The Irish Economy: Recent Growth, European Integration and Future Prospects
Dermot McAleese
Address at the Centro Informação Europeia Jacques Delors,
Lisbon, Friday 12 October 2001
INTRODUCTION
Writing a decade ago on Ireland's dismal economic performance, an eminent Irish historian concluded that no other European country, east or west, north or south, has recorded so slow a rate of growth of national income in the twentieth century. Professor Lee's analysis of Ireland's economic ills had a time frame that lasted from Independence in 1922 to 1985. During that period, national income per head had grown by an average 1.8% per year, about the same as the UK, but well below the growth rate experienced in continental Europe. Membership of the European Community was generally seen as having been helpful, but there was little sign of the catch up on European incomes that had been hoped for at the time of accession. Ireland’s GDP per head languished at under two-thirds of the EC average in 1985, up only slightly from 59% in 1973.
During the past decade, a profound change in economic performance has occurred. The Irish economy has been transformed from the lame duck economy depicted in Lee's book Ireland 1922-1985 (Cambridge University Press, 1989) to a shining exemplar of the 1990s. In 1994, its performance was likened by a Morgan Stanley economist in London to that of the Asian Tiger economies; whence the birth of the Celtic Tiger.
Since 1994, Ireland’s GNP has grown at an unprecedented 8.6% per year. Anamazing turnaround was how the OECD described it. The turnaround confounded the best forecasters, native and foreign. In the early 1990s a growth rate of 3% would have seemed highly satisfactory. Estimates of potential growth rates using standard estimation techniques have been at least 3 to 4 percentage points below the growth rate actually achieved (with substantial price stability) for the past decade.
Economic success arouses curiosity and demands explanation. The list of publications on the Irish growth experience continues to lengthen. The Irish economy became the equivalent of a Hollywood starlet, with all the wondrous benefits and dangers of that position. Its example has been frequently cited in the international literature. Ireland is among a very select number of comparators in the IMF’s latest (November 2000) Country Report on Portugal; and an insightful analysis of Ireland’s growth experience by Dr Miguel de Freitas is included in a recent edition of the Bank of Portugal’s Economic Bulletin.
Why this interest in such a small and relatively insignificant economy? One reason is that Ireland’s experience constitutes a dramatic instance of convergence and catch up in the context of European integration. The poor do not always have to get poorer. A second reason is that the upsurge in growth was accompanied by a sharp shift in economic policy orientation based on three pillars: a) increased reliance on the market system and competition, b) macroeconomic stability and c) globalisation and integration. This coincidence seems like a striking vindication of the new consensus economic policies that have swept through the world during the past two decades. Hence, as a case study, Ireland has appeal for a wide range of specialists: regional economists, core-periphery theorists and policy analysts.
This paper is divided into three sections. The first section comments on some key features of the growth process. The second section examines the extent to which membership of the EU contributed to this growth. Third, we comment the implications for Ireland of a) the change in status from below average to above average income, b) the advent of the euro, c) the increasingly active role of Union institutions in fiscal policy and d) Enlargement and the Nice Referendum. Fourth, we briefly examine the effects on the Irish economy of the global economic downturn, and the worsening outlook following the attack on the US on 11 September and the subsequent military action in Afghanistan.
CHARACTERISTICS OF IRISH GROWTH
Initially many economists thought the post 1993 growth rates were a statistical illusion. There was talk of a soufflé economy, the product of transfer-pricing-inflated multinational profits in high tech sectors rather than ‘real’ bread and butter economic activity. Suspicions were strengthened by the slow reaction of employment to growth – ‘jobless growth’ was another favourite description of the early process.
As tax revenues started to boom, these doubts evaporated. The government budget deficit of 13% in 1987 was steadily transformed into an eventual budget surplus of 4% in 2000. The debt/GDP ratio, which had exceeded 120% in the late 1980s, declined to 47% in 2000 and is expected to decline further to 34% by end 2001.[1]
Moreover, growth eventually did generate jobs, albeit after a certain time lag. Numbers employed rose by 600,000 between 1992 and 2001, a rise of over 50%. This huge expansion in job opportunities had three far reaching repercussions on the labour market and on Irish society: a) unemployment fell from 16% to 3.6%, b) female labour participation rose dramatically and c) Ireland changed from being a country of net emigration to one of net immigration.
