Economics:Reduction in labour force growth expected if construction contracts and overall economic activity slows.

In my last column, I advised readers that medium-term forecasts of Irish economic growth which assumed the continuation of large-scale immigration should be approached with caution. My argument was that immigration to Ireland is such a recent phenomenon and our knowledge of it so sparse, that projecting how it might evolve was an exercise in poorly informed conjecture. There may have been an unintended suggestion in all of this that I believe immigration to be a determinant of growth in the Irish economy, and that, if only we could be reasonably certain about its future scale, we could be reasonably confident about our economic growth forecasts.

Indeed, this is precisely the inference that at least one reader drew from the column and subsequently made the subject of a lively telephone exchange.

Suitably chastened, I thought it important to return to the issue and clarify a thing or two.

Perhaps the best place to start is with the distinction between the economy's potential and actual growth rates.

The potential growth rate is what the economy could attain if all available resources of labour and capital were fully utilised. In the context of a discussion about immigration, it may be thought of as the rate of economic growth that we could achieve if immigration continued at something like its recent rate of 70,000 per annum. (Mind you, this raises interesting questions about the economy's capacity to continue absorbing large numbers of immigrants, but that's another story).

Of course, economies don't always expand in line with potential: actual growth rates can and often do fall well short of what's possible. Ireland's recent economic history so starkly illustrates this truth that it's surprising how many commentators seem to overlook it.

Take the years 1980 through 1986, for example. Over this period, GNP increased at an annual average rate of about 0.5 per cent (compared with a potential growth rate of perhaps 4 per cent at that time) and unemployment almost doubled, from less than 10 per cent to 18 per cent.

The fact that Ireland had then, as it has now, a plentiful supply of young and reasonably well-educated people did not save the economy from recession. Something went badly wrong.

That "something" was a sequence of serious policy mistakes in the management of the public finances that plunged the government into massive debt, greatly increased the burden of taxation, and spawned a set of deeply pessimistic expectations among households and firms about the future.

To complete the picture, the economic environment deteriorated so much that there was a big increase in emigration, which reduced labour supply and cut the economy's potential growth rate.

The early 1980s offer two lessons that are germane to any consideration of the economy's future prospects as of now.

One is that healthy demographics are no guarantor of a healthy economy. Strong demographics may be a necessary condition for strong economic growth, but they don't provide a sufficient condition. To subscribe to the view that they are sufficient is to subscribe to a naive, mechanistic and misleading view of how the economy operates.

The second lesson is that an unhealthy economy can beget unhealthy demographics. This is especially true of a small, open economy characterised by a high degree of labour mobility, as Ireland is. Simply put: when times are good, people rush to join the party; when times turn bad, people head for the exits.

How do these lessons relate to post-Celtic Tiger Ireland? Well, we are currently experiencing healthy demographics, in terms of strong population and labour force growth, because the pace of economic activity is so robust.

Immigrants are pouring into Ireland because of the abundance of employment opportunities here.

Granted, it is true that their arrival also boosts demand, not least the demand for housing, and to that extent helps to boost growth, at least in the short run. But, it still makes much more sense to think of immigration as the consequence of Ireland's economic growth rather than its cause.

Forecasts for this year see the economy maintaining a growth rate close to potential. Looking beyond 2007 however, forecasters are increasingly mindful of the possibility of something happening that will cause the growth rate to fall significantly below potential. That "something" could be a sharp correction in international financial imbalances that would cause a dollar collapse and damage Ireland's competitiveness, or an abrupt correction in the domestic property market that would see house prices tumble and prompt a sharp contraction in the output of the construction sector.

Some people seem to think that our favourable demographics insulate us from the latter risk on the grounds that strong population growth will sustain the existing demand for houses. But, if there is a bubble in house prices (and the overwhelming balance of available research suggests that there is), this view is just plain wrong.

If a market is trading well above the levels justified by the fundamentals (which is precisely what is meant by a bubble), the mere maintenance of fundamental factors at their current values cannot logically sustain prices. In such circumstances, what is supporting the market is not fundamental factors but sentiment, and sentiment is a treacherous ally.

What would happen to immigration if construction output contracted sharply and significantly depressed the pace of overall economic activity for a few years? In light of my introductory remarks, I don't want to strike too definite a note in answering this question, but it's safe to say that the rate of immigration would decline. It might even be the case, depending on the depth and duration of the economic slowdown, that sufficient numbers of immigrants currently resident here would return home to turn the flow of net migration negative again.

The result, in any event, would be a reduction (perhaps a sharp reduction) in the rate of labour force growth and, all other things equal, in the economy's potential growth rate. In summary, to use the jargon of economics: in Ireland, demography is endogenous; it is not a given.

Jim O'Leary lectures in economics at NUI-Maynooth. He can be reached at jim.oleary@nuim.ie