Boom follows orthodox theory

Warnings that the Irish economy is overheating or will overheat have intensified recently, reaching something of a crescendo with the intervention of EU Commissioner Pedro Solbes Mira. The reaction of Finance Minister, Mr McCreevy, that textbook economics do not work in the Republic, neither reassured nor provided a persuasive counter-argument to the line from Brussels. In our (NCB's), view the reverse is the case.

The performance of the Irish economy is perfectly understandable within the confines of orthodox economic theory. Fears of overheating misread the forces that have produced the boom.

Economic textbooks tell us overheating occurs when growth is stoked up beyond an economy's capacity to deliver. Capacity for growth is determined by growth in labour productivity and supply.

High productivity has been sustained in the Republic in the past four decades.

The has been because it has been transforming itself from being largely agriculture based into a modern industry and service-based economy. Improved education has also contributed to the quality labour force.

High productivity alone explains why economic growth has been consistently stronger than among our European partners - where productivity growth has been declining - but is not sufficient to explain the 1990s upsurge in growth.

For this, we must examine the dramatic changes in labour supply. The labour force growth rate from 1960 to 1990 averaged 0.5 per cent - similar to the EU generally. During the 1990s, however, growth in the labour force took off sharply. The driving factors were the coming of age of the 1970s' baby boom and a sustained acceleration in female participation in the labour force. Growth was enhanced by net inward migration and there was substantial spare labour resources in the form of a high unemployment rate in the early 1990s. Therefore, the Irish economy's capacity to grow rose substantially.

Domestic demand grew, the level of dependency declined and discretionary income rose.

In addition, population growth in the 1990s was concentrated in the main earning and spending age groups and this had a direct impact in expanding the domestic market.

The upsurge in demand has fuelled the rise in house prices. These developments are the fundamental driving forces behind the Irish economic boom, augmented of course by inward investment.

We pointed out in our 1998 document, Population & Prosperity, that demographic change will continue to maintain relatively high growth rates in the Republic for the coming decade. In these circumstances, spending to remedy the infrastructure deficit and tax cuts aimed at encouraging increased labour force participation are justified, even if they have a short-term impact on demand.

Given productivity trends and demographic prospects in the rest of Europe, sustainable GDP growth for the EU as a whole is probably no higher than 2.5 per cent. Against this background, the Republic's 9 per cent growth must look excessive almost by definition to the uninformed. Since Commissioner Solbes's portfolio is economic affairs, however, he has little excuse for being in that company. His citing of the recent rise in the Irish CPI as proof positive of overheating was particularly disingenuous since increased taxes (which, ironically, he appears to favour) account for almost 1 percentage point of the acceleration while higher fuel prices and the swings in mortgage rates account for much of the rest.

On our estimates, the inflation rate stripped of these factors was 2.6 per cent in January, up from a low of 2 per cent in the middle of last year. Given that the trade-weighted Irish pound exchange rate fell by about 8 per cent in the last year, this is a modest enough response. One suspects that other EU members would be willing to accept an underlying inflation rate barely a half per cent higher than the ECB's target for price stability in exchange for a GDP growth rate four times the EU average.

The period over which the Irish economy has notched up stellar growth rates is sufficiently long that judgments on the sustainability of the boom deserve genuine investigation of the causes rather than uninformed preconceptions.

Dermot O'Brien is Head of Economic Research at NCB Stockbrokers