The publication of the IMF's Article IV assessment of the Irish economy drew an interesting set of reactions. In the Irish media, the positive comments were emphasised - the reference to the "spectacular" economic performance of recent years and the conclusion that growth was unlikely to moderate significantly in the near term. Reaction in Britain put the emphasis firmly on the IMF's concerns, especially the statement that signs of overheating had become more pronounced.
Reading the IMF report dispassionately, though admittedly not entirely unbiasedly, there is more balance in its assessment than press reaction on either side of the Irish Sea would lead one to believe. The remarkable turnaround in the past 10 years, in terms of fundamental improvement in economic performance and fiscal health, is fully acknowledged, as is the likelihood that strong growth will continue in the period ahead.
At the same time, the IMF is clearly unsettled by the acceleration in inflation over the past year and evidence of upward pressure on wage rates. Its worry is that strong demand will push inflation and wage costs to unsustainable levels, entailing a painful adjustment later and, as an additional concern, that high rates of house price inflation risk a destabilising correction in the future.
The views of an organisation as prestigious as the IMF cannot be dismissed lightly, even if part of the function of Article IV reviews is to point out the things that can go wrong. There is, however, a considerable difference between what might be possible and what is probable. The IMF report errs in emphasising the former at the expense of a realistic assessment of the latter.
The central problem with the IMF review is a failure to adequately appreciate the largely organic nature of the Irish growth surge. Low interest rates, fiscal stimulus and attractiveness to foreign investment have all played a part, but fast growth has been driven fundamentally by enhanced capacity for growth, as the result of demographic change. While the supply-side impact of this is understood to a degree, the demand-side effects are largely ignored.
Put simply, the age balance of the population is changing, such that growth is being concentrated mainly in those age cohorts with the highest earning and spending potential. Therefore, apart from the effects of rising real incomes, the size of the domestic market for goods and services is increasing in a structural way.
Nowhere is this more evident than in the housing market. Housing demand has risen mainly because the household-forming part of the population is growing more rapidly. This will continue to support strong demand for most of the coming decade, making the kind of fall in house prices the IMF worries about extremely improbable.
The positive implications of population change for the supply and demand sides of the economy are by no means exhausted, and this is the key reason for confidence that relatively strong growth can be sustained for an extended period. Underestimating this central feature of the Irish story, the IMF overestimates the pressures entailed in the current pace of demand and, thus, the possible inflationary consequences. The link between the rate of economic growth and the acceleration in inflation in the past year, despite appearances, is not strong. The IMF did not entirely ignore the external sources of the inflation increase, but it still left an impression of substantial domestic causation. The facts are that the current inflation rate has little to do with the strength of the economy.
Rising prices in the sheltered sector explain very little of the five percentage point increase in the inflation rate in the past year. As many domestic economists have pointed out, inflation would not be materially different were the economy growing at half its current rate.
Equally, the link between inflation and wage rates is tenuous. Rates of wage increase have been rising for more than two years now and were accelerating at a time when inflation was falling.
The IMF rightly points out that labour market conditions are the key factor behind this. Thus, when the inflation rate eventually falls back we should not expect to see wage rates do likewise. Nor is wage inflation likely to respond to whatever package the Government offers to keep the current national pay deal alive.
Wages are responding to the transfer of power in the market to the seller of labour and away from the buyer. Labour supply is still growing appreciably but the available pool of unused labour - with the unemployment rate under 4.5 per cent - is a lot smaller than it used to be.
Acknowledging market realities does not, however, imply the need for panic about the State's competitiveness. Double-digit productivity growth in the exporting sector provides substantial capacity to absorb the rise in wage rates.
Nor is inward investment likely to be deterred. Pay costs are a relatively small part of the attraction of this country for these industries. Influences such as the tax regime, the availability of the right quality of staff and membership of the EU are equally, if not more, important.
This is not to advocate complacency. Strong growth has produced strains that should be addressed. More than anything else, however, the policy response should seek solutions that ease supply constraints so as to facilitate the realisation of our growth potential, rather than those that look to limit demand.
Dermot O'Brien is head of economic research at NCB Stockbrokers
