Wednesday 20 June 2018

Dan O'Brien: Overheating is not one of our main economic worries

'Given trends in house prices, financial assets and debt since then, household net worth is now likely to be at or above the last high-water mark.'
'Given trends in house prices, financial assets and debt since then, household net worth is now likely to be at or above the last high-water mark.'
Dan O'Brien

Dan O'Brien

There has been quite a bit of talk of late about the economy overheating. The 'upside risk' of too much growth has been getting more attention than the 'downside risk' of too little. In my view, the risks for the economy are still heavily weighted to the downside, with Brexit, bubbly financial markets and coming increases in interest rates all capable of derailing Ireland's recovery.

With the public and private sectors both heavily indebted, things could go sharply into reverse even if there were to be a mild recession of the kind that most economies experience every decade or so.

The focus here today, however, is not on those worries but on why we don't need to worry about upside risks, ie overheating, for quite a while yet.

Concerns about overheating appear to be based to a large extent on what is happening in the property market. Prices have been rising at a rate well beyond what anyone would like to see in the longer term. Rents have been rising more rapidly. All of this has created great anguish for many people in different ways. It brings to mind the severe overheating of 2002-07.

But unlike that period, when credit was turbo-charging the economy, the reason property prices and rents are surging is a chronic undersupply of new housing. With just half the number of people employed in the construction sector today compared to a decade ago, the industry is underheated not overheated.

It is also important to say that rising prices of one good or service can never be taken as a sign of general overheating in an economy. To assess whether an economy is growing beyond its potential, aggregate consumer prices and at average wage developments need to be considered.

When an economy overheats prices and wages begin to rise above sustainable levels. Neither is happening now.

Inflation in Ireland has been dead for some time and one has to go back to the 1930s for a period in which price pressures were so weak. The price level is lower today that it was a decade ago. In recent years there has been almost no change - in August prices were less than half a percentage point higher than in the same month three years earlier.

As this column discussed before the summer, in the basket of consumer goods and services falling food and clothing prices, most notably, have been almost perfectly offset by rising prices in housing and in some services. It is true that inflation is higher in the non-internationally traded sectors of the economy, but even there it is low by any historical standard and - crucially - shows little sign of taking off.

On the wages front there is a little more inflationary action. Earnings in the second quarter of the year were up by around 2.5pc, the fastest rate of increase since the crash. But there is no indication that wage growth of this kind is not justified on the basis of competitiveness gains after almost a decade of near-stagnant pay growth. Only if earnings were to accelerate sharply would there be a reason to worry about overheating.

That could happen, but with a plentiful supply of workers available it seems unlikely.

The Irish labour market is extremely open. The large diaspora and 500 million Europeans are free to move here any time they want. Non-European workers are another source of labour - one does not hear corporate executives in multinationals complaining that they have great difficulties getting work permits for non-EU staff.

If earnings rise significantly more people will come, thereby dampening wage pressures. That is largely what happened during the Celtic Tiger, when private sector earnings growth actually slowed after the turn of the century (it is likely that the housing shortage in many urban areas will limit inflows of workers, but it will not cut the source of supply off completely).

The other source of labour supply is those who are already here but who are not at work. Despite comments from politicians and some economists, the labour market looks to be a distance from full employment, something that cannot be measured merely by looking at one indicator (the standard unemployment rate, which stands at 6.3pc) as often happens. Consider some other measures.

In August the numbers claiming unemployment benefit fell below a quarter of million for the first time since the traumatic month of September 2008. However, that is still 100,000 higher than in the years running up to the crash. At the current rate of decline it will take more than two years before the live register returns to pre-crisis levels.

A better measure of the proximity to full employment is the share of the adult population at work. Before the crises the 'employment rate' reached 69pc. At its low point five years ago it was 59pc. As of the first quarter of this year only two thirds of that gap have been made up.

But even when the pre-crisis employment rate is reached, in 2019 if trends continue, there is no reason to believe that we will have reached full employment. That is because Ireland's share of its working age population at work is well below peer countries. It is 75pc in Britain and a bit higher again in Germany, the Netherlands and Sweden.

Ireland can and should close the gap with these countries. If this government or its successors declare that we have reached full employment when our employment rate remains well below peers it will represent, to put it mildly, a lack of ambition.

* * * *

Figures published by the Central Bank last week suggest that the economy has reached, or is about to reach, an important milestone in its recovery. In the first quarter of this year, the new figures showed that Irish households were worth €670bn when the value of all their assets is added up and their collective debt subtracted.

That figure is now only marginally below its peak in 2006. Given trends in house prices, financial assets and debt since then, household net worth is now likely to be at or above the last high-water mark.

The most encouraging part of this picture is the continuing decline in household debt. Although it remains high when compared to other countries, it continues to fall quite rapidly. In the first quarter of the year it had fallen below 150pc of disposable income. There is still a distance to travel, however. On average across the Euro area household debt is under 100pc disposable income, and even that, arguably, is imprudently high.

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