Wages and prices must rise to ease growth

The statement last week by Prof Francesco Giavazzi of Bocconi University in Milan, that inflation is now part of the Irish adjustment process and that earnings should increase to slow down the rate of economic growth, will not come as a surprise to most Irish economists.

In the EMU entry debate, Irish economists were all too aware of the dangers of adverse economic shocks such as a weakening of the sterling exchange rate, a crisis in the agricultural sector or a slowdown in the US economy.

The question of how the Irish economy would adjust to such shocks, given the constraints imposed by EMU membership, received considerable attention.

The Irish experience to date has not transpired as expected. Far from suffering recession, the Irish economy has enjoyed eight years of unprecedented growth, accompanied by a dramatic fall in unemployment.

However, now that unemployment is down to 3.5 per cent and core or domestic inflation has pushed up to 5 per cent, the current rate of economic growth cannot be maintained. One way or another, the Irish economy must adjust to a slower and more sustainable growth path.

The adjustment issue, therefore, is still highly pertinent. The difference is that the economy is in the more palatable position of slowing down from a boom rather than moving up out of the mire of recession.

The main change brought about by EMU membership is a shift in the burden of adjustment away from the money and foreign exchange markets to fiscal policy (government expenditure and taxation). Post-EMU entry, fiscal policy takes centrestage in the adjustment process.

Given that the economy is over-heating, the appropriate policy response is to introduce a deflationary fiscal policy. However, the Minister for Finance, Mr McCreevy, sees things differently and has instead introduced a succession of expansionary budgets. His view is that tax cuts will expand the supply side of the economy and this should facilitate a continued high rate of growth.

Prof Giavazzi, however, describes this policy as implausible, as indeed does the European Commission. But leaving this particular debate to one side, the result is that fiscal policy cannot be relied upon to bring about the necessary curtailment of economic growth. The important implication is that the burden of adjustment now shifts to the labour market. In other words, the adjustment process has moved from money and foreign exchange markets and fiscal policy on to the labour market.

The result is that it is both necessary and desirable that wages and inflation should increase and that there is an associated loss of competitiveness to slow economic growth. Inflation and living standards are now an essential part of the adjustment process.

This policy prescription may seem difficult to accept, particularly by firms competing in international markets. However, think of it in terms of the recession that prevailed in the Republic in the 1980s. At that time, workers were urged to accept low pay increases in order to improve competitiveness.

Today, the situation is the polar opposite: higher earnings, resulting in a higher standard of living, is the appropriate response. To a large extent, this is already happening. Wage inflation is running at 8 per cent per annum and, despite the PPF agreement, numerous trade unions are pursuing wage claims in excess of 30 per cent through the new "benchmarking process".

The other side of the coin is that, if and when recession does arrive, it will be necessary to reduce earnings and improve competitiveness. Wage deflation is also very much part of the adjustment package.

The danger in all of this is that there are no guarantees that the adjustment process will arrive at a real wage consistent with a sustainable growth path. A wage-price spiral could easily lead to over-shooting, giving rise to the possibility of recession.

Another major problem is that the economy is now far less flexible than in the pre-EMU days. The labour market is clearly much more rigid and slow to adjust than the money and foreign exchange markets. Small changes in interest rates and/or exchange rates have a fast and significant impact on the economy. Changing wage rates across different sectors is far more cumbersome and considerably less effective.

The implication is that the whole economy will be much more sluggish in reacting to economic disturbances. As a consequence, booms and recessions will tend to last longer and this increases the probability of abrupt about-turns or hardlandings.

The Republic is the first clearcut example of how an overheating economy adjusts within EMU. As the story unfolds, the next year or so should provide a valuable insight into economic life inside EMU.

Dr Anthony Leddin is senior lecturer in economics at the University of Limerick.