In exploring the medium-term prospects for the Irish economy, this article argues that a pessimistic scenario, in which the rapid growth of recent years inevitably ends in a crash, is not plausible. But neither is it realistic to expect a continuation of "Celtic Tiger" growth rates.
Under Irish conditions, GNP growth in excess of 3.5 per cent a year leads to falling unemployment. When "full employment" is reached, further reductions in unemployment lead to rising wage inflation. In the absence of an exchange-rate adjustment, high wage inflation leads to a loss of competitiveness. This acts as a brake on growth. For these reasons the realistic, medium-term prospect for the Irish economy is that the growth rate will revert to its long-run average in the region of 3.5 per cent.
For the last five years the rate of growth of output has been extraordinary, both by comparison with the long-run Irish record and by international standards.
The rate of growth of GDP since 1993 has been exceptional and that of GNP only slightly less impressive. But the growth of employment has been most spectacular, averaging 4 per cent per year over the period 1994-98. Employment growth at this pace is without parallel in the OECD countries. Indeed, the estimated 6 per cent increase in the numbers at work between 1997 and 1998 is surely a world record.
Because employment has been growing so rapidly, the rate of growth of output per worker has been far less spectacular than that of total output. In fact, the annual average growth rates in GNP per person at work before and after 1994 are surprisingly similar. Although the long-run rate of growth of productivity has been satisfactory, it did not increase markedly after 1994. If attention had been focused on output per worker, rather than total output, the phrase "Celtic Tiger" might never have become popular.
The historical decline of the Irish population and chronic high rates of unemployment and emigration have made job creation a national priority. The exceptional growth of employment has therefore been widely welcomed. But we should now question the importance of the size of the economy, relative to improvements in average living standards, as a goal of economic policy.
Recent growth rates have been more than adequate to absorb the growth of the labour force and stabilise unemployment. Women's labour force participation rates have risen to the European average and emigration has been replaced by significant net immigration.
It is timely, therefore, to ask what is to be gained from further rapid output growth in itself. We should now focus on raising the living standards of the population rather than trying to maximise the level of employment. At least it would be appropriate, as suggested recently, to modify the criteria applied in cost-benefit analysis of job-creation programmes to reflect the congestion and other external costs associated with growth.
Some see hubris in Ireland's current boom and a hard landing as the inevitable consequence. They have in mind a replication of the crashes that countries like South Korea, Indonesia, Thailand and Malaysia experienced in 1997.
This collapse was shocking primarily because of the vast scale of the human suffering it has brought in its wake. The suddenness with which it occurred and the lack of warning from the international economics profession are also worrying. In October 1996 the International Monetary Fund (IMF) had referred to the "buoyant growth prospects" in Asia. Some believe a similar fate awaits the Celtic Tiger. They anticipate that a collapse in asset prices, notably residential and commercial property values, will lead to a loss of consumer and investor confidence and to a flight of capital from the country. The trigger might be a cyclical downturn in sectors such as microelectronics, pharmaceuticals or international financial services. A severe recession would be the inevitable consequence.
It is true that the recent exceptional growth of the Irish economy has been very dependent on the growth of world trade and inflows of foreign direct investment (FDI), motivated by the use of Ireland as an export platform. Exports grew much faster than output during the 1990s.
It is therefore only realistic to conclude that a contraction of world trade would have a very severe impact on Ireland. The label pessimist should be reserved for those who believe that the current Irish boom will lead to an Asian-style crash, even in the absence of a global recession. The pessimistic view implies that our nemesis will be "overheating", a retribution for the exceptional growth that has been achieved.
THIS scenario may be queried on several counts. In the first place there is no economic law that says "the faster they grow the harder they fall". The evidence does not show that rapid growth, at either the national or regional level, inevitably leads to a bust. True, financial bubbles do recur and they are frequently not recognised until it is too late. In many Asian economies the crash was preceded by bubbles in real estate values.
But the behaviour of Irish house prices - at least until end-1997 - can be accounted for by fundamental factors such as the growth of the number of households, the rise in disposable income and falling interest rates. A slump in house prices is unlikely to trigger a recession in the way that the collapse in speculative real estate booms preceded the Asian crises. In those countries real estate speculation was fuelled by inflows of capital attracted by high interest rates, and corrupt banking systems led to massive misallocation of resources. In Ireland FDI has been the main type of capital inflow and this is much less destabilising than portfolio investment.
