Previous Medium-Term Reviews, which forecast relatively rapid growth in the economy, were greeted with a certain amount of incredulity at the time they were published, although history subsequently proved them to be somewhat pessimistic. This latest Review published by The Economic and Social Research Institute covers the period to 2005. This publication is unique in presenting a comprehensive forecast for the Irish economy over an extended period and it benefits from the wide range of research carried out in the ESRI. The analysis highlights a number of strategic issues which are crucial for the long-term development of the economy, issues which are often ignored in the debate on economic policy in Ireland.

Our analysis suggests that the Irish economy is fully wound up and moving very fast but that over the next decade it is likely to unwind gradually and eventually return to the EU average rate of growth after 2010. However, there remains the danger that either external shocks or domestic mistakes could put this benign scenario at risk. The purpose of this publication is to explore the implications of this forecast, to consider how events might prove it wrong, to analyse the risks and opportunities which the economy currently faces, and to consider the policy options for the future.

Understanding the past

In order to understand the forces driving the economy the Review begins by examining Irish economic performance over the last 20 years. This analysis in Chapter 2 shows that there has been a steady convergence of productivity levels towards the EU average over the last 25 years, but it was not until the 1990s that this translated into a convergence in income levels and living standards.

The External Environment

As an exceptionally open economy, with total trade amounting to almost 200 per cent of GNP, Ireland is very much dependent on what happens in the rest of the world. Chapter 3 considers the medium-term prospects for Ireland's key trading partners. Because of the under-performance of many of the economies in the EU in the 1990s, there is significant scope for output in those countries to grow more rapidly in the coming years, using some of the spare capacity (including the reserves now evident in their high levels of unused labour).

For the US, the medium-term prospects are also considered reasonably favourable, although there remains some uncertainty about the likelihood and nature of any future slowdown.

Finally, the UK economy is performing somewhat better than might have been expected, given the strength of sterling, and this augurs well for its prospects over the next few years.

All in all, the international outlook appears quite favourable for Ireland for the immediate future.

Demographic Assumptions

A key factor underlying the exceptionally strong performance of the Irish economy in the 1990s has been its unusual demographic structure. From having the highest rate of economic dependency in the EU in the 1980s, it will have one of the lowest by 2005. This affects the economy, directly through releasing a very large number of people into the paid labour force, and indirectly through reducing the tax burden.

The combination of a large natural increase in working age population and rising female labour force participation has resulted in the labour force growing rapidly - by an average of 3 per cent a year over the period 1990-95. The numbers employed have also been swelled by the major fall in unemployment.

However, in the next five-year period to 2005, even with higher net immigration, the rate of growth in labour supply is forecast to fall to an average of 2 per cent a year, with a further fall to 1.5 per cent in the period to 2010. In addition, there is much less scope than in the 1990s for further falls in unemployment.

The Central Forecast

The Central Forecast for the economy to 2005 is described in Chapter 5. This represents our best estimate of the prospects for the economy - the actual outturn is as likely to be higher than forecast as lower. However, as discussed in Chapter 6, if the economy were to be hit by an adverse shock, the potential loss of output, and the resulting divergence from the Central Forecast, would be likely to be greater in absolute magnitude than would be the case if the economy exceeded expectations.

Underlying our forecast is an assumption that the next National Plan will provide for a major increase in public investment in infrastructure. Because of the dangers the economy could face from overheating, we also assume that the next two budgets provide for under-indexation of tax bands and allowances - a tightening of fiscal policy. Thereafter, once the economy has slowed down, we allow for major cuts in taxation over a period of years. These policies would see continuing budgetary surpluses over the next decade, culminating in the full repayment of the national debt by 2010 and would allow the government more scope to cushion the economy from any future shock through a counter-cyclical fiscal policy.

The main points that emerge from the analysis are:

As shown in the figure [reproduced on this page], the economy is currently fully wound up and growing very rapidly at over 6.5 per cent a year. The most likely scenario for the next decade is that it will gradually unwind, with a reversion to a `more normal' European growth rate after 2010. This would see a growth rate for GNP over the next 5 years of around 5 per cent a year, with Irish income per head reaching EU average levels by 2005. The superior performance of the economy to that of the EU as a whole is attributable to a much higher growth in labour supply, as well as a somewhat higher growth in productivity.

There will be a gradual shift from high-tech manufacturing to market services, especially internationally traded services, as the engine of growth over the course of the next ten years. This pattern of development has already been seen in other developed economies.

