Originally published in THE BOSTON GLOBE
Tuesday, January 5, 1999
"Currency's effects on booming economy worry some"
Ireland's euro struggle
Martin and Kathleen Feldstein
The Republic of Ireland is one of the eleven countries of Europe that have just shifted to a single currency, the euro. But not everyone in Ireland is happy about the new European Economic and Monetary Union and its implications for the Irish economy. While those who support EMU are optimistic that it will bring long-term benefits to Ireland, others worry about EMU's near-term impact on the Irish economy.
The problems that the new monetary arrangements pose are significant not only for what is happening in Ireland today but also for what the Irish experience portends more broadly throughout Europe. Although most of the larger European countries are experiencing slowing economic growth, Ireland is booming and could use some restrictive economic policies.
Ireland enters EMU as one of the economic success stories of the last decade. Average growth over the last 10 years has been over 6 percent, the strongest growth rate in Europe and three times that of Germany, France, or Italy. A major reason for that strong performance is that Ireland has been very attractive to business investment from abroad. That attraction is based not just on an English-speaking work force, but also on the relatively low labor costs and relatively low real estate prices.
Ireland's relatively low cost of production has also helped Irish companies increase growth through ex- ports to the rest of the world. Ireland's trade surplus is now 15 percent of gross domestic product, also the high- est in Europe.
But recently the economic boom has become a superboom that is threatening to push up both wages and real estate prices at a pace that would weaken Ireland's international competitiveness. Last year real GDP grew at a startling 8 percent and the unemployment rate has halved since 1994. So its not surprising that Irish government officials and central bankers at the Bank of Ireland would like to cool the economy down to maintain Ireland's competitiveness and to sustain its prospects for long-term economic growth. The normal prescription for Ireland's present economic situation would be for the Bank of Ireland to raise short-term interest rates. That would reduce the excess demand and allow ~Ireland both to continue attracting outside investors :and to maintain competitive exports.
That's where the problem with EMU comes in. A . central feature of the new monetary union is that it shifts monetary policy making from the individual national central banks to a new European Central Bank located in Frankfurt. The new bank will have to be concerned with monetary policy for Europe as a whole and not for any individual country.
With the single currency there can be only one set of interest rates for the eleven countries of EMU. Although Ireland would now benefit from an increase in interest rates to rein in its explosive growth, the major continental European countries want lower interest rates to stimulate their slowing economies and prevent even higher unemployment.
The divergence of appropriate economic responses has already had a negative effect on Ireland. In the runup to the start of EMU on Jan. 1, Ireland has had to cut its reference interest rate from 5.5 percent to 3 percent, the predominant rate set by the German Bundesbank. The decrease in interest rates has exacerbated an already overheated economy in Ireland.
Because excess demand is not being cut off by high- er interest rates, during the coming year Ireland is likely to see prices and wages rise faster than elsewhere in Europe. This will undermine Irish competitiveness and could hurt long-term economic prospects. Although the rising wages in Ireland have attracted reverse migration by some of the overseas Irish, it is unlikely to be enough to damp wage increases, especially in the areas of high labor demand like information technology.
With monetary tightening impossible, the standard alternative way to limit demand would be by cutting government spending or raising taxes. But the Irish government doesn't want to cut government programs and it would rather cut taxes to stimulate incentives. So Irish demand is likely to stay too high, punishing Ireland's internationally engaged industries. Over time, those industries could be forced to contract and Ireland's firms could come to focus more on the domestic market. During this transition, the Irish unemployment rate would rise, perhaps for a contracted period of time.
Ireland's situation indicates the inherent problem in the one-size-fits-all monetary policy inherent in the new European single currency. In the future there will be other countries that need more stimulus or conversely more restriction than a single pan-Europe policy will al- low. Chances are that it will be the smaller and weaker countries of Europe that will have to withstand inappropriate economic policies.
Euro advocates like to point to the United States as a successful monetary union. It is true, of course, that the US economy operates successfully with a single monetary policy for a large and diverse continental economy. But Europe lacks the key ingredients that make this possible: a single dominant language, a geographically mobile labor force, and flexible wages. Until Europe develops labor mobility and flexible wages, expect to see more countries like Ireland struggling to adjust to an inappropriate monetary policy.
Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.