European Economic Policy
European economic policy & Ireland
Charles Larkin gives an overview of the interaction between
current European monetary policy and the Irish economy
Since August 2007 Ireland and the
rest of the world have witnessed
extraordinary economic events
that have fundamentally changed
economies. The global “Great
Recession” has plunged economic
activity into its longest downturn since
the Great Depression of the 1930s.
All European economies have suffered
increases in deficit and debt levels as
rising unemployment and reduced
tax revenues have placed strains on
their respective fiscal systems. This has
highlighted the role of monetary policy
as key to liquidity supply, regulatory
support and inflation management.
The European Central Bank’s (ECB)
monetary policy is clearly defined as
maintaining HICP inflation at no more
than 2 per cent and M3 money supply
growth at no more than 4.5 per cent
(2 per cent inflation + 2.5 per cent
annual Gross Domestic Product (GDP)
growth).
The recent economic downturn has
de facto changed the ECB’s principal
concern from one of inflation to deflation
and to supporting the various European
economic stimuli plans. This has placed
it in direct political confrontation with
France and Germany. The ECB, much like
its counterparts in Washington and London,
is engaged in firefighter operations,
attempting to keep markets sufficiently
fluid to facilitate the steady flow of funds
between banks and provide the day-to-
day liquidity that enables the economy to
function. Central banks are now having
to consider the long-term implications of
these actions and the question of an exit
strategy. Furthermore, quantitative easing
has created concern about future inflation
and the difficulty of reducing central
bank liquidity without stalling a delicate
recovery. Given the moderate recovery of
France and Germany, these are the ECB’s
main concerns.
Interest Rates
Will there be an interest rate increase? Not
in the immediate future, but if the Franco-
German recovery is robust and the Benelux
countries see similar improvements, the
ECB may slowly begin the process of
reducing liquidity and potential increasing
Public Affairs Ireland
“Any discussion of the monetary
policy of the Eurozone must start
from the following essential facts.
Ireland is a small open economy.
This means that it subsists through
trade and does not have any
position of market dominance, so
that it cannot determine prices,
interest rate or incomes.”
interest rates. The economic status of
other members of the Eurozone, especially
larger members like Spain and Italy, and
European Union countries with extensive
banking (i.e. borrowing) connections to
major Eurozone banks may however delay
actions that would suit France and Germany
alone. So where does this leave Ireland?
Any discussion of the monetary policy
of the Eurozone must start from the
following essential facts. Ireland is a small
open economy. This means that it subsists
through trade and does not have any position
of market dominance, so that it cannot
determine prices, interest rate or incomes.
Ireland is thus a price taker, subject to
all economic decisions and disturbances
originating in larger economies such as
the United States, France or Germany.
Furthermore, Ireland has never since the
foundation of the State had direct or indirect
control over its monetary policy. From
1922 to 1979 Ireland’s monetary policy
was determined by the Bank of England
“Quantitative easing has
created concern about future
inflation and the difficulty of
reducing central bank liquidity
without stalling a delicate
recovery.”
directly. From 1979 to 1999 a system of
exchange rate mechanisms linked Irish
monetary policy to the Bundesbank. For the
past decade, membership of the Eurozone
has given Ireland extensive protections
from speculative currency attacks. This
protection has been particularly beneficial
during the current crisis. Finally, Ireland’s
economy is asymmetric vis-à-vis the major
economic centres of the Eurozone, namely
France and Germany. These are the factors
which must colour discussion of Ireland’s
monetary policy.
Interest rates have been held at 1 per
cent since 13 May 2009. Germany and
France have begun the process of pulling
out of their recessions with second quarter
GDP gains of 1.3 per cent and 1.4 per
cent respectively. Ireland’s first quarter
2009 returned an 8.5 per cent reduction in
GDP. (German and French GDP shrunk by
6.9 per cent and 3.2 per cent respectively
in Q1.09). Ireland’s economic downturn
remains much deeper, its deficit much
larger (2009 estimate -10.8 per cent), and
its unemployment rate moderately higher
(12.2 per cent) than the Eurozone and EU
averages. This relative asymmetry places
Ireland’s economy is a difficult position
of being subject to an ill-fitting monetary
policy. This lack of symmetry was partly
responsible for the unsustainable expansion
of the construction sector due to easy credit
prior to the Great Recession. This is not to
say that Ireland would have been protected
if it had been taking policy direction
from the Bank of England or the Federal
Reserve. Both the US and UK economies
had policies of easy credit and slid into a
destructive housing boom-bust cycle. The
bursting of the credit and asset bubbles has
also brought about a degree of introspection
on the part of all central banks: lavishing
attention on price inflation is now seen as
being too parochial. In hindsight it was the
massive and largely ignored asset price
inflation that fed the housing/construction
and capital market booms.
Monetary policy, like many elements of
the economic policymaker’s toolkit, is a
blunt instrument, more akin to a mallet than
a scalpel. National governments, through
regulation (which can have unintended
consequences) and fiscal policy (which
is slow to take effect and imprecise in
its targeting) can significantly influence
economic policy even without control
over monetary policy. Many aspects of
3
European Economic Policy

macroeconomic policymaking are more

art than science. In spite of these caveats,
it would be wrong for Ireland to dwell
too extensively on interest rate policy
when there exists a much larger and more
menacing elephant in the room – fiscal un-
sustainability.

