Devaluation: the Irish Story

The building of a favourable business environment rather than devaluation of the national currency is the factor driving the economic growth in Ireland.

The Irish economic growth of 1987-2007 is a unique phenomenon, an aggregation of effective economic policy decisions and the benign impact of external environment. As to currency devaluation, tens of other countries did devalue, yet none of them have been able to replicate the Irish success story as yet. The statement that Ireland's success was on account of devaluation is not true; similarly, there are no grounds at all to assert that in the given case the devaluation effects had been positive.

Ireland's Failing Attempt

Regarding the economic history of Ireland of recent decades, let us look at the cornerstones of Irish economic headway.

In years between 1973 and 1986, Ireland pursued a policy of fostering aggregate demand, based on the popular Keynesian doctrine about achieving faster economic growth through fiscal and monetary expansion, i.e. by increasing government spending and devaluing national currency. The budget deficit in 1980-1987 averaged 12% of GDP; in 1983 and 1986 Ireland devalued its national currency in response to depreciating exchange rates in the UK and US, its major trade partners. As a result, for instance in 1985, the exchange rate of the Irish pound was 22% below the 1979 level.

These fiscal and monetary policy moves notwithstanding, the outcomes were albeit modest. Ireland was still Europe's geographical periphery and one of the poorest EU countries. In 1987, GDP per capita by population purchase power in Ireland was 63% of the UK level. Unemployment soared at 17%, and massive emigration to the US was continuing. There were no hopes of a swift income convergence toward the level of the rich countries as economic growth rates were lagging behind those in the UK and continental EU countries. The government debt amounted to 117% of GDP, and a further increase in the budget deficit intensified concerns about state debt sustainability, hence substantially pushing up the state default (or insolvency) risk premium due to which interest rates in Ireland were up to 15 percentage points above the level of Germany.

Reducing Budget Deficit and Tax Rates, Restoring Confidence

In 1987, a massive fiscal consolidation was launched, with the government spending cut substantially and tax burden easing. The dropping budget deficit restored confidence in the economic recovery, while the alleviation of tax burden ranked Ireland first among low-tax EU countries; as a result, foreign direct investment inflows into production increased. In order to avoid the EU import duties, the US and other producers from non-EU countries moved their companies to Ireland, to later take the output produced in Ireland to other EU countries. Exports expanded more dynamically than imports, with the export/import gap at 9% in 1986 and 71% in 2003. The demand for labour increased, bringing unemployment down to 4%, and labour shortages began to be felt. The emigration trend persisting for decades was reversed as the country became the destination for immigrants: prior to the turn of centuries, Irishmen returned from the US, while prior to the EU enlargement, hundreds of thousands of citizens from the new EU Member States opted for Ireland as a dreamland. As a result, within 12 years after the launch of fiscal consolidation, Ireland became the EU's second wealthiest country (after Luxemburg) with its GDP per capita by population purchase parity reaching 114% of the UK level in 1999.

Can the episode of Ireland, the Celtic Tiger, serve as an example to be repeated by any other country? The Irish economic boom was underpinned by the interaction between a targeted confidence-restoring policy and a number of favourable external factors. First, a gradual departure from protectionism policy began in the 1970s, to be replaced by a strategy of free trade and integration into the continental EU countries (major former Ireland's trade partner was the UK). Second, it was in the 1980s that the highest tax and public spending ratio to GDP was reached in several EU countries due to which Ireland's attractiveness for foreign direct investment was boosted. Third, the Irish nation has formed a large foreign diaspora (mainly in the US), and when labour shortages surfaced in Ireland,  people returned home, thus reducing labour deficit and further promoting the growth of the Irish economy.

Theoretical and Practical Impact of the Irish Story, Useful also for Latvia

The Irish success story and its uniqueness have impacted both overall development of economic thought and activities of several EU countries. Ireland has demonstrated that some other fiscal policy effects outside the Keynesian theory may prove more viable than the Keynesian effect.  And namely, according to Keynes, the reduction in the state budget revenue has a negative effect on the economic growth; the Irish reality, however, evidences that the effect of boosting confidence through budget consolidation can outdo this theoretical effect. In practice, other EU countries followed suit in the 1990s and moved gradually toward a lower tax burden and smaller ratios of public spending to GDP; as a result, low budget deficit is among the decisive criteria to be met for participation in the euro area.

The current situation in Latvia has many similarities with the mid-1980s Ireland: a large budget deficit does not foster its economic activity; on the contrary, it undermines confidence in sustainable economic growth and intensifies concerns about an even heavier tax burden in the future. All this adversely influences business development opportunities. The current uncertainty should be minimised as soon as possible, for it only magnifies businesses' risk perception; a balanced budget should be achieved consistently with the last year's economic stabilisation and growth revival programme for Latvia.