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Monday, May 14, 2007

Irish Economists: The Optimists in Retreat

Dan McLaughlin with Health Minister Mary Harney T.D. at a Women In Banking and Finance (WIBF) Ireland forum.

Whether or not punditry is your cup of tea, it's hard to avoid it in today's world.

A number of qualities or maybe I should say characteristics are essential in the pundit and one of them is a brass neck. However, prognostications and forecasts are often forgotten by the audience as fast as they are made and besides it's difficult to rate the soothsayers because some excuse for being off target, is never too hard to find.

Dan McLaughlin, Chief Economist of the Bank of Ireland and Austin Hughes, Chief Economist of IIB Bank have been Ireland's most optimistic practioneers of the dismal science in recent years.

Last Friday, McLaughlin said in an address to the Irish Housebuilders' Association that it is not clear from some of the more bearish forecasts on the Irish economy whether the authors envisage a cyclical slowdown or a structural shift in Irish growth. The former would be relatively short lived as in time lower interest rates would eventually prompt a cyclical recovery, as in the 2001 – 2003 period.

A move to a lower potential growth rate would be more serious but it is not obvious why the potential growth of the Irish economy should fall from 5.5% - 6% to 3.5% - 4% in eighteen months as it would require a sharp fall in productivity or a substantial fall in labour force growth. Some even argue that the Irish potential growth rate is not currently in this 5.5% - 6% range, but if lower, unemployment would have surely fallen, when in fact it has been very stable over the last few years.

As the outlook for the Irish economy has dimmed somewhat because of a slowing in the very crucial construction sector, the Economic and Social Research Institute forecasts that economic growth in 2008 will slow to the lowest level since 1993 - the first year of the emergence of the Celtic Tiger.

In The Irish Times today, Michael Casey, former economist at the Central Bank asks: Are politicians chasing a poisoned chalice prize: electoral victory only to preside over an unavoidable recession?

Casey writes that: There are two historical reasons why such an economic slow-down seems probable. First, the Celtic Tiger and subsequent years constituted Ireland's "catch-up" period. There is, however, no evidence internationally that a country, having caught up on its peers, can then move ahead of them in a sustained way.

Theory would suggest that what is far more likely to happen is that the country would revert to the growth path of the peer countries - about 2 per cent in Ireland's case.

The second reason is that even if Ireland's potential growth rate is as high as 4-5 per cent, it must be remembered that this is basically a long-term average. Since we have been growing over the past 15 years by well in excess of this, it follows that the growth rate must fall for a considerable period to well below the average of 4-5 per cent.

Other less theoretical reasons for expecting a slow-down can be divided into two groups: those that were latent even in the boom years of the Celtic Tiger and those that emerged during the past five years.

In the earlier period, say the 1990s as a whole, it became apparent by looking behind the headline figures that there were serious problems beginning to emerge in relation to loss of competitiveness and unsustainable rises in property prices. Towards the end of that period, the rise in the value of the euro was singularly unhelpful to Irish exports to non-European countries.

The lack of preparedness of the public sector to cope with huge infrastructural demands, and the inevitable mistakes, levied serious costs on the economy.

Casey refers to a number of the often highlighted issues that have arisen in the economy, including a fall in productivity and says that the latter : is a worrying development, bad in itself and also because it casts doubt on the extent to which Ireland Inc has transformed itself into a knowledge economy.

It is hard to avoid the impression that the economy will run out of steam in a couple of years and there is little that any government will be able to do to offset it. We may get lucky again if foreign direct investment picks up but there is now much more competition for this sort of investment.

On the demand side we don't have control of interest rates or the exchange rate. We can't count on fiscal policy if only because of the apparent inability to estimate revenue. Social partnership will not provide any solutions and may become more fraught - recent pay claims by nurses and teachers do not bode well. And the stand-off regarding medical consultants' contracts is positively dangerous.

Celtic Tiger II: The Sequel

In February 2004, The Sunday Independent reported that Dan McLaughlin was the toast of the Society of Chartered Surveyors annual dinner at the Burlington Hotel: In a virtuoso performance, he declared that this country is currently enjoying an unprecedented "Golden Age of Construction" and - to thunderous applause - announced that "the Celtic Tiger is Back".

If the definition of an optimist is one who sees the bottle half full and a pessimist says it's half empty, the BofI economic guru left his audience of 1,300 property professionals in no doubt where he stands. "The economy in general has emerged from a period of sub-trend growth in remarkably rude health and is poised to enjoy a much more favourable global backdrop, which will propel Irish growth towards the potential of 6% over the next eighteen months," Dr McLaughlin opined.

And so it transpired!

However, during the Sequel, construction became even more dominant in the Irish economy than in the late 1990's when the total employed in the sector jumped from 126,100 in early 1998 to 281,000 in late 2006.

We have become even more dependent on foreign direct investment (FDI) today than we were a decade ago but having lost competitiveness, at a time when competition for mobile investment has increased.

Slogans about creating a knowledge economy when venture capital investment in Irish business continues at a pathetic level compared with investment in overseas commercial property, is hardly a harbinger of a sustainable future, when the equivalent of the oil wells - construction - run dry.

More background here.

Interpreting Data

It's interesting how the economists Dan McLaughlin and Austin Hughes were slow to adjust their forecasts for the European Central Bank key interest rate even though markets were pricing in much higher rates.

Most data sets can be viewed and interpreted from different angles but there is a need to look beyond construction even though demographic factors may sustain an above trend demand for some years to come.

We have been a one-trick pony and the problem is that it will take a long period to get other sectors back on track.

We should be looking beyond the short-term horizon and get real about the challenges.

Surprise as it may be to some, the free lunch has yet to be invented.

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