Conditions even better for joining EMU at the start

With the announcement of initial EMU participants and bilateral entry rates in early May, the economic environment for all EU countries will be significantly changed. The status quo of recent years, based on a shifting assessment of probabilities concerning participation and entry rates, will disappear. Countries will be either in, like Ireland, or out, like the UK, Denmark and Greece.

Although uncertainty will persist about whether or when the out countries will choose or be able to join, the initial division will be clear-cut and will have consequences which are, to a considerable extent, predictable.

Since the project was first mooted, it has always been obvious that for a small peripheral country such as Ireland there would be risks in either inclusion or exclusion from EMU. When we assessed these conflicting risks in the ESRI study on Ireland and EMU in 1996, we concluded that there would be a modest quantifiable benefit to Ireland in joining the first wave of EMU, even if the UK remained outside.

Naturally, conditions have changed substantially in the 18 months or so since we published our report so, with formal entry approaching, it is worth recording the balance of risks to see if our conclusions still hold good.

The Risks of Entry

The main risks attached to entering EMU are the interlinked dangers of a serious loss of competitiveness and the reduction in the policy options to deal with such problems. So far as the risk of a domestically-generated loss of competitiveness through excessive pay settlements is concerned, there has been little fundamental change since mid-1996.

Pay increases may have accelerated slightly in response to the tighter labour market, but our basic finding that pay is reasonably responsive to changing conditions appears to remain valid.

With regard to external shocks to competitiveness, the risks now are palpably lower than in 1996. With the Mediterranean countries other than Greece now likely to be EMU participants, the concern about competitive depreciations of the lira or peseta affecting some Irish firms in their continental markets have receded.

Sterling, of course, will remain outside EMU initially, but the potential danger of this has diminished substantially. In the first place, the massive appreciation of sterling means we are now talking of a possible depreciation from around 0.84 sterling to the Irish pound, rather than from around 1.03 sterling to the Irish pound in 1996.

More fundamentally, the change of UK government has resulted in a policy shift in relation to EMU so that an absence of extreme sterling volatility has become a necessary element in keeping open the possibility of UK entry after the next UK election. Meanwhile, the handing of responsibility for setting interest rates to the Monetary Policy Committee of the Bank of England is an important step in reducing the likelihood of a severe sterling depreciation.

It remains true that entry to EMU will reduce the policy options of the Irish Government in response to internal or external shocks. There is no change from the obvious assumptions made in 1996 that currency and monetary options will effectively disappear.

With regard to fiscal policy, the room for manoeuvre has increased significantly with the further strengthening of the public finances since mid-1996. A deterioration of over £1,500 million in the general Government deficit, equivalent to roughly 10 per cent of tax revenue, would have to take place before the constraints of the Stability and Growth Pact would apply. Thus, the danger, which was remote even in 1996, that the Government could be left without effective fiscal options, has receded even further.

Finally, while the dangers of a possible loss of competitiveness and the curtailment of policy instruments have slackened, the employment consequences of any such shock have also diminished. Structural changes in the past 18 months have increased employment in the modern dynamic sectors of the economy, while employment in the firms and sectors recognised as vulnerable has tended to decline, for reasons unconnected with sterling competitiveness.

At the same time, rapid economic growth has improved the prospects of re-employment in the buoyant service sector for any workers who may lose their jobs in the vulnerable sectors of the economy.

The Risks of Remaining Out

Turning to the conflicting risks that would be inherent in not participating in the initial stage of EMU, there has been no equivalent diminution of the dangers. The virtual certainty that a lack of credibility in an independent Irish monetary and currency policy would be penalised by a significant interest rate premium has not changed since 1996.

The size of this penalty in the medium term remains uncertain, but there has been no evidence to suggest that it would be lower than the one percentage point assumed in our study. Thus, the adverse long-term consequences for the public finances and the domestic business environment remain unchanged.

Similarly, there has been little alteration in the additional transaction costs which would be entailed by a staying out of EMU, although the probable entry of more countries than had been assumed would marginally increase the costs compared to being in EMU.

Although we did not quantify the risks to the flow of foreign direct investment from remaining out of EMU, we did point out that they could be significant. With the increased inflow of such investment since 1996, and with explicit statements by potential investors that its decision to remain out could jeopardise the future flow of direct investment into the UK, it now appears that the risk to either existing or new foreign investment if Ireland were not in EMU could be substantially greater than we assumed.

The Balance of Advantage

In summary, the risks attached to EMU entry have diminished significantly since mid-1996, while some of the risks that would be faced had Ireland opted to delay entry to EMU have tended to increase. With hindsight, it appears that our 1996 assessment underestimated the advantages of initial entry. The balance of risks now seems to confer a clear-cut and substantial benefit to Ireland from the decision to join EMU at its outset.

Terry Baker is a senior economist with the ESRI

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