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Booming Ireland puts euro policy to the test

Early test of the one-size-fits-all approach provides fodder for the eurosceptics, who warn of what could happen in the UK

Diane Coyle,Philip Thornton
Sunday 18 June 2000 19:00 EDT
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Walk down a high street in the Irish Republic and the evidence of an overheating economy is all around. The shops are packed, the skyline is dotted with cranes and other signs of booming construction and house prices are soaring. As one economist puts it: "Ireland is an Asian tiger on the wrong side on the planet."

Walk down a high street in the Irish Republic and the evidence of an overheating economy is all around. The shops are packed, the skyline is dotted with cranes and other signs of booming construction and house prices are soaring. As one economist puts it: "Ireland is an Asian tiger on the wrong side on the planet."

Although Irish growth is in a different league, the economy has some similarities to its next door island, the United Kingdom, which is also experiencing a consumer boom and resurgent housing market.

But one key difference is Ireland's membership of the European single currency. Its interest rates are now set by the European Central Bank in Frankfurt.

Even after the recent rise to 4.25 per cent, this is far lower than needed to cool the booming Irish economy, making this the first real test of one-size-fits-all monetary policy in the single currency - a test of particular relevance to the UK as the temperature rises in the single currency debate. By contrast, interest rates have risen to 6.0 per cent in the UK.

And Ireland is paying the price in higher inflation. Retail prices are now rising at 5.2 per cent a year - the fastest for 15 years and the highest amongst the 11 eurozone countries. In fact, inflation is three times the EU's 1.7 per cent average and compares with 0.5 per cent in the UK. Charles Dumas, an economist at Lombard Street Research, said: "Ireland is like a laboratory experiment in testing the limits of unsound policy."

Ireland's jobless rate fell to 4.6 per cent in May, its lowest for 18 years and in stark contrast to the continuing large levels of unemployment across continental Europe. This has inevitably created dire shortages of skilled workers, allowing average wages and bonuses to be bid up, adding to inflation.

Meanwhile, house prices are rising at around 20 per cent year, as low mortgage rates have combined with a strong labour market and a demographic boom. A recent study forecast prices would grow 60 per cent in the next four years.

The inflationary pressure partly reflects the fact that Ireland simply went into the single currency with higher inflation and stronger growth than most of the other ten.

"Ireland was not convergent in the sense that the other members were, and they went in with their eyes open," according to Alison Cottrell, chief economist at Paine Webber. "The economy was out of synch with the others, but it was seen as worth joining for the longer term benefits."

The country also has strong links to the UK economy. With 25 per cent of its exports going to the UK and 35 per cent of its imports coming from its neighbour before monetary union, the fall of nearly one fifth, at one stage, in the euro against the pound was bound to fuel an export boom and higher import prices.

The Irish government's only room for macroeconomic manoeuvre is through fiscal policy - taxes and spending.

Ms Cottrell argues that the government scored an own goal by announcing a big increase in tobacco tax late last year, which added a full point to the headline inflation rate. "With the pay round starting, this has taken inflation to a level where it is a problem for competitiveness," she says.

The government finally reacted last Thursday with a package of measures aimed at dampening the overheating market. It includes a 2 per cent tax on non-occupying owners aimed at speculators, punitive taxes on landlords who fail to develop residential land and special exemptions for firsttime buyers.

The Prime Minister, Bertie Ahern, has also said he may have to introduce price controls and has opened talks with the trade unions.

The country's central bank - though unable to tighten monetary policy - has warned that it is "uneasy" with the current levels of inflation. The Government has raised its forecast for annual inflation by a full percentage point to 4 per cent.

Pedro Solbes, the European Commissioner responsible for the single currency, says tighter fiscal policy is the best solution. Speaking at the Centre for European Reform in London last week, he said: "Ireland is in an extraordinary situation. Even more debt reduction must be the solution."

The difficulty with this prescription, which most economists would support, is that the government already has a budget surplus because of the boom. "Fiscal policy is not tight but it is difficult to convince voters of the merits of tighter policy if your headline surplus is enormous," said Ms Cottrell.

The Organisation for Economic Co-operation and Development agrees. In its latest economic outlook, it said: "With fiscal and structural policies, the only instruments now available, the focus should be on strengthening the supply side of the economy."

The problem provides fodder for British eurosceptics who believe the Irish example shows what could happen when the UK joins. Stephen Lewis, chief economist at Monument Derivatives, said: "This is an economy with a preponderance of borrowing on short-term rates. So when short-term rates are pushed down through the one-size-fits-all policy of the ECB [it] results in monetary conditions that are far too lax at a time of strong demand in the economy."

Certainly, Ireland's boom lends weight to Gordon Brown's caution about the need for the UK to achieve a degree of convergence before joining the euro. But those on the pro-euro sidereckon this is exaggerated.

The Irish economy grew at 8.7 per cent last year and, according to the OECD, will expand by almost 10 per cent this year. But there are signs of slowdown, to a forecast 8 per cent in 2001. House price inflation is down from 35 per cent in 1998 to around 17 per cent according to the latest figures.

There have been big productivity gains which limit inflationary pressure, and Ireland's GDP per head has overtaken the UK's to reach the levels enjoyed in France and Germany.

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