Irish Private Sector Credit as % of GDP 1999-2007: Well over half of this stock of credit is directly linked to the housing market: in June 2007, some 41 per cent of total private sector credit was to the personal sector (34 per cent directly related to housing finance), while a further 21 per cent was in real estate activities. This is excluding credit to the construction sector, at over 7 per cent of the total, much of which is also be property related. And the latest credit figures suggest that three-quarters of the increase in credit in the year to June 2007 was property-related. It can also be seen that growth in private sector credit has begun to slow since the end of 2005, although still at double-digit rates and well above the low growth rates recorded in the 2002-2003 period.

For 2008, the Institute expects the unemployment rate to average 5.6 per cent compared with a current rate of 4.5 per cent.

The August Exchequer Returns indicated a dramatic slowdown in tax growth rates, especially in capital taxes and an Exchequer deficit of almost €1.4 billion is forecast for 2007, rising to €3.2 billion in 2008.

The ESRI forecasts are based on the assumption that the European Central Bank will raise interest rates once more this year and that the turmoil in the financial markets would ease by the end of the year.

The Institute says that economic growth rates fall by 1.2 per cent for every 10,000 fewer houses built in the country.

The Institute says that in 2006, housing accounted for almost 16 per cent of total GNP. It says that the revisions to its growth forecasts especially for 2008, may well turn out to be overly optimistic. Data from the 2006 Census indicate that between the period 2002-2006 the total number of households increased by 182,000 while an additional 320,000 houses were built. Even allowing for some obsolescence of the existing housing stock, these figures point to a 40 per cent rate of vacancy for new houses built in this period. In the Spring 2007 QEC, the Institute argued  that this very rapid growth in the demand for second dwellings may explain its estimate that house prices in 2006 were 15 per cent overvalued. Factoring in the forecast decline in house prices in 2007 and 2008, together with a lower rate of house completions, means that this over-valuation falls to under 10 per cent by 2008. The ESRI says that given the great great deal of uncertainty in world financial markets, this could well lead to a more significant fall in the demand for second homes than that implied in the forecasts. Were this to happen, then ESRI estimates suggest that house prices could fall further in 2008.

Some of the main findings of the analysis include:

• ESRI has revised downwards our growth forecast for 2008, relative to the June Commentary. Whereas in the June Commentary, it forecast GNP growth in 2008 of 3.7 per cent, it is now forecasting GNP growth of 2.9 per cent.
• The growth forecast for 2007 has also been revised down, although to a more modest degree; 4.4 per cent, down from the 4.8 per cent forecast of three months ago.
• The dominant factor in these downward revisions is house-building. ESRI now expect completions to be 78,000 in 2007 and 65,000 in 2008, compared with the June forecasts of 82,000 and 76,000 respectively.
• Although "we are conscious of the uncertainties that currently exist in financial markets, we do not factor them into our forecasts because of their unknown impacts and duration. Our forecasts do take into account an anticipated slowdown in the US, with growth there now expected to be 1.9 per cent in 2007 and 2.1 per cent in 2008," the report says.
• As a result of the general slowing in the economy, employment growth will slow in 2007 and 2008 relative to 2006, with rates of 2.5 per cent in 2007 and 0.6 per cent in 2008. For 2008, ESRI expects the unemployment rate to average 5.6 per cent.
• The public finances will also be affected by the slowdown, with the General Government Surplus forecast to fall from a surplus of 2.9 per cent of GDP in 2006 to zero in 2008.

In the General Assessment of the economy, the ESRI makes the following points:

• The adjustments in the housing market, both in terms of building activity and price, are part of a process of returning the Irish economy to a sustainable growth path. The ESRI does not see that there is a role for government in artificially propping up either prices or building activity.
• Current expenditure in 2008 will have to be curtailed relative to the very high growth rate of 12.9 per cent in 2007. Nevertheless, given the generally healthy state of the public finances, a mildly stimulatory budget in 2008 is affordable in the context of overall macroeconomic management, including the full implementation of the National Development Plan.

Consumption and House Prices in Ireland

Vincent Hogan (University College Dublin) and Pat O'Sullivan (Bank of Ireland Private Banking).

Special Article in the Quarterly Economic Commentary, Autumn 2007.

(The authors are not members of the ESRI staff)

In this paper Hogan and O'Sullivan examine the link between private consumption and housing wealth in Ireland. They find that until very recently Irish households have not used the equity built up in their residential property to fund everyday consumption.

Hogan and O'Sullivan explain that the fact that a boom in house prices and a consumer boom have been coincident "does not allow us to infer causation". In the Irish case at least, there is a plausible alternative explanation for both:

• the large increase in national income since the early 1990s could in principle be responsible for both the boom in house prices and the boom in consumption.

A possible explanation is that Irish households faced liquidity and credit constraints and were unable to access the positive equity that had begun to accumulate. Anecdotal evidence would indicate that:

• the availability of mortgage equity withdrawal has only become more widespread in Ireland in recent years, while it has been a common feature of the UK housing market for 15 years or more.
• the vast bulk of any equity withdrawal that has occurred in the Irish market has been used for residential investment purposes (e.g. providing house deposits for children, extensions to existing properties etc.) rather than for personal consumption purposes.

Unfortunately, data are not published in Ireland that can identify the use of mortgage equity withdrawal and therefore it is difficult to be precise about its influence. Hogan and O'Sullivan believe that the latter of these reasons explains why the increase in housing wealth has not influenced personal consumption over the period under review.

The authors believe that the implication of these findings is that:

• if households have not used housing wealth for personal consumption purposes to date then personal consumption would remain unaffected by a fall in house prices. This would imply that the recessionary effects of a decline in house prices would not be as severe as might otherwise be expected.

However, the authors point out that it has to be borne in mind that even if a decline in house prices does not affect the economy via the wealth channel examined in this paper, it may affect the economy in other ways. Given the importance of the housing construction sector on the Irish economy, any significant decline in the levels of activity would have a direct impact on the overall economy.

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Preserving Electricity Market Efficiency While Closing Ireland's Capacity Gap

Sean Lyons, John Fitz Gerald, Niamh McCarthy, Laura Malaguzzi Valeri and Richard S.J. Tol (ESRI)

Special Article in the Quarterly Economic Commentary, Autumn 2007.

As of the 1st of November, 2007, there will be a single electricity market between Northern Ireland and the Republic. Wholesale electricity will be sold through a central trading system. The market design has the potential to deliver adequate capacity, and it includes incentives to encourage efficient investment. However, for these incentives to work, they must be perceived to be long-lasting.

The main findings are:-

• Regulatory credibility is hard to establish in any new market, but particularly in the SEM: new capacity is needed soon, building a new plant takes several years, the Irish government owns the main generator (ESB) and the market rules are complex.
• A lack of regulatory credibility would reduce the investment in both flexible generating plants and those that run continuously. However, it would pose particular risks for investment in flexible plants because they depend more heavily upon regulated capacity payments.
• Ireland has a shortage of flexible generating capacity, which will be aggravated by scheduled plant retirements and the growing importance of wind power. The new market can deliver flexible capacity, but only if market rules are credible.

The paper suggests policies that could help improve regulatory credibility:

• The Irish government's 2007 White Paper suggests measures to obtain extra generating plants independent of the SEM rules. This could undermine existing capacity incentives. These measures should be reconsidered or at least clarified.
• Future ESB investments should be treated (and described) by government as commercial decisions, rather than related to market capacity objectives.
• The regulators could commit further in advance to the level of capacity payments or the formula used to set them.