Ireland's Adoption of the New Policy Consensus

Colin O'Flaherty – Senior Freshman

The new economic policy consensus has been embraced by Irish policymakers as the best route to growth and development. Colin O'Flaherty takes examples from our economic history since independence to explain the emergence of this agreement and analyses how it benefits the Irish economy.

Introduction:

The recent success of the Irish economy seems to have come about in the wake of some paradigmatic policy shifts. This essay seeks to determine whether or not the adoption of this New Economic Policy Consensus (NEPC) has been good for Ireland by examining our economic history between 1921 and 1993. The description of NEPC with which I intend to work is provided by McAleese. He describes the it as consisting of three pillars:

1^st Pillar: An increasing emphasis on the use of market mechanisms to achieve objectives rather than supplanting them with state intervention.

2^nd Pillar: Macroeconomic policy is now orientated more to ensuring a stable economic framework rather than achieving proactive counter-cyclical targets or national plan growth rates and investment targets.

3^rd Pillar: National policies have become more outward-looking, as is evident by the successful completion of the Uruguay Round, the steadily increasing membership of GATT, the relaxation of controls on capital mobility and the globally more benign stance towards foreign investment.

McAleese tells us that economic policies throughout the world are converging in the mid-1990's around these three basic principles. It is my intention in this essay to firstly show, very briefly, that by 1993 Ireland had signed up to these principles and then more importantly to show, by reference to examples from our economic history in the period 1921 to 1993, that we were right to ‘sign-up' to this consensus.

By 1993, Ireland had undoubtedly moved towards ‘smaller' government. Privatisation and deregulation were by then important words in Irish economic circles. The deregulation of the airline market in 1986 and the privatisation of major enterprises such as Irish Life act as proof of this. Even in the public sector, market-type activities such as tendering for contracts were becoming more common. Also, moves were afoot to reduce taxes to help create a more enterprise friendly environment. Indeed the 10% Manufacturing Tax made Ireland somewhat of a tax haven for certain organisations. Income tax cuts were also evident.

There is no doubt that deregulation is good for Ireland after the 1986 airline market deregulation. This lead to much cheaper air fares for Irish consumers and more importantly helped boost Irish tourism. Any jobs which were lost in Aer Lingus were more than compensated for by the increase in employment not only in competing airlines, but throughout the revamped tourism industry. The above illustration proves the point that markets perform more efficiently if there is competition.

The benefits of privatisation to the Irish economy may not be quite so clear cut because the State Sponsored Bodies (SSBs) which started as far back as the 1920s were generally successful agents of economic development especially (in Jonathan Haughton's words): "in the first few decades after independence, when the private sector did not appear to be very enterprising".

Finally, as regards the 1^st Pillar, there is no doubt at all that a reduction in taxes is good for the Irish economy. There are many reasons for this, but the primary one would have to be the reduction in economic distortions in the employment market which comes with such a move. Between 1984 and 1993 the employment rate never fell below 13%. A rigid labour market, where the incentive to work was weak due to high unemployment benefits and high marginal tax rates did not help solve the problem. New measures were needed and a fall in taxes leading to a decrease in the tax wedge can only be good for Ireland in her effort to solve the scourge of the 1980s and 1990s – unemployment.

The second pillar consists of two main sub-sections. That is to say that macro-economic stability consists of price stability on the one hand, and fiscal stability on the other. Ireland had by the mid-1990s undoubtedly signed up to these principles, if for no other reason than to be eligible to join EMU. After all, the criteria for such membership included low inflation and a budget deficit not exceeding 3% of G.D.P; another key element of the Maastricht Treaty was that public sector debt must be approaching 60% of G.D.P. On both of these aspects, Ireland was making giant leaps.

If the 1980s were perhaps the key decade for proving the importance of the 1^st Pillar, we need only go back one decade further to see the importance of price stability and the implementation of a stable economic framework rather than using proactive counter-cyclical Keynesian measures. The key difficulty in adopting demand-stimulating policies is knowing when to stop; i.e. when such policies are no longer necessary or useful. Ireland in the 1970s was a case in point. The recession caused by the ‘oil shock' in the early 1970s passed a few years later, but the Irish government did not discontinue their use of Keynesian policies (which had initially helped prevent economic crisis) because they worried about unemployment.

By the late 1970s, counter-cyclical measures had become pro-cyclical and as always the costs came with a lag. Heavy government borrowing used to stimulate demand through increased public expenditure led to a huge increase in the debt to GDP ratio from 52% in 1973 to 129% in 1987. The result was a huge increase in taxes to try to gain the revenue to pay back even the interest on the debt. The resulting disincentive effects such as high tax rates helped exacerbate the very problem which the government had tried to solve in the 1970s – unemployment.

This was further compounded by the fact that workers naturally saw tax increases as justifying nominal wage increases, thus making Irish labour less attractive to employers. Only with huge drops in government spending and strict wage restraint were the problems eventually lessened. However, even as late as 1993, unemployment had not recovered – a strong ratchet effect was evident.