Ireland: Real Annual Average Growth RatesGDP / GDP per capita / Employment / GDP per worker
1960-80 / 4.1 / 3.1 / 0.5 / 3.5
1980-93 / 3.3 / 2.9 / 0.0 / 3.3
1993-2000 / 8.3 / 7.4 / 4.7 / 3.5
Thus, from being one of Europe’s poorest countries in 1973, Irish GDP per capita at PPP surpassed the UK level in 1996 and the EU average shortly afterwards. By 2000, Ireland’s GDP per person had reached 119% of the EU average, compared with 59% when Ireland joined the then Common Market in 1973.[2] The impact of growth on living standards was magnified by the accompanying fall in the dependency ratio. Whereas in 1990, every 10 people at work had 21 dependants to support, a decade later the figure has fallen to 14 (and it will decline further to 12 in the year 2006).
A crucial feature of the Irish experience has been the expansion of employment. From 1993 to 2000, employment increased by 4.7% per year. This compared with a situation of zero increase for the previous three decades. With astonishing rapidity, Ireland was transformed from a labour abundant economy with a chronic shortage of job opportunities to a situation of full employment and labour scarcity.
As employment grew, many low productivity workers, who were previously either unemployed or considered unemployable, were drawn into the labour market. In these circumstances, a sharp fall in labour productivity growth might have been expected. Most of the additional employment was generated in the services sector where productivity growth has always tended to be lowest and this would be further reason for anticipating a weakening productivity performance. In fact, no such decline occurred. GDP per worker grew by 3.5% per annum 1993-2000 compared with 3.3% 1980-94. Disaggregated figures suggest that this can be explained by a rise in productivity in the services sector from 0.8% to 1.6% between the two periods. The combined force of rising employment and maintained productivity growth ensured a major acceleration in the rise in living standards.
De Freitas (2000) draws attention to one further twist in the productivity story. Total output growth is determined by growth of inputs such as labour and capital, and also by improvements in the way these inputs are deployed. This is called total factor productivity or the Solow residual. The Solow residual rose significantly during the boom years. Kennedy estimates this as rising from 2.3% in 1980-93 to 3.6% per annum 1993-2000. These figures are consistent with de Freitas’ estimates for the shorter period to 1998. This growth in TFP is highly significant in so far as it relates to the influence of improved economic policies and stronger integration within Europe (see below).
Another remarkable feature of the decade has been the decline in labour’s share of total value added. It fell from 57% at the start of the decade to 50% in 2000. The corollary is a significant increase in the share of corporate profits and earnings of the self-employed. Kennedy estimates an increase in the share of profits in industry’s net domestic product from 47% in 1993 to 58% in 2000 and a rise from 25% to 38% in the services sector during this period. This radical factor income shift from labour to capital needs careful interpretation. (Lane 1998). It is not due to increased capital intensity of production. The exceptional profitability of multinational subsidiaries has certainly had an impact. There is abundant evidence of a quantum leap in profitability, which took place against a background of pay restraint across the economy.
