Irish economic statistics remain a hugely confusing mix, in terms of understanding what it actually going on. According to GDP figures, we are in a technical recession. However pre-budget debate warns of the danger of the economy “overheating”. But what exactly does this mean and are we really in danger?
1. Understanding overheating
An economy that is overheating is, fundamentally, one that is growing above a sustainable level. “Overheating is when the economy reaches the limits of its capacity to meet all of the demand from individuals, firms and government”, with little slack or spare resources, according to an explainer published by the Central Bank. Like a car with an overheating engine, this generally means trouble. Overheating keeps inflation high – particularly in areas of the services industry reliant on the domestic economy. An upward spiral in wages and prices can follow. In time this can hit competitiveness, reduce real incomes and lead to growth falling off. As the Central Bank put it: “The problem with overheating is that it tends to result in a harmful downturn.”
By fuelling excessive borrowing, overheating can also mean a bubble in asset prices, as we remember from the financial crash when the price of houses and commercial property first inflated and then collapsed, with terrible consequences. The goal of economic policy is to keep an economy growing at a sustainable level. In terms of controlling growth rates, monetary policy – mainly via interest rate changes – and fiscal or budget policy are the two big tools. Irish interest rates are controlled from Europe, so budget policy takes on a more significant role in terms of what an Irish government can do. Controls on borrowing imposed by the Central Bank – mainly relating to mortgages – also have a part to play.
2. Where is the Irish economy now?
As ever, the signals are mixed, with some slowdown in multinational exports leading to a fall-off in GDP, the most-used measure of the economy internationally though one that is heavily distorted in the Republic. However, indicators of the domestic economy are a lot stronger, with consumer spending in particular healthy. The domestic economy is clearly “running hot”, as ESRI research professor Kieran McQuinn put it at the publication of its most recent outlook and the Government is also not short of warnings here from the Central Bank, the Fiscal Advisory Council and the Department of Finance.
So what are the key signs we should look at?
The first indicator is the jobs market. Unemployment has fallen to its lowest level in recent history: 3.8 per cent. Given that there are always some people changing jobs and some people without the skills or ability to get a job, this is close to what economists call full employment. Job vacancy levels remain very low.
The market is strong but is it topping out? In terms of the professional jobs market, a recent survey by recruiter Morgan McKinley showed more than 16,000 new professional job opportunities in the second quarter, a strong result but more than 15 per cent down on the first quarter. The recruiter put this down in part to business caution in sectors such as finance and parts of industry as interest rates rise and global growth slows, but also to the sheer difficulty of finding new staff in sectors such as construction.
Meanwhile, CSO data out this week showed a small 0.2 per cent monthly fall off in total job numbers in May, though they remain a healthy 2.7 per cent ahead of the same month last year and near a record high of over 2.4 million. And we are all familiar with the stories of domestic businesses desperately searching for staff.
So the signs are that the jobs market is running hot, even if the global slowdown may be having some impact. This has pushed up wages, though the latest figures show an annual increase of 4.3 per cent in average earnings in the first quarter. This was behind inflation and does not, according to recent Central Bank analysis, suggest major wage pressures across the economy, though there have been strong increases in some sectors.
The second sign to look at is inflation data. This is hard to interpret, as the surge in prices post-pandemic did not generally result from overheating, but rather from an upward move in energy prices and some problems in supply chains. So the annual rate has fallen back to 6.1 per cent in June – but of course this is still very high. And we are now seeing the second round hit, as companies pass on higher costs, with notable increases in some areas of the domestic services economy, such as the price of hotel accommodation, the cost of eating out, recreation such as gym memberships and concert tickets and airfares. Some of this reflects rising costs for these businesses – but some also reflects strong consumer demand. This trend in home-grown inflation will be vital to watch. So called core inflation, excluding volatile energy and food costs, was over 7 per cent in June, thought an important factor here was rising mortgage costs due to higher ECB rates.
A third area to look at is asset prices. House price growth has eased significantly – partly due to higher interest rates. ESRI researchers had previously calculated that house prices had drifted above the level which would be justified by economic activity – by around 7 per cent at the end of 2021 – though to nothing like the extent we saw in 2008. However unlike in 2008, households are generally not exposed to massive mortgage debt, even if the pace of interest rate rises will cause trouble for some. And of course the clearest sign of overheating pressure in recent years has been the rental market, with costs continuing to climb strongly right into this year. Shortages of economic and social infrastructure – houses to buy and rent, childcare, hospital beds, a big enough energy grid – are themselves signs of overheating and of an economy without the capacity to deal with its current size.
Finally, economists try to calculate using macro data whether the economy is operating above or below its potential growth level – the latest data from the Department of Finance suggests that the Irish economy is operating at a bit above full capacity. The question is whether an international slowdown and higher interest rates will change this as the year goes on, meaning the economy could look a bit less frothy heading into the autumn.
3. What this means for policy
All the main research bodies have warned the Government about adding demand to the economy via the budget. Pumping money into the economy when it is already at full capacity could add to wage and inflationary pressures, Central Bank economists warned in a recent research paper. They cautioned that the Government might have to consider taking money of the economy via higher taxation in the next couple of years if overheating pressures grow. While this makes sense economically, politically, it would be very difficult.
The plans for Budget 2024, as outlined in the recent Summer Economic Statement, are a cabinet compromise, allowing spending to rise a bit faster than planned, but salting away significant resources in investment funds to help pay future bills. How the final sums add up here will be important, with the Fiscal Advisory Council criticising the Government for increasing spending ahead of its own 5 per cent rule, warning of the overheating risk. The small increase above the 5 per cent level in permanent spending is unlikely to make much impact, but the council wants to lay down a marker – and the Government could add to demand further via once-off spending measures to support households. Ministers will point to the significant sums being put aside and a large planned budget surplus.
Supporting households through the cost-of-living crisis versus not adding to demand is an almost impossible tradeoff. And it does not end there. The State desperately needs additional investment in housing, infrastructure, energy and so on. Making progress in these projects could ease inflationary pressure in the long term by giving the economy more capacity. But in the short-term more investment spending adds to demand and could mean bad value for the State given the lack of spare capacity in the construction sector.
Attracting more migrants to work here could help to provide the construction workforce – and thus help to hold down pressure on wages. But it would risk more pressure on another area of shortage – housing. In short, the State has no choice but to invest heavily to support the long term, but this could add to short-term overheating pressures. The Central Bank research points to the option of raising taxes elsewhere to offset the additional demand from more investment spending, but politically this would be difficult.
So the real risk of overheating greatly complicates the trade-offs facing the Government in the months ahead, in the budget and beyond.
