Sunday 19 January 2020

Short-term threats exist, but fears of an overheating economy are premature

There are dark clouds on the horizon such as Brexit, Trump and higher interest rates - but another crash isn't something to worry about
'Last week, there was again talk of the potential negative effects of the economy growing too fast. That came about because a new report by the Economic and Social Research Institute (ESRI) said, among many other things, that the economy was at risk of overheating' Stock photo: Depositphotos
'Last week, there was again talk of the potential negative effects of the economy growing too fast. That came about because a new report by the Economic and Social Research Institute (ESRI) said, among many other things, that the economy was at risk of overheating' Stock photo: Depositphotos
Dan O'Brien

Dan O'Brien

Don't fight the last battle. This is a lesson that soldiers the world over are taught. So traumatising is combat, it is said, that it leaves an indelible mark on those who engage in it.

The natural tendency when going into battle again is to believe that events will play out in the same way as in one's previous experience. Military types say that this can be a fatal mistake.

Ireland's property crash was a traumatic event. It has left an indelible mark. It is only natural to fear that it will happen again. When signs appear that trigger memories of the period before 2008, the alarm is quickly raised.

All this is understandable, and has happened since the crash. Three years ago, for instance, there was quite a sudden and rapid rise in property prices in Dublin. The rate of increase then was similar to levels recorded during the bubble. This led some to believe that another bubble was inflating, when, in fact, prices were merely rebounding from a very low level (today, three years on, they remain far below peak).

Last week, there was again talk of the potential negative effects of the economy growing too fast. That came about because a new report by the Economic and Social Research Institute (ESRI) said, among many other things, that the economy was at risk of overheating. Much of the media commentary highlighted this aspect of the report, despite the ESRI analysis giving more attention to the downside risks associated with Brexit and the policy promises of the new US President, both of which have the potential to clobber the Irish economy.

But the ESRI's concerns about too much growth, rather than too little, seem odd. "If unemployment were to fall below 5.5pc, this would almost certainly confirm that the domestic economy is overheating," the ESRI said. That implies that the economy could be in overheating territory by the end of the year, given that the unemployment rate currently stands at 6.6pc and is falling quite fast.

There are two specific reasons to quibble with the overheating assessment, and a host of more general ones related to a range of indicators across the economy which suggest that the economy is a long way from getting too hot.

The first specific reason to take issue with the ESRI's warning is its 5.5pc threshold for unemployment. While a jobless rate moving towards lower single digits can be a sign that an economy is running out of road, it is not necessarily so.

Gauging spare capacity in the labour market requires looking at more than one metric. Because the unemployment rate excludes all adults who don't work but who are not formally jobless, it can sometimes suggest a labour shortage when no shortage exists.

Looking at something called the "participation rate" gives a better perspective. It measures the number of people in the workforce (employed and unemployed) as a share of the entire adult population.

When massive job destruction took place from 2008 to 2012, the share of adults in the workforce in Ireland fell sharply, as one might expect. But despite strong growth in employment since then, the participation rate has recovered very little ground.

This points to considerable hidden unemployment, which, in turn, suggests that there is more spare capacity in the labour market than the standard unemployment rate might have us believe.

A second reason not to be concerned about too-low unemployment causing overheating is migration. The extraordinarily open nature of Ireland's labour market means that Irish expats are quick to relocate if opportunities beckon here. So, too, are other EU citizens, particularly those from low-wage economies on the eastern side of the bloc. And with free access to the UK labour market closing to Poles, Lithuanians and Romanians, a high-wage, high-growth economy like Ireland's will look additionally attractive in the future. Looking across the economy more generally, it is hard to see signs of overheating now or in the foreseeable future.

Take the building industry, which the ESRI was particularly concerned about as a source of overheating risk. Currently, the number of people working in the sector is the same as in 1999, three years before the property bubble began to inflate. It is now almost exactly half its peak in 2007. From this it is very hard to conclude that the industry has yet returned to a level of employment that might be considered natural and sustainable. No reading of the construction-jobs data points to overheating in the industry.

Nor is there likely to be overheating in the sector any time soon. Last year the number of planning permissions granted was lower not only than any year in the first decade of the century, but lower than any year in the 1990s, including the depressed first half of that decade.

Every other indicator on housing output shows the industry is still in the early stages of recovery and will have to expand to meet demand.

Another important indicator of whether an economy is accelerating towards crash speed is credit. Excessive lending and borrowing, as this country knows to its cost, can end in a great many tears. Here, again, no reading of the credit data would suggest the banks are splashing cash now in a way that would imperil the economy.

Traditionally, the most closely watched signs of overheating in an economy are rising prices and pay. If both begin to take off, and particularly if they start chasing each other, trouble isn't far behind.

Take inflation first. One has to go all the way back to the 1930s to find a period of time when there has been so little increase in consumer prices. A basket of goods and services today is almost the same price as a decade ago. More pertinently, it is cheaper now than six months ago.

While this is largely an international phenomenon, the absence of inflation is more marked in Ireland and elsewhere. In February, Ireland had the lowest annual rate of inflation among the 28 members of the European Union.

And then there is pay. Wages and salaries have been showing some sign of life over the past couple of years, but increases are still minuscule for most people.

The latest figures, for the final months of last year, show that average hourly earnings across the economy were up by just over 1pc over the previous 12 months. Average weekly earnings rose by half that already meagre amount.

None of this is to say we don't have plenty to be worried about in the short term. Our nearest neighbour is heading for a very hard exit from the economic space we share, with major consequences for the Irish economy, and the farming and food sectors in particular.

Donald Trump is committed to using both carrot and stick to make American companies bring jobs home and he is hellbent on reducing sales of foreign goods and services into the US.

Add the growing prospect of mortgage interest rates starting to rise next year and the risks to the Irish economy are still - in economist speak - heavily "weighted to the downside" for the rest of the decade.

Overheating risks, if they arise at all, will be for the next decade.

Sunday Independent

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