Pay restraint was organised through Social Partnership. Ireland adopted a unique model of wage determination, involving extensive consultation and agreement between the social partners. The key element was: wage restraint in return for income tax cuts and ongoing participation in economic decision making through social partnership committees. This policy is not favoured by economic orthodoxy but it has produced tangible benefits for Irish employees and employers alike. Business received a boost to profits, and employees got more jobs and better pay. Compensation per employee in the business sector rose by 43% since 1993, compared with a cumulative consumer price increase of 25%. National pay agreements kept the lid on pay claims during a period of unprecedented output growth and thus enabled this growth to translate into higher employment and lower unemployment. Reductions in income tax meant that take home pay increases substantially exceeded nominal pay increases.[3]
THE EFFECTS OF EUROPEAN INTEGRATION
It is sometimes said that economists have been unable to explain the causes of Ireland’s boom. This is only partly true. There is general agreement on the list of factors that contributed to growth and that these contributory factors interacted positively with each other -- in a Myrdalian process of cumulative and circular causation. The main subject of contention concerns the weight to be attached to the different causal factors. Thus while the OECD stresses foreign investment and Ireland’s education policy, others emphasise the role of macroeconomic policy and the introduction of competition and lower taxes. Another view stresses the role of Ireland’s social consensus model of wage determination and policy formation. De Freitas considers the boom as the result of transient, self-limiting factors and long run factors. Thus transient factors such as the decline in unemployment and the rise in female labour participation made a big impact on growth, but they can be sustained only up to the point. After this point (full employment for instance), further improvement of living standards requires growth in long run productivity. It will be some time before there will be sufficient data to determine which of these various interpretations carries most weight.
What part did membership of the European Union play in delivering faster growth to Ireland? This is a question of enduring interest to all countries and regions with living standards below the EU average, and especially to the 12 new applicants. In Ireland, this has been a comparatively neglected topic to date, but in the light of the NO vote in the Nice Referendum and the Commission’s reprimand of the Irish government’s handling of fiscal policy earlier this year, now might be a timely occasion to consider this issue.
In principle, economic integration can affect economic growth in several ways. First, it ensures access to other members’ markets, an important advantage to countries with a competitive cost structure. Integration also enhances the attraction of a lower cost country to foreign investors. Second, membership provides access to financial assistance of various sorts from the centre to the less prosperous member states. Third, new members operate in the context of an agreed institutional framework and policy guidelines. Fourth, membership can help growth by moderating extreme nationalist sentiments and subsuming them in a broader “European” context. Each of these issues will now be considered in turn.
a)Trade and Foreign Direct Investment
Export growthcontributed significantly to overall growth, as one would expect in a highly open economy like Ireland’s. Export volume increased by 16.5% per annum 1993-2000 compared with 9.2% 1980-93. The contribution of total net exports to real GDP growth averaged 3.8% p.a. 1991-99 compared with 1.4% in the previous decade (Arora and Vamvakidis 2001). The EU economy was in the doldrums for most of the 1990s, so there was limited direct stimulus from that source that differed from earlier periods. OECD market share statistics indicated that Irish export growth owes slightly more to increased market share, both in Europe and in the US, than to market growth.
The performance of the US economy proved to be of crucial importance. During the 1990s, American corporations enjoyed exceptional levels of profitability and as a result were ready to invest abroad. The level of US FDI flows into Ireland increased significantly during the 1990s. Ireland’s share of US FDI within the EU doubled, from 3% to 7%. This FDI was concentrated on fast growing high tech industries with a predominantly export orientation. For these industries, the single market reforms were of crucial importance and came just at the right time.
Ireland’s favourable regime of corporate profits taxation (CPT) was an additional investment incentive. This took the form of a preferential tax rate of 10% on all corporate profits earned in manufacturing and traded services industry. In 1998, under pressure from the European Commission, a new CPT regime was negotiated. The CPT rate was raised to 12.5%, applicable to all sectors, effective from 2003. The 10% rate was ‘grandparented’ up to 2010 for companies already enjoying this preference. In addition to tax incentives, financial grants are offered to new enterprises in respect of capital spending, R&D and labour training, but these were being pared back during the 1990s. The European Commission showed considerable flexibility and helpfulness to Ireland in these negotiations. Also, the Commission’s restrictions on state aids in the more developed regions were necessary in order to make the Irish incentives effective. The more developed member states would have been willing to match Irish incentives had the Commission not prevented it and the inward investment boom would have been halted in its tracks.
