Overheating Irish economy would need urgent remedial action

Nobody who has followed the political discourse of the last month could miss the fact that an economic recovery is well under way even if there is disagreement on how evenly spread the benefits are.

With growth in GNP likely to average over 5 per cent a year over the four years 2013-2016, this performance is, by European standards, rather spectacular.

However, anybody living in Ireland knows that there are some significant problems with the unbalanced nature of the economic rebound.

In particular, the rising population, assisted by the turnaround in emigration, means that the housing market is facing exceptional pressures.

More generally, for economic and social reasons, it is urgent that investment in the economy is rapidly increased.

If investment accelerates it will provide a further major stimulus to the Irish economy, and unless there is an EU slowdown this could see a continuation of our high growth into 2017 and 2018.

After four years of buoyant growth it is important to consider whether the economy is expanding beyond its potential and at risk of overheating.

The standard EU measure would suggest that output in the Irish economy is above its sustainable level. However, many economists, myself included, believe that this EU test is a far from satisfactory or an accurate measure of likely overheating.

My own assessment is that our current level of output is sustainable, and matches the potential output of the economy this year.

However, if high growth persists we are likely to see output expand beyond what is sustainable and run the risk of another bubble economy, like that which preceded the 2008 collapse.

If the consumption boom now getting under way is supplemented by an investment boom, quite quickly we will run out of domestic savings. To finance investment (including new housing) we will then need to borrow from abroad, giving rise to a growing current account deficit for Ireland.

If this scenario develops the new government will need to stave off the risk of another boom-and-bust cycle by easing the pressure through running a budget surplus. This might not be required to meet EU rules or reduce our debt but rather to forestall the risk of another unsustainable bubble. The need for such fiscal tightening could arise next year but more likely in 2018.

Raising taxes

Tighter fiscal policy could be achieved either through raising taxes or cutting spending. The objective would be to bring savings into balance with investment and free up resources for that investment, while holding back on a major growth in consumption.

However, public spending is low by the standards of developed economies, and there are growing demographic pressures in education, health and pensions.

That points to tax increases as a preferable way to relieve pressures if the economy is not to overheat. From an economic and environmental perspective, any additional taxes are best raised on consumption, carbon or property.

If a fiscal tightening is needed in 2017 or 2018, this would run directly counter to the expectations built into every political party manifesto. All of them have assumed that the so-called fiscal space could be used to fund better public services or lower taxes.

However, the fiscal rules as written don’t adequately reflect the importance of governments undertaking counter-cyclical measures to stabilise the macro-economy.

If successful fiscal tightening can stabilise the economy there may be some scope for fiscal relaxation towards the latter end of the next government’s term of office, which would allow some of their manifesto commitments to be delivered.

In formulating the programme for the next government the parties involved would be wise not to overcommit to delivering on items in their election manifestos.

All the parties de facto accepted that changed circumstances could require changes in policy. However, they were probably thinking of what might happen if the economy underperformed. But if the economy starts to overheat that would also require urgent remedial action to avoid another crash.

The experience of the last decade has taught us that in economic policy it is better to play safe rather than to be sorry.

If there is a choice between delivering on manifesto commitments to the letter, at the risk of generating another crash, or being charged with broken promises, it is preferable to go slower on delivery. Those negotiating the next programme for government should be prudent in the scale and timing of any new commitments.