The weakness of the pound against sterling in recent months has encouraged much comment. The danger for Ireland of a strong sterling is that British goods become more expensive in pound terms. In the absence of offsetting factors, this can result in higher inflation. There are offsetting factors at present though, in that the pound is strong against the deutschmark, making D-mark-denominated goods inexpensive.
The Central Bank is to be commended for the way it has managed the exchange rate since the currency crisis of 1992/93. The pound has moved between the deutschmark and sterling, so that the consequences of sterling weakness or sterling strength have been offset by appropriate weakness or strength of the pound against the deutschmark.
The problem about Ireland joining EMU while Britain remains outside is that this option, of balancing a strong sterling by having the pound appreciate against the deutschmark, will no longer be available. If we were already in EMU, the inflationary consequences for Ireland of a strong sterling could not be offset by an appreciation of the Irish currency against the deutschmark.
Most economists are probably more fearful of a weak sterling, because of the consequences for competitiveness. Weak sterling damages those sectors of Irish industry that export to Britain or compete against British products. If sterling fell and we were locked into EMU, there could be no possible competitiveness gain through depreciation against other currencies.
This possibility was taken into account in the ESRI report on the "Economic Implications for Ireland of EMU" commissioned by the Government last year. The main benefit focused upon by the ESRI study concerned the lower-interest rates that it deemed likely under EMU. The ESRI asserts that rates will fall basically to German
levels because there will be no possibility of the Irish currency being devalued within EMU. Critics respond that different interest rates attach to the debt of various US states even though there is no currency risk vis- a-vis other US states.
Most criticism of the ESRI report has therefore focused on the benefits identified, arguing that they are exaggerated in the report. But my disagreement with the report concerns the downside. I argue that the costs of possible sterling weakness are in fact greater than the report suggests. My argument revolves around two issues: the different skill levels of workers in sterling-sensitive and in non-sterling-sensitive sectors of the economy, and the degree of wage flexibility that the report assumes.
The ESRI report outlines how it believes the economy would react to sterling weakness. It accepts that sterling-sensitive sectors (or "traditional" industry generally) are labour intensive relative to modern industry. An adverse shock to these sectors would throw more people out of work than an equivalent shock to modern - hi-tech - industry.
The increased unemployment that would result would, however, over time, reduce wage demands. Simultaneously, inflation in Britain would rise, as would wage demands, in response to the weakness of sterling. In these ways, the ESRI says, the loss in Ireland's relative competitiveness position would be moderated over time, leaving no lasting effects.
But there is plenty of evidence to suggest that less-skilled workers, once unemployed, are much less likely to be able to find new jobs than are highly-skilled workers. Thus unemployment may not return to initial levels after a shock. The report thus overestimates the ability of the economy to adjust to a sustained bout of sterling weakness.
A more serious criticism concerns the degree of wage flexibility the report assumes. In the picture painted by the ESRI, downward adjustment of wages plays an important role in reducing unemployment after the initial "sterling shock". The report uses data from 1983 to 1995 to model the response of wages to price movements. Each sharp fall in sterling over this period though was followed by a devaluation of the pound against the deutschmark; the data is therefore based on fairly continuous weakness in the pound.
There is no guarantee that wages would fall back in response to a suddenly strong Irish currency. Indeed, the refusal on the part of Irish unions to renegotiate nominal wage agreements downwards when sterling fell sharply on departure from the ERM in 1992 suggests that such wage adjustment will not happen.
On the basis of a simple economic model, I estimate that the job losses associated with sterling weakness could be more than twice as large as predicted by the ESRI, when its assumption of downward wage flexibility is replaced by the arguably more plausible assumption that wages will not fall in response to such currency developments.
The conclusion of the ESRI study was that the benefits it deemed likely to flow from EMU membership would narrowly outweigh the employment losses associated with a weak sterling. If I am right in assuming that wages would not come down in response to an unanticipated fall in sterling, it suggests that the "narrow verdict" in favour of EMU membership reached by the ESRI report may well be overturned, and that Ireland should not enter EMU without Britain.
The debate over the correct response to the current strength of sterling should reopen our eyes to the ties that bind our economic well-being to the value of the British currency.
Dr Frank Barry is a senior lecturer in economics at UCD.
