The Euro and the future of the Irish boom
Samuel Brittan: Dublin 01/12/00

Introduction

A few of you may know the story of the Anglo-Hungarian economist, the late Nicholas Kaldor. It was said that, whenever he visited a country to give advice, his departure was followed by a revolution. Please do not dismiss this as a wicked slur - he put it into circulation himself and was quite proud of it.

I am not so ambitious. I have no hope of triggering a revolution. Nor do I have any wish to tell Ireland or any other country how to run its economy. I leave this sort of thing to the experts from the international organisations, as well as to leader writers on both sides of the Irish Sea. What I can bring is a little perspective (which is what speakers often say to excuse their ignorance) as a friendly observer from the Other Island.

The “Tiger“ in Perspective

Your conference programme asks: how much of Ireland’s recent rapid growth can be attributed to the low interest rates and weak exchange rates that EMU membership has entailed? The short answer is: almost none of it. The growth rate of Irish GDP started to turn up in 1988 and accelerated after 1993. It has lately risen yet again. It exceeded 10 pc in 1997; and after a very slight dip looks like doing so again in 2000. But the acceleration of the last few years is the froth on the top of the boom, which Ireland would be better off without.

I do not want to dampen your spirits; but the growth figures cited give an altogether fantastic impression. In making a few adjustments I draw unashamedly on a paper by Patrick Honohan of the Irish Institute of Economic and Social research. He examines not just the last frenetic few years, but the trend GDP growth rate, which averaged 6.7 per cent per annum over the last decade.

Why is this misleading? As Mr Honohan reminds us, about 15 per cent of total Irish GDP consists of the profits of multinational corporations, which use transfer pricing to boost their Irish profits, because they are subject to low corporation tax, at the expense of profits elsewhere. These profits are not merely large, but are growing as a proportion of GDP.

There is an other source of bias. High tech products, which are important for Irish exports, tend to fall in price relative to other goods; and this leads to deteriorating international terms of trade. If we correct for both the effects of transfer pricing and the terms of trade, the average annual rise in potential living standards over the last ten years goes down from per cent to an estimated 5.4 per cent p.a. (RNDI, Real National Disposable Income), still the highest in Europe.

Even this reduced figure exceeds the rise in productivity. Irish productivity growth (GDP per person) has of course been higher than the recent Euro average of 1 - 1½pc. per cent p.a. But so it should have been. I do not need to remind you that Ireland has been coming up from a much lower starting point. What I did not realise until I studied some OECD figures is that Irish productivity growth of about 4 per cent per annum has not been higher in the last decade than in the 1960s or 70s - although it has been higher than in the depressed first half of the 1980s. The Irish “tiger“ has been running for a very long time. Further corroboration is provided by estimates of total factor productivity, which covers the contribution of capital as well as labour. This too has been little higher in the last ten years than in earlier decades.

The "Employment Miracle"

The standard of living in a country depends not merely on productivity, but on the proportion of the population employed. If there has been a miracle it has been in employment. The working age population has risen relative to the total population for demographic reasons. (The baby boom came later to Ireland than to other countries.) Even more important: the participation rate in the labour force rose; and the effect was further boosted by the dramatic rise in the employment rate among those registered as part of the labour force. Unemployment has come down from one of the highest rates in Europe to one of the lowest - only the Netherlands and Austria are lower still.

In many ways what needs explaining is not the fact of the Irish boom, but its lateness in coming. Real income per head of population was only 50 per cent of the average of OECD countries as recently as 1980; it has only now more or less caught up.

The most widely accepted reason for the Irish growth spurt is of course the large inflow of overseas direct investment, mainly American. Inward investment has average 2pc pa., four fifths of that from the USA. By 1996 foreign owned firms were responsible for 47 pc of manufacturing employment and 66pc of manufacturing exports. But again we need to look further back. Why have both the quantity and the effectiveness of US investment been so high in recent years?

The cliche answer is tax incentives. I have to admit that I am a little sceptical. For if this were the main factor all a country poorer than the United States would have to do would be to tax its own population to bribe American investors to enter, and then receive in return a gain well above the cost. It is really all too easy to be convincing.

