by Patrick Honohan

Read to the Trilateral Commission, Dublin Castle, October 1992

There might be a temptation to concentrate in the time available this morning only on the positive features of the current economic situation in Ireland. However, I don't think I would succeed in pulling the wool over your eyes in this respect. Besides, the most interesting feature of the Irish economy at present is the contrasting development of the main indicators of performance. Let me begin by itemising a few key facts which will serve to anchor the discussion:

If its recent rapid growth, low inflation, and huge balance of payments surplus might seem to qualify the Irish economy as a star performer, yet the high and growing unemployment, heavy government indebtedness and also the level of short-term real interest rates point in the opposite direction. It is this apparent paradox which I would like to explore and at least partially resolve. An underlying theme will be that there can be contrasting developments in different aspects of Irish economic performance as a result of the overwhelming importance of external influences in this, the most open economy in the World.

Like many of the smaller European economies, Ireland's productive structure has steadily evolved rather over the last forty years from predominantly agricultural production to a more balanced productive structure with an important manufacturing component and a large service sector. The most striking feature of this transformation has been the role of inward foreign direct investment, especially in manufacturing. Almost half of the manufacturing labour force, and more than seventy per cent of manufacturing production comes from foreign-owned firms. These are the highest proportions for any OECD country. Key subsectors here are data processing equipment and pharmaceuticals, though foreign firms are represented in all branches. For the most part manufacturing is dependent on imported raw materials, and most of the output of foreign-owned firms is exported. To take one example, the office machine sector sources only 4 per cent of its industrial input needs domestically.

The attractions of Ireland for these MNCs are many: educated labour force, location within the EC, and much of the credit for attracting such a large fraction of mobile investment in Europe to Ireland must go to the marketing skills of the industrial development authority IDA-Ireland, armed not only with grant assistance negotiated on a case-by-case basis, but above all with the low ten-per-cent corporation tax on manufacturing profits.

The strength of the foreign-owned sector in manufacturing has its counterweight in a comparatively weak indigenous sector. Some of the largest companies here have been those based on local raw materials such as meat processing and alcoholic beverages. However, some of these are no longer Irish-controlled, and indeed it is becoming increasingly difficult to provide a coherent definition of what is to be regarded as an Irish firm. Of the companies that have not been taken over by MNCs, a few have themselves grown significantly through acquisitions abroad - one may mention the building products company CRH and the paper and packaging enterprise Smurfit. But for the most part the Irish-owned manufacturing company is small: only a handful (fewer than twenty) employ more than 500 persons.

In the service sector the largest Irish-based companies have also diversified internationally. This includes the two largest banks, and the large aircraft-leasing firm GPA.

Irish agriculture, based essentially on animal products especially beef and dairy, benefited strongly from EC membership, though with a progressive squeeze on farm prices and especially the imposition of quotas over the past decade, the prospects for substantial income growth for the small family enterprises which make up the bulk of the sector have waned.

It is despite these structural weaknesses, therefore that the extremely rapid economic growth of the last few years has taken place. Growth has been accompanied by high profitability, though this has translated into acquisition of foreign assets rather than being reinvested in home industry, a worrying feature which (combined with the improved fiscal balance) is an important reason for the high and rising balance of payments surplus.

How can this vigorous productive performance be reconciled with soaring unemployment? Part of the reason is the relatively low labour content of recent economic expansion - even in the boom years since 1986, cumulative employment growth has averaged barely one per cent per annum. Furthermore, jog growth in Ireland has been conspicuously low by international standards over a long period: less than 0.2 per cent per annum on average since 1960 - the second-worst performance among 16 OECD countries. Admittedly this has been during a period during which there has been a steady drain from the land, but that problem has been common to many other industrial countries over the last few decades. Job creation has been a policy priority for many years, and many different approaches have been tried with enthusiasm, varying broadly in line with international fashions: tax breaks from the 1960s, public spending in the 1970s, and now the fostering of an "enterprise culture". But I am afraid that we really don't know why job creation has been so far below the needs of full employment. The simple old-fashioned view, that Irish wage rates have been pitched too high, may have something to it. In particular, there are those who argue that corporatist wage setting has been an important contributory factor to high wage increases over the years, though it must also be remembered that access by Irish workers to jobs across the Irish sea also places a market-determined floor beneath Irish wages, at least for skilled workers.

