Republic must not let high wages erode competitiveness

 

Future pay negotiations in the Republic must take into account the impact that rising labour costs can have on pushing up inflation rates, writes Danny McCoy

Yesterday's consumer price inflation figures are remarkable, if only for their predictability. The annual rate recorded for May at 4.7 per cent is the fifth straight month that the inflation rate has hovered close to 5 per cent, echoing the average rates experienced over the past two years.

The resilience of consumer price inflation, despite the sharp oscillation in economic activity, over the past year is notable. This resilience is arguably the most potent threat to our economic prospects, with the Republic once again heading the EU inflation league with a rate that is twice the euro-zone average.

As a small open economy within a large monetary union, the inflationary process in the Republic is significantly, although not exclusively, determined by external factors. However, this cannot absolve the role played by domestic cost factors feeding into higher prices.

The transmission from high-wage settlements into higher general price inflation is often under- acknowledged. The increase in prices in what can be termed the non-internationally traded sectors of the economy has been quite pronounced in recent years. Given its typically high labour component, the cost base of this sector is substantially determined by wage growth, which has been experiencing high rates over the past two years as validated by the social partnership process.

The latest inflation statistics show that price growth of more than 10 per cent in the health category in the Republic is four times the euro-zone average rate, while the rate of increase in recreation and culture is more than five times the average, and in services, broadly defined, it is more than double.

This has to be of concern. Higher prices in these non-traded sectors increase the cost base for the internationally traded sectors of the economy.

Absence of market power means the traded sector cannot pass on higher costs to its world markets as higher prices. Consequently, profitability of firms in this sector gets curtailed, potentially leading to retrenchment in their operations and job losses.

The rising cost base in the economy is also likely to give rise to a reduction in the attractiveness of the Republic as a location for foreign direct investment.

In addition to a rising domestic cost base, the Republic would face substantial competitive losses from potential further euro appreciation, if the recent currency trend is to persist. While an appreciating currency can be expected to dampen inflation by reducing the price of imports, restoration of competitiveness - upon which our real living standards as an exporting nation depends - would still require control of domestically determined costs.

The control of domestic costs is not just about wages. Lack of effective price competition in many sheltered sectors of the economy fosters high price mark-ups, particularly through a period of rapid disposable income growth that we have just encountered as a nation.

The higher relative inflation in the State need not be of concern if we were assured that it reflected higher productivity in our economy. However, in the still near full-employment labour market conditions prevailing in the run-up to a new social partnership renegotiation, it will be difficult not to let the high inflation rate itself, rather than productivity, be used as a demand for a higher standard of living-preserving wages. This is the chicken-and- egg problem in the making.

The possibility of a wage-price spiral has the potential to erode many of the significant achievements of the Irish economy in recent years, in terms of employment and real incomes growth. It is imperative that future pay determination in the Republic acknowledges the impact that high wage settlements, regardless of the sector in which it occurs, can have on higher Irish inflation rates, leading to the erosion of competitiveness.

The relatively high inflation rate revealed over the course of this year must not be disinterestedly dismissed or there will be an even higher price to pay.

Danny McCoy is an economist with the Economic and Social Research Institute.