By Steven Pearlstein
Wednesday, June 21, 2006

DUBLIN

The irony of the Irish economic miracle is surely not lost on the countries of Western Europe that poured billions of dollars into their poor, struggling neighbor to help integrate it into the much wealthier European Union.

In one respect it was a tremendous success, creating the continent's fastest-growing and most productive economy.

But in another, Ireland's success represents a profound embarrassment for the European establishment. In terms of the markets for its products and the source of its investment capital, Ireland is much more heavily oriented toward the United States -- and euro holdout England -- than it is to the countries of Western Europe. With its low tax rates and flexible labor markets, its economic model and business culture are "more Boston than Berlin," as the saying goes here. And although Ireland's booming economy now attracts tens of thousands of ambitious young immigrants each year, the vast majority come from the fast-growing states of Eastern Europe rather than high-unemployment states of Western Europe.

Success, however, presents Ireland with a new set of obstacles.

While its export sector continues to expand and move toward higher-value manufacturing, Ireland's domestic service economy remains uncompetitive and its public sector inefficient. That means relatively high costs for energy, transportation and business services, and higher living costs for workers who are now in a good position to demand higher wages.

This is a common problem in Europe. In Ireland, much of the blame lies with public-sector unions that have successfully won the right to have their salaries "benchmarked" to the private sector, without a similar benchmarking for productivity, job security, vacations or fringe benefits. But rather than get into a Thatcherite or Reaganese confrontation, Ireland's helplessly reasonable and polite politicians and union leaders have agreed to a strategy of quiet, piecemeal reforms in which flexibility is traded for higher pay.

There are other warning signs. One of the big success stories in Dublin is a joint venture between Allied Irish Banks and Bank of New York, providing back-office services to hedge- and mutual-fund managers. But with wages in the financial sector now rising 20 percent a year, managing director Lorna Sherlock decided this year to open a second office in Cork, where she estimates that costs are 20 percent less. But Sherlock warns that if labor and other costs continue to rise at the current rates for another year or two, "we'd find we would not be competitive" -- a warning I heard more than once during a weeklong visit.

Just as threatening to the Irish economy is a real estate bubble that, by some measures, surpasses the ones in midtown Manhattan or downtown Washington. Over the past 20 years, average new-house prices have increased six- and sevenfold, to around $400,000, far outstripping the otherwise impressive increase in household incomes. Two-bedroom condos in Dublin sell for more than $1 million, with three-bedroom houses on small lots fetching double that amount. New housing developments routinely sell out in a single weekend.

The frenzy is driven by several factors: newly confident twentysomethings desperate to get on the housing ladder before it's too late, the arrival of European banks offering mortgages with no money down and interest-only monthly payments, and a national preoccupation with landowning that probably dates back to when all land was in the hands of British gentry. The accompanying construction boom accounts for half of the country's job growth in recent years.

This bubble sets up the Irish economy for a terrible blow when it finally bursts. And while it is impossible to say when that will happen, it is probably instructive that owners of two of the largest real estate firms decided to sell out in the last two weeks.

Even more troublesome is the fact that so much of Ireland's newfound wealth is being reinvested in real estate, at home and abroad.

Anthony O'Reilly, the former chief executive of Heinz, is not only one of Ireland's richest citizens, but also one of its best raconteurs. Last week, he regaled me with the story of his butler, Martin, who, after pouring him a cup of tea one recent afternoon, asked his famous boss for his view on "Bulgarian property." Turns out Martin had invested in not one, but three condominium apartments with a view of the Black Sea, after taking a holiday at a new Bulgarian resort.

And Martin wasn't alone. According to data compiled by the Dublin real estate firm of Hamilton Osborne King, Irish investors poured somewhere between $6.5 billion and $8 billion into foreign property last year, with $10 billion more likely this year. One can only imagine what kind of economic growth could have been generated if even half that money had been invested in innovative and productive Irish firms.

Starting, financing and growing such firms is now the top priority of the Irish government's formidable economic development apparatus. While officials will continue to use modest subsidies and tax breaks to continue to attract foreign investment from giant multinationals, particularly in the area of research and development, officials realize that part of the European disease has been an over-reliance on giant multinationals in generating jobs and economic growth. Ireland's next big challenge is to build an entrepreneurial economy, more like that of Israel or Finland, that is capable of starting its own globally competitive firms.

Even a decade ago, that would have been unthinkable. Not only did Ireland lack the necessary capital, technology and management talent, it suffered even more profoundly from a national lack of confidence that manifested itself in a disinclination toward risk-taking and a resentment of anyone who achieved economic success.

But now, thanks to the decade-long economic boom, that curse has been lifted. The best and brightest of Irish youth no longer "strike for something permanent and pensionable," as O'Reilly's father used to put it.

"The biggest change I see is the sense of confidence," reports John Hegarty, who, like many of his generation, sought his fortune in the United States -- at Bell Labs and the University of Wisconsin -- before returning home to become provost of Trinity College in Dublin. "The world is now there for them, they can do whatever they want, and they don't have to leave Ireland to do it."

Steven Pearlstein can be reached atpearlsteins@washpost.com.