From my limited contacts with US investors here, my impression is that the English language, the pleasant natural environment, the ease of contacts with government departments and the relative lack of bureaucracy are in total much more important. To this must be added the availability of a well educated labour force, which was not in fact true in the early post-war decades. Once international investors became convinced that the protectionist and inflationary policies had been jettisoned and there would be an environment of political and economic stability, investment flowed in to take advantage of the low labour costs.

But even then, I doubt if we have the whole story. One clue is provided by an OECD chart: of relative unit labour costs in manufacturing denominated in dollars, which is one approximate measure of the real exchange rate. In the dozen years up till 1998 they had fallen by 60 per cent compared with the UK and by 40 - 50 per cent compared with the euro zone and the rest of the industrial world. This was due to a combination of faster Irish productivity growth, wage moderation and exchange rate movements, most of which took place well before the euro was launched.

A falling real exchange rate was surely a demand side effect. This was more than enough to offset some contractionary impulses from fiscal policy. The overall general government deficit fell from 12 per cent of GNP in the early 1980’s to virtually nothing in recent years. Indeed this elimination of the fiscal deficit was almost certainly a plus factor for inward investment. For it helped to remove a doubt in the minds of foreign businessmen about the stability and sustainability of government finances.

Euro Influences

It is in fiscal policy that we may see an indirect euro effect. The Amsterdam Treaty was signed in the winter of 1991-92. Ever since then Irish governments knew that they had to put their house in order if they were to become members of European Monetary Union. Of course this is not the only reason for fiscal retrenchment; but it certainly played a part.

There are parallel examples. A lot of German financial opinion was against including Italy among the initial members of the union because it thought the country was chronically unstable and deficit prone; and Italian Treasury officials have often told me that their heroic effort to slash the public sector deficit would not have been possible without the incentive of euro membership.

The political background is of course decisive. In both Italy and Ireland the political desirability of a single European currency was taken for granted. The position would have been very different in a euro-sceptic country such as the UK, where any suggestion that public spending was being increased, or that tax rates were higher than they otherwise would have been, for reasons to do with European Union would have produced an outrage if not downright riots.

There is one European aspect which is sometimes overplayed. This is the contribution of European Structural Funds and the Common Agricultural Policy. At their height these funds amounted to 3 or 4 per cent of the national income. But a transfer of resources is not the same as a stimulus to domestic growth. The OECD estimates that on the most generous possible basis, making maximum allowance for indirect effects, transfers from the EU accounted at their greatest for half a percentage point of the Irish growth rate; and as we all know they are coming to an end. Much more importance should be attached to the Single Market programme whioh the OECD estimates to have added 1pc pa to Irish growth since 1992.

Irish "Inflation"

It is no news that the recent blemish on the Irish boom has been the inflation rate - whether we look at the 6.8 per cent from national Irish statistics or the 5.5 per cent from the harmonised EU index. This is the other side of the coin to the undesirably rapid increase in demand in the last couple of years; which has brought not only a faster rise in the published cost of living, but many of the other symptoms of inflation such as soaring property prices, congestion and queues - not to speak of the notorious difficulty of finding a taxi in the Dublin area.

The official line is that the inflation is externally induced. True enough; but what we have to explain is why even on the EU harmonised rates inflation in Ireland is so much higher than in the rest of the euro zone where it is still wellbelow 3 per cent. After all the euro depreciation affects all members of the area.

The main reason lies in the peculiar nature of Irish trade. Trade with countries outside the euro zone accounts for a much higher proportion of both Irish exports and imports than is the case than any other euro member. This above all applies to trade with the UK, which takes one quarter of Irish exports (recently just exceeded by the USA) and supplies one third of Irish imports. Thus the depreciation of the euro has given the Irish economy a much greater stimulus, but also a much bigger inflationary impulse, than it has to other countries.

