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News : Irish Economy Last Updated: Sep 27, 2010 - 12:49:12 AM

Irish Economy: Some unpleasant dynamics and the prospect of poorer European countries being asked to help 'rich' Ireland
By Michael Hennigan, Founder and Editor of Finfacts
Sep 24, 2010 - 5:41:20 AM

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Source: Peterson Institute for International Economics

Irish Economy: In a commentary on Thursday, a US-based economist discussed some unpleasant dynamics in the current Irish economic stew and the prospect that  poorer European countries would be asked to help or bailout 'rich' Ireland.

Jacob Funk Kirkegaard works at the Peterson Institute for International Economics think-tank in Washington DC. He is Danish and this is important as many American economists including Paul Krugman and financial commentators, had provided alarmist and sometimes ignorant analyses during the sovereign debt crisis last May.

Kirkegaard says it is clear that without a credible strategy for Irish banks and longer-term budget solvency, Ireland will be plagued by lingering financial and fiscal concerns. He says speculation about what Ireland might have to do remains justified.

When thinking about a possible future crisis assistance package for Ireland by the European Union (EU) or the International Monetary Fund (IMF), he says several issues arise.

First, from which pot of money would any assistance package come? Though the Eurozone’s €440bn European Financial Stability Facility (EFSF) received AAA-ratings from all major agencies this week - - and hence moved closer to being operational - - this new facility may not be the most likely source of aid.

Instead, the economist says the smaller €60bn European Financial Stability Mechanism (EFSM) guaranteed by all the EU-27 via the European Commission budget (along with €35bn in uncommitted funds from existing Balance of Payment facilities originally intended for new noneuro member states) would seem to be a better candidate. Far less political implementation risk surrounds this facility. Its predecessor entity was already tapped for Hungary. When spiced up with an additional 50% IMF contribution, the nearly €100bn EFSM and Balance of Payment facility should suffice for an assistance package to Ireland (Ireland’s GDP is roughly two-thirds that of Greece).

Kirkegaard says the new head of the EFSF, Klaus Regling, has stated that he thinks no country will ever use it. He may well be right. But that does not mean that the European Union won’t be able to bail out smaller members like Ireland or Portugal. After all, the EFSF was intended to deal only with a “large member state emergency.” Given Spain’s recent steady performance, that has become much less likely.

The economist says there is an issue of the conditionality attached to any assistance to Ireland. The IMF-led program for Greece contains a very long list of tough and urgently needed structural reforms, and obviously the same regime would likely be applied to Ireland. Several particular political concerns arise about any conditionality for aid to the erstwhile Celtic Tiger, however.

The Slovakian government infamously refused to participate in the Greek bailout, comparing it to a “reverse Robin Hood transaction,” in which the poor Slovakians would be subsidizing the richer Greeks.

Kirkegaard says imagine, however, the uproar across the Eurozone if voters in these countries were asked to help Ireland, which in 2009 had the second highest GDP per capita in the European Union. Only Luxembourg was higher (the duchy's high level is partly explained by the fact that a high proportion of its workforce lives in neighbouring countries). The relative income is illustrated in figure 1 above. In 2009, Ireland had a GDP per capita more than 20% higher than the Eurozone average (and more than 30% higher than the EU-27). He says this is not the most promising basis for a “solidarity handout” from its poorer European partners, already politically exhausted from bailing out Greece.

Reflecting the very large presence of foreign multinationals in the Irish economy, figure 1 also includes data for net national income per capita for 2009.1 Here Ireland is much closer to, but still above, the Eurozone average at just 101.4%.

That might seem like a better reason for getting help from the European Union - - better, anyway, than higher GDP numbers. Yet the reason for the large difference between Ireland and other countries in its GDP and net national income is for sure not one that Ireland wishes to remind its European partners to remember.

The economist says a large presence of foreign multinational companies in the Irish economy can be traced back to the pioneering Irish slashing their corporate tax rate from 40% in 1993 to 12.5% today. However, what happened was that in 1997, the European Commission agreed with the Irish government that 1) the general high corporate tax rate, 2) an exemption from tax on exports profits that had been introduced in 1956 and 3) a 10% tax on manufacturing that was introduced in 1981 initially to provide a low rate for firms that were losing the 100% exemption, would be replaced with one rate of 12.5%. For example when Intel began production in Ireland in the early 1990s, its tax rate was 10%.   

Kirkegaard says in many ways this tax cut was an example of the benefits of “EU regulatory competition,” which has led to a significant reduction in overall EU and OECD corporate tax rates[pdf]. However, when viewed by the principal sponsors of any future Irish bailout among its EU partners - - France and Germany in particular - - the race to cut taxes could amount to a classic “beggar-thy-neighbor policy” aimed at bribing EU companies to relocate to Ireland.2

The economist says leaving aside Ireland’s corrupt ties among real estate developers, banks, and politicians, the country is not perhaps as politically undeserving of European solidarity as “systemically corrupt” Greece (Prime Minister Papandreou’s words[pdf]). But there will nonetheless be substantial obstacles.

He says that just as Delaware’s low corporate tax policies would not likely survive a hypothetical federal bailout (or from the national governors association!), Ireland’s corporate tax rates will probably not survive unchanged following a future bailout. Despite the obvious harm to the Irish economic model of a likely substantial increase in its corporate tax rates, you can’t bite the hand that feeds you in a crisis. It would be hard to imagine that substantial “upward tax harmonization” would not be politically demanded by Paris and Berlin in return for any bailout. Indeed the first German politicians have already made this type of demand in advance. Beggars can’t be choosers will bring an end to beggar thy neighbor in the Irish case.

Kirkegaard says obviously, the Irish decision makers know this and can consequently be expected to try to avoid an EU bailout. It is even possible that Ireland, were the need to arise, would prefer to go directly to the IMF. Or perhaps Ireland will try to avoid such an outcome by agreeing for a time to pay market interest rates higher than what would be available under “conditional EU funds.”

Ireland’s relative affluence when compared to its partners, when combined with the punishment meted out to the Latvians - - another country caught up in a boom-bust cycle - - suggests that truly draconian cuts would be demanded of the Irish in return for an EU bailout.

After all, were Ireland to suffer a decline in GDP per capita similar to that of Latvia -- about 20% - - it would merely be down at around the Eurozone and EU average income level and back at Irish income levels in the late 1990s (in real terms). "Extremely unpleasant, yes, but hardly the potato famine," he says.

Kirkegaard concludes that though such a deflationary cure could wreck Ireland’s debt to GDP ratio by shrinking the numerator dramatically, Irish leaders would be ill-advised to bet against this political dynamic materializing in any European bailout.

SEE also, Finfacts article, Sept 17, 2010: Ireland in a state of chassis

1. Net national income corrects for the presence of foreign-owned enterprises in a country by including net foreign income (interests and dividends, also known as net foreign factor income) flows and subtracting indirect taxes and depreciation.

2. Ireland can be argued to have shown that the old Laffer curve argument actually does work - - however, only if you can attract huge amounts of tax revenues from abroad, rather than by actually growing the existing domestic economy any faster.

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