Investment will remain high over the period to 2005, reflecting the fact that, while Ireland is enjoying an EU standard of living, it has not yet reached the average EU stock of wealth, especially in terms of infrastructure. The need for a high level of investment, especially in public physical infrastructure and housing, which is needed to close this gap, will limit the resources available for consumption.

Provided that wage expectations do not run ahead of the ability of the economy to deliver, it seems possible that the labour market will see almost full employment in the medium term, with the unemployment rate hovering around 5 per cent.

Over the past 20 years, in order to generate a major increase in employment, Ireland's competitiveness had to improve dramatically through the share of profits in total output rising continuously. However, looking to the next decade, the rate of growth in employment is likely to be much lower, reflecting the expected sharp fall in the growth in the labour force. It will be sufficient if the level of competitiveness, as measured by the profit rate, stabilises at roughly its current level. While more of the benefits of growth in the 1990s were taken in the form of increasing employment than in increasing real wage rates, for the next decade real wage rates are expected to rise more rapidly.

Over the next decade, because of the demographic pressures, there will be a continuing need for 45,000 or more new dwellings a year. While the supply side has to date responded to this challenge, the rate of inflation in house prices continues to be very high. A resolution of this problem must await investment in the necessary infrastructure.

Because of the dramatic fall in the dependency ratio, the burden of providing necessary public services is likely to fall in the period to 2005. Once the economy has slowed down, probably in 2002 or 2003, this will allow the possibility of fairly dramatic cuts in the level of taxation. This should be possible, while still providing for a high level of investment in infrastructure, full indexation of social welfare payments to wage rates, and a continuing limited improvement in public services. As shown in the table [reproduced on this page] this could result in full repayment of the national debt by 2010.

Shocks and Surprises

While the Central Forecast represents the best estimate of how the economy will progress out to 2005, it is almost certain that the actual out-turn will be a more bumpy ride. Chapter 6 examines what would be the impact of a series of unpleasant surprises. This analysis suggests that the negative effects of external shocks could be magnified in the short term by three domestic factors: a potential bubble in house prices, excessive wage inflation in the coming years, and a failure to implement the necessary investment in physical infrastructure.

If, for example, there were to be a sudden shock to the US economy from collapsing equity prices, or to the EU economy from a monetary policy shock, the consequences could be a temporary dramatic fall in house prices, with other related effects on the domestic economy. Such a shock could see GNP reduced by 3 percentage points or more for a limited period, giving rise to a severe but temporary recession.

Probably the most serious problems that the economy could encounter would be an external shock along the lines of the oil crises of the 1970s, or a sustained explosion in labour costs combined with escalating public sector pay problems, and a continuing failure to deal with the existing infrastructural deficits.

Finally, the possibility that the economy could grow more rapidly through higher immigration or through higher productivity growth is examined. In the case of the former, there would be an even greater need to upgrade the country's physical infrastructure.

However, these scenarios suggest that the economy is reasonably robust. If handled correctly by domestic policy-makers, external shocks need not do lasting damage, though, of course, they would be very unpleasant while they last. The strength of the public finances means that in the future, governments should have the scope to offset some of the worst effects of asymmetric shocks through counter-cyclical fiscal policy. This option was not available in the 1980s.

Policy Implications

Chapter 7 reviews the policy implications of the analysis in this Review. As discussed above, there is no certainty that the benign scenario of the Central Forecast will be realised. However, there are a range of policies which might be adopted which could help make the economy more robust in the face of shocks. The favourable scenarios painted in this Review also allow the possibility of making significant progress over the next decade in achieving a number of the long-term goals of economic and social development. It also seems certain that Ireland in 2010 will be a very different economy and society from today and this will require a rethinking of our strategic objectives.

Policy Measures

The policy measures that could help promote the benign Central Forecast are:

The successful implementation of the programme of investment in public physical infrastructure, identified as being necessary in the report on National Investment Priorities [published by the ESRI in April]. To be successful there will have to be major changes in the planning and implementation process.

A renewed social partnership that guarantees a significant dividend from the rapid economic growth to all citizens, while still maintaining the country's competitiveness. Providing that it dealt with the escalating problem of public service pay it could help ensure a stable domestic economic environment.

In order to reduce the economy's exposure to unpleasant shocks, fiscal policy should be tightened over the next two years. This would involve severely limiting tax cuts in the next two budgets in return for the prospect of very substantial reductions once the economy slows down.

