Restraint not necessarily antidote to economy's ills

Not surprisingly, the scale of Ireland's economic success over the past five years makes many observers nervous.

Predictions of "tears before bedtime" have become commonplace, especially since the comfort blanket of an independent monetary policy is about to be removed.

A few commentators at home and, more seriously, some influential organisations in Europe, have called for the anticipated reductions in interest rates to be offset by a significant further tightening of fiscal policy, including the eschewing of tax reductions in the next Budget.

Of course, it is true the recent rate of economic expansion cannot continue indefinitely, as it has rested in part on the absorption of previously under-utilised capacity in businesses, the infrastructure and, especially, in the labour force.

This slack is becoming exhausted, and so supply constraints are likely to bring the rate of growth back towards a sustainable potential of around 5 per cent.

It is also true that as particular supply constraints take effect, there will be sectoral inflationary pressures, such as have already been seen in the property market.

In these circumstances it is clearly appropriate that much of the tax buoyancy resulting from extraordinary economic growth should be devoted to reducing the national debt, as it is this year and undoubtedly will be again in 1999.

This is in keeping with the existing consensus economic strategy, and is necessary to minimise the economy's future vulnerability and to make room for an eventual switch to the domestic funding of infrastructure needs as EU funding is scaled back.

This normal fiscal prudence should result in a general government surplus of about 2 per cent of GDP in 1998 and a larger surplus next year, with a consequent substantial reduction in the debt/ GDP ratio.

Calls to go beyond this by avoiding further tax cuts appear to rest on a faulty analysis of Ireland's situation.

Standard economic theory, naturally enough, has been derived mainly from the consideration of large, relatively closed, economies.

In such countries it has been observed that the potential output growth is constrained by the degree of capacity utilisation, including labour supply, and by the savings ratio, which determines the rate of capital accumulation.

If domestic demand grows faster than potential output for a significant period, then inflationary pressures occur, resulting in rising prices and a deterioration in the balance of payments.

To prevent or alleviate such pressures, measures need to be taken to check the growth of demand, through monetary or fiscal policy or a combination of both.

THIS simple model is of limited application to an economy as small and open as Ireland's, especially one whose productive investment is closely linked to global rather than domestic trends and whose export sector is largely decoupled from the domestic market.

Thus repeated studies have found consistently that the Irish rate of price inflation is determined overwhelmingly by external factors, including the exchange rate, and the buoyancy or otherwise of domestic demand has little impact on prices.

The recent moderate acceleration in the consumer price index can be explained by the lagged effect of exchange rate movements over the past year or so. There is no evidence that a restriction of domestic demand through a further tightening of fiscal policy would significantly affect the Irish price level.

What will affect Irish price inflation in the longer term, and what should provide great comfort to those fearing loss of control over interest rates, is that we are joining a monetary union.

The vicious circle of rising prices and currency depreciation reinforcing each other in an inflationary spiral can no longer occur.

Irish prices may rise faster than in other parts of the union, but only moderately and temporarily, with a strong tendency to revert towards the average.

Adjustments within EMU will come about largely through changes in relative wage rates.

If Irish wages rise significantly faster than in partner countries, after due allowance for productivity, then Ireland will lose competitiveness, with obvious consequences for the trade balance, future investment, and thus employment.

Because we do not yet know the speed or the strength of the employment response to changes in relative wage rates within EMU, it seems obvious that we should, collectively, be cautious in the extent to which we allow pay in Ireland to grow faster than in other euro countries.

Studies in Ireland and other countries have shown that the size of the tax wedge between employers' costs and workers' take-home pay has a major influence on pay bargaining.

In the Irish case this relationship is formalised within Partnership 2000, with pay moderation explicitly traded off against reductions in direct personal taxation.

There is an obvious need to maintain pay moderation to avoid finding out the hard way the effects of a sudden large loss of competitiveness.

Rather than the nebulous, and possibly non-existent, benefits of stronger fiscal contraction, the balance of advantage seems to lie clearly with the Government honouring its commitments on tax reduction, while taking a strong line, as an employer, against undue sectional pay claims within the public service.

Terry Baker is an economist with the Economic and Social Research Institute