European Monetary System did not favour Ireland

 

The independent Irish pound is dead before its 20th birthday. After just two decades of monetary autonomy within the exchange-rate mechanism of the EMS, Ireland now largely abandons monetary sovereignty as it enters EMU. But these waters are not uncharted for us. In many respects it is like a return to the pre-1979 era of the sterling link.

Let it be stated now for once and for all, the EMS was not kind to Ireland. A good exchange and monetary regime should deliver financial credibility, contributing to low inflation and a low cost of capital. The EMS did neither. Nor did it live up to its promise of stabilising exchange rates. Monetary policy can also contribute to macroeconomic stability. But, as often as not, Irish monetary policy during the EMS destabilised the real economy.

Look at the facts. To be sure, inflation has now been tamed but, over the 20-year period of the EMS, Irish inflation was no lower than it had been in the previous two decades under the sterling link (whether on average or in terms of the peak year), and was actually higher than in Britain. By tying our currency loosely to the deutschmark in the EMS, we had hoped to bring inflation down quickly to German levels; it was not to be. During the sterling link years, by contrast, our inflation had been essentially the same as that in Britain.

Damaging too was the fact that, during the EMS, the cost of capital in Irish pounds was persistently higher than in the anchor currency (the D-mark) - 4 per cent higher in nominal terms, 2 per cent after adjusting for exchange rate changes. To the extent that this mainly reflected exchange rate uncertainties, it was not just a transfer from borrower to lender, but a reflection of avoidable macro uncertainty. Once again, the EMS experience was much worse for us in this dimension than the sterling link, which had ensured interest rates very close to those in the UK.

Nor can it be said that exchange rate stability was achieved and maintained even before the narrow band system fell apart in 1993. One indication: a 34 per cent depreciation against the deutschmark, anchor currency of the system, during the two decades - a considerably weaker performance than was achieved by Britain. In both of these dimensions we can now be confident of improvements. Irish inflation and interest rates will be close to those throughout the euro zone. Admittedly, monetary policy will not be geared to stabilising the real economy in Ireland. But things were no better on this front during the EMS. With monetary policy geared primarily to avoiding outflows that would trigger a realignment, Irish interest rates were repeatedly pushed up just when Irish competitiveness was under threat from sterling weakness. Before 1988, almost no attempt was made to stabilise short-term domestic financial conditions through liquidity policy. The highest interest rates and the highest excess returns were during the worst of the recession.

Perhaps little more could have been done by monetary policy alone under the difficult fiscal circumstances of the time, but the message is that our autonomous monetary policy during most of the EMS period has not been a stabilising force.

We should not therefore be fazed by the fact that monetary policy will not be specifically directed to stabilising the Irish macro scene: we lived with such a regime for quite a long time. To be sure, the recent glide-path to entry has seen a deliberate policy of keeping interest rates a bit high to try to dampen the boom; but this was a brief and recent feature, an exception that proves the rule. The fact that interest rates have now tumbled when an increase would, in the current boom, seem more timely, merely illustrates that monetary policy in the future will do no more to stabilise the economy than it did in the past.

It is only fair to note that overall economic performance in the past 20 years owed much to other aspects over which the monetary regime has little influence. Nevertheless, we should have little regret for the passing of this regime. It was far inferior to its predecessor, the sterling link.

What is different is the toughness of the new regime. Look again at the inflation and exchange rate performance of the past: the soft policy of the past is over forever. We cannot be too careful heading into the new regime in our approach to wage setting. The old safety valve of currency softness is just not going to be there to bail us out.

Dr Patrick Honohan is a former research professor at the ESRI and now works for the World Bank.