Celtic tiger on Euro trail

The Republic of Ireland's booming economy - the "Celtic Tiger" - is one of the few to qualify for European Monetary Union (EMU). All Irish political parties are determined that the country ends up in the first wave of members; and public opinion is enthusiastically in favour of the project. Nevertheless, many Irish economists question the wisdom of joining while the UK remains outside. Why this is so raises a variety of issues, some peculiar to Ireland and all relevant to the wider debate on the merits and feasibility of EMU.

It is not difficult to see that Ireland and the core economies of continental Europe make an odd partnership in the absence of the UK. In academic jargon, they fail to meet the criteria for an "optimum currency area". Standard arguments suggest that monetary unions should work best between countries with flexible labour markets, high levels of labour mobility, extensive mutual trade and exposure to similar external shocks. Ireland and the UK together meet the labour mobility and mutual trade tests, whereas Ireland and the rest of the EU, without the UK, probably fail all. More serious from the perspective of coping with asymmetric shocks is the absence of any system of compensating income transfers. Not only is there no provision for such transfers in the EU, but the "Stability Pact" in effect proposes pro-cyclical transfers: countries with severe budgetary deficits may be fined even when these arise from local recessions.

As against all this, it is often noted that the UK's share of Ireland's exports has been in decline for decades, and is now below 30 per cent. But this misses two important points. First, it is not just exporters who face competition from the UK. Proximity, a shared language and, in recent years, deregulation driven by the single market have made Ireland a natural target for UK firms in all sectors, including some thought of as non-traded. Secondly, the firms responsible for the growth in Ireland's exports to continental Europe, many of them in sectors such as chemicals and computers, are disproportionately foreign-owned, high-margin and capital- intensive. This makes them less vulnerable to exchange-rate fluctuations than Irish-owned firms. For these reasons the exposure of Irish GNP and employment levels to sterling is greater than the UK share of exports would suggest. There is a danger that a sterling depreciation, relative to the euro, could cause damage to the indigenous sector and knock stripes off the Celtic Tiger.

It is generally agreed that one of the reasons for the sustained growth of the Irish economy is a social consensus, institutionalised in national wage agreements, which have ensured industrial peace and wage moderation. It is the same logic which argues that domestic aspects of competitiveness have been significant in the need to maintain competitiveness by avoiding an inappropriate exchange-rate peg.

While proponents of Irish EMU membership concede that sterling-euro fluctuations might cause difficulties for competitiveness, they argue that the costs would be more than offset by the benefits of lower interest rates. However, this can mean at least three different things, none of which would be guaranteed by joining EMU.

First, it can mean low nominal interest rates. The view that EMU will ensure this is widespread reflects a common assumption that the euro will inherit the hard-won credibility of the mark. This is questionable, with the German government resorting to creative accounting to meet the Maastricht criteria and the new French government proposing a "Stability Council' with real powers. In this new environment it is possible the Irish Central Bank will need to establish its anti-inflationary credentials by keeping rates above the level which mark rates would have attained.

Secondly, low interest rates can mean the absence of a risk premium relative to foreign interest rates, such as lreland experienced between September 1992 and January 1993. Perhaps the best rule of thumb is that countries get the interest rates they deserve. If the markets took the view that a depreciation of sterling relative to the punt was likely to put intolerable strains on the economy, they would mark down Irish government bond prices.

Finally, lower interest rates can mean permanently low real interest rates. But who wants them? Not the Central Bank of Ireland. It has warned that the boom may lead to a revival of inflation, necessitating an increase in rates. The irony is that the strength of sterling is part of the problem since it risks contributing to overheating. The Irish punt has followed sterling up as far as it can go without leaving the permitted ERM range. The policy dilemma reflects the kinds of problems which would be exacerbated in EMU by the need to tailor a single policy for a group of countries with different problems.

Of course, in Ireland, a common response to the case against EMU is that the project is a political one. To this, it is tempting to reply with Bill Clinton's slogan "It's the economy, stupid!". If EMU results in a deterioration in economic performance it could slow rather than hasten progress towards the deepening of the single market, the admission of new members and the reform of institutions. Perhaps the difference between the debates in Ireland and the UK is that most Irish opponents of EMU share these objectives. The subtleties of such a Europhile, yet paradoxically Eurosceptic, position seem unlikely to influence Irish leaders. If EMU goes ahead on schedule Ireland will almost certainly enter without the UK.

Peter Neary is Professor of Political Economy at University College Dublin, and a Research Fellow in the Centre for Economic Policy Research's International Trade programme. For further information about CEPR, call 0171 878 2900.

See J P Neary and D R Thom: 'Punts, pounds and euros: In search of an optimum currency area', Working paper No 96/24, Centre for Economic Research, University College Dublin, October 1996.