Ireland in EMU

Ireland's startling rate of economic growth has not faltered since it entered EMU. But soaring property prices, accelerating real wages and consumer price inflation (CPI) running at 6.2% have lead some to view Ireland as a runaway economy escaping from the ECB's goal of price level stability. At a lunchtime meeting held in London on 13 October 2000, Patrick Honohan argued that the focus on CPI inflation is fundamentally misplaced, as the surge in inflation is an equilibrium response to the euro's movements on the forex market. He reviewed the sources of Ireland's economic growth, the role of EMU in accelerating it and speculated on how the current boom is likely to end.

After decades of underperformance since the country's independence, Ireland's current expansion has been uninterrupted for the last 12 years. Output growth accelerated sharply after 1993, and over the last five years GDP growth rates have fluctuated between 7% and 11%. In fact Irish GDP per capita is now higher than the UK's. Honohan argued that these often quoted GDP figures were, however, highly misleading as a measure of aggregate growth and tended to exaggerate the productivity element of the expansion. He described Ireland as the 'entrepôt economy', in that Ireland's relatively low corporation tax encourages multinationals to announce profits in Ireland rather than elsewhere. Even GNP figures give an exaggerated impression of the growth in Irish living standards; the short product-cycle of many of the high-tech exports means there is a systematic tendency for the terms of trade to deteriorate for Ireland. A more accurate measure, claimed Honohan, is Gross National Disposable Income adjusted for terms of trade, which takes account of this problem. Over the 1990s, this grew by an average of 5.4%, compared with 6.7% for GDP.

Honohan stressed that the main characteristic of the expansion had been employment growth not productivity growth – productivity growth has occurred but it has been healthy rather than miraculous. The last 12 years have seen unemployment fall from over 16% to its present level of 3.8%, a level unknown for a generation and essentially corresponding to conventional concepts of full employment. Even the long-term unemployed have fallen to under 2% of the total workforce. As a result, measures of poverty have declined from a range of 9-15% in 1994 to 6-8% in 1998.

Sources of Expansion

No single explanation can account for Ireland's expansion, and Honohan believed it essential to think in terms of factors occurring at three different frequencies: a series of short-term boosts, which together with a medium-term change in public attitude had been superimposed on longer-term foundations. The short-term effects began with the defensive devaluation of the punt in mid-1986, responding to a phase of sterling weakness, which was turned into a valuable competitive edge by the subsequent strengthening of sterling during the Lawson boom. At roughly the same time, world interest rates were falling, a crucial boost for a heavily over-indebted public sector. And the doubling of the EU structural funds came at a crucial moment, allowing many urgently needed public infrastructure programmes to move forward. The EU funds peaked in 1993 at about 3% of GDP and have continued to fall since. As the fiscal position became sustainable, internal and external confidence was boosted. This may explain the surge in inward investment from the US that kicked in just as EU funds were winding down. It is not the actual investment that makes the difference, but the transfer of technology and working practices, noted Honohan.

Honohan believed there had been a substantial change in attitudes, which owed much to a shared realization that the way forward had to be built on a realistic self-help approach. This realization extended not only to the new generation of trade union and business leaders, coming together in restrained pay agreements that undoubtedly contributed to the climate for recovery, but also to the individual decisions made by young labour market entrants, who adopted a more pro-active approach in the labour market. The key long-term factors were the steady growth in human capital, dating back to the introduction of free secondary education in the 1960s, and the high birth rate, which delivered a steady supply of labour market entrants. Finally, Honohan argued that the increased demand for new technology products favoured Ireland's circumstances: 'computer-based work is more forgiving of imprecision and a casual approach, more rewarding of impatience and impetuosity', he said.

The Role of EMU

The question of whether EMU was a suitable regime for Ireland had been discussed endlessly in economic terms before the decision was made – on political grounds. Evidently the euro does not offer an ideal peg. A very low share of Ireland's transactions (less than 30%) are with the euro area. Euroland accounts for a much higher proportion (about 40%) of Ireland's goods exports than of imports (about 20%). About 50% of goods imports come from the UK and US and reliance on imports from these hard currency sources has had an impact on CPI inflation.

