Honohan defends pro single currency stance of ESRI against sceptics' attacks

 

THERE was standing room only at the eagerly awaited debate on the merits of entering monetary union, which was the centrepiece of the weekend Kenmare Economic Policy Conference. In one corner were the economists from the Economic and Social Research Institute, whose recent study had backed EMU membership; in the other were the sceptical stockbroker economists and some academics.

All the speakers made their cases strongly but, while a few punches where thrown, the fight never really ignited. On many of the major issues the antagonists basically agreed with one another, while differing on where the balance of advantage lay for Ireland. However, it did focus the minds of delegates on the pivotal role sterling plays in our economy and on the challenges facing Ireland in preparing for EMU.

Prof Peter Neary and Prof Rodney Thom, both of UCD, presented a theoretical expose of the pros and cons of Ireland joining monetary union. The central thesis of their argument was that Ireland did not "fit" in a currency union with France and Germany.

The characteristics and trading patterns of the economy did not make it a natural fit with the core continental European members of monetary union, the economists argued. They also took issue with the ESRI's analysis that the benefits of lower interest rates still left it in Ireland's interest to join the EMU even if sterling stayed out, despite the job losses which might result from sterling weakness.

The two economists warned that unless the Irish jobs market became much more flexible, joining EMU without Britain would expose Ireland to risks from temporary but possibly severe bouts of sterling weakness.

They argued in their paper that the ESRI "underestimates the likely costs of a severe depreciation of sterling" and overestimates the gains from lower interest rates.

The key conclusion of the ESRI was that if Britain stayed out, lower interest rates in Ireland would provide a significant enough benefit to outweigh any potential costs from sterling volatility.

The ESRI economists presented a review of their paper on the benefits of joining the single currency, the euro, in which they defended its main conclusion. On balance, according to Prof Patrick Honohan of the institute, Ireland was better off entering monetary union. At the end of the day there were not sufficient economic negatives to outweigh the political advantages of joining, Prof Honohan suggested, pointing to the strong political momentum now behind the single currency.

It was also futile to hanker after a sterling link, he said, as it was not in practice available, unless Britain joined monetary union.

Joining a monetary union with a small group of countries accounting for only a quarter of our trade might not appear an obvious choice, he said. But the choice must be seen in its "unique" institutional and political context. It should be evaluated not against some hypothetical but unobtainable regime, but against the limited range of practical alternatives available.

He said that the next best alternative to joining monetary union would be for Ireland to join an ERM II mechanism which would require the currency to trade in a broad range against the euro. This would work if Britain were to enter monetary union within a few years. But it was a relatively unattractive option, and could be more badly affected by domestic policy errors than would membership of EMU, Prof Honohan said.

Mr Jim O'Leary, chief economist at Davy Stockbrokers, took issue with one of the central planks of the ESRI's analysis. According to the institute, lower interest rates would be one of the principal benefits for Ireland in joining EMU.

However, Mr O'Leary insisted that membership of monetary union would expose Ireland in an "unprecedented way" to the risk of sterling volatility. Also, membership of EMU would almost certainly mean the inflation rate would be more volatile than otherwise, as the authorities would have lost control over the key variable of interest rates.

The Irish economy would continue to be affected by sterling volatility, which would have a key impact on the inflation rate, he argued. But with interest rates set centrally in Europe, real interest rates - interest rates adjusted for inflation - could be extremely volatile and lead to great difficulties in economic management and the danger of "boom and bust" cycles.

He also took issue with the ESRI conclusion that not joining EMU could limit foreign investment into Ireland.

While policy makers from the Department of Finance and the Central Bank were represented at the conference, it remains to be seen whether the views expressed will have any impact on official thinking.

With the Government and the Central Bank doing everything possible to qualify for the single currency, the sceptical voices from Ken mare will not be welcomed and the ESRI's conclusions are likely to be the ones on which policy makers will continue to rely to support their case for membership.