[email protected] – the Irish Experience

EMU at 10: The Irish Experience

May 2008 marks the tenth anniversary of the decision to move to the third and final stage of EMU, with the list of member countries finalised and a commitment to launch the euro on January 1st 1999. This has been marked by the European Commission with the publication of a major report, ‘[email protected] – Successes and Challenges After Ten Years of Economic and Monetary Union’.

Accordingly, it is timely to evaluate the performance of the European Monetary Union, especially in relation to its impact on the Irish economy. A further motivation is the current round of national pay talks, since the macroeconomic impact of domestic wage increases can only be understood in the context of membership of the currency union. At the area wide level, the ECB can be awarded high marks for the successful launch of the euro and conduct of monetary policy over the last decade. The ECB has had to deal with a succession of major shocks – the collapse of the tech bubble in 2000; international recession and the 9/11 disturbance in 2001; wide and persistent fluctuations in the euro-dollar exchange rate; the rise of China as a major economic force; the sharp increases in energy, commodity and food prices; and the international financial turmoil that has persisted since Summer 2007. In spite of these shocks and some wobbles in its communications strategy, it has successfully delivered considerable monetary stability for the euro area. Moreover, it cannot be accused of being excessively hawkish – inflation has been above its 2 percent target for most of this period. In terms of the impact of the euro on Ireland, EMU has represented a much bigger structural change for the ‘peripheral’ members of the euro area than for countries such as Germany, the Netherlands and Belgium that already had a long history of low interest rates and bilateral exchange rate stability. The replacement of illiquid domestic-currency financial markets by a broad and deep euro-denominated system that was backed by a European central bank with a strong and credible commitment to medium-term price stability led to a structural decline in interest rates. In turn, this transformed the financial possibilities for many firms and households, prompting a credit boom. By tapping the European money markets, Irish banks were able to vastly increase the scale of lending to domestic residents without taking on foreign currency risk. The most visible impact has been the attendant construction boom and run up in property values. A second factor that has made Ireland an atypical member of the monetary union is that its strongest trade linkages are with the United Kingdom and the United States. For this reason, the sharp movements in the euro-dollar rate have had a greater impact on the Irish economy (and Irish inflation) than on the euro area as a whole. Similarly, the substantial depreciation of Sterling in recent months has comparatively little relevance for the aggregate euro area but represents a significant macroeconomic shock for the Irish economy. The strong growth of the Irish economy and the large movements in our trade-weighted exchange rate help to explain why Irish inflation has typically been higher than the average for the euro area. It is understandable that this track record of high inflation now influences expectations about the level of wage growth that is required to maintain living standards. However, membership of a monetary union means that wage moderation is the main mechanism to ensure that adverse macroeconomic developments (contraction in the construction sector, appreciation against the dollar and Sterling) do not trigger a prolonged period of under-performance. Since the ECB is concerned only with the area-wide aggregate macroeconomic environment, a local slowdown in Ireland will not trigger a reduction in interest rates (in contrast to the aggressive Fed response to the risk of recession in the United States). Moreover, excessive domestic wage growth cannot be undone through currency devaluation. The experience of other member countries (most notably Portugal) is that restoring economic health to an economy in which relative wage levels have grown too high can involve a prolonged period of below-trend growth. Accordingly, it is far more desirable to avoid the onset of a slump through a judicious period of wage moderation. Indeed, this is the lesson of Ireland’s own macroeconomic history. After all, Ireland was in an effective monetary union with the United Kingdom until 1979 and the attempts during the 1970s to maintain rapid wage growth despite a deteriorating external environment sowed the seeds for a lost decade of macroeconomic stagnation. In the same vein, the appropriate fiscal response to the slowdown is also clear. In particular, it is difficult to justify much increase in the baseline level of public sector pay during a period in which private-sector workers face an increased risk of unemployment. In contrast, maintaining a vigorous public capital programme (conditional on a rigorous appraisal of the quality of investment projects) is important in ensuring that a high rate of medium-term productivity growth and improvements in the quality of life can be attained. While this diagnosis has also been outlined in government policy statements, it is important to ensure that it is implemented through the negotiation of the new social partnership agreement. Finally, the incoming taoiseach has outlined a strong commitment to improving the effectiveness of public service delivery, with the recent OECD report providing a number of suggestions as to how public sector reform might proceed. Accordingly, the current social partnership talks provides an ideal opportunity to secure agreement for comprehensive public sector reform – with public sector pay increases tied to the verified implementation of changed work practices and improved productivity. This is entirely in the spirit of Economic and Monetary Union, in which the monetary discipline provided by the ECB allows the government and the social partners to focus on the long-term drivers of productivity growth.

A version of this post was published in the Sunday Business Post on May 18th 2008: See

http://www.sbpost.ie/post/pages/p/story.aspx-qqqt=MARKETS-qqqm=nav-qqqid=32904-qqqx=1.asp

