Presented at a conference of the Institute for European Affairs, Dublin, 5 November 1998

1. How different will EMU be for Ireland?

After two decades of monetary autonomy within the EMS, Ireland now largely abandons monetary sovereignty as it enters EMU. This is a very different type of regime than has been in effect for the past two decades, but we have, in a sense, been here before: it is in many respects like a return to the days of the sterling link before 1979

How will the performance of the new regime compare with the past? I would like to begin by focusing on the specifics of the monetary system per se, rather than considering the wider economic context which will no doubt, however, be strongly affected by monetary conditions. The major elements on which an exchange and monetary regime can be expected to deliver include: (i) low inflation, (ii) financial credibility contributing to a low cost of capital and (iii) institutional stability in the financial sector. Monetary policy also has the potential to (iv) contribute to macroeconomic stability. Other elements could be added, including the efficiency of the payment system and of finance in general.

(i) The EMS has not been kind to Ireland. By now inflation has been tamed, but over the 20-year period Irish inflation was no lower than it had been in the previous two decades under the sterling link (whether on average or in terms of the peak year), and was actually higher in Ireland than in the UK. By any reasonable standards, it could not be said that exchange rate stability was achieved and maintained – even before the narrow band system fell apart in 1993. One indication: a 34% depreciation against the DM, anchor currency of the system, during the two decades - a considerably weaker performance than was achieved by the UK. (During the sterling link years, by contrast, our inflation was essentially the same as that in the UK).

(ii) Another damaging aspect of experience during the EMS is that the cost of capital was persistently higher in Ireland than in the anchor currency (the DM). (Figure) To the extent that this mainly reflected exchange rate uncertainties it was not just a transfer from borrower to lender, but a reflection of avoidable macro uncertainty. Once again, the EMS experience was much worse for us in this dimension than the sterling link, which had ensured interest rates close to those in the UK.

In both of these dimensions we can now be confident of improvements.

(iii) So far as institutional stability in the financial sector is concerned, we must count two significant failures during the EMS period, the first in Irish financial history since the 19^th Century. (I refer of course to the PMPA and IC I insurance companies – lesser events like the 1974 Irish Trust Bank are below the threshold). Ireland is not, of course, far from being the only country where the incidence of failures increased. I cannot say whether our experience in the EMU will be better or worse, but I will speak in a moment about the administrative arrangements being put in place at European level.

(iv) Irish monetary policy during EMS delivered neither price stability nor countercyclical buffering: geared as it was primarily to avoiding outflows that would trigger a realignment, Irish interest rates were repeatedly pushed up just when Irish competitiveness was under threat from sterling weakness. Before 1988, almost no attempt was made to stabilize short-term domestic financial conditions through liquidity policy. The highest interest rates and the highest excess returns were during the worst of the recession.

Perhaps no more could have been done by monetary policy under the difficult fiscal circumstances of the time, but the message is that our autonomous monetary policy during most of the EMS period has not been a stabilizing force.

There have been some positive features during the EMS: especially the fact that, despite the fiscal pressures, no significant financing of the government deficit was undertaken by the central bank (not forgetting that there was some in 1988-90, masquerading under the title of advance payments of surplus income). It is only fair to note that overall economic performance in the past twenty years owed much to other aspects over which the monetary regime has little influence. But overall, we should have little regret for the passing of this regime. A corollary here is that the fact that monetary policy will not be specifically directed to stabilizing the Irish macro scene should not faze us: we have lived with such a regime for quite a long time. To be sure, the very recent history has been of a very deliberate high interest rate policy designed to dampen the boom; but this is a new feature, an exception that proves the rule. The fact that interest rates are now coming down when an increase would, in the current circumstances, seem more timely, merely illustrates that monetary policy in the future will do no more to stabilize the economy than it did in the past.

What is different is the toughness of the new regime. Look again at the inflation and exchange rate performance of the past: the soft policy of the past is over forever. We cannot be too careful heading into the new regime in our approach to wage setting. The old safety valve of currency softness is just not going to be there to bail us out.

 

2. Making EMU work

Let me turn now to the question of how EMU will perform on these different dimensions of inflation control, contributing to the maintenance of macroeconomic stability and ensuring sound financial institutions.

With the question of "whether" out of the way, commentary in recent months has begun to focus on the "how" of EMU. This focus is not before time. For a long time I have been concerned at the way in which the implementation of the single currency idea is working out. It is not the fine details that concern me–there I think that much good work has been done. But at several major decision points it seems that the considered view of the international academic community of economists has been rejected. Attentive readers of the IEA's publications will find many of the issues now at last being aired in the international financial newspapers – independence of the ECB, composition of its decisionmaking board, the role of Finance Ministers in influencing exchange rate and monetary policy; and the lack of formal links between national bank supervisors – already highlighted in the IEA's 1991 volume by Rory O'Donnell and myself.