There is still a need for a comprehensive programme of tax and welfare reform to improve the efficiency of the economy and to ensure that all of the population share in the fruits of growth. In the case of corporation tax, after 2010 the common rate should probably be raised somewhat above the 12.5 per cent promised for 2003. Ultimately some form of carbon tax will be essential if Ireland is to meet its objectives in reducing greenhouse gas emissions at minimum cost to the economy. A series of other environmental taxes and charges are needed to ensure that the environment is not overused and that efficient use is made of public infrastructure. Rationing road space by congestion and exhaustion is less efficient than using appropriate charges. In the case of housing there is a need to concentrate State support on the area of social housing and to reform the current channels through which this latter support is currently provided.

There is an urgent need to improve the efficiency of many sectors of the economy, especially public utilities. Public/Private Partnerships (PPPs) should not be used to raise finance - the State is not short of money. Where PPPs have an important role is in the efficient production of goods and services, a task where the private sector generally has a comparative advantage.

Living Standards

The most obvious first call on the fruits of future growth is to raise the living standards of the population as a whole.

If the Central Forecast were to be achieved, it seems likely that real after-tax wage rates for those in employment could rise by around 3 per cent a year over the next decade, almost 1 per cent a year faster than in the 1990s.

We have assumed that welfare rates will be indexed to average earnings so that those dependent on welfare will also share in the growth.

While the single biggest group in poverty in the 1990s has been the unemployed, there are other groups that may be at particular risk in the medium-term. These include lone parents and their children, and those in low-paid employment.

A rapidly growing problem, contributing to poverty and hardship, is the shortage of social housing. Tackling this problem in the next five years will require substantial additional resources.

Strategic Priorities

The changing nature of Ireland's economy and of the wider society raises issues about the strategic priorities for the country in the next decade.

The change in lifestyles, in particular the rising participation of women in the paid labour force, will require more far-reaching changes in the way we organise society, and work in particular. In the interests of parents and children it will be necessary for the paid work place to show much more flexibility and for there to be a major development of childcare facilities. This is not specifically a labour market issue but, rather, an issue about the quality of life.

Already there is substantial net immigration into Ireland, with the majority now no longer being Irish citizens. The bulk of the current immigrants are very highly educated and they are making a significant contribution to the growth of the economy. However, as Ireland becomes one of the most attractive labour markets in the world over the next decade, the traditional pattern is being reversed, with many foreigners seeking the type of access to Ireland that young Irish people had to such markets elsewhere in the past. While Ireland can not solve all the world's problems, its growing wealth will require it to play a bigger role than in the past.

The next 10 years will see an unusually favourable demographic situation with the burdens on State services falling. The government should act to ensure that no single generation has to carry too heavy a burden of caring for the aged through the pension system. The current proposals to develop a state pension fund to help promote intergenerational equity are to be welcomed. In the past the public perception has been that the most important benefit to Ireland from EU membership has been EU transfers. In fact, the major benefit has come from the opening up of the economy and culture to the outside world and, in particular, access to the growing EU market. While Ireland will become a net contributor to the EU budget over the next decade, this will be a small change compared to the huge importance to the economy of market access. As a result, in the longer run, the enlargement of the EU is likely to benefit Ireland. These changes will require a change in the vision of Ireland's strategic role in the EU, as well as the shouldering of a larger burden in supporting world economic development through overseas aid.

Articles

The Review concludes with two special articles: Celtic Cubs? Regional Manufacturing in Ireland by John Bradley and Edgar Morgenroth, and Medium-Term Prospects for the Irish Financial System by Colm Kearney]

Bradley and Morgenroth in an article on Regional Manufacturing in Ireland examine the distribution of manufacturing output and employment across the regions in Ireland. The article discusses the factors that have given rise to this outcome. It shows that industry was quite concentrated in the Dublin region in 1960 but by 1980 it was much more evenly distributed. More recently, some regional heterogeneity has crept back. However, they suggest that the original policy of dispersion of foreign firms may have reduced the overall impact of the foreign investment on the economy. They conclude that policy over the period 2000-2006 should try to ensure that the more remote geographic areas are facilitated in their efforts to link into urban growth poles through the development of physical infrastructure and the identification of sectors that can thrive in non-urban environments.

Kearney, in a separate article on Medium Term Prospects for the Irish Financial System, argues that the trend towards increasing economies of scale in the provision of financial services is creating a tendency towards institutional conglomeration and geographical concentration. In the absence of appropriate policy, small regional economies like Ireland will face the prospect of being financially serviced to a greater degree by foreign institutions and markets. The article describes recent developments in, and prospects for the money, foreign exchange, bond, equity and over-the-counter markets, and it also discusses the important institutions including the banks, the National Treasury Management Agency, the Irish Stock Exchange and the International Financial Services Centre. It examines regulatory issues, including the new international financial architecture and the proposed single regulatory authority for Ireland.