This can cut both ways. For if either the dollar or sterling were to fall and therefore the euro were to rise, Ireland would receive a much bigger contractionary impulse. This might at first be welcomed as a corrective to recent hyper activity. But it would be much less welcome if it got to the stage of deflation and recession.

It is easy to see that Ireland’s problems would be eased if the UK were to adopt the euro. In that case Ireland would become much more like a normal member of the euro zone, although even then somewhat more exposed to trade from outside the area. But it can hardly be news that, however sympathetic the British government may be, its decision on euro membership will not be based on Irish needs.

The British euro-sceptics are not however waiting for further evidence before proclaiming that the Irish case already provides evidence of the harm done by the euro. They say that, instead of being able to raise interest rates the Irish Central Bank Ireland has had to accept relatively low interest rates designed for a European area which is growing more slowly and which had a good deal of slack in its economy.

At this point, however, one needs to be careful. The difficulty of peripheral regions in living with a centrally determined monetary policy is not confined to the euro zone. The Bank of England governor, Eddie George, has to wear protective clothing when he visits the North of England where he is attacked for maintaining a monetary policy more suited to the booming South East.

The US of course has long been familiar with this dilemma. If there is a local boom in Oregon that state still has to accept a policy drawn up by the Federal Reserve to fit the average needs of the whole of the US. There is an argument for treating the Irish economy, like that of Oregon, as a regional one. Indeed it is tempting to argue that the inflation rate in any currency zone is the rate at which that currency loses purchasing power over the zone as a whole. There cannot be a Scottish or a Texas rate of inflation different from that applying to the UK or the US.

The fundamental role of prices in a market economy is to convey information - e.g. a rising price of oil indicates a supply shortage. One of the biggest drawbacks of inflation is that the information that should be conveyed by changes in relative prices is lost when the measuring rod - that is money - itself depreciates at a fluctuating rate.

But look at long established monetary unions. Is an increase in prices in Oregon a sign of an inflationary disease or is it a relative price change of a fundamentally healthy kind, which attracts labour and capital to Oregon and provides a slight competitive advantage to the rest of the US?

What harm, then, can rising prices do in a euro region such as Ireland?. If Ireland still had an independent currency then that currency would ultimately depreciate. The danger would be of an inflationary spiral in which the exchange rate and the internal value of money follow each other downwards. One benefit of membership of a monetary union is that this spiral cannot develop. For the crucial stage - an exchange depreciation which validates a high rate of domestic inflation - is cut off at source.

Irish Domestic Policy

It is said that Ireland is in a particular policy dilemma because it has no political scope for tightening fiscal policy. But nor have most other regions in long established monetary unions. In fact, although members of existing federations such as the US states or the German la“nder, may have considerable say over public spending; they do not use variations in their budgets as a deliberate measure for smoothing the business cycle. They survive without the fiscal weapon.

Complacency is always dangerous. If wages are bid up and profits squeezed too far in the export sector, then Ireland could indeed become uncompetitive within the eurozone and unemployment return. But how sensible is it to assume that exporters, many of them large multinationals, would be so foolish as to grant pay and price increases which they know cannot be sustained under a regime where devaluation is no longer an option?

Economists in organisations like the IMF and OECD worry that the 1999 Irish budget loosened the fiscal stance (on some estimates by 2 percentage points of GDP.) Under the pay pact with the unions (PPF). the government has promised further tax cuts in the December 2000 Budget in return for pay restraint. So that avenue of demand restriction is closed.

We are left then with the problem of what to do about price increases in the Irish domestic sector. Whether we choose to call them inflationary or not the symptoms are very familiar: rapidly rising land and house prices in Dublin; many kinds of labour being almost impossible to get, and queues and shortages developing. A good many bogus cures are in circulation, most of them no more advanced than those of the Roman emperor Diocletian, who tried to control prices by edict.

There is an unfashionable and unpopular formula, which is to let let economic forces have their way. The normal manner in which a boom was curbed under the gold standard, was that as labour shortages developed, wages rose at the expense of profits and the incentive to invest declined, bringing with it an economic slowdown and an end to inflation. If the Irish pay accord prevents this from happening, then it may have outlived its usefulness. The share of labour incomes in value added has fallen sharply since 1987 and is now probably below its equilibrium value.

