have a significant impact. But domestic considerations will also come very much into play. Fiscal policy and spending priorities will be crucial to achieving a rapid rebound from what is going to feel like a recession. And it is still well within the Government's capabilities to make mistakes and to prolong, or indeed worsen, the economic downturn.

The key to a rebound from an external perspective is, firstly, a decline in the value of the dollar. The ESRI team has pencilled in an exchange rate of around $1.07 to the euro next year, which would allow the US economy to recover rapidly.

However, it would also give rise to serious competitiveness problems for Irish firms - many of which would already be suffering.

The equivalent sterling exchange rate is likely to be around 90p sterling for the pound, according to ESRI researcher Mr David Duffy.

However, a scenario in which the dollar remained around current levels over the course of 2002 would see the recovery delayed by quite some time, although the slowdown may not be quite so sharp.

The optimum, from an Irish perspective and from that of other world economies over the medium term, could be a sharp depreciation in the value of the dollar, according to Mr FitzGerald.

Conversely, a sharp upturn in the value of the euro would put enormous pressure on some domestic industry. Wage rates would continue rising quite rapidly in 2002, further aggravating competitiveness.

This escalation could taper off quite significantly in 2003, depending on the outcome of the benchmarking pay review process.

One result is that it could be 2007 or 2008 before the full adverse effects on the labour market would have worn off and the economy would have returned to its current "full employment" level.

The answer, according to the ESRI, lies in some downward adjustment to wages. There would be little impact on current job losses in the high-tech sector but it would be likely to be of more benefit to traditional sectors within the economy.

House prices will be a little faster to recover. According to the ESRI analysis, they will be back to where they would otherwise be by 2005. Next year will see the largest falls as people worried about losing their jobs postpone the decision to buy. However, Mr FitzGerald was keen to stress that prices should not tumble the way they did in Britain in the late 1980s, as interest rates are likely to be falling and the economic downturn should be shorter and less severe.

In addition, the public sector needs to invest in social housing, while, over the medium term, demographics will ensure that demand remains strong. "This could be a one-off bargain basement time for social housing acquisition," Mr FitzGerald pointed out.

One positive aspect of the slowdown is an end to inflation worries. According to the more severe "slowdown" forecast, the consumers' expenditure deflator used by the ESRI to measure inflation would grow by just over 2 per cent, compared to the benchmark forecast of just under 4 per cent.

One message that the ESRI will be hoping the Minister for Finance, Mr McCreevy, will heed is the importance of a neutral budget, in the sense that it neither seeks to stimulate nor to deflate the economy.

Mr FitzGerald warned that another expansionary budget could push the public finances further into deficit, possibly by up to 2 percentage points of GNP. This would require a tightening in fiscal policy at some later date.

"As seen in the 1980s, such a development, where the Government has to tighten fiscal policy while the economy is growing below potential, could prove quite damaging," the review warns.

"The bottom line is that governments should aim for policies that will be robust in the face of surprises."

Mr FitzGerald argued that it should still be possible to significantly improve the quality of public services in the medium term, while meeting the Government's fiscal surplus target.

Future governments should be able to choose either a more rapid improvement in services, with some increase in taxation, or slower growth in public services accompanied by limited cuts in the real burden of taxation. However, he was also assuming that the National Development Plan would be implemented in full, which would be vital to expand the capacity of the economy to grow in the future. The signs of this are not encouraging, with the Government likely to find it easier to put off some capital projects than postpone day-to-day expenditure.

If this was to continue, it could mean around 1 percentage point off growth in every year for the foreseeable future. This, Mr FitzGerald said, would have a large compounded impact at the end of the decade.

Perhaps the biggest longer-term development on the future of wage rises will be the choices made by individuals between higher pay or better working conditions.

The ESRI points out that GDP per head is higher in the US than the EU. However, GDP per hour worked is similar in the US and Germany. The difference in living standards between the EU and the US is due to a preference among workers in the EU for more leisure at the expense of less income.

Currently, Irish workers have longer holidays than in the US, while hours worked in manufacturing remain longer than the average in the EU but shorter than in the US.

According to the ESRI, Irish workers will over the coming decade have to make this choice and, ultimately, it should be a choice made by individuals. Of course, this necessitates greater flexibility in the labour market to accommodate preferences.

There is also an issue relating to family life and flexible working arrangements. According to the ESRI, this could include the provision of improved childcare facilities as well as a wider acceptance that both parents should be free to take time off to care for their children. The ESRI also stresses the importance of obtaining value for money in public services. The review points to the doubling of current Government expenditure on the health service since 1996. It questions whether the development, which has been piecemeal, has been very effective and says that the returns on this very substantial increase in expenditure levels remains an open question.

It is vital, it argues, that the focus is on improving services at minimum cost.