Celtic Tiger Irelands Growth Economics Essay

Celtic Tiger Irelands Growth Economics Essay The Harrod-Domar (CITE!!!) model developed in the 1940s was originally intended to analyse business cycles, but has since been adapted to economic growth. In the model, growth is dependent on the levels of labour and capital. As developing countries typically have a plentiful supply of labour, their growth is more dependent on physical capital and savings to create growth. Growth is achieved through net investment which will lead to capital appreciation thus producing higher levels of output and income; with higher levels of income there will be higher levels of saving. Thus, economic growth is dependent on policies and practices that will promote savings and/or create technological advancements that will decrease the capital-output ratio. However, this does not provide a complete picture and as a result, further models have since been developed. The traditional neoclassical growth model as developed by Solow (1956) and others builds on the Harrod-Domar model by including labour as a factor of production. However, the model allows little room to explain any impact other outside factors, such as foreign direct investment, may have on economic growth. In the model there are diminishing returns to capital and long run growth will be determined through exogenous factors such as technological advancement or population growth. Growth only lasts for a transitional phase until the economy reaches its new steady state level of output and employment. The model also states that growth rates are inversely related to a countrys income per capita; a poor country with similar endowments to a richer country will grow faster and eventually converge to the income per capita level of the richer one. Exogenous factors will only affect growth in the short term and the only way they can have lasting effects is via permanent technological shocks. H owever, Romer (1986), Lucas (1988) and Barro and Sala-i-Martin (1995) among others are credited with the development of the endogenous growth model which considers technological advancements as endogenous to the model. In his seminal paper on growth, Romer (1986) provides an alternative model for long term economic growth. He states that income per capita among developed countries does not necessarily converge with that of developed countries and that in fact there may be differing levels of growth. In particular, less developed countries can exhibit low levels of growth or may not grow at all. The factors that do lead to growth are not dependent on exogenous technological changes or differences between countries, but rather technology is endogenous to the model. Even holding technology, population and other factors constant, the most important idea is to ignore the traditional assumption of diminishing returns. Thus, long run growth will come from the accumulation of knowledge. Knowledge can demonstrate increasing returns and marginal product and can have limitless, constant growth. New knowledge will be transferred between firms and have positive externalities thus leading to increased growth. Ro mer (1986) argues that these positive externalities are able to explain growth and are necessary for an equilibrium state to exist. Similar to Romer, Lucas (1988) adds technology or human capital to the neoclassical growth model. The model in his paper also considers learning by doing as a way of capital accumulation. Population growth is held constant and both physical and human capital are included. Physical capital is taken from the traditional neoclassical growth model and human capital boosts productivity, where a stable effort level will lead to stable growth rates in productivity. For a closed economy, poorer countries will continue to stay poor, but will actually have the same growth rates as richer countries. Therefore, there will be constant growth rates and a steady distribution of income. For the open economy with free labour mobility and free trade of capital inputs, externalities and spillovers will lead to higher wages and higher skill levels, thus increasing the wealth of a country. Lucas also states that different growth rates amongst countries can be due to different levels of human capital grow th associated with different goods. Accordingly, it is evident that the same levels of technology and human capital are not available in every country as the neoclassical model assumes. Barro (1991) examined 98 countries to test the neoclassical idea that poorer countries will grow faster than richer countries. Rates of school enrolment were used to measure levels of human capital. The results find that GDP per capita growth rates are significantly positively related to initial endowments of human capital and based on these initial levels, growth is negatively related to the initial level of GDP per capita. These findings seem to support the neoclassical model that poorer countries will eventually converge with richer countries. However, this only holds for the poorer countries that have relatively high levels of human capital, meaning that the human capital level is above what would be expected given the relatively low level of GDP per capita. The paper also takes into account other factors, such