One can't imagine Mr Alan Greenspan, head of the US Federal Reserve, travelling to Rhode Island and lecturing the residents there on the need to rein in local inflation. Yet his counterpart in Europe, Mr Wim Duisenberg, president of the European Central Bank (ECB), did the equivalent last week when he rode into Dublin and told his Irish audience that inflation here would have to be tackled by the Irish Government alone. He then rode out again, refusing to elaborate or answer questions.
In fact, the speech was not generally country-specific and had that whiff of academia common in texts prepared by the research department of the ECB. He did offer, however, an unscripted remark to the effect that the Republic was experiencing a little bit of a free ride (on inflation) and that "policy can deal with this or the market will deal with it in a more painful way later".
His listeners might be forgiven some irritation about this, in view of the fact that Ireland gave up its interest rate and foreign exchange sovereignty to the ECB against a promise that the latter would deliver price stability. Yet here was the president of that organisation saying the bank couldn't help curb Irish inflation.
Worse, the audience was told that Ireland would itself have to adopt appropriate policy to curb price pressures. The usual temptation to shoot the messenger bringing unpalatable news should be resisted for the moment, at least until the message is given due consideration. In this case, it is arguable that the ECB president did not give sufficient weight to the specifics of the Irish inflation story, so drawing inappropriate conclusions as to what can and should be done to dampen inflation here.
Like Rhode Island, the smallest state in the US, Ireland is tiny in relation to the overall size of the euro zone. Ireland's GDP is around 1 per cent of the total, so even if Irish inflation was to accelerate to 10 per cent, it would add only 0.1 per cent to the total inflation rate of the zone. Consequently, developments in Ireland will have no impact on ECB policy, which sets interest rates to influence inflation in the zone as a whole. In practice, this means that price trends in Germany, France and Italy will dominate ECB thinking, as together these economies account for some three-quarters of the output of the euro zone.
So while interest rates in the euro zone, at 4.5 per cent, may well be at or near the level required to curb inflation in Germany and France, they may equally be too low for those smaller countries, like Ireland, with much stronger growth. Thus do the wide differentials in inflation rates across the zone persist.
To compound this problem, the 11 economies in the euro zone differ markedly in their dependence on foreign (that is, non-euro) trade. On this, many foreign commentators fail to appreciate the degree to which the Republic stands out. Quite simply, little of the Republic's trade is with the euro zone, so the Irish economy and its price levels are much more dependent on the euro's value against sterling, the dollar and the yen than any other member-state.
Trade data to the end of May, for example, show that the Republic's total imports in the first five months of the year amounted to £17.1 billion, with only £3.8 billion (less than a quarter) sourced from the euro zone - the bulk, therefore, is subject to foreign exchange. This compares with figures of 30 per cent for Portugal and 35 per cent for Austria, similarly small economies. Furthermore, Ireland is much more open to foreign trade than others in the euro zone (merchandise imports in 1999 amounted to half of GDP). Non-EU import prices therefore have a huge impact on the Irish price level, whereas most other euro states trade with each other and, as such, price trends will be largely determined by internal rather than external factors.
Had the euro risen sharply since its birth, the Irish airwaves would be filled with the cries of exporters bemoaning the loss of foreign markets and economists warning about the unemployment consequences. In the event, to Ireland's cost in terms of inflation, the euro has fallen sharply over the past 20 months.
Clearly, then, Irish inflation would probably be much higher than would anyone else's in the euro area, simply through this effect on import prices, regardless of whether the domestic economy was growing by 2 per cent or 10 per cent.
In fact, we are still growing by at least 10 per cent, probably 13 per cent, and not all of the inflation can be put down to the weak euro - inflation in the service sector does reflect the strength of consumer spending. As Mr Duisenberg pointed out, this requires policy action by the domestic authorities.
But what policies does he mean?
They include measures to increase competition and to make markets - including the labour market - more flexible, but in the short term the onus is on fiscal policy, which means adjusting Government spending and taxation. In simple terms, this means that fiscal policy should be tighter following a fall in the euro, reflecting the fact that interest rates are too loose for the Republic's specific circumstances.
Yet, arguably, fiscal - or budgetary - policy here is already very tight. The Government planned this year to raise £5.5 billion more in revenue than it could spend on day-to-day items like public sector pay, social welfare payments and debt interest, but the tax base is growing so rapidly that the current budget surplus may well reach £6.5 billion by year-end. This amounts to over 8 per cent of GDP, which is a large surplus in anybody's language and raises the question as to what level of surplus would be enough to satisfy the ECB: £7.5 billion, £8.5 billion, even £10 billion?
Of course the Government does spend additional monies on building up Ireland's infrastructure, and the deficit on the capital side of the balance sheet will be around £3 billion in 2000. This gives an overall budget surplus of perhaps £2.5 billion, equivalent to 3.2 per cent of GDP. Again one has to ask what size of a surplus the ECB deems appropriate.
The politics of tightening fiscal policy here is another question, particularly in the light of the recent PPF agreement, but the fact is that the impact on inflation would be so small as to question the validity of the whole operation. If Mr McCreevy stood up in the Dail in December, announced a Pauline conversion to the ECB view and proceeded to raise the standard rate of income tax to 25 per cent, the impact on wages and growth might be severe, but one doubts if he would knock much more than half a percentage point off the annual inflation rate.
Indeed, on the same date The Irish Times reported Mr Duisenberg's speech, it carried a report from the World Economic Forum which stressed that high tax rates were an important factor in dampening Irish competitiveness. The forum put Ireland in fifth place in the world in terms of competitiveness, but only 22nd when the sustainability of the competitive gains was the criterion.
Two of the key impediments to the economy's competitiveness were identified as the transport infrastructure and high marginal rates of income tax. On this analysis, the Government's policy of increasing capital spending and lowering tax rates was vindicated.
The conclusion has to be that tax cuts should still be proposed by the Government and that it is whistling in the dark to imagine that politically acceptable changes in the Budget can have a big impact on inflation. An impact, yes, but if the euro falls further, Irish inflation will rise regardless of what happens to tax rates.
The overwhelming contradiction to ponder, though, is that Ireland is in a monetary union with 10 other countries, but is mostly trading with countries outside that union. As such, it is paying a short-term economic cost for what was ultimately a political decision, a cost borne by all Irish consumers and savers.
Dr Dan McLaughlin is chief economist with ABN - Amro
Tomorrow: Danny McCoy of the Economic and Social Research Institute
