Central bankers issue warnings - that is one of the main things they do. Since they operate the interest rate lever of monetary policy, their warnings are invariably directed elsewhere. The usual target is the government, specifically its fiscal and incomes policies, though their attempts at morals are often directed more broadly at both borrowers and lenders.

Wim Duisenberg, president of the European Central Bank, visited Dublin briefly last week and issued a warning that budgetary policy needed to be tightened.

This should have been unsurprising, given the recent surge in consumer prices that has taken Ireland to the top of the inflation league within the euro area. Duisenberg went further and suggested that Ireland, along with a number of other euro participant countries experiencing strong economic growth, including his native Netherlands, was getting a "free ride" within economic and monetary union. This was a reference to the fact that the interest rate, common to all within the euro zone, is lower than economic circumstances would deem appropriate for some countries.

Using the term "free ride" was misleading, since the point being made is that inappropriately low interest rates may be a short-term boon for an economy in terms of output growth but are potentially very costly in terms of inflationary pressures and are far from free.

The chairman of the US Federal Reserve in the 1950s, William McChesney Martin, memorably described the job of a central banker as to "take away the punch bowl just as the party is getting started" by raising interest rates when economic growth looks like resulting in inflation. When the euro party started, the ECB felt in a position to lower rates to encourage growth without stoking inflation. Ireland arrived already growing strongly.

Now that the party is getting going, with growth picking up in the euro area along with emerging inflationary pressures, the ECB has starting pushing interest rates back up. The host, in the form of the ECB president, has started to warn those displaying excessive zeal about the potential hangover and the need to take corrective measures.

Duisenberg's remarks have been met with indignation from some domestic commentators on the grounds that the advice fails to appreciate the unique circumstances of the Irish economy. This dismisses the warning too readily and fosters complacency. The laws of economics are not currently in abeyance in Ireland.

The question Duisenberg chose to address in his Dublin lecture, "Are different price developments in the euro area a cause for concern?", is pertinent. The difference between the highest and lowest annual national inflation rates in the euro zone increased to 3.8 percentage points in July this year, from an average of less than 2 percentage points in 1998 and 1999. While inflation increased in all euro zone countries in recent months, predominantly on the back of rising oil prices, Ireland with the highest rate has single-handedly contributed to the increased differential.

Is this a cause for concern? The short answer is, "it depends". From the point of view of the ECB, their primary objective is to ensure price stability within the euro area. The target they have set themselves is an inflation rate of not more than 2 per cent for the aggregate of countries within the euro zone, weighted by the respective size of their economies. Inflation rate divergences can be significant among countries without ECB exceeding the aggregate target.

Ireland at the top of the inflation league is less worrisome than a larger country like Italy because, in terms of impact on the aggregate inflation rate, the Irish contribution is minimal. The Republic's weight is less than 1 per cent, a share that will most likely get smaller as new members adopt the euro, regardless of our impressive economic growth rates.

Large differentials between Ireland and other countries can exist without causing concern to the ECB. But they still do. Ireland is being looked upon as a test case for euro-sceptics to point to as an economy suffering from the "one size fits all" monetary policy within the euro zone. From this perspective, it is in the interest of the ECB to advise that those domestic policies still under the control of the Irish Government be used, where possible, to dampen growth in demand.

While, from an Irish point of view, the rise in the inflation differential with other euro zone members may be expected, it should still be of concern. In the short term, the widening inflation differential can arise from a number of factors, since trade patterns, production structures and tax systems differ across the euro area. For example, the fall in the value of the euro can be expected to impart a higher inflationary impulse in Ireland given its higher exposure to non-euro zone trade.

Long-term differences in inflation can be expected to arise from price level convergence within a monetary union. The completion of the single market in Europe, alongside a single currency, should give rise to greater cross-border price transparency for tradeable goods and services, resulting in greater price convergence. In addition, price-level convergence for non-internationally traded goods and services, such as personal services like hairdressing, is also to be expected. The process through which this latter effect comes about is subtle but extremely important in understanding Irish inflation.

Countries experiencing more rapid growth in productivity, in addition to getting rising living standards, experience faster rates of increase in their price levels. In Ireland, as elsewhere, productivity growth in the traded sector (the sector subject to competition from abroad) tends to be faster than in the non-traded sector (largely services are not subject to foreign competition). This drives up wages in the traded sector but does not require higher traded prices, as these wage rises are matched by increased productivity.

With labour mobile between sectors, the lure of higher wages in the traded sector forces employers to offer higher wages in the non-traded sector. These non-traded sector wage rises are not matched by increased productivity and so must be paid for by higher non-traded goods prices. The danger with this process is that non-productivity-justified wage rises followed by price rises can quickly spiral upwards eroding a country's competitiveness.

This type of vicious circle is sometimes referred to as the "Dutch disease". In the 1970s, the Netherlands found oil but instead of it being a universally good thing for their economy, it unleashed a serious competitiveness loss, as high wage growth in the oil sector spilled over into other sectors without any productivity rises. Dr Duisenberg understands this process well, because he was a minister for finance during the 1970s in the Netherlands, so his warning is from hard experience. The success of the social partnerships agreements in Ireland has been the avoidance of this type of phenomenon thus far.

OVER the longer term, the output growth of a national economy, and in turn its living standards, is determined by the sum of both employment and productivity growth. Employment growth in 1999 in Ireland was exceptionally high at 6.3 per cent and output growth is estimated to have been 9.8 per cent, indicative of an overall economy-wide productivity growth of 3.5 per cent.

Employment growth is slowing and over the longer term, unless migration into Ireland increases significantly, this source of output growth will be similar to elsewhere. That leaves productivity growth as the main determinant of growth for a national economy.

Productivity rates in the mainly traded industrial sector greatly exceed those in the mainly non-traded services sector. Based on preliminary output and employment figures for 1999, service sector productivity growth in Ireland may even have been negative last year. While this may yet prove on revision to be too dramatic an estimate, it may reflect the tightness of the labour market, whereby higher productive workers are being enticed away from service-based employment by higher wages in other sectors, to be replaced by less productive, inexperienced workers.

At the same time, the services component of the consumer price index has been rising consistently over the last year, reflecting high wage growth in this labour-intensive sector as the economy approaches full employment.

The reason this trend in wage growth in the non-traded sector should not be viewed complacently is that Ireland is indeed not like most other national economies. It displays many features of a regional economy, the small scale of its domestic market and its extreme openness to international trade being the most notable.

The success of a regional economy depends on its ability to be a profitable export base, and for that, competitiveness is the key. Non-productivity-justified wage growth will quickly erode competitiveness and eventually, if unchecked, the locational decisions for foreign direct investment flows. With the budgetary process increasingly being subsumed into social partnership arrangements, the comments by Dr Duisenberg should be viewed as a warning on the competitiveness impact of both fiscal and income policies. We can ignore the messenger, if we wish, but it would be unwise to ignore the message.

Danny McCoy is an economist at the Economic and Social Research Institute

Tomorrow: The man who christened the Celtic Tiger - Kevin Gardner from JP Morgan