One of the major problems here is, I believe, the systematic attempt by national central banks to retain as much national control of monetary issues as possible. An attempt to match the considerable anti-inflationary success of the Bundesbank by squeezing the ECB into a Bundesbank-like template has also been a factor.

The recent decisions to impose reserve requirements, and to announce an explicit target for monetary growth represent examples of "make it look like the Bundesbank" thinking. This even though very few economists now consider the rate of monetary growth to be a reliable indicator of monetary pressures in industrial countries–and certainly not at a time of structural change. (Reserve requirements might not be such a bad thing, especially considering the daft investments that some banks have recently owned up to).

Other widely discussed design flaws include the failure to build-in a structural majority for the ECB head office representatives on the governing council of the ECB. At present a dozen national central bank governors are ex officio members of this as compared with just six executive directors. This has seemed to many to be a recipe for the re-introduction of national politics through the back door, perhaps not at first (with experienced central bankers as the initial nominees), but potentially later.

I believe that Ireland's interest lies firmly in the internationalist camp in an environment where national central banks are showing a strong tendency to try to maintain as much autonomy as possible.

I mentioned already that it is hard to know whether the new regime will bring greater assurance of soundness in the conduct of financial institutions. A major problem is that no formal arrangements for centralizing the supervision and regulation of banking and financial institutions across Europe were included in the Maastricht Treaty.

Decentralized banking supervision within a single monetary area could lead to a variety of problems. The flow of information between the ECB and the national banking regulators is sure to be much weaker than that prevailing today even in those countries where the supervision of banks is assigned to an institution other than the central bank. As the ECB is the only potential lender of last resort that can intervene in unlimited quantities, an imperfect flow of information could be most damaging here. Time is often of the essence in the case of banking crashes, and the lack of a zone-wide regulator must be deplored. It now seems likely that there will have to be a couple of major crises of decision-making within the EMU before this institutional design weakness is remedied.

A plausible or even likely crisis scenario is where a national central bank and the ECB come to different conclusions as to whether a failing bank should be rescued with lender of last resort facilities. After all, "Too Big to Fail" is a relative concept. In the case of such a conflict, I would anticipate seeing the national central bank concerned providing the needed liquidity instead of closing the bank, even at the risk of this action being found illegal. The operational procedures that have been decided for the system are so decentralized as to make it possible for a rogue national central bank to behave in this way. Knowledge of the inflationary pressure that could result from large-scale lending of this type normally provides some restraint on a central bank considering the bail-out of an insolvent bank, but in EMU the inflationary pressures will be largely exported.

Despite these avoidable design flaws, I am on the whole confident that the system will muddle through, learning on the job. By resisting the pressures of national politicians, and building, by means of a greater openness than is yet evident, a broad consensus of public opinion in favour of its policies, the ECB is generally well-placed to make (most of) Europe a zone of monetary stability – promised for the EMS in 1978, but not delivered.

 

3. Scope for domestic policy in managing the Irish boom

Even if the ECB does a good job Europe-wide, we still have a domestic economy to worry about, and there is no end of international commentary on how out of kilter Ireland is at present. How much should we worry about the economy overheating and in what dimensions? Of course it is clear that we are in an unprecedented and very strong boom - even though the official growth rates of GDP that are usually quoted exaggerate, by as much 3 percentage points, the contribution of the production boom to growth in real gross national disposable income. I want to make six points here.

First, we need not worry about a generalized inflation in the price of goods and services. Admittedly there is still room in the short-run for some price pass-through from the depreciation if the Irish pound since early 1997. But for the longer term, the monetary policy set by the ECB on an EMU-wide basis will anchor the overall value of the euro, and competition from imports will keep the price of goods and services in Ireland broadly in line. Probably a bit higher - but I would be surprised to see CPI inflation running at more than about one percentage point higher than the EMU average, taking one year with another. To the extent that uncompetitive practices make for excessive retail mark-ups, these will continue, though this will not contribute to the rate of growth of prices, and will unwind when economic growth slows. Services which are protected from foreign competition, such as legal services, hotels, restaurants etc. will fall into the same category: their relative price has increased as a result of the boom, and they will hold this higher relativity as long as the boom continues.

Second, there seems to be no risk of a sudden collapse in external flows, such as hit the East Asian countries. In contrast to the badly affected countries in that region of the world, we have been running a huge balance of payments surplus and do not have substantial foreign short-term debt.

