A 5-year long economic boom ended in 2001, but not before major imbalances had built up. Falling real and nominal interest rates encouraged the private sector to incur high debt levels, and blunted the government’s incentive to rein back the growth of primary spending. The public sector debt-to-GDP ratio stopped falling, and prolonged high demand pressure widened the inflation differential with the euro area. Private demand started to weaken in 2001, but GDP growth was sustained that year by buoyant public spending on both investment and consumption, especially wages and salaries. By early 2002, it became evident that the 2001 budget deficit was going to exceed the Stability and Growth Pact 3 per cent limit by a substantial margin, and that public debt was on the rise. Retrenchment has had to begin in the public sector, and is still ongoing in the private sector. Domestic demand is expected to have stagnated in 2002, and there are no fundamental reasons for expecting it to stage a strong recovery soon. Hence the challenge for policy over the next few years will be the adjustment to weakened domestic demand in an international environment which has yet to regain strength, and with no demand-side help from fiscal policy. The adjustment will be eased, and gains in real incomes increased, to the extent that the supply side of the economy functions more efficiently, with resources moving to more productive uses.