New economic traffic heading to Ireland

Why do multinational firms locate in the Republic? There was a time, as recently as 10 years ago perhaps, when the answer was: the low corporate tax rate, generous IDA grants, low labour costs, and little else. Then, the common and largely correct perception was that multinationals in the Republic formed a low-cost tax-driven export enclave that was almost entirely disconnected from the rest of the economy.

Things have moved on a good deal in the meantime. Today, not only is the answer different, but the very question has changed. Now it is: why are multinational firms in knowledge-intensive industries locating in Ireland in increasing numbers?

The answers are provided by a branch of economics called the "new economic geography", popularised by well-known economists such as Paul Krugman and Michael Porter, which is concerned with the spatial distribution of economic activity. Its central thesis is that there are powerful forces that produce the clustering of particular types of activity in particular locations. The most important of these so-called agglomeration economies are: the development of deep and liquid labour markets in industry-specific skills; the emergence of specialist producers of the materials and services required by an industry; and knowledge spillovers that arise from personal contact between people working in the same industry.

As far as high-tech industry is concerned, these forces have been gathering strength in the Republic over the past decade. Employment in electronics and software, for example, has risen from 25,000 in 1990 to 65,000 now, greatly deepening the relevant labour markets in the process. Purchases of Irish-produced goods and services by overseas firms located here have risen by 20 per cent per annum in volume terms over the same period, reflecting the rapidly growing network of specialist sub-suppliers. A vibrant indigenous software industry has emerged, testimony in part to the existence of knowledge spillovers.

Other influences that tend to produce clustering of activity have also been at work, including the forging of strong symbiotic links between high-tech firms and third-level education institutions, and the building of responsive lines of communication between such firms and government agencies.

In addition, there have been pure demonstration effects. The fact that so many of the world's leading electronics, pharmaceuticals and software companies have set up and prospered here has acted as a powerful signal to others. Of course, if it were all about centripetal forces, all economic activity would gravitate towards one location. The fact that this doesn't happen, means that influences that tend to disperse activity away from the centre start to operate at some stage.

The most important of these are wage inflation and congestion. We know a couple of things about these centrifugal forces that are of relevance to the Republic at this time. The first is that the activities that succumb to such forces are those that are most susceptible to cost-competitive pressures, i.e. those that are relatively low down the value-added chain.

The second is that a region can remain a very attractive location for high-tech activity long after cost inflation has started to accelerate. Seattle and Silicon Valley, for example, are high-cost US locations that remain thriving centres of high-tech industry.

At the moment cost inflation in the Republic is accelerating. Many commentators think that the inevitable consequence of this is that the current boom will give way to recession. We regard this as a form of blinkered pessimism. It is based on the notion that the relationship between economic activity and production costs is a one-way street in which activity must respond to rising costs by contracting. But, of course, the relationship between costs and activity is a much more complex and dynamic one than this simple notion suggests.

Consider what has been happening in the Irish economy over the past decade.

Not only has the rapid expansion resulted in a huge increase in total economic activity, but it has also produced big changes in the composition of that activity.

Among IDA-supported companies alone, there were 84,000 jobs created between 1994 and 1999, but there were 37,000 jobs lost. The jobs have been almost exclusively in the skill and knowledge-intensive areas like electronics and software; the lost jobs have been in less sophisticated operations in these sectors or in industries like textiles.

This restructuring has been accompanied by a significant acceleration of productivity growth, from less than 3 per cent per annum in the 1991-96 period to 3.7 per cent over the past three years.

The high-tech sectors have continued to grow strongly, and have been competing with other sectors for increasingly scarce resources, thereby pushing up the prices of these resources. Viewed in terms of the language of the new economic geography, the positive influence of agglomeration economies has continued to dominate high-tech activities (strikingly illustrated by the recent announcements by Intel, Cisco and IBM), while activities down the value-added chain have succumbed to the centrifugal forces.

Recent Government initiatives in respect of the telecomms infrastructure, R&D funding, and the regulatory framework for e-commerce seem likely to further boost the Republic's attractiveness for a range of new economy activities in the years ahead.

The Irish economy stories that have dominated media coverage have been those of accelerating CPI inflation and the threat to "wage restraint". In our view, however, the really big story of the Irish economy is that leading international companies in industries like pharmaceuticals, electronics and software continue to expand or establish operations here, despite rising costs and growing congestion.

If there's a problem here, it is that the State is too attractive, not that it's in imminent danger of going down the tubes.

Jim O'Leary is chief economist at Davy Stockbrokers