Ireland
Ireland is currently borrowing €400 million
a week in order to sustain current spending
plans. This clearly cannot be supported
over the medium term. The Growth and
Stability Pact was approved in 1997 as
the method for enabling the convergence
of the original European Monetary Union
economies prior to the introduction of
the Euro. Countries that deviated from
the Growth and Stability Pact after the
introduction of the single currency would
be required to comply with the Excessive
Deficit Procedure, which resides in
Article 104 of the European Community
Treaty (Amsterdam), which outlines, in
conjunction with Council Regulation (EC)
No 1466/97, the procedures necessary to
maintain budgetary discipline.
Because of excessive deficits and
the considered opinions of economists
rapidly increasing public debt levels (the
such as Professors Paul Krugman, Brad
ESRI estimates Gross Debt at 99 per cent
DeLong and Simon Johnson indicate a
of GDP in 2009: comprising normal debt
at 57 per cent, NAMA at 30 per cent and
“Ireland is currently slow “L-shaped” recovery with a “jobless
recovery” being the most likely scenario
recapitalisation at 12 per cent) Ireland borrowing €400 million over the medium-term. Such predictions
was required to submit a Stability and
a week in order to sustain do not bode well for Irish exporters.
Convergence Programme at the end the
European economic policy does have a
2008 under the framework of the Excessive
Deficit Procedure. This was amended in current spending plans. This significant impact upon the Irish economy
but it alone does not shape economic
January 2009. The programme, which was clearly cannot be supported destiny. Economic policies undertaken
agreed with the European Commission,
by all large economies have affected
outlines how Ireland will eliminate its over the medium term.”
Ireland’s economic debt. Ireland cannot
budget deficit by 2013. To quote the
be sole master of its economic destiny, as
submission itself:
a matter of fact, not as a matter of choice.
The Government has agreed to put in
Membership of the Eurozone has placed
place a five year plan to restore balance considerable quantities of “low hanging the Irish economy under a protective
to the public finances by 2013. This will fruit,” it is necessary both to make direct umbrella while the country experiences
include as a priority the elimination of the cuts and to stop growth. structural adjustment. This does not mean
current budget deficit by 2013, that is to
that Ireland’s domestic policymakers are
stop borrowing for day-to-day spending, Exchange rates absolved of their prudential responsibilities.
and in that period to also bring the General The Irish Government in its submission As outlined above, the role of domestic
Government deficit to below 3 per cent to the European Commission raised policy is now more significant than ever
of GDP, while maintaining a high level of concerns with respect to exchange rate as the government attempts to fulfill
capital expenditure. exposure with major trading partners. its obligations to the Excessive Deficit
The Report of the Special Group on Ireland’s recovery will be partly driven Procedure. Ireland’s position requires it to
Public Service Numbers and Expenditure by the export sector, which defined the be prepared for its economic partners to
Programmes led by Dr Colm McCarthy of heady days of the Celtic Tiger. Even enter recovery with competitive exports
UCD attempts to effect the fiscal policy though Ireland trades extensively with and an amiable environment for FDI.
changes necessary to place Ireland’s Eurozone countries, the UK and the US Continued fiscal iniquity is the true road
budget deficit level below 3 per cent by are significant markets, especially since to perdition and domestic policymakers
2013. Dr. McCarthy has recommended the US is Ireland’s main source of Foreign must not only seek economies in public
approximately €5 billion in budget Direct Investment (FDI). This exchange expenditure but also engage with the
cuts in his report and provides the basis rate exposure has been highlighted by expertise of the elements of the European
for reducing the fiscal burden over the the Government as a potential pitfall to Union and ECB to discover novel solutions
medium term. As he outlined in several the 2013 target, most especially if it is to the “Great Recession.”
statements over the past year, the key to exacerbated by continued weak demand
remedying 1980s fiscal impasse was not due to a weak recovery. International Dr Charles Larkin is a research associate
by cutting directly but slowing growth Monetary Fund (IMF) statements on in Trinity College Dublin
in public expenditure to zero. Now, with the US and UK economies, as well as

4 Public Affairs Ireland