John FitzGerald: We must guard against the real risk of an overheating economy

In the pre-crisis period we took a benign future as a given. Over the past seven years we have become used to considering instead what might go wrong with the public finances and in the financial sector.

Therefore little attention has been given to the implications of things turning out better than expected. This helps explain the slow response to pressures in the housing market.

Undue concentration on the possibility of a shortfall in growth could result in a repeat of past mistakes if growth were to remain strong.

Since the middle of 2012 the Irish economy has seen a vigorous recovery, with employment growing each year by about 2.5 per cent and gross national product growing by between 5 and 6 per cent.

Initially the recovery was driven by demand from outside Ireland but more recently domestic demand has made an equal contribution. While output per head today exceeds the pre-crisis peak, employment is still well below the 2007 level, and unemployment is still high at 7.8 per cent. Thus the economy is still below its potential and there are no signs to date of inflationary pressures.

The pace of recovery shows no signs of slowing. If it were to continue on course through next year and into 2018 the economy would then reach capacity.

The unemployment rate has been falling at 1.7 percentage points a year since 2012. If this were to continue for the next two years the economy would effectively be at full employment by the middle of 2018 (between 4 per cent and 5 per cent, recognising that in a dynamic economy there are always people between jobs).

However, the forecasts above assume that the objective of raising housing output to 25,000 or 30,000 units a year would not be achieved. If housing output reached this rate by 2018, using the Hermes macroeconomic model, my estimate is that this would add an extra 1.5 per cent to the level of GNP and reduce the unemployment rate by a further 1.5 percentage points.

Full employment

If Ireland had already achieved full employment by 2018, this could pose an overheating problem.

In the period 2003-2006 a series of ESRI reports advised the then government that if it wanted to have a major investment programme, especially in housing, a lot of money needed to be taken out of the economy through increased taxation to make space for all the building.

Unfortunately this advice fell on deaf ears, and we know the consequences.

This time around if the Government succeeds in ramping up investment, especially in housing, the pressures on an economy that was already growing rapidly could be excessive.

To avoid a repeat of past mistakes this would require the budget for 2018 to implement a substantial rise in taxation to take the steam out of the economy, and run a surplus to make space for increased building.

Spending cuts

While spending cuts would achieve the same effect that would seem unwise given the low level of public services after seven lean years.

This risk of possible future overheating was recognised by the Irish Fiscal Advisory Council (IFAC) in its report published this month.

As well as recommending a mildly contractionary budget for 2017, it recognise that monetary policy operated by the European Central Bank could be undesirably loose from an Irish point of view in 2018, necessitating further tightening of fiscal policy to avoid a repeat of the mistakes of the 2000s.

The IFAC report also repeatedly warns about the uncosted nature of many elements in the programme for government.

While the 2017 budget may take on board only some of these commitments, there could be a major political problem in preparing the 2018 budget if it had to take a lot of money out of the economy through a substantial increase in taxation. The Government would face a dilemma: ignore promises in the programme and protect the economy or implement the programme and risk another boom-bust cycle.

Because the scenario of an overheating economy was not widely canvassed until the recent IFAC report, it will need extensive discussion over the coming year.

It will be important that the wider public comes to understand that just when everything seems to be going very well the Government, in all of our interests, may need to tighten our belts.

We must not repeat the past mistake of throwing petrol on the flames of an overheating economy.

Of course if Brexit happens that could be enough to deflate the economy, but then many of the programme commitments might also be unaffordable.