ECONOMICS:THE IRISH economy is now wedged between a rock and a hard place, and it will extract itself from this uncomfortable position only with extreme difficulty.
The hard place is the domestic economy, where profitability is crumbling. Construction activity is collapsing. The steep downturn in house building will, by itself, subtract four percentage points from this year's growth rate. As a result, the official forecast for economic growth this year has now been cut to an anaemic 0.5 per cent.
The destruction of jobs and incomes in the construction sector, and the erosion of confidence it has engendered, is now infecting consumer spending. Retail sales volumes in May were 4.8 per cent lower than a year earlier, the biggest annual fall since 1987. This is not an aberrant observation. Seasonally adjusted, sales volumes in stores and supermarkets have been falling for four successive months.
Thus, fixed investment volumes are in freefall and consumer spending is on the slide. Within the domestic economy, the only remaining player left on the pitch is the Government. But the Government is in no position to help anybody. It has financial problems of its own. As a result of reduced domestic spending, the exchequer now estimates that its tax revenues will be some €3 billion adrift of budgetary expectations this year. As a result, relative to its previous plans, Government will be siphoning off demand from the economy rather than adding to it.
Assuming a 1 per cent increase in the volume of consumer spending in 2008, a 15 per cent fall in gross fixed investment and a 4 per cent rise in real current Government spending, the Economic and Social Research Institute has calculated recently that the volume of expenditure in the domestic economy will decline by 2.6 per cent this year
No sizeable rebound is in prospect for the home market next year. At this stage in the game, nil looks like a good score for domestic demand growth in 2009.
So, with home demand a veritable desert, businesses should be switching to export markets. Sales trends in the markets served by Irish businesses - Britain, the euro zone and the US - are not exactly buoyant, but they are stronger than markets at home. However, in seeking to switch from domestic to foreign markets, the rock of diminished competitiveness gets in the way.
The deterioration in Irish price competitiveness is attributable to two principal factors.
First, the prolonged boom has made Ireland a very expensive country. In 2006, the absolute level of consumer prices facing households in Ireland was 24.9 per cent higher than the EU average, 21.9 per cent ahead of average price levels in the euro zone and 12.7 per cent above British price levels*. The costs of doing business in Ireland mirror the elevated cost of living. As a result, the absolute costs of doing business in Ireland are very high relative to competitor countries.
Second, and more recently, Ireland's real exchange rate has increased sharply due to the declining fortunes of sterling and the US dollar on foreign exchanges. In the two years to May 2008, Ireland's real exchange rate - the actual exchange rates against our trading partners weighted by their shares in Irish trade adjusted for differences in inflation rates - has risen by 11.0 per cent. Almost all of this exchange rate appreciation is attributable to changes in actual exchange rates.
Thus, businesses seeking to escape into export markets are hamstrung on two counts. First, as far back as 2006, Ireland was a very expensive place in which to do business, as evidenced by its high cost of living. Second, the real exchange rate has appreciated by 11 per cent since May 2006**, making the penetration of export markets - particularly the British market - ever more difficult.
While it takes time for exchange rate changes to affect export demand, the auguries are not encouraging. Export volumes in the first three months of 2008 were just 0.5 per cent higher than in the first quarter of 2007.
The standard policy response to an overvalued exchange rate is to devalue the currency. However, as a member of a single currency, the devaluation door is now closed.
Nor can any assistance be expected from the European Central Bank (ECB). In our interview with Jean-Claude Trichet, published today, the ECB president makes it abundantly clear that the bank's monetary policy is framed "to be optimal at the level of a continent". Countries in difficulty, such as Ireland and Spain, can expect no favours. Restoring competitiveness is primarily a matter for national governments and Mr Trichet advocated structural reform measures, the containment of unit labour costs and faster productivity growth as conduits to enhanced competitiveness.
Even where such interventions are successful, they will be insufficient in the short run to offset the scale of competitive losses that have accumulated since euro entry.
This leaves just one alternative, and it is extremely unpalatable. Where an open economy is uncompetitive and cannot flex its prices downwards to match those prevailing on world markets, then the burden of adjustment must fall on output and employment. Put another way, if price competitiveness cannot be regained, then the cost will be counted in closed businesses and lengthening dole queues.
