Textbook on cooling our overheating economy has not been written yet

When pressed to explain in simple terms what actually happens when an economy overheats, a respected bank economist resorted to a story. A good friend of his was an accountant in a semi-state company, he explained. A few weeks ago the friend's deputy had been head-hunted to take up a job as financial controller with an up-and-coming technology company. On her first day in the new £50,000-a-year-plus-car-plus-bonus job, she had rung her old boss to ask him how to compile a simple VAT return.

The anecdote and the "help wanted" signs stuck up on windows across the State are the evidence of the labour shortage which itself is the clearest sign yet that the Republic's economy is overheating. Economists prefer to talk in terms of the service and related expenditure component of the consumer price index, which has risen 6.5 per cent over the last 12 months. Wages are spiralling upwards as companies find it harder and harder to hire staff.

After months of saying that there was nothing to worry about and that inflation would average 3 per cent for the year, the Minister for Finance, Mr McCreevy, has finally admitted defeat. The out-turn for 2000 is likely to be nearer 4 per cent, Mr McCreevy now concedes.

What that means for the new wage agreement, which assumed 3 per cent inflation, is obviously not good.

When an economy overheats in the way that the Republic's gives every indication of doing, textbooks predict the following sequence. Workers start demanding more money because the cost of living is going up and employers start having to charge higher prices for goods in order to pay their workers. The so called inflation cycle sets in. Eventually, according to the textbooks, the cycle pushes wages and prices up to such a level that Irish goods and services are no longer competitive on a world stage. Demand falls, companies stop recruiting and possibly start letting people go, and wage pressure decreases.

Of course, in a textbook situation things never get this bad because the authorities step in and take remedial action. Traditionally, they have responded with higher interest rates and a tighter budget - higher taxes. This serves to take the money out of people's pockets and slow the economy gradually.

This is the so-called "soft landing", the tenderness of which depends on how well-timed and accurate the intervention is. The problem for Mr McCreevy and his advisers is that traditional textbook situations don't apply to the Republic. The one they need - on how regional economies function in the year-and-a-half-old European single-currency area - has not been written The Government cannot raise interest rates as it is now set by the European Central Bank at a level judged appropriate for the euro zone as a whole. Raising taxes, the other possibility, is really a non-starter in the current political climate. Instead, the Government seems to have decided to let events take their course and allow the economy heat up in the hope that the inevitable loss of competitiveness will slow things down gently.

The best example of this type of approach is what happens in the United States. "You don't see the head of the US Federal Reserve worrying too much about the rate of inflation in Wyoming, according to Mr John Fitzgerald of the Economic and Social Research Institute.

Competition serves to iron out regional inflation in the price of goods across the US, while a loss of competitiveness eventually controls wage inflation in the different regions, explains Mr Fitzgerald.

With luck something similar will happen here, but not before we see worse congestion, higher house prices, worse service in restaurants and all the other manifestations of overheating. But if the US is the model for what will happen to the overheating Irish economy, then the risk of a hard landing is very real according to Mr Fitzgerald. When a loss of competitiveness due to regional inflation is combined with a regional economic shock, parts of the US tend to go into recession, he warns. Examples of regional shocks include the defence spending cutbacks which threw the economy of New England, where many big contractors were based, into recession in the early 1990s.

In the Irish context there are three factors that could turn a soft landing into a hard landing, according to Mr Austin Hughes, economist with IIB Bank in Dublin.

A slow-down in the US economy could have a dramatic impact on the Irish economy as the US is the source of much of the investment that is driving the Irish economy. Similarly, if worldwide demand for the computers and software being produced by the industries that have grown substantially over the last few years slows, the impact on the Irish economy will be severe. The third factor that would bring about a hard landing is a sudden strengthening of the euro. The weakness of the common currency has compensated for the growing lack of competitiveness of some Irish exporters, according to Mr Hughes. If the economy has a hard landing, a whole new range of economic problems will become apparent, according to Mr Fitzgerald.

The most serious of these is a collapse in the housing market. Before that happens the bubble in house prices will first add to the economic problems as high property prices and rents will discourage migrants from coming to the Republic to work. They may also drive people working here to look elsewhere for employment. If all goes well and the landing is soft, the fall off in demand and the increased availability of new houses should serve to bring some sanity to the housing market, says Mr Fitzgerald.

If the slowdown in the economy is dramatic enough to cause house prices to fall sharply, the situation will be somewhat different. As people see the value of their major asset diminish and in some cases become negative, they will stop spending money, he explains.

Banks which have extended large amounts of money to people to buy houses will also get a nasty shock. If that happens, the Republic's economic goose will have been well and truly cooked.