The collapse of the residential property market in England in the early 1990s was caused by a unique combination of factors. These included the removal and reimposition of domestic rates and major changes in the tax treatment of mortgage interest. It is true that the recent convergence of Irish interest rates on euro-zone rates is an unwelcome pro-cyclical influence on house prices.
The removal of the residential property tax was also inappropriately pro-cyclical and has precluded the use of property taxes as a way of calming the housing market. But, despite these considerations, the parallels with the situation leading up to the English housing bust are not close.
In summary, while the risks of speculative bubbles and resource misallocation are not absent from the Irish economy, the situation is not very similar to that prevailing in the Asian economies before the crash of 1997.
A scenario in which the Irish boom ends in a home-grown bust is not very plausible. But that does not imply that the good times will roll on for ever. A global recession would lead to a hard landing, but it is more likely that the boom will run out of steam due to the operation of basic economic constraints.
At the other end of the spectrum from those who expect the current boom to be followed by a crash are optimists who see no reason why Ireland's exceptional growth should not continue long into the future.
The rosy scenario envisaged by these commentators is based on a belief that several favourable trends can be maintained. These include:
rapid labour force growth.
rapid productivity growth.
wage moderation.
In addition, it is believed that existing infrastructure and housing deficits can be rapidly eliminated.
These assumptions are questionable. The supply of labour is no longer as elastic as it was in the 1990s. The rapid growth of the labour force over the past decade was due to nonrepeatable factors, such as the sharp rise in women's labour force participation rates and the arrival on the labour market of the 1970s baby boom.
Further increases in women's labour force participation rates will only be elicited by higher rates of pay to compensate for rising work-related costs, childcare and transportation, for example. The reversal of net emigration was also important, but as the supply of returning emigrants dries up, the rate of immigration will be increasingly constrained by housing shortages and by restrictive policies towards non-EU citizens.
The contrast with some US regions, where rapid growth is helped by a virtually free flow of low-wage labour from Latin America and further afield, is striking. The parallel between the booming Irish economy and regions of the US is not as close as might appear. The growth of productivity will be checked by the fact that the recent "shakeout" of the labour force cannot be continued. The decline of low-productivity employment will be proportionately less important in the future. Irish manufacturing has been transformed by the inflow of high-tech FDI, and additional projects will have a reduced impact on average productivity. Employment in service sectors is growing in importance and productivity gains are generally much smaller here than in manufacturing.
The prospects for continued wage moderation should be linked to the impact of rapid growth on unemployment and the labour market. Finally, optimism about the prospects of rapidly overcoming our infrastructure deficits is not warranted. The binding constraint is not financial. The public finances could accommodate significant increases in capital spending, and there is also ample scope for public-private financial partnerships.
The bottlenecks are in the planning, implementation and management of large projects, as well as in emerging labour shortages in the construction sector. It may be decades rather than years before the existing backlogs in urban and industrial infrastructure housing and the national transport network are removed.
There is no evidence of a sea change on the supply side of the economy to justify this optimism. In fact, all the evidence suggests that we are now approaching the point where the constraints on growth will become increasingly binding.
The most striking aspect of the current boom is the rapid growth of employment. The rate of growth of output per employed person has been much less impressive. Because long-run gains in living standards depend on the rate of growth of productivity, it is argued that the rate of growth of output should not be regarded as an end in itself and more attention should be paid to the growth rate of output per worker.
It is suggested that neither a super-optimistic scenario, with output continuing its recent very rapid growth, nor a pessimistic one, in which the Irish boom inevitably crashes, is realistic. It is more likely that rapid growth will be checked by well-established mechanisms - the links between rapid output growth and falling unemployment and between falling unemployment and rising wage inflation.
The historical evidence suggests that GNP growth in excess of 3.5 per cent leads to falling unemployment under Irish conditions. There are no grounds for believing that this relationship changed in the current economic boom. Continued rapid growth will reduce unemployment further and lower unemployment will generate higher wage inflation. There is growing evidence that this process is already under way. The partnership approach to wage bargaining is unlikely to halt it.
Rising wage levels and deteriorating competitiveness will slow the economy's growth to a sustainable rate. The historical evidence suggests that a GNP growth rate in the range 3.5 to 4 per cent is consistent with a stable unemployment rate - the most plausible medium-term prospect.
The above is an edited extract from an article which appears in the Spring 1999 edition of Irish Banking Review
Brendan Walsh is Professor of Economics at UCD