For even if job creation was stronger, the effect on unemployment would be less than one-for-one because emigration would be lower. This part of the unemployment story is much more amenable to explanation. Quite simply, the Irish worker is more likely to migrate than any other European. When the labour market is strong at home, or weak in the UK, the secular emigration trends are reversed quickly and vigorously. The consequence is that fluctuations in UK and Irish unemployment are tightly linked. The links are best illustrated graphically (figure).

The same story explains the recent surge in unemployment. From 1982 to 1990 a net 6 per cent of the population (207,000) emigrated - the traditional safety valve of a labour-surplus economy. But since 1990 the depressed UK labour market has reduced outflows and there has been some reflow.

In this case many of the returning emigrants are coming back not to jobs, but to a social welfare structure which in some respects is comparable to that in the UK with the result that those who prefer to work at decent wages in England than not at all at home, nevertheless prefer to be unemployed in the family home in Ireland. However, it is possible to exaggerate the generosity of the unemployment benefit system as an explanation for high unemployment in Ireland.

About one-half of the unemployed have been so for more than one year, and this has prompted efforts to reintegrate these people into employment through training programmes and special public employment schemes. Indeed, Ireland spends proportionately more on such schemes than most OECD countries, but this spending has not evidently succeeded in holding down unemployment in the way such schemes appear to have worked over the years in Sweden, for example.

Ireland's inflation fell rapidly during the early 1980s, and has been at or even below the EMS average since 1985-86. This disinflation has wrongly been characterized by some as a consequence of the hard-currency policy adopted when Ireland joined the EMS in 1979. I believe that this view is largely mistaken. First of all, we should remember that the EMS began for Ireland as a de facto soft currency area: the pound sterling, with which the Irish pound had previously been linked at one-for-one for a century and a half appreciated rather sharply immediately after the EMS began, and the Irish pound was worth only £0.81 sterling on average during 1981-85. Furthermore, most non-EMS countries also experienced a sharp fall in inflation in the early 1980s. Finally, I think that it is fair to say that, unlike the UK, disinflation was not perceived as the most important policy priority in the 1980s, being overshadowed by the need to reduce Government borrowing. The fall in inflation thus occurred serendipitously as a by-product of the domestic recession induced by fiscal contraction, assisted by favourable external conditions in terms of world commodity prices, and disinflation elsewhere, especially in the UK.

So far as the EMS is concerned, the policy on realignments within the EMS was at first a rather lax one involving seven devaluations against the DM in the first eight years of the system. Admittedly only one of these was unilateral (in August 1986, designed to reverse the effects of a sharp decline in sterling), but at each realignment at which more than two currencies were devalued against the DM, the Irish pound was among the devaluers. Nevertheless, as mentioned, Irish inflation did converge to EMS narrow band levels, and allowed Ireland to enjoy a period of stability in exchange rates for five years from 1987, cemented by entry of sterling in October 1990. Recent currency chaos and the withdrawal of sterling has plunged the EMS into a crisis which is nowhere felt more deeply than in Ireland. The problem is no longer one of competitiveness overall, but the fact that such an appreciable part of our export business still goes to the UK, whose currency has depreciated rapidly in the last few weeks has both put pressure on certain exporters, and (more to the point) led financial markets to suppose that a devaluation of the Irish pound in the EMS was imminent. Fighting the resulting outflows has resulted in high short-term interest rates, and it is not clear what it will take to bring confidence back.

