OPINION:Irish fiscal policy needs to counter the 'one-size-fits-all' side effects of European Central Bank interest rate policy, writes Michael O'Sullivan.
THURSDAY'S EUROPEAN Central Bank (ECB) meeting will most likely deliver a historically large 50 basis point cut in euro zone interest rates, taking some pressure off Irish households, who are far more indebted than the average European household.
At the best of times, the workings of monetary policy are arcane, though these days the man in the street is more aware than ever of indicators such as TED spreads (the difference between short-term, three-month US government debt and the three-month eurodollars contract as represented by the London Interbank Offered Rate), fed fund futures and bond curves.
Above all, as the nearly daily cavalry charges of central banks such as the US Federal Reserve and the ECB into the money markets show, monetary policy is currently crucial to our economic wellbeing.
However, Ireland is something of a misnomer here. When 10 years ago many commentators referred to the US as the Goldilocks economy, because like the porridge in the children's fable it was neither too hot nor too cold (in other words, it enjoyed a combination of healthy growth and surprisingly modest inflation), they could apply the same analogy to our own economy, but in an inverse way.
More specifically, in the past six years at least, our economy has been too hot (growth and especially inflation have been too high), and now with the deepening of the credit crisis it is approaching "too cold" territory in that a couple of years of contraction lie ahead.
One of a number of reasons we have lurched from fairytale economy to scare story is the level of our interest rates. For Ireland, the reality is that monetary policy is controlled from Frankfurt rather than Dublin and from the perspective of the European Central Bank, Ireland is little more than an interesting statistical outlier, or at best a lead indicator of the vibrancy of the European economy.
The ECB is much more focused on the issues facing the broad euro zone, which are driven by larger economies such as Germany and France. As a result the level of interest rates in the euro zone may be inappropriate for smaller countries such as Ireland. In particular, interest rates were most likely too low for Ireland in the period 1999 to 2004, and too high in 2007 to August 2008.
As a result, inflation was too high in the former period, and growth too weak in the latter.
If, like our neighbours in the UK (whose economy has many of the same structural issues as Ireland, such as high mortgage debt) we had an independent central bank, then interest rates in the early part of this decade would likely have been much higher than they were, and would most likely have fallen a lot more quickly from the beginning of this year. Of course, some recklessly generous budgets over the past six years, easy credit from the banks and property speculation have all made the above situations worse.
This is not an argument for Ireland to leave the euro zone. As the examples of countries on the periphery of the euro zone such as Iceland and Hungary currently show, the fortress-like qualities of the single currency are to be valued. Rather it is a call for more innovative and sophisticated economic policy making in Ireland.
The simple fact is that euro zone monetary policy exerts a very big influence on our economy, and we need to find inventive ways of balancing its sometimes inappropriate side effects. At a time when world governments are sitting down to reshape the global financial system, Ireland has some financial engineering of its own to do.
In more detail, fiscal or microeconomic policy needs to offset the effects of euro zone interest rates. When these are too high, fiscal policy and regulation need to dampen down its effects, such as slowing the flow of credit in the economy, or reining in specific economic activities where growth is simply too high. It is easy to say so with hindsight but such an approach could well have halted the bubble in the property and construction sectors.
On the other hand, when interest rates are prohibitively high, tax and export credits, labour market incentives and capital market development are just some of the measures that can re-invigorate growth in certain areas of the economy.
This approach is new and complex, and has relatively few precedents. One could point to the individual states and municipal authorities across the US though their situation is nothing as complicated as some of the smaller euro zone nations. At the same time, countries on the periphery of the euro zone such as the Baltic States, or the Gulf States who themselves are planning a currency union, could have much to learn from such an approach.
In practical terms, this kind of programme would be run jointly by the Central Bank and the Department of Finance, with, say, the Central Bank having some formal role in indicating whether euro-zone interest rates are too "hot" or "cold" for the Irish economy, and the Department of Finance, or other independent, transparent body recommending specific microeconomic policy actions. This might also take some of the politics out of policymaking, though this is an entirely different problem, and well beyond the scope of this article.
The basic goal here is to avoid a boom-bust type economic cycle and to foster a more stable economic profile under which organic service and industrial sector growth can stem. A necessary condition of putting a plan like this into action is that Ireland have complete freedom over fiscal measures such as corporate taxes, and not less as some of its euro zone neighbours would prefer. Loss of monetary independence has created its own problems, and loss of fiscal policy would make these a lot worse.
The credit crisis should provide the motivation and the opportunity for Ireland's politicians and policymakers to thoroughly address all of the faultlines underlying our economy, and to take clever and decisive action to upgrade our range of policy options.
The pre-eminent historian of modern Ireland, Joe Lee, wrote that "small states must rely heavily on the quality of their strategic thinking to counter their vulnerability to international influences" and this essentially is what Ireland's policymakers need to do now with economic policy if they wish to get back on the path to steady economic growth.
• Michael O'Sullivan is the author of Ireland and the Global Question(Cork University Press, 2006)