EU membership was also important to the development of the International Financial Services Centre (IFSC) in Dublin. Contacts developed through EU institutions helped to get the project started, and the common institutional framework within the EU made Dublin a credible alternative to other financial centres (White, 2000). With over 8,000 people now at work in IFSC activities (strictly defined), the IFSC has turned out to be an important employer and a source of significant tax revenue.[4] In 2000, tax revenues were estimated at £500 million or 0.5% of GDP.
FDI is important in explaining the Irish catch-up but it is not the whole story, no more than FDI is just a tax incentives story. American subsidiaries accounted for only about 10% of the total economy-wide increase in employment since 1989. Even if each of these jobs generated a multiplier effect of one further job elsewhere in the economy (as is often assumed), this still leaves 80% of the employment growth unexplained. Besides the FDI programmes had been operating successfully through much of the previous decades in terms of attracting new industries to Ireland. As was often pointed out at the time, there were no comparable successes in the domestic economy. During the 1990s something dramatic was going on in the services sector, where 80% of the new jobs were being generated, and in the entrepreneurial climate in the domestic economy generally. Without explanation of what that something was, no account of the Celtic Tiger can be complete.
b)Financial Assistance
Integration agreements usually include provision for economic and technical co-operation and modest financial transfers from the richer to the poorer members. The amount of transfers provided by various EU development and convergence programmes over time has been quite exceptional. While modest amounts of aid had been disbursed through the ERDF and the ESF since the early 1970s, a major stimulus came with the launch of the Structural Funds programme in 1989.[5] These programmes were set up as "regional counterbalancing" measures, designed to avoid any widening in regional inequalities, especially in regions where innovative sectors were absent and scope for exploiting economies of scale limited.
Irish Receipts from the European Union 1975-2000IR£m current prices / 1975 / 1986 / 1991 / 1997 / 2000
GROSS RECEIPTS / 109 / 1147 / 2201 / 2504 / 2049
PAYMENTS TO EU BUDGET / 10 / 240 / 348 / 514 / 847
NET EU RECEIPTS / 99 / 907 / 1853 / 1990 / 1202
(% GNP) / 2.9 / 5.9 / 7.6 / 4.8 / 1.8
Source: Department of Finance, own estimates, figures for 2000 are provisional
During the decade 1989-99, Ireland's structural fund receipts have averaged about 2.6% of GNP per annum. This scale of assistance can be compared with aid flows to middle income developing countries of 1% of GNP (World Bank estimates). Aid to populous poor countries such as India and China amounts to even less than this.
Although many continental Europeans firmly believe that Ireland has grown rich on the back of the European taxpayer, the actual impact of the Structural Funds seems to be considerably smaller than one would expect. Simulations by Bradley (1992) suggest that Ireland's GNP would be 2.7 percentage points (and GNP per head only 0.8 percentage points) higher by the year 2000 as result of the 1989-93 programme. Later, using a similar methodology based on a large macro model, Honohan (1997) estimated that the combined impact of the two EU structural aid programmes spanning the decade up to 1999 would add only 2 percentage points to GNP in the long run.[6]
Perhaps some specific areas of spending failed to yield the return they should have. Tansey, for example, argues that while structural funds from 1989 greatly increased participant numbers on active labour market programmes, "the evidence that they have significantly improved the national training effort is at best mixed" (Tansey 1998 p. 133). On the other hand, the Structural Funds programmes boosted confidence and enhanced the acceptability of many of the EU 'level playing field' initiatives that might otherwise have been considered unacceptable. Also the obligation to account to Brussels for the spending of the funds has led to considerable improvements in the way public sector investment is planned and monitored. The adoption of multi-annual programming encouraged national authorities to think beyond the single year planning horizon. As Alan Gray observed, the contribution of the European Commission in influencing Irish planning and evaluation methods "deserves more than a footnote in Irish economic history" (Gray 1998 p 52). The structural funds framework also led to greater co-ordination in activities co-financed by the Community. Cynics will say that it was all done merely in order to obtain the EU money, and in part they are right. But mind-sets have also changed - for the better.