THIS is a fine report. It is delivered with the intellectual rigour and balance one would expect of its principal authors. It is free of tendentiousness and the kind of unsupported assertion that has characterised much of the debate on Ireland and EMU. Hopefully it will help to guide future instalments of that debate along rational lines and away from the empty sloganeering of the more voluble protagonists.
The report's conclusions are sobering. The authors make plain their belief that participation in EMU is not a matter of life and death. Compared with the benchmark scenario where both Ireland and Britain remain outside, participation without Britain is seen as stimulating GNP by 0.4 per cent and employment by 10,000 over the first five years. These are modest gains. In the event that both Ireland and Britain join, the gains are not much more dramatic the boosts to GNP and employment rise to 1.4 per cent and 20,000 respectively.
The projected net effects of EMU membership on GNP under these two scenarios are summarised in the table below. In both cases the benefits from lower interest rates dominate. This is especially true of the Ireland in/Britain out scenario where the costs of membership from a loss of competitiveness and the risk of adverse shocks are relatively large. The analysis clearly implies that the economic case for Irish participation stands or falls on the interest rate argument, especially if Britain stays out.
Given the critical role that interest rates play, this dimension of the ESRI's analysis is worth exploring. I will do this under three headings (i) the size of the interest rate penalty that Ireland would suffer outside EMU (ii) the channels through which the interest rate benefits of membership flow through to output and employment, and (iii) the sensitivity of the results to different assumptions about interest rates.
The Interest Rate Premium. The ESRI takes the view that, if Ireland was to remain outside EMU, Irish interest rates would eventually settle at a level 1 per cent higher than if the country was to participate. The ESRI postulates that in the first two years of EMU, the margin would be higher than this at 1.75 per cent. The argument here essentially reduces to the proposition that the Irish pound would be regarded as a riskier currency than the Euro, and that investors would seek a higher return from their Irish pound positions by way of compensation.
As a representation of the most probable outcome, the ESRI's view is not unreasonable and is in marked contrast to the claims made by some commentators who have asserted that interest rates would be as much as 3 per cent higher outside EMU than inside. However, there are other plausible outcomes. One such outcome springs from the possibility that EMU will suffer from a protracted credibility problem with the financial markets, resulting in Euro interest rates having to be pitched at a high level relative to their US and Britain equivalents. In these circumstances Irish interest rates outside EMU could be lower than they would be inside, at least for an initial period of several years.
The Flow of Benefits. The ESRI identifies three channels through which the benefits of lower interest rates under EMU would be realised (i) the public finances (ii) the profitability of private sector investment, and (iii) spending by households. The report is not explicit on the relative importance of these conduits (i.e. on how much of the projected 1.7 per cent interest rate boost to GNP is attributable to each). This is a pity. However, the text suggests that the third channel would be relatively unimportant and my own judgment is that the first channel would be the most significant.
In this regard there are two problems with the ESRI's analysis. The first arises from the assumption that the debt service savings accruing to the Exchequer from, lower interest rates would be passed on in tax cuts rather than absorbed by higher non interest public spending. This is an important assumption since tax cuts, by dint of their benign effect on labour costs and competitiveness, are likely to yield materially greater overall economic benefits than increases in public spending. However, all the evidence of the past decade or so suggests that Irish governments have a pathological inclination to use debt service savings to finance higher spending. If the assumption in the ESRI report were replaced by one consistent with the historical record, the projected net benefits from EMU membership would undoubtedly be reduced, perhaps to the point where they would disappear.
The second problem is that the ESRI appears to assume that under EMU the reduction in government bond yields would be the same as the reduction in wholesale interest rates. This may not be the case. In the Ireland in/Britain out scenario, Irish bond yields would probably rise relative to yields elsewhere in the single currency areas during periods of acute sterling weakness, reflecting (i) the upward pressure that a fall in sterling would put on the Irish budget deficit on foot of a rise in unemployment and a fall in tax revenues and, more significantly, (ii) the risk that Ireland would pull out of the single currency in order to restore lost competitiveness vis-ii-vis Britain. In this regard it is worth noting that, for so long as individual member states retain political sovereignty, the prospect of a multilateral agreement to terminate the single, currency or a unilateral decision by one member to withdraw from membership can never be ruled out.
Sensitivity of Results. Given that interest rates are critical to the assessment of the economic consequences of EMU, it is important to know how the projected net benefits to the economy vary with different assumptions about interest rates. In its benchmark scenario, the ESRI assumes the interest rate reward that EMU membership would confer on Ireland would be 1.75 per cent in the first two years, 1.5 per cent in the third year, 1.25 per cent in the fourth year and 1 per cent in the fifth and subsequent years. As indicated above, the benefits generated by this lower trajectory for interest rates are projected to amount to 1.7 per cent of GNP on average over the first five years of EMU and this exceeds the costs of membership in the Ireland in/Britain out scenario by an underwhelming 0.4 per cent of GNP.
However, the ESRI indicates that with a slightly different assumed trajectory for interest rates (where the interest rate margin starts at 1.75 per cent in Year 1 but falls to per cent from Year 2 instead of Year 5), the projected gross benefits from lower interest rates declines to the equivalent of 1.2 per cent of GNP on average over the first five years of EMU. This is not enough to outweigh the costs that arise in the Ireland in/a Britain out scenario, and the economy becomes a net loser, albeit marginally, from EMU membership in this ease.
The ESRI report does not constitute the ringing endorsement of EMU membership that its advocates might have hoped for. The net economic benefits projected to flow from Ireland's participation, whether Britain opts in or out, are small enough to fall within the margins of error associated with any set of medium term economic forecasts. In the Ireland in/Britain out scenario it requires no more than marginal modifications of the ESRI's assumptions in relation to interest rates and fiscal policy to convert these net benefits into net losses.