But, third, there is a risk of property prices overshooting. With demand tending to outstrip the limited stock of housing, office and hotel property, and no immediate sign that this situation will be reversed, buyers may bid prices that will not subsequently prove to be justified. This is hard to assess, as the sustainable price depends on the likely duration of the period of strong demand. Certainly the sharp fall in interest rates, and the confidence that they will remain low, has increased the price that that could be justified by investors. Nevertheless, a comparison with property prices in other cities, and the availability for redevelopment of large tracts of depressed city centre land, suggests to me that prime property prices could well be already somewhat over-priced with the potential for a downturn. A downturn in property prices need not be disastrous for wealthy individuals or well-capitalized firms. It would have a negative effect on confidence, and weaken the incentive and capacity of local firms to invest. It might also reverse the (perhaps exaggerated) positive signals that are being received by foreign investors. If the downturn is severe, and if financial institutions prove to have permitted too high a loan-to-value ration (they deny this, but they may collectively have lent more than any one institution realized), the losses may be transmitted to the banks. These are, however, highly capitalized, and a serious meltdown doesn’t seem on the cards.

The fourth element is interest rate policy. As already mentioned, I am not too concerned about the undoubted fact of interest rate policy being set at the EU-wide level without regard to Irish conditions. For various reasons Irish interest rate policy during the EMS period has generally been inappropriate to the economy’s stabilization needs and often pro-cyclical. I don’t think we will do any worse on average in the next twenty years on this front than we did in the past.

The fifth factor is wages. This is the most serious risk factor. Because of the unexpected currency depreciation since early 1997 – only partially reversed – the foreign purchasing power of Irish wages has fallen and the corresponding profit boom has put a lot of pressure on the pay deal. The boom has not depended on this degree of wage restraint (after all employment has been booming since 1993), and I suspect that industrial peace will demand some adjustment. It is crucial that any such adjustment should take account of the realities of the new EMU environment, and indeed the early start to the negotiation of a new pay is desirable given that we are entering this new environment. It is also crucial that we avoid a return to the confrontational approach to industrial relations which marked previous decades, and whose absence for the past dozen years has provided a context within which additions to the labour force have, on average, meant additions to the numbers at work. For that has been the true key to the Irish boom: the willingness and ability of Irish labour market entrants to make an economic contribution.

I cannot refrain from adding that, early or late, negotiations for a new pay round should look again at the potential for introducing optional profit-sharing or exchange risk-sharing formulae for firms vulnerable to the sorts of shocks that will no longer be cushioned by depreciation. (Given what happened to the sterling exchange rate, wouldn't employees be happy now if their unions had in 1996 negotiated such an arrangement as that proposed at the time be Paddy Geary and myself, among others).

Assuming there is a new pay round, and if it does incorporate some up front adjustment to cover the lost ground of the past few years, the key will be to ensure that the brakes are re-applied for later years. The big risk is that an up-front adjustment could establish an expectation of continued high annual increases. This is what has to be managed, as mistakes here will be accommodated by a collapse in job growth, and certainly not by any special concessions from Frankfurt or Brussels.

Finally, on fiscal policy, I do not share the view that the government’s deficit or surplus has no influence on the level of economic activity. I believe that the historical evidence for Ireland confirms that it is only under exceptional circumstances that fiscal tightening might fails to have its conventional effect: a tightening now would surely dampen the boom.

Besides, there is a good case to be made for fiscal surpluses in the years ahead. . It is quite clear that these golden years will not be sustained indefinitely. The future will predictably bring additional spending needs for which it is appropriate to make provision now in the good times. Thus, while the old pressure was to reduce the national debt, it may soon become appropriate to think in terms of a national reserve fund. Just because we satisfy the Maastricht criteria is no good indicator of whether we are making the correct intertemporal and intergenerational allocation of our greatly increased resources. A relentless pursuit of lower tax rates cannot be sustained indefinitely, and if we do follow that path it is clear that a painful reversal will ensue. As well as ensuring that public services match our enhanced national prosperity, we need to continually concerned about building our capital stock– including human and physical capital, but also financial capital (public as well as private). One clearcut goal for the accumulation of public financial capital is to be making provision for foreseeable future pressures on the public finances from the future needs for pension payments – our pensions! The recent Pension Board report has already advocated moving social insurance onto a partially funded basis. This would be one way of building a national reserve fund. Philip Lane has recently endorsed this idea in a wider context.

There is of course no need to push this fiscal conservatism to the point of reneging on what was promised in the Partnership 2000 agreement.

To the extent that further tax concessions are made, I suggest that consideration should be given towards encouraging long-term saving–effectively encouraging more private pension saving as well as public. in the current boom situation, fiscal concessions that result in increased private saving are clearly preferable.

5 November 1998