Last week, a friend felt somewhat flushed and wondered if it was a fever due to COVID-19 or simply the unusually warm weather outside. Fortunately, a PCR test showed he was free of COVID-19. At the same time the Irish economy has been overheating with many pointing to outside causes. However, a closer examination shows the Irish economy is not as lucky.
While the ebb and flow of petrol and electricity prices grab the headlines, there is a deeper problem in the economy. Ireland’s domestic service sector is overheating. Ireland now has second highest rate of inflation in services in Western Europe, with only Iceland faring worse. It is this change relative to our neighbours that puts Ireland’s competitiveness at risk, and ultimately jobs.
Ireland’s inflation is home-grown and here to stay.
Ireland’s inflation has been explained by forces beyond our control such as high oil prices, and a bounce back from deep discounting during the height of the Coronavirus pandemic. However, this cannot explain Ireland’s worsening inflation. Compared to two years ago, the price of goods in Ireland has risen only moderately, at one of the lowest rates in the EU.
In contrast, price hikes in the Irish service sector have outstripped those of our neighbours. The cost of a wide range of services is rising as everything from legal fees to a night out becomes more expensive. This is in a country which already as amongst the highest costs of living in Europe. Rising prices of services gives a better indication of the overheating of the Irish economy. This is as the price rises cannot be explained by outside forces as these services are produced in Ireland.
Nor can a bounce back from previous price cuts explain the rise in the cost of services. Comparing today’s prices to those in 2019, Irish service inflation is above the Eurozone average in all major categories from communications to recreation.
Ireland’s rising cost of services is due to the government pumping money into an economy ill-equipped to supply consumers with what they demand. Ireland has had one of the biggest government responses (in terms of extra spending and taxes cut) to COVID-19 in the OECD. This gave relief to the vulnerable, while the more fortunate were able to save money. This gave Ireland the biggest increase in household savings in the OECD.
As this savings glut is released, the service sector has been unable to supply consumers with what they demand. Although government intervention was necessary, a more balanced approach would have been to raise taxes rather than allow the relatively well-off build up their savings.
Like a virus spreading, prices have now risen across a broad range of services. The general rise in inflation has given firms cover to raise their own prices with less threat of a backlash from consumers. In recent press announcements firms have pointed to general trends in inflation to justify their own price increases.
As prices rise the value of people’s savings is being eroded. This will continue until the value of the savings glut has been spent or eroded away. The Irish public is now paying for the Covid-19 measures, but through higher prices rather than higher taxes.
Over the medium term, forces outside our control will further add to inflationary pressure. The ECB is reluctant to increase interest rates. This is partly due to bad experience when the ECB raised rates too quickly following the Financial Crisis. In contrast, the Bank of England has already raised rates and will soon be followed by the US Federal Reserve. This makes holding a Euro relatively less attractive than a dollar or sterling, decreasing its value. A weaker Euro means a higher cost of imports, and higher prices for consumers.
Although there may be some easing of overall inflation if oil prices fall in the short-term, over the longer term the cost of energy will continue to rise. As agreed in COP26 relatively cheap fuels such as coal are being phased out. This is necessary as the price of such fuel does not fully incorporate the cost of the damage they do to the environment. However, a price must be paid, and this price is more expensive energy.
These are the early signs of problems in the Irish economy, and there is time to act.
While interest rates and inflation are beyond Ireland’s control, the government can deal with the domestic causes of inflation. This can be done by giving a renewed focus to cutting insurance costs and legal fees, to build on progress made in the past. In addition, by raising taxes the government can help take some of the heat out of the economy.
When my friend felt a high temperature, he took swift action to limit any negative effects. So far, the government has shown no appetite to prevent the economy overheating.
Rory O’Farrell lectures economics in TU Dublin and previously worked with the OECD.
Rory O’Farrell is an economist at the Dept of Economics, OECD, with extensive post-PhD international work experience. His research has been in the area of public policy, labour economics, fiscal policy and monetary policy. He has experience with macroeconomic modelling, calibrating Mortensen-Pissarides matching models and forecasting.