Undoubtedly prioritising low inflation (or price stability) is needed if we are to have stable fiscal policies. However this requires lower government spending. Otherwise we risk returning to the days when high government spending expanded the economy and brought about inflation. With inflation comes increasingly vociferous calls from employees and their trade union representatives for wage increases which will maintain the value of their wages in real terms. If such calls are heeded (and it is often difficult in times of rising prices for a government not to heed them) the economy can quickly spiral into a vicious cycle of low competitiveness. Such a cycle is difficult to escape from. The helpful effects of a return to fiscal rectitude could be clearly seen in the Irish economy in the late 1980s and early 1990s as the ratio of debt to GDP fell, primarily as a result of lower government spending, and a period of robust economic growth dawned on the Irish economy.

There can be no doubt that Ireland has fully espoused the need for free trade between world economies. Our eager membership of the European Union and indeed of the GATT shows this more clearly than any number of words can. Likewise, the hugely important role played by foreign direct investment (and the encouragement given to it by the aforementioned 10% manufacturing tax) have proved crucial in the development of the Irish economy and our subsequent economic boom.

Let me begin this argument with a point that could quite possibly also be used with reference to either of the preceding pillars. Ireland is a very small open economy. We must follow world trends because we do not have the strength to go against them. At any rate, the Irish market is so small that greater efficiency of production by Irish companies requires Irish access to foreign markets and this can't be achieved if we deny others access to our market through tariffs.

We attempted to initiate self-sufficiency in the 1930s and it didn't work. For one thing, import-substitution ran its course as early as 1936. There is only so much the Irish economy is capable of producing, particularly without importing foreign raw materials. For Irish business to be successful we need access to certain inputs, such as coal or oil for example, though the list is almost endless. For the most part these inputs need to be imported. Let us not be fooled. No other country in the world will provide us with the necessary inputs for our productive factors if we do not allow their exports access to the Irish market. It doesn't matter that the Irish consumer base is small, it is a point of principle.

Also, like in the previous example, the costs of the 1930s came with a lag, and much of the blame for the gross inefficiency of the industrial sector in the 1950s has been attributed to factors which developed during the 1930s. As I alluded to previously, efficiency comes with competition. A stand-alone Irish economy, as the 1930s showed, can't provide such competition. Quite simply our markets are too small. Between 1938 and 1943 Irish exports fell by a half, and imports fell even more. Industrial employment also fell, primarily as a result of the scarcity of raw materials which thus restricted the range of production opportunities open to Irish producers.

Furthermore, Irish entrepreneurs and businessmen were left with no way of expanding their business in a restrictively small Irish economy. The reason for this is to do with the issue of economies of scale. Irish producers producing solely for the Irish market will not be able to avail of such economies of scale, which come with producing large quantities of products. Such large quantities of products will obviously only be viable if one is serving a large market; the Irish market for most products is not of sufficient size to enable many producers to benefit from the said economies of scale. We need to be selling abroad - we need a larger network of buyers.

Finally such a policy stance will leave the Irish consumer with relatively little choice as a result of the drop in imports, which it may also be said leads to higher prices. The reasons for this are obvious. The greater the variety of products we import, the greater the choice provided to the Irish consumer. Also the greater the number of products entering the Irish economy, the less risk there is of demand exceeding supply and thus driving up prices.

Some people have suggested that short-term protection for infant industries can be a good thing but here again this is controversial. There is always the risk that this might breed inefficiencies which will only be discovered when the industry in question is eventually subjected to international competition. As J.J. McElliott put it in the 1920s when warning of the danger of protection: "To revert to free trade from a protectionist regime is almost an economic impossibility".

Another reason for the adoption of free trade is the beneficial role which export led growth played in the Irish economy in the 1960s. Haughton tells us that this policy of export led growth stood on two legs – trade liberalisation and the attraction of foreign direct investment.

Trade liberalisation called for the reduction of tariffs - which made inputs dearer and thus inhibited exports, which became more costly to produce as a result of increased prices for imported raw materials.

Foreign direct investment, on the other hand, helped to bring new skills to the country and also helped increase overall investment in the economy. Indeed by 1974, many foreign companies had set up in Ireland and new industry accounted for 60% of industrial output.

I conclude merely by saying that Ireland is right to adopt fully the new Economic Policy Consensus. Only by doing so can Ireland hope to succeed in the future, as evidence (outlined above) from the past clearly shows. In the immortal words of Santayana: "Those who ignore history are condemned to repeat it". I therefore urge the Irish policy-makers to learn from the evolution of Irish history with regard to the three broad themes outlined above. Let us not in the future repeat the mistakes of the past.

Haughton, J. (1995) "The Historical Background" in O'Hagan, J.W. (ed.) (1995) The Economy of Ireland. Gill and MacMillan: Dublin.