In the European Economy Report 2007*, prepared by the
European Economic Advisory Group (EEAG), that is published today, the senior economists led by Giancarlo Corsetti, Department of Economics, European University Institute, Florence, who wrote Chapter 2 of the Report, Ireland is seen as an example of how asset prices, especially housing prices, may play a much larger role in the dynamics of adjustment in a monetary union than was understood earlier. Through their impact on housing prices, expansionary monetary conditions can fuel sustained construction booms, which outlast the initial demand shock, and contribute to a cumulative process or real appreciation.
The Report says that the pace and intensity of housing investment have arguably been amplified by monetary stimulus, through low interest rates. The strong expansion in the construction sector and the high market valuation of real estate clearly point to the risk of a significant reversal, which could amplify the contractionary effects of real appreciation once a downturn starts.
In 2005, the construction sector in Ireland accounted for approximately 20 percent of the country’s GDP and employed more than 10 percent of the labour force.
In response to booming demand, Irish labour costs relative to the Irish trading partners, which were on a downward trend between 1985 and 2000, have increased fast in the years of the euro. According to the European Commission data shown in Table 2.1, in the period 2004 to 2006, the rate of growth of real compensation per worker in Ireland exceeded by 10 percentage points the average for the euro area. Due to the high productivity growth, relative unit labour costs have increased by less, but the rises have still been significant. Figure 2.2 displays an index of the real effective exchange rate between 2000 and 2006 for a sample of European countries based on unit labour costs relative to 15 trading partners.
Two countries stand out most vividly: Germany, which recorded the largest fall in relative unit labour costs (hence the largest gain in competitiveness), and Ireland, which recorded the largest rise.
Figure 2.3 shows the level of hourly labour costs in 2005 for a selected sample of European countries. For 2005, the hourly labour costs in Ireland are comparable with those in the UK and France, higher than the Italian ones, although still substantially below the German ones (about 25 percent lower).
The loss of cost competitiveness relative to the other European countries, as well as relative to the world at large (especially after the euro started to appreciate in 2002), has not so far translated into a notable slowdown in exports. Arguably, this is due to the fact that Irish exports are concentrated in sectors, like ICT, which respond quite positively to the current high growth in the global economy.
However, the Report says that the concentration of Irish exports in dynamic sectors with a high elasticity with respect to world demand makes Ireland’s export performance vulnerable to changes in the world trade pattern, or to a global slowdown. By the same token, the macroeconomic performance of Ireland would be heavily exposed to a correction in property prices, likely to cause a severe drop in activity in the construction sector. For these reasons, there is substantial macroeconomic risk built into the current state of the Irish economy.
The Report says that in the case of a sharp slow down of the construction sector, adjustment would require some combination of migratory outflows and changes in the sectoral composition of employment. Such a slowdown would also raise the demand for public support of unemployed foreign workers, putting pressure on the Irish welfare state. In this respect it is worth stressing that a large fraction of migrants to Ireland are from the EU10 countries. In 2005, for instance, 26,200 out of 70,000 immigrants came from the EU10; in 2006, it was 37,400 out of 86,900 (Central Statistics Office 2006).
The Report says that clearly, migration flows from outside the euro area have helped contain labour shortages, especially for low-skilled workers. Absent the flow, we would have observed an even faster wage and price adjustment. However, to some extent, the contribution of migration to adjustment is hampered by its indirect, destabilising effect on demand, due to the fact that new workers also raise domestic aggregate spending. Migration actually can magnify (rather than bridge) demand imbalances. In Ireland, the demand for new housing by migrants is one of the factors contributing to the strong dynamics of the real estate market, hence to the prolonged boom in the construction sector.
The Report says that the macroeconomic risk of a hard landing after a strong expansionary period is illustrated by the experience of the Netherlands in the last decade, as reviewed by the European Commission (2006). This country is similar to Ireland as regards its degree of openness. (Although the high volume of exports and imports reflects to a large extent the importance of Dutch ports in Europe.) In contrast to Ireland, however, its growth is arguably no longer driven by income convergence. Over the turn of the millennium, the Netherlands rapidly lost price and wage competitiveness, especially relative to Germany, its main trading partner. When the boom in internal demand faded away, low competitiveness exacerbated the slowdown.
*On the European Economic Advisory Group at CESifo (EEAG): The EEAG Group consists of eight internationally renowned economists from eight European countries. Chaired by Lars Calmfors (Stockholm University), it includes Seppo Honkapohja (Universities of Helsinki and Cambridge), Giancarlo Corsetti (European University Institute Florence), Michael P. Devereux (University of Oxford), Gilles Saint-Paul (University of Toulouse), Hans-Werner Sinn (Ifo Institute for Economic Research and University of Munich), Jan-Egbert Sturm (KOF Swiss Economic Institute, ETH Zurich), and Xavier Vives (IESE Business School, University of Navarra).
See Also: Report on the European Economy 2007: Economists say that it is hard to justify further interest rate rises by the ECB
