Our ability to sustain boom will be tested in 1998

For the past couple of years the economy has managed to maintain extraordinarily strong levels of economic growth with a very moderate rate of inflation. But next year will be a crucial test of whether this performance can continue. There is a danger serious problems will surface.

The economy is already growing at record levels, with the Department of Finance estimating that Gross National Product will rise by 7.5 per cent this year and around 7 per cent next year. All the evidence is that, if anything, these may be underestimates, with all areas of the economy firing on full cylinders at the moment.

Next year the engine of the economy will get a couple of further turbo-boosts. Interest rates are set to fall and borrowers could benefit from a fall of 1.5 to 2 percentage points in rates over the course of 1998. And in April next year the tax reductions in the Budget will start to kick-in.

It is difficult to estimate just how significantly these factors will boost economic performance next year. But the economy has already built up a head of steam and there is no doubt that the fall in interest rates, in particular, will provide a significant boost to consumer spending and a further push to house prices.

The danger of an unsustainable growth rate feeding through to a rise in inflation is generally referred to as "overheating". So far the economy has managed to avoid any clear warning signals that this will happen, with the important exception of the sharp rise in house prices. But a further acceleration in growth next year will test the ability of the economy to continue the heady mixture of being top of the EU growth league and bottom of the inflation table.

The story of why the economy has grown so successfully in recent years is a complex one. At its centre is a huge increase in the productive capability of the economy; for example, investment in education over the years has allowed the surge in demand for high-skilled jobs in sectors like electronics to be met, without a jump in wage inflation.

There is no doubt increased competition in all areas of the economy is also playing a part. In a range of key sectors from retailing to telecommunications to manufacturing, companies are facing new competitors and are constantly under pressure to provide a better service or product at a cheaper price.

Some argue that this process of globalisation is keeping a lid on international inflation and is transforming the international economic environment fundamentally. But it is too early to sit back and stop worrying about a resurgence in inflationary pressures.

A further push to Irish economic growth will put pressure on a number of areas of the economy. First, house prices are set to continue to rise, buoyed by the further fall in interest rates and the likelihood that rates will remain low and stable once monetary union starts in 1999. Provided interest rates stay low and stable, then borrowers may not get into trouble.

But inevitably an inflationary bubble in house prices carries dangers in the longer term. What happens if interest rates rise across the euro area within monetary union? What happens if the economy slows and the housing market comes off the boil, leaving many borrowers with outstanding mortgages greater than the value of their homes? The Irish jobs market also faces pressures. Shortages are emerging in many high-skilled sectors. At the lower end of the market, employers say it is difficult to get workers to take on unskilled employment.

Partnership 2000, the national agreement, is keeping a lid on wage inflation for the moment, but in the higher-skilled areas employers are being forced to offer ever more generous packages and bonuses to recruit and hold on to staff.

Normally the implications of a bubble in the housing market, or pressures on wages, would be clear. The Central Bank would raise interest rates to try to keep a lid on inflation. This would slow economic activity and keep a lid on the price of assets such as houses.

However, now the Central Bank is impotent. Because monetary union starts on January 1st, 1999, short-term interest rates here will converge on the level in other EU states by that date. Because our rates are much higher than elsewhere, they will have to fall in the New Year.

This means the Government will be not be able to put any restraint on the booming economy next year. And once we enter monetary union full control of interest rates will move to the European Central Bank in Frankfurt, which will set borrowing costs in the light of economic conditions in continental Europe.

So an unsustainable rise in areas like housing prices will not lead to the normal "boom and bust" cycle, whereby interest rates rise sharply and the economy heads downwards.

But what will happen is unclear. Monetary union is new economic territory. The advent of the single currency will bring new competitive pressures. It will mean that anything which leads to price pressures which threaten to make a small peripheral economy such as Ireland uncompetitive will not be punished through the normal medicine of higher interest rates. Instead they will be directly reflected in the economy in areas such as employment and growth.

If Ireland is hit by an unsustainable house price bubble, or widespread pressure on wages, there is very little the Government will be able to do to try to control the overall level of activity and ease the problem.

Overheating will not lead to higher interest rates. Instead the price will be paid through a longer term impact on growth and jobs.