A partial safeguard against inflationary overheating in the labour market has been the influx of returning Irish workers - thus tackling inflation by increasing supply to meet the rise in demand. But this safety valve may no longer be sufficient, unless Ireland adopts the fully liberal course of opening its borders to immigrants of any description, unskilled as well as skilled.

Migration Policy

The real question for the Irish economy is not the euro, about which you cannot do much, nor British membership of the euro about which I am also afraid you can also do rather little. It is in the last analysis about population density and migration.

No doubt Irish growth will fluctuate according to the movement of the real exchange rate and the international business cycle over which the Irish authorities have very limited influence. But the longer run trend will depend not on any financial or business cycle variables but on the trend of migration.

It is here that there has been a really dramatic turnround. In the 110 years up to 1991 net emigration from the country was 2.8m persons. As late as the 1950s the annual rate of emigration in net terms amounted to 1½ per cent of the population per annum.

After a false dawn in the 1970s a real reversal began in the mid-1990s. Emigration has fallen drastically and immigration has shot up. This turnround has contributed more than 1¼ percentage points per year of population. At present more than half the immigrants are Irish citizens of an inflow which amounted to 44,000 in gross terms in 1998. The proportion is probably a good deal higher if we were to include immigrants of Irish extraction. But it will not be possible to rely on Irish re-entrants indefinitely. According to a recent academic estimate there are up to 200,000 Irish workers living abroad. Many of them are now of an age where they are unlikely to take work in Ireland whatever dreams they have of retiring to a dream cottage in the west.

Under EU provisions member countries have to accept immigrants from any part of the EU. The likely inflow could increase when the union has enlarged to take in former Communist countries such as Poland and the Baltic states. But if we allow both for likely delays in entry and a transitional period that these countries are likely to have, it will be a full decade before they will have automatic entry into the rest of the EU.

As there is now very little unused domestic labour left and as the productivity trend is unlikely to change very much, growth prospects depend on whether this net immigration will continue and to what extent. If Ireland wants to keep up anything like its recent growth rates it will have to open its gates and actively recruit right outside the EU in the wider world.

Growth by itself is not of course a sensible object of policy. What matters is the change in the standard of living. I cannot promise that an one door immigration policy would bring spectacular results in terms of take home pay for the existing Irish population. There may still be unexploited economies of scale from having a larger economy, but I would not wish to exaggerate here.

The main reason for encouraging immigration is that the population density is still very much less than in other parts of Europe. At 52 a square kilometre it compares with 237 in the UK, 230 in Germany and 107 in the less densely populated France. (Candour compels me to say that the USA is even more underpopulated than Ireland with a population density of only 28 per square kilometre).

A large increase in the Irish population is not an immediately enticing prospect given the congestion in Dublin and the other main Irish growth centres resulting from suppressed inflation. But we need to look beyond the present conjuncture and hope that an infrastructure can be developed which would entice immigrants and domestic residents to the less populated parts of the country.

The present Irish policy, like that of most other European countries, is to recruit immigrants with advanced skills, especially in information technology. This may however be short sighted. One of the few predictions I would venture to make is that in 10 or 20 years there will be throughout Europe a plethora of computer specialists and the like; and the real shortages will be in the traditional service trades: carpenters, home helps, plumbers, nurses, and so on.

Ireland is better placed than most other EU countries to follow an open door policy in line with the words on the American Statue of Liberty:-

Give me your tired, your poor,
Your huddled masses yearning to breath free,
The wretched refuse of your teeming shore.
Send these, the homeless, tempest-tossed to me,
I lift my lamp beside the golden door!

In saying this I am departing from my own attempt to avoid giving policy advice. But if there is a country which can afford to depart from the mean spirited attitude of most country to refugees and the so called non-economic immigrants it is Ireland.

I do not come from a country which is in any position to preach. But as a human being I cannot avoid this observation even at a specialist financial conference.