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Ireland’s race against inflation can’t be won with the euro

Irish inflation has just hit 6.2% and Irish opinion is aghast. The government of Mr Ahearn had promised it wouldn’t go above 5% or so and stitched the unions up with an agreement last March to keep wage increases to about 5.5% over three years.

Well, those union leaders are far from impressed and are demanding the same again now, with whatever it takes later to keep up with this much faster inflation. Nurses and train drivers have already been awarded 12% increases; construction workers’ earnings are 14% up. The opposition has demanded the recall of the Dail and so on. What did they all expect?

It was always going to be a rough ride. When the euro was launched in January 1999, Ireland was already overheating, with a growth rate of 8% for the sixth year in a row. As a tiger economy attracting massive - mainly American - foreign investment in software and other new products, the prices of its traded goods and services were going to rise faster than those of its mature competitors in the rest of the euro zone. New products can command better prices than old ones in world markets.

On top of this, because productivity is bound to be growing far more slowly in the more staid domestic market sectors, prices there will rise still faster. These two sources alone would mean that Ireland would have a higher inflation rate than the euro average, perhaps as much as 3 or 4% higher; that alone would mean some 5-6% inflation.

But on top of this Ireland is the euro’s prize diverger. The euro zone’s interest rates have been dominated by the uncertain recovery of Germany and Italy from the Asian crisis; they are still only 4.25% and throughout 1999 were 3% or below. Ireland needed rates at least as high as ours, probably higher in the 8-10% range, to control the dizzy growth of its demand. Then the euro fell in order to stimulate poor continental competitiveness. This meant still higher prices in punts for its already popular Irish traded products and a further demand stimulus.

Even though immigrants have been flowing in - in reverse potato famine style - this has only partially relieved the shortage of labour while adding to that of land and housing; house price growth has averaged around 25% per annum over the last three years.

As we could have told them from two decades of experience pre-Thatcher, incomes policy cannot hold up against market forces. One or other group will face such excess demand that it will break the policy and then other unions will not be able to avoid putting in catch-up claims because "social partnership" will have been shattered.

Shay Cody, deputy general secretary of the largest public service union, IMPACT, has accused the government of "gambling with the partnership model". The teachers’ leader, Senator Joe O’Toole, has demanded an extra 5.5%, a demand echoed by Mike O’Reilly, leader of the transport and general workers - and it seems by Uncle Tom Cobley and all.

The government has responded in desperation by cutting taxes (out of its large, growth-fed surpluses running at about 4% of GDP) to "sweeten" the wage packet and buy union support for the incomes policy. Yet while this may indeed buy a little time from the unions, it only serves to increase demand and so worsen inflation. A large temporary ("regulator") purchase tax might help by pushing spending into the future; but raising taxes looks politically out of the question.

In any case any such tax measures would be like spitting into a monetary gale. With interest rates at 4.25%, inflation at 6.2%, and house price rises at 25%, the sensible course for households is to borrow and buy, buy, buy.

Where will it all end? There seem to be two main possibilities. First, the Irish government could try to sweat it out. With the exchange rate fixed, Irish prices would eventually hit a ceiling and price themselves out of the euro and world market. Investment would then drop off, incomes would fall, unemployment would rise and consumption would slow. However, that ceiling may be a lot higher than where prices now are.

Suppose Ireland has become, with its 4m people, a sort of Greater London - a hi-tech tourist magnet. If so, its house prices are a third below London’s. So are its wage costs. Then prices and wages could rise 10% for two or three years before settling down at similar rates to the rest of the euro area. And bitter experience suggests that prices could overshoot the ceiling and create a bust with high unemployment before falling back to their sustainable level - a hard and politically murderous landing.

The second possibility is the unthinkable one of leaving the euro. Even at this late stage a rise in interest rates to 10-15% and the accompanying sharp rise in the punt (30%?) could stop the boom getting completely out of hand. Real wages would rise as import prices fell and spending would be restrained by high borrowing costs - steering inflation back out of the stratosphere. Relative to the rest of the world, the necessary rise in prices would have been achieved without a sharp inflation - by the rise in the currency.

For the Irish government this seems to pose a nasty dilemma. By leaving the euro it risks losing its EU perks. By staying it risks being ejected from office. That shows it is actually no contest: infinitely worse to face the ire of the people than that of the EU. The EU in any case would probably not do much, as the Irish would dress it all up as a temporary withdrawal - "until the pound joined the euro", no doubt, thus shifting the blame again onto those reluctant Brits.

It also shows the Achilles heel of a monetary union between sovereign nations. Any of them can, at any time, decide to leave with little recourse by the others. Has the EU got an army to stop them, or funds that it can legitimately withdraw? The Austrian case has shown the absurdity of sanctions. The euro would not be under threat from Irish withdrawal, but the precedent would be ominous.

Patrick Minford is professor of economics at Cardiff Business School  

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