A hot time for the emerald isle
Samuel Brittan: Financial Times 26/10/00

The Republic of Ireland’s experience of inflation is not yet a conclusive argument against 'one size fits all’ monetary policy

The experience of Ireland will provide hard evidence on the economic case for Britain’s adopting the euro.

The Irish economy is, in many ways, more like the British economy than that of continental Europe. A large proportion of its trade is with the UK. Its business cycle is more in line with the US and British than the continental one. In addition, its financial institutions are closer to the Anglo-American than to the Rhineland model.

It does, however, have a labour market subject to a corporatist-type incomes policy with the New Labourish title of the Programme for Prosperity and Fairness (PPF).

The eurosceptics are not waiting for further evidence before proclaiming that Ireland already provides a case against the euro. Irish inflation, at 6 per cent, is more than twice that of the euro-zone. But instead of being able to raise interest rates, the Irish Central Bank has had to accept relatively low rates designed for a European area that is growing more slowly and has had a good deal of slack. 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. Eddie George, governor of the Bank of England, 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.

If there is a boom in Oregon, that state still has to accept a Federal Reserve policy designed to fit the whole of the US. Indeed, it is tempting to argue that the inflation rate in a monetary union is the rate at which that currency loses purchasing power over the whole zone. There cannot be a Scottish or a Texan rate of inflation different from that for the UK or the US.

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

The fundamental role of prices in a market economy is to convey information - eg, a rising price of oil indicates supply shortage. A drawback 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.

It helps to look at the US. 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 capital to Oregon and provides a slight competitive advantage to the rest of the US?

Some economists argue that Ireland is in a particular bind because it has no political scope for tightening fiscal policy, for under the PPF the government has promised further tax cuts in return for pay restraint. Enthusiasts for fiscal fine-tuning are often enthusiasts for incomes policies as well; and here the two enthusiasms get in each other’s way. But that is hardly the fault of the euro. In fact, members of existing federations, such as the US states or the German Länder, do not use variations in their budgets as a deliberate measure for smoothing the business cycle. They survive without the fiscal weapon.

Ireland’s problems are those of prosperity.

The commonly cited 10 per cent growth rate is misleading, as international companies use transfer prices to take their profits in Ireland, which has a low rate of corporation tax. But, even at 6 or 8 per cent, the growth rate is the highest in Europe.

Ireland was a backward economy until a decade or two ago. But once international investors became convinced that the protectionist and inflationary policies of the De Valera regime had been jettisoned and there would be a stable business environment, investment flowed in to take advantage of the low labour costs.

A previously backward country can, of course, achieve a higher rate of productivity growth than its neighbours because it is catching up with best practice elsewhere. But the labour market is not divided into rigid segments. Wages that reflect productivity growth in the traded sector influence wages and prices in sheltered domestic sectors, where the opportunity for productivity growth is less.

Thus a country such as Ireland can have an “inflation rate” higher than its main trading partners without becoming uncompetitive.

Why worry then? An argument against benign neglect is that in a rapidly growing and overheated economy, credit will soar and demand be stimulated by far more than can be justified by differential productivity gains. If profits are squeezed in the export sector, Ireland could indeed become uncompetitive within the euro-zone. But to say this assumes that exporters, many of them large multinationals, would be so foolish as to grant pay and price increases that they know cannot be sustained under a regime where devaluation is no longer an option.

To the extent that overshooting of pay and prices nevertheless develops in the traded sector, the British eurosceptics would have won a point. To the extent that it does not do so, euro supporters will have the advantage.

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 familiar: rapidly rising land and house prices in Dublin; waiting lists and labour 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.

Until recently the main safety valve against inflationary overheating was 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. And even a liberal could query the overspill costs of adding further to congestion and land hunger.

There is an unfashionable and unpopular formula, which is to let let economic forces have their sway. The normal way 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, it may have outlived its usefulness.