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ESRI too optimistic on labour Back  
The economy cannot grow at 5% without labour shortages and wage inflation, and supply side tax measures deserve more consideration, writes Professor Brendan Walsh in an analysis the ESRI’s Medium Term Review
T he ESRI’s forecast of the country’s medium-term economic prospects has now become a keenly-awaited event in the diary of Irish economic commentators. It provides an opportunity to take stock of the past as well as to assess future prospects. The Medium Term Review contains a wealth of well-presented material, covering topics as diverse as urban congestion, energy taxes and ‘quality of life’ issues.

Given the uncertainty that must surround predictions, caution has to be exercised in the use of results stretching out into the middle of the next decade. Economists have been taken by surprise by one of the dominant economic features of the 1990s - the strength and duration of the current boom in the US. Similarly, no one in Ireland anticipated how fast our economy would grow, although the ESRI came closer than most.

The greatest challenge lies in trying to anticipate turning points, as is shown by the suddenness with which the economic crisis in East Asia developed during 1997.

The three Reviews prior to the current one significantly underpredicted the growth of the economy and of employment. The level of GNP is now about 10% and employment about 14% higher than would have been expected if the ESRI’s successive forecasts were applied to the 1990 base. This does not seem to be a large error, given the widespread scepticism about the genuineness of the boom in the early 1990s. Each of these five-year projections has a shelf life of only about three years. Forecasts were revised as new evidence became available. The 1991 Review projected a cumulative growth over the 1994-96 period of only 11% - just half the 22% actually recorded over these years. In the 1994 Review the forecast for this period was revised up to 17.9%.

The Central Forecast
The ‘central forecast’ in this year’s Review foresees an average annual growth rate of 5% over the period 1999-2005. This is based on a some econometric modelling and judgments as to what the economy is capable of achieving provided there are no major shocks or upsets.

There is some danger that too much reliance may be placed on a point estimate of this type. The Review might have highlighted the uncertainty of the medium term forecasting exercise by producing a range of forecasts (high, medium, and low), or a ‘fan’ of growth rates

The Bank of England’s forecast for GDP growth over the period 1999-2001 ranges from +1% to +4.75%, with a higher probability attached to the middle of this range. But it has to be acknowledged that users are likely to plump for the middle of any range of published forecasts and treat it in much the same manner as they will the ESRI’s ‘central forecast’.

The authors of the Review try to allow for uncertainty by simulating the effects of possible ‘shocks’ on the economy. This is a worthwhile exercise. But it has to be remembered that ‘shocks’ are of their nature unforeseeable, as regards timing and content. It is possible that something will materialise suddenly out of the blue to render the central forecast irrelevant. It is salutary to recall how optimistic the IMF commentaries on the South Asian economies remained as the crisis of 1997 approached! This suggests that the real merit of forecasts is not in creating a consensus as to how fast the economy is likely to grow, but in identifying its strengths and weaknesses and stimulating a debate about the appropriate direction for policy.

Despite the ESRI’s underprediction of growth since the mid-1990s, its central forecast for the coming six years is slightly below the forecast for the period 1996-2000 in the 1997 Review and significantly lower than the likely outturn for that period. Plausible worries about the capacity of the economy to maintain the pace of the current boom leads the authors to anticipate a slowdown. Nonetheless, the basic message is very optimistic. Annual GNP growth is forecast to fall only from 6.5% between 1995-00 to 5% between 2000-05. Although 5% real growth may seem like a recession in Ireland after the vertiginous growth of the 1990s, it is exceptional by any standards. There is room for scepticism about whether the Irish economy can maintain this pace for six more years.

My main reservation arises from the current tightness of the labour market. The Review envisages a further increase of over one third in the size of the economy but virtually no reduction in unemployment, which is forecast to fall only from 6.5% in 1999 to 5.3% in the year 2005. The Quarterly National Household Survey for the second (March-May) quarter of 1999 showed that the unemployment rate fell by 2.1 percentage points (from 7.8% to 5.7%) between the second quarter of 1998 and the corresponding quarter of 1999. Thus one year of 7.5% growth reduced the unemployment rate by almost as much as ESRI allows for over six years of 5% growth.

The historical record shows that GNP growth in excess of about 3.5% tends to trigger a reduction in the rate of unemployment. Although crude, this ‘Okun equation’ summarising the relationship between the growth of GNP and the change in the unemployment rate has been quite stable over the years. The ‘central forecast’ in the Review implies a break with the past - the Irish economy is projected to achieve more growth for a given reduction in unemployment than has been typical in the past. While the historical relationship is not exact, there is no evidence that a structural break occurred during the 1990s. There are now reasons to expect the labour force to be a more binding constraint on growth than it has been in the past.

he short-term unemployment rate - which is the best indicator of the numbers actively seeking employment - is down to 3.2% of the labour force. The ‘natural increase’ of the labour force is slowing. Women’s labour force participation rates have reached the EU average in most age groups and the scope for further increases is lessening. Immigration from the UK and Europe is likely to moderate as unemployment rates in the sending countries fall and Irish housing costs continue to rise. The supply of labour is likely to be much less elastic in the years ahead than it has been since the mid-1980s. If the historical link between growth and changes in unemployment continues to hold, an annual average growth rate of 5% would imply a reduction of three percentage points in the unemployment rate between now and 2005, bringing it below 3% of the labour force. Long before we reach this stage, however, wage inflation is likely to increase and moderate the growth rate. The wage-inflation/unemployment trade-off (the Phillips curve) was very well-behaved throughout the 1990s. Unemployment dropped by 10 percentage points without a resurgence of wage inflation. It is usual to attribute this phenomenon to ‘social partnership’. This arrangement is now under greater strain than it has been for many years. While many culprits may be linked in the popular mind with the break down of wage moderation - ranging from the existence of Ansbacher accounts to the nurses! - the most obvious explanation is the low unemployment rate. Falling unemployment and the associated rise in wage costs are already slowing the economy’s growth and they could undermine the ESRI’s central forecast.

The Review sheds light on the possible impact of accelerating wage inflation. One of ‘shocks’ whose consequences are explored is a loss of competitiveness due to an increase in the rate of wage inflation and increased congestion. The authors estimate that an increase in wage inflation of 1% a year above that assumed in the central forecast would knock one percentage point off the forecast growth rate. The implication is that if things get really out of hand on the pay front, the growth rate will fall sharply.

Apart from a brief consideration of the possibility of a higher level of immigration, the Review does not explore policies that might sustain a higher growth rate. It sends conflicting signals in regard to tax policy. On the one hand there is a plea for counter-cyclical fiscal policy, even if this entails ‘under-indexing’ personal income taxes while the boom continues. On the other hand some reforms of the social welfare system designed to reduce work disincentives are advocated, while full indexation of benefits to average earnings is assumed. Overall it is clear that the authors do not subscribe to the notion that major supply side effects would result from reducing the marginal tax rate at the lower and middle ranges of the income distribution. This is surprising in view of the fact that single workers still face a marginal tax (PAYE plus PRSI) rate of 52.5% on income between £14,000 and £25,000. It is not widely understood that the move to tax credits in last year’s Budget actually lowered the threshold at which this penal marginal tax rate kicks in. Perhaps concern about the tightening labour market will focus attention on this issue. But it is unlikely that changes in the income tax code will be on a scale that would significantly relax the labour market constraint.

I would not be surprised to see a sharper deceleration of the economy over the medium term, even in the absence of an adverse shock. But the basic message is credible: a soft landing rather than a crash seems probably, provided, of course, the global economy holds firm.

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