8 Responses to "[email protected] – the Irish Experience"

  1. koteli   May 19, 2008 at 8:53 pm

    Trying to make it more readable:May 2008 marks the tenth anniversary of the decision to move to the third and final stage of the Economic Monetary Union (EMU), when the list of member countries was finalised and a commitment was made to launch the euro on January 1,1999.This has been marked by the European Commission with the publication of a major report, ‘[email protected] – Successes and Challenges After Ten Years of Economic and Monetary Union’. Accordingly, it is timely to evaluate the performance of the EMU, especially in relation to its impact on the Irish economy. A further motivation is the current round of national pay talks, since the macroeconomic impact of domestic wage increases can only be understood in the context of membership of the currency union.At the area-wide level, the European Central Bank (ECB) can be awarded high marks for the successful launch of the euro and conduct of monetary policy over the last decade. It has had to deal with a succession of major shocks: the collapse of the tech bubble in 2000; international recession and the disturbance following the events of September 11, 2001; persistent fluctuations in the euro-dollar exchange rate; the rise of China as a major economic force; the sharp increases in energy, commodity and food prices; and the international financial turmoil that has persisted since the summer of 2007.In spite of these shocks, and some wobbles in its communications strategy, it has successfully delivered considerable monetary stability for the euro area. Moreover, it cannot be accused of being excessively hawkish – inflation has been above its 2 per cent target for most of this period.In terms of the impact of the euro on Ireland, the EMU has represented a much bigger structural change for the peripheral members of the euro area than for countries such as Germany, the Netherlands and Belgium, which already had a long history of low interest rates and bilateral exchange rate stability.The replacement of illiquid domestic-currency financial markets, by a broad and deep euro-denominated system that was backed by a European central bank with a strong and credible commitment to medium-term price stability, led to a structural decline in interest rates.In turn, this transformed the financial possibilities for many firms and households, prompting a credit boom. By tapping the European money markets, Irish banks were able to vastly increase the scale of lending to domestic residents, without taking on foreign currency risk. The most visible impact has been the attendant construction boom and run-up in property values.A second factor that has made Ireland an atypical member of the monetary union is that its strongest trade linkages are with Britain and the US. For this reason, the sharp movements in the euro-dollar rate have had a greater impact on the Irish economy (and Irish inflation) than on the euro area as a whole.Similarly, the substantial depreciation of sterling in recent months has comparatively little relevance for the aggregate euro area, but represents a significant macroeconomic shock for the Irish economy. The strong growth of the Irish economy and the large movements in our trade-weighted exchange rate help to explain why Irish inflation has typically been higher than the average for the euro area. It is understandable that this track record of high inflation now influences expectations about the wage growth required to maintain living standards.However, membership of a monetary union means wage moderation is the main mechanism to ensure adverse macroeconomic developments (contraction in the construction sector, appreciation against the dollar and sterling) do not trigger a prolonged period of under-performance.Since the ECB is concerned only with the area-wide aggregate macroeconomic environment, a local slowdown in Ireland will not trigger a reduction in interest rates (in contrast with the aggressive Fed response to the risk of recession in the US).It is eminently desirable to avoid the onset of a slump, through a judicious period of wage moderation. Indeed, this is the lesson of Ireland’s own macroeconomic history. After all, Ireland was in an effective monetary union with Britain until 1979, and the attempts during the 1970s to maintain rapid wage growth, despite a deteriorating external environment, sowed the seeds for a lost decade of macroeconomic stagnation.In the same vein, the appropriate fiscal response to the slowdown is also clear. In particular, it is difficult to justify much increase in the baseline level of public-sector pay, during a period in which private sector workers face an increased risk of unemployment.In contrast, maintaining a vigorous public capital programme (conditional on a rigorous appraisal of the quality of investment projects) is important, in ensuring that a high rate of medium-term productivity, growth and improvements in the quality of life can be attained.While this diagnosis has also been outlined in government policy statements, it is important to ensure that it is implemented through the negotiation of the new social partnership agreement.The social partnership talks provide an ideal opportunity to secure agreement for comprehensive public-sector reform – with public sector pay increases tied to the verified implementation of changed work practices and improved productivity.This is entirely in the spirit of the EMU, in which the monetary discipline provided by the ECB allows the government and the social partners to focus on the long-term drivers of productivity growth.Philip Lane is professor of international macroeconomics at Trinity College Dublin

  2. koteli   May 19, 2008 at 9:14 pm

    On the other hand, I don’t why “membership of a monetary union means wage moderation is the main mechanism to ensure adverse macroeconomic developments (contraction in the construction sector, appreciation against the dollar and sterling) do not trigger a prolonged period of under-performance.”Membership to wage moderation? Or better distribution of incomes?Oh yeah, “the appropriate fiscal response to the slowdown is also clear. In particular, it is difficult to justify much increase in the baseline level of public-sector pay, during a period in which private sector workers face an increased risk of unemployment.”After lots of money and help from outside, incredible GDP growth and an enormous housing bubble, growing inequality and eye-shocking differences between downtown Dublin and neighbourhoods, we need monitoring public sector pays and wage moderation.Dear Philip,Read, please, Fantasy Island, by Larry Elliott and Dan Atkinson.A good review here:http://books.guardian.co.uk/extracts/story/0,,2082838,00.htmlPS: Day after day, I think that the only way for economists speaking their mind is the real opening of free-market capitalism to foreign economists. Dean Baker is right! But too late.Best wishes!

  3. eparisi   May 19, 2008 at 10:34 pm

    Nice post. Where do you see EMU in 10 years? And Ireland?

  4. Guest   May 20, 2008 at 1:21 am

    Ireland is at the cutting edge of the call-centre economy & the best producer of GUINNESS DRAUGHT!

  5. Guest   May 20, 2008 at 1:27 am

    Wow!To eparisi,Where do you see USA in 10 years?Exporting debt to Mars, maybe?

  6. eparisi   May 20, 2008 at 9:09 am

    I see the U.S. making a fresh start, but I don’t know the Irish economy.

  7. Guest   May 20, 2008 at 8:05 pm

    Neither I do, but would you ask this same question to Nouriel?Today, I received here in Europe a T-Shirt of Obama from a friend in Boston. A nice T-Shirt with good design…My nephew is working in Dublin, shocked by prices and differences between downtown and neighbourhoods…I’ve been told that lots of americans get divorced twice in 10 years…I got it, Martians are economists!