Into the mystic with EMU


It is more than four years now since we described the Irish economy as a Celtic Tiger. Alas, we didn't take copyright. During this period Irish GDP has probably grown in real terms by more than two-fifths, a compound rate of roughly 9 per cent a year, almost four times faster than its European Union partners. This pace, if sustained, would make Ireland the world's most prosperous country, on a per capita basis, in about seven years' time.

It is easy to generate faster growth, at least for a while, at the expense of higher inflation. But so far Irish inflation has been remarkably well-behaved. Since 1994 each percentage point of growth in Ireland has been accompanied by just one-quarter as much inflation as in the rest of the EU. This is a spectacular performance by any standards.

Meanwhile, Ireland's external and budget balances remain in good shape: headline and underlying accounts are sound. Fiscal policy in particular looks more prudent than it did, with Mr McCreevy eschewing a more dramatic Budget last month, to target instead a continuing substantial budget surplus and a debt ratio which is little more than half its levels of a decade ago.

If the Celtic Tiger analogy was at all misplaced, it will have been only because the role model slipped. The original Asian Tigers have faltered recently and some, in retrospect, seem to have been enjoying little more than an old-fashioned, deficit-fuelled inflationary boom.

Of course, the speed with which the Asian success story has come to grief warns even now against hubris. We noted at the beginning of 1998 how the euphoria enveloping Dublin was obscuring significant risks; and despite last year's sparkling performance, our fears are not completely assuaged. Ireland's economy is entering unknown territory as it joins the single currency.

Inflation in Ireland is being flattered, as it is across the western world, by low commodity prices and cheap imports. Most recently, of course, it has also been restrained by falling mortgage rates. But with industrial pay growth running at more than 6 per cent, and with unemployment dipping to its lowest levels in a generation (and at the fastest pace on record), some inflation risk remains, recent performance notwithstanding. And within the single currency, inflation might become a problem at lower levels than in the past.

Ireland's small size means that the European Central Bank is extremely unlikely to raise interest rates to tackle a unilateral rise in Irish inflation. With interest rates pegged at low levels, savers could see their real returns wiped out by a relatively small acceleration in prices. And pensioners' incomes could also be eroded.

The architects of EMU note that a country with an inflation problem will lose competitiveness. This will act as an automatic stabiliser, pulling inflation back down into line as order books shrink and growth slows.

But this adjustment mechanism could take many years to be effective. In the meantime, the government might have to stand ready to help spread any pain more evenly.

Nor is there any guarantee that the current boom will continue through 1999: indeed, it is quite possible that the cyclical risks ahead include not just a revived inflation threat but also a sharp slowdown in growth. One obvious danger here is the likely near-stagnation in Ireland's biggest export market - British manufacturers and retailers have too many unsold stocks sitting on their shelves for comfort, and the New Year is likely to see them cut orders to suppliers sharply.

Some of this year's fizz must surely fade.

And there are cyclical risks closer to home. With mortgage rates and taxes tumbling, and property prices still flying, domestic business prospects look superficially solid. But there is much new supply coming onto the market; and expectations are high. After a borrowing binge on the scale seen recently, any shortfall in cashflow could cause serious problems, low interest rates notwithstanding. Booms rarely end smoothly.

If Irish growth does falter, the warm embrace of a one-size-fits-all monetary policy may start to feel like a straitjacket. Outside EMU, interest rates would be free not only to rise to tackle an inflation threat, but also, if necessary, to fall in order to avert a recession. Within EMU such flexibility is missing.

At the London-based Centre for Economic Policy Research, Prof Willem Buiter has suggested in another context that these circumstances are what God made fiscal policy for. However, while Ireland's accounts are in good shape, fiscal forecasts are no more infallible than any others. And taxes and public spending are not such nimble tools as the textbooks suggest, and can damage the long-term business climate if not used sensitively.

Beyond the business cycle two structural issues need to be watched carefully. First is the continuing lack of an infrastructure adequate to Ireland's rapidly-growing needs, even after Mr McCreevy's welcome new plans. Secondly, and perhaps more subtly, Irish policy makers will have to guard against political Continental drift.

IRELAND'S success has owed a great deal to the deliberate creation of a business-friendly culture, to a plentiful supply of educated workers, and most visibly to low taxation. Ireland's effective tax rate is estimated by the OECD at 36 per cent of GDP, the lowest in both the EMU zone and the EU as a whole (which has an average rate of 45 per cent).

However, the single currency must eventually lead to some form of panEuropean federation, however loose; and as this political union develops, Ireland will have to guard against bigger and more bureaucratic government, and against increasinglydetermined attempts to harmonise taxation (upwards). The UK government has recently been drawing solace from the fact that EU-wide tax policies can be subject to national veto. But at the informal euro-11 level, Ireland's partners can do what they want, and the potential peer group pressure which could be exerted might yet dent Irish resolve.

Faced with an EMU bloc in which 10 countries levied an average harmonised corporate tax rate of (say) 30 per cent across 99 per cent of the bloc's economic activity, and in which the 11th, Ireland, levied a tax rate of 12.5 per cent across just 1 per cent of the market, would a potential investor think taxes in the 10 were about to drop to 12.5 per cent, or that the 12.5 per cent would soon become 30 per cent?

This listing of potential economic dangers might read rather worryingly. Mr McCreevy and his successors will have to be alert, not just to the obvious cyclical risks, but also to the more subtle distributional and political dimensions of life within EMU. But I remain optimistic that Ireland's economic transformation will continue.

Who knows? Maybe in 10 years' time, an economist in the Far East, searching at the last minute for a title for his report on a reviving Hong Kong economy, could do worse than call it an Asian Ireland.

Kevin Gardiner is a senior economist at Morgan Stanley in London: he is writing in a personal capacity.

Tomorrow: Can the boom continue? John FitzGerald of the Economic and Social Research Institute.