As this is probably the most pressing policy issue at present I will say a few more words about it. Ireland has the lowest percentage of its trade with partners of any of the fully participating EMS countries, and sharp movements of sterling certainly create problems (even though they are sometimes exaggerated). Some economists have advocated a devaluation now, others have proposed some new exchange rate regime designed to plot a middle course between the EMS currencies, sterling and perhaps the US dollar. My own view has two different elements. First, there is nothing inconsistent about the failure to devalue now in comparison with devaluations of the past. Sudden sterling weakness has hit us only three times since the EMS began in March 1979. In August 1986 this resulted in an average appreciation of the Irish pound by 10.6 per cent (against all currencies) in a twelve month period: that prompted the 8 per cent devaluation of the Irish pound within the EMS. In 1989-90 the fall of sterling resulted in a smaller - 9 per cent - average appreciation of the Irish pound: this did not result in a devaluation. The average appreciation of the Irish pound this time around is about 7.5 per cent, so this particular trigger (which I don't think is that used by the Government) hasn't gone off yet.

I mentioned the level of Government debt as an apparently negative factor in the list of main economic indicators, and indeed it is the only one of the Maastricht criteria for adopting the common currency which we are unlikely to be able to fulfil. However, I think that it has to be recognized that this debt is an inheritance from the past and does not really reflect current developments.

In a way, Ireland's fiscal performance during most of the 1980s is the mirror image of that in the 1970s. The 1970s see a rapid expansion of public expenditure and a reduction in taxation; emigration - the norm for a century and a half - is replaced by a net inflow of returned migrants. But this success is built on a growing mountain of debt.

Thus Ireland began the 1980s with government spending running well ahead of tax revenue and resulting in a massive level of Public Sector borrowing - 20 per cent of GNP in 1981. Obviously not all of this could be met from domestic savings, and heavy foreign borrowing ensued. From 1981, government struggled to bring this imbalance under control, at first largely through tax increases but also through efforts to control expenditure (which inevitably were somewhat slower to take effect). It was not until 1987 that the non-interest account of the government moved into surplus, and by that time there had been a massive increase in Government debt, including foreign debt.

The fiscal correction was an uphill struggle because the deflationary impact of fiscal retrenchment had an immediate effect on unemployment - which fed back into budgetary costs. At the same time, the still-growing debt led to increasing real interest rates on the borrowing. Finally the fiscal correction was initiated during a recession in our main trading partners. In time, all of these factors reversed themselves: unemployment stopped growing - and even declined a little as the UK labour market tightened; the international boom of the late 1980s especially in the UK also helped boost tax revenues, and the resulting improvement in the prospects for the budget helped to lower interest rates. This all helped to cement a further policy tightening which took place from 1987 on. By 1989, Public Sector borrowing was down to 3 per cent of GNP.

There has been quite a lot of international interest in the idea, apparently exemplified by Ireland's recent experience, that fiscal contraction could be expansionary overall because of the favourable impact of sound fiscal policy on business and consumer expectations. Well I am afraid that the evidence for this theory cannot be found in Ireland. It is true that the years of most rapid reduction in Government borrowing - 1987-89 - were also years of strong growth. However when you look at the composition and source of that growth, it becomes evident that the economic recovery was not led by confidence-inspired investment or even domestic consumption. Instead it was exports which led the way in 1987 and to a large extent in 1988. Only by 1989 was there any significant contribution from investment. Thus budgetary discipline did not cause the boom: indeed the reduction of the budget deficit in each of these years greatly exceeded the Government's expectations as a result of the unexpected strength of the boom.

Even if the last couple of years have seen some renewed deterioration in the public finances, and there are grounds for worrying about the opening budgetary position for 1993, when many deferred public sector pay increases fall due, there has undoubtedly been a change in public attitudes to the role of government in the economy. Indeed, though none of the main parties adopted a doctrinaire stance comparable to that of the Thatcher government in the UK, one can say that economic debate in Ireland has been transformed by the fiscal crisis of the 1980s. In particular, the limitations of government spending policy have become all too evident even to the average voter. This has political as well as economic consequences and those I will leave to other speakers.

At the same time, the combination of unemployment and balance of payments surplus has suggested to some that fiscal expansion would now be appropriate. The high level of government indebtedness means that would be a risky strategy. Furthermore, previous experience suggests that unemployment might not respond as expected. What is really needed is for the private sector to invest more in productive capacity. Unfortunately, the main Irish firms already feel overexposed to the domestic economy and are looking more to investment prospects in the rest of the EC and indeed in North America. So we will probably remain heavily reliant on foreign investment as an engine of growth.