Euro-zone club can offer comfort but at a price


The Irish experience shows that membership of the EMU is not without its costs, write Anthony Leddinand Brendan Walsh 

ONE OF the few bright developments on an otherwise dismal economic horizon is the 1.75 percentage point cut in interest rates by the European Central Bank (ECB) over the last three months. A cut of this proportion can be expected to boost consumer spending and investment.

Small and large economies alike - Iceland, Poland, Hungary, and possibly Denmark and the UK - are seeking the safe haven from the credit crisis storm that is membership of the Economic and Monetary Union (EMU).

As Ireland knows only too well from the 1992 currency crisis, a small, independent currency can be easy fodder for currency speculators. So while the ECB accepts the plaudits, and EMU seems an increasingly attractive proposition for storm-tossed independent nations, it might seem somewhat perverse to argue that membership of the euro zone actually lies at the root of some of Ireland's current economic malaise.

Iceland and the other EMU aspirants could do well to examine carefully the Irish experience in the EMU before opting to replace their currencies with the euro.

The argument revolves around the observation that the Celtic Tiger economy was essentially a game of two halves. The first part, 1994-2000, was essentially an export, investment, consumer-led boom.

Driven by significant gains in price competitiveness (initiated by the 1993 devaluation), cuts in income taxes, and falling interest rates, the real growth rate averaged 8.5 per cent per annum, unemployment fell from 14.7 per cent to 4.3 per cent, 500,000 net new jobs were created and surpluses were recorded on both the government finances and the balance of payments.

It was clear that this pace of economic expansion was unsustainable and a slowdown inevitable. The evidence lay in rising inflation, falling price competitiveness and net exports.

Inflation shot up from 1.5 per cent to 7 per cent in 2000 and this initiated a wage-inflation spiral outside the national wage agreements culminating in the first Public Sector Benchmarking Body's awards in 2001. Combined with an appreciation of the euro against both the dollar and sterling, the result was a massive loss of price competitiveness.

Between 2000 and 2003, the Irish economy suffered a 30 per cent loss in price competitiveness relative to all our trading partners taking both exchange rates and relative inflation into account. This loss of price competitiveness hurt domestic export and import-competing firms, leading to a fall in the growth rate and inflation but placing the economy closer to a sustainable trajectory.

An independent Central Bank of Ireland would undoubtedly have started the adjustment process earlier - raising interest rates as inflation rose and unemployment fell. But, as a member of the European System of Central Banks, the Irish authorities were limited to sounding unheeded warnings in the Quarterly Bulletin.

Later on, as the evidence of a housing bubble was clearly documented by staff economists in articles in this bulletin, the Central Bank used none of the admittedly limited instruments still at its disposal to check the feeding frenzy.

Contrary to what was required under Irish conditions, the ECB cut interest rates from 4.75 per cent to 2 per cent between 2001 and 2003. Given the high Irish inflation, the result was negative real interest rates which added fuel to the already unsustainable boom.

These developments, combined with loose credit regulation, sustained the boom in building and construction and in consumer spending. On the supply-side, the inflow of labour from the new Accession States made the Irish labour force the fastest growing labour force in the OECD.

Following two years at a sustainable growth rate in 2001/02, the economy again picked up and the real growth rate averaged 5.3 per cent per annum between 2003 and 2007. Unemployment averaged 4.5 per cent and another 290,000 net new jobs were created. But inflation remained well above the EMU average and price competitiveness continued to deteriorate.

The growth in output was increasingly concentrated in the non-traded construction sector, fuelled by an irrational bubble psychology. Employment in construction more than doubled between 1997 and 2007, to reach 14 per cent of the total. The windfall surge in tax revenue from this sector covered up the collapse of fiscal discipline and an explosion in the public service pay bill.

When the building and construction sector finally collapsed in 2007/08 the Irish economy, its public finances, and household debt were left in an extremely parlous condition. Most important, a €10.3 billion deficit was recorded on the current account of the balance of payments in 2007 compared to the surpluses throughout the 1990s.

There was little serious analysis of the deterioration in price competitiveness. One leading politician recently remarked that he had never heard of the "real effective exchange rate index" - which is the best available measure of trends in competitiveness. Trade unionists persistently argued that Ireland's high cost base was only marginally due to high labour costs - preferring to blame everything from housing prices and energy costs for the problem.

The Government was happy to enjoy the bonanza in tax revenue that flowed from the construction boom. Between 2002 and 2006 Capital Gains Tax and Stamp Duty receipts rose almost fourfold and their share of total tax revenue rose from 5 per cent to 12 per cent. Budget 2008 was framed on the assumption that this bonanza would continue. This is the main reason the public finance predicament facing us in 2009 is so severe.

So while borrowers welcome the recent cut in interest rates and the euro offers protection from currency speculators, the costs and benefits of the Irish experience as a member of EMU requires much deeper analysis. Aspiring EMU members could do well to note that the adverse repercussions of the doctrine that "one monetary policy fits all" can be serious.

Dr Anthony Leddin is head of the Department of Economics at the University of Limerick. Prof Brendan Walsh is Professor Emeritus, Department of Economics, University College Dublin