Still, Honohan highlighted how EMU had delivered substantial changes to Ireland. It was assumed that the euro would mean a vulnerability to movements in sterling. A fall in sterling was the principal risk envisaged, but the reality has been the opposite. Lower interest rates were also expected as a consequence of EMU, and this is one area where the single currency has delivered – real interest rates are currently negative. These lower interest rates must surely have fuelled the property boom, but longer term they are beneficial, as the former exchange rate risk premium put a wedge between the cost of capital and the expected rate of return to savers.

Ireland has proved to be an EMU outlier, its boom contrasting with the more subdued conditions in euroland as a whole. The loss of autonomy over monetary policy can be regretted, but Honohan noted that the current situation of the ECB essentially ignoring Ireland when setting interest rates is not too dissimilar to the previous administration, the Central Bank of Ireland, which itself often paid little attention to the Irish economy when setting rates. Lower financial transaction costs were expected, but they have not arrived. Retail money transmission charges were, Honohan argued, still extraordinarily high.

The Current Boom

Most current commentary focuses on the relatively sharp increase in CPI inflation to 6.2%. This is more than three times the ECB's ceiling, but Honohan stressed that it was important to realize inflation has been driven primarily by the fall in the euro. Imports from the non-euro area account for a vastly higher share of GDP than in any other member country, and it is therefore not surprising that the depreciation of the euro should have had a much larger impact in Ireland than elsewhere. Up to the start of EMU, and for the next three quarters afterwards, Irish CPI inflation hovered around a 2% average. It is only since the end of 1999 that there has been a sharp acceleration.

CPI inflation is not the only problem. The most immediate danger is that the current wage deal may unwind in the face of higher than expected inflation. Helped by the pay round that took effect in 1997, real wages have been rising steadily since then and had increased by about 10% by late 1999. Although the jump in real wages began well before EMU started, the CPI acceleration must now be adding its own twist to wage developments as the surge in prices represents a fall in living standards for the affected workers. Of course, the increased wage payments will not help reduce inflation, but neither are they its central cause. The risk is that an excessive permanent boost to wages could prove a costly mistake if the euro should rebound.

Furthermore, Ireland has seen rapid increases in property prices, which are not fully captured by the CPI. Driven by the fall in interest rates brought about by EMU, house price inflation now stands at a figure of approximately 20%. With unemployment at such low levels, Ireland has started to attract immigrants, especially from Eastern Europe. Many of these, said Honohan, are young people who wish to learn English but do not stay long because of high property prices.

The Future

Higher wages mean lower profitability and lower labour competitiveness. But Honohan thought this was not necessarily a bad thing: congestion and full employment point to the need for a relative price adjustment. International comparisons suggest that, even after a further 10-15% increase in relative wage rates, Ireland still has some way to go before reaching the average wage costs of Germany. Spiralling house prices are also a worry: Ireland has never seen such a rise in house prices that has not ended in a crash. However, it seems a financial meltdown is unlikely. Lenders insist that they have mortgaged houses only to a modest percentage of market value – about 70% on average for the largest mortgage lender. A fall of 30% in house prices would not, therefore, trigger much fear of default.

With monetary policy now determined from Frankfurt, fiscal policy would seem to gain more potency. Yet if domestic demand factors are not central to the recent price surge, then adjusting the fiscal balance is misplaced. Instead, Honohan recommended focusing on the microeconomics of budgetary policy: ensuring adequate government spending not only to ease congestion and provide the physical infrastructure needed to sustain the higher level of economic activity, but also to pay for those social, educational, health and childcare requirements which a more prosperous population is entitled to expect (some of which, under current arrangements, will not be adequately provided if not subsidized by the state).

Honohan concluded that the economy looks quite capable of a soft landing. Unlike the economies of East Asia in the mid-1990s, Ireland is not especially overborrowed and is actually running a current account surplus – about 4% of GDP. But the surplus is shrinking. Full employment has been reached, and the natural increase in population is steadily slowing. Real wages are catching up. EMU has been only one, generally positive, shock among many which have contributed to the Irish boom. The fall in the euro makes nominal wage policy now especially tricky, but manageable given flexibility and ingenuity.

Patrick Honohan is at the Economic and Social Research Institute, Dublin, and is a Fellow in CEPR's International Macroeconomics Research Programme.