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