Low wage rise policy is vital to maintaining boom

As we stand on the threshold of EMU, some commentators foresee disaster in the Republic's near future. Their reasoning can be paraphrased as such: "Ireland is in the midst of an unprecedented period of strong growth. The economy is booming, house prices are going through the roof and inflation is starting to take off."

In such circumstances, the authorities should be tightening the economy before it blows a gasket. Instead, we have signed up for a single currency which necessitates a cut in interest rates of as much as 3 per cent. This will add fuel to the fire, making it all the more likely that this boom will end in bust.

Soon, wages will head skywards, companies will be rendered uncompetitive, we'll all lose our jobs and the houses we paid so much for will be worthless.

This gloomy perspective is held by those who oppose the Republic's entry into EMU. Thankfully, there are good reasons to believe that it is not a realistic portrait of our future.

By casting-off monetary independence at a time of record growth, the Republic is entering unknown territory. In such circumstances, there is an inevitable degree of doubt about what lies ahead. While there are good reasons to believe that the boom will not end in tears, the Doomsday Forecast outlined above does raise some issues which need to be addressed.

Inflation has accelerated in recent months to a worrying degree. From a trough of 1.0 per cent in August of last year it rose to 2.5 per cent in April and will rise further in the months ahead. Higher inflation places upward pressure on wages, increasing the cost base of companies and leading to a loss in competitiveness. The Central Bank is not in a position to respond to this development because EMU requires a common European interest rate and this is likely to be 4 per cent or less when the single currency starts next January.

However, to talk only of higher inflation and the effect of rising wages is to leave the story incomplete. Those pressures are a direct result of a sharp fall in the pound which boosted the Republic's competitiveness in the first place. Although Republic's trade-weighted exchange rate has risen 4 per cent in the past two months, it is still more than 8.5 per cent below its peak of December 1996.

This fall in the exchange rate has cut the Republic's cost base by 8.5 per cent relative to our competitors. It is a competitive gain which affects both indigenous companies and multinationals alike. The recent rise in inflation and the resulting higher wages will erode this competitive advantage but, as long as we make the right choices, there should be no net loss. It's simply proof that there is no such thing as a free lunch.

So what needs to be done to ensure that wages do not rise out of control and that the Republic maintains flexibility? Obviously, the outcome of negotiations for the successor to the P2000 wage agreement (set to take place next year) will be crucial.

To date, the national wage agreements have served the Republic well. They have set a low base for wage growth, while allowing high growth sectors to set preferential wage deals. This has served the dual purpose of setting a competitive wage base while allowing the flexibility which a dynamic economy requires. However, as the Republic's enters a phase of high wage growth, the factors in this equation are changing quickly. Not only will the strong growth and higher inflation place pressure on the Government to be generous, but its ability to trade tax cuts for wage increases will be limited. The European Commission recently warned that further tax cuts would be dangerous in the current conditions.

Obviously, if another moderate wage agreement can be reached, the Republic's long-term interests would be well served. However, if this proves impossible, the Government will face a particularly tough choice. To reject a high-wage growth agreement could throw the State into industrial turmoil, but agreeing to it might institutionalise a high-wage environment. A look at the experience of Germany suggests that a bad wage agreement would be worse than no wage agreement. Germany's lack of competitiveness in the 1990s owes much to the repeated implementation of high national wage agreements. While moderate national wage agreements allow flexibility from a low base upwards, it is much more difficult to achieve downward flexibility from a high base. If a high level of wage growth is set across the board, workers in lowtech sectors could soon find themselves without a job. Although we might feel uncomfortable abandoning a mechanism that has served us so well, it would be better to have negotiations take place at a micro-level where there is greater awareness of industry constraints. In some sectors, productivity is high enough to allow substantial wage growth in the coming years. In other sectors, most notably clothing and footwear, more moderate wage gains are required.

With the appropriate wage-setting framework, the Republic has little to fear in the years ahead. Given the sharp fall in the pound and the high productivity gains in many sectors, average wage growth can afford to be reasonably robust. After a number of years in which corporate profitability has risen sharply, it is also appropriate that a larger share of the cake is apportioned to workers. However, a sharp rise in wages in every industry (regardless of productivity or profitability) could leave large numbers of low-skilled unemployed.

As long as we make the right choices, we can ride this wave.

Kevin Daly is treasury economist at Ulster Bank Markets. The views expressed here are personal.