The euro's rise has been four times more damaging to Irish price competitiveness than inflationary excesses, writes Paul Tansey

THE SEVERITY of the slowdown in the domestic economy is growing more pronounced by the day. Yet, the conventional wisdom now holds that, whatever the economy's current travails, it will rebound to reasonable health in the years from 2010 onwards.

The key text quoted in support of this consoling prognosis is the Economic and Social Research Institute's Medium-Term Review 2008-2015. The ESRI does indeed foresee annual average growth of 3.8 per cent in real Gross National Product between 2010 and 2015 in its central forecast.

But this forecast is grounded on the assumption that the domestic productive base can remain competitive.

The regaining of competitiveness would allow the economy to switch the source of growth from the domestic to the export sector. With the ESRI forecasting that activity will revive in Ireland's principal foreign markets by 2010, the spillover from foreign growth would push the Irish economy back into the fast lane.

A growth revival in the economies of Ireland's major trading partners is a necessary condition for increasing export demand. But it is not a sufficient condition. No matter how strong the market, goods and services must be priced to sell.

Thus, the sufficient condition is the recapturing of international price competitiveness.

This is the tipping point. The ESRI notes that "the benchmark forecast assumes that domestic policies will accommodate the objective of maintaining competitiveness over the medium-term".

However, the central problem lies in the fact that it may not be within the capacity of domestic policies to revive Irish price competitiveness. Ireland's arsenal of policy instruments was depleted on entry to the euro. Monetary policy and exchange rate policy were surrendered to Europe.

Thereafter, the use of both policy instruments was dictated by the requirements of the core euro zone economies, not by the needs of the peripheral players such as Ireland.

Most of the members of the euro zone trade principally with each other. Ireland is atypical in that two of its principal foreign customers - Britain and the United States - lie outside the euro zone. As a result, the strengthening of the euro against both sterling and the dollar has greatly diminished Irish price competitiveness in two of Ireland's principal export markets.

In recent years it has been the strength of the euro, not the pace of domestic price increases or the rate of wage increases, that has been killing Irish competitiveness. This is demonstrated in the table.

This shows Harmonised Competitiveness Indicators (HCIs) for Ireland, as compiled by the Central Bank. Column 1 shows Ireland's trade-weighted exchange rate, termed the nominal HCI. Because Ireland trades so extensively with Britain and the US, both sterling and the dollar have significant weights in this exchange rate basket.

The second column shows the trend in real price competitiveness. This series adjusts changes in the trade-weighted exchange rate for cumulative differences in consumer price inflation between Ireland and its trading partners. The result is the real exchange rate, the ultimate measure of price competitiveness.

As can be seen from the table, Ireland's trade-weighted exchange rate declined quite significantly in the first three years of euro membership due to the strength of the dollar and sterling against the fledgling single European currency. At the same time, price rises in Ireland were outstripping inflation in competitor countries.

However, as late as April 2002, the depreciation of the exchange rate was sufficient to shrive Ireland's inflationary sins, with the real exchange rate falling slightly relative to 1999.

Thereafter, the euro began to strengthen continuously, first against the dollar, later against sterling. As a result, by April 2008, Ireland's nominal trade-weighted exchange rate was 26.7 per cent higher than six years earlier.

The hardening of the trade-weighted exchange rate has caused a steep appreciation of the real exchange rate. Between April 2002 and April 2008, the real exchange rate has appreciated by almost one-third, rising by 31.8 per cent.

In broad terms, this implies that over four-fifths of the loss in real Irish price competitiveness over the past six years has been caused by the strength of the euro and less than one-fifth is due to Ireland's inflationary excesses relative to trade rivals.

Over the past two years, virtually all of the erosion in real price competitiveness has been caused by the slippage of the dollar and sterling against the euro. Differences in inflation rates have not been a major issue in the calculus of competitiveness.

This is supported by the fact that Irish inflation in the year to May, as measured by the Harmonised Index of Consumer Prices (HICP), precisely mirrored euro zone inflation at 3.7 per cent in the same period.

The overwhelming importance of the euro exchange rate in the determination of real Irish price competitiveness creates an immense headache for Irish policy makers. They cannot control the exchange rate, the factor exerting the greatest influence on price competitiveness.

The devaluation option, exercised successfully both by John Bruton in 1986 and by Bertie Ahern in 1993, is no longer available.

While moderate pay settlements, public sector reform, quicker productivity growth and stronger competition policy are all estimable in their own right, they cannot come within shouting distance of compensating for the competitive losses caused by the recent strength of the exchange rate.

So, in the competitiveness sphere, Irish policy makers are left in an unenviable position. They are waiting for something - the exchange rate - to turn down.