as fertility rates, government expenditure, political instability and corruption, and price distortions. Despite these considerations, Barro concedes that the results are unable to explain the poor growth rates for countries in Latin American and Sub-Saharan Africa and suggests that other factors must be involved. Convergence or Regional Boom? From the theory, it is evident that convergence of less developed countries is not automatic and that many factors are responsible for economic growth. For the case of Ireland, there is debate as to whether or not it was simply a matter of delayed convergence or as a result of a regional boom. There are several papers arguing both sides, which will now be examined. Ó Grà ¡da (2002) argues that the economic performance of Ireland in the 1990s is mainly a matter of delayed convergence and making up for many decades of underperformance. He finds that Ireland underachieved compared to other Western European countries from the end of World War II until the late 1980s. Throughout that period, the 1960s provided a glimpse at possible future economic growth. If the period is extended to 1998, Ó Grà ¡da states that Ireland performed as expected given the low initial level of income per capita in the 1950s in order to achieve convergence. Thus, the economic slowdown evidenced at the time of writing, 2002, seems to be in line with convergence theory and to be expected as Ireland had reached its new steady state level. However, if the Celtic Tiger is simply a matter of delayed convergence, then why it took so long also needs to be examined. Ó Grà ¡da attributes this to poor fiscal policy practices and protectionism during the 1970s and early 1980s. Ó Grà ¡da and ORourke (1996) examine in detail why Ireland underperformed in previous decades relative to other Western European countries. Ireland experienced much lower rates of GDP growth as evidenced in Figure 1. The richest countries in 1950, Switzerland (CH), UK and Denmark are compared with the poorest countries, Greece and Spain. Ireland is the clear outlier and exhibits much slower growth than would be expected. They attribute the weak performance to a variety of factors particularly trade protectionist policies, heavy reliance on agricultural exports, and rent-seeking behaviour. In particular, Ireland failed to participate in the economic recovery of the rest of post WWII Europe by maintaining barriers to trade and waiting to open up the economy until the 1960s. However, they do not find that low levels of investment in human and physical capital to have been significant factors. Ó Grà ¡da and ORourke also suggest that Irelands proximity and reliance on the UK cou ld have led to slower growth rates since the UK, while not underperforming, was not experiencing particularly high levels of growth. Figure 1: Average annual growth rates, 1950-1988, for Western Europe Source: Ó Grà ¡da and ORourke (1996) Honohan and Walsh (2002) also take the view that Irelands economic performance can be attributed to delayed convergence. They argue that there was no productivity miracle but instead the boom was mainly due to a change in fiscal and monetary policies and an improvement in the labour market, which allowed productivity to finally catch up to the levels of the rest of Europe. While an increase in the population employed and demographic trends are unlikely to be repeated, Honohan and Walsh argue that if the policy changes had been made earlier, Ireland would have achieved convergence earlier. The argument that the increased growth was due to a regional boom is also considered. However, it is immediately discounted when Irelands population and economic growth is compared to that of individual states of the U.S., ranking 23rd out of fifty (Honohan and Walsh, 2002). Barry (2000) examines if Irish growth can be attributed to changes in policy and to what extent, which would support the convergence hypothesis. The most important factor is correct microeconomic and industrial policy, which Barry argues is the main reason for the delay in development. However, he finds that there are other certain characteristics necessary for convergence to be achieved, including a stable economy, an effective labour market, a developed market for exports, and sufficient levels of education. Thus, Barry seems to provide mixed support for the convergence theory. The delayed convergence hypothesis suggests that Irelands economic growth was simply a matter of catching up with the rest of the developed world. However, it has some shortcomings including not satisfactorily explaining why Ireland failed to converge sooner like the other peripheral EU countries of Spain, Portugal and Greece. Delayed convergence also does not give a role to the large increase in foreign direct investment as the theory does not suggest that anything other than sound economic and industrial policies are necessary. The theory also suggests that since convergence has been achieved, all that is required to maintain it is to ensure the same sound policies are followed. The regional boom theory, on the other hand, does take into consideration other non-traditional factors such as FDI and the boom of the US economy. It particularly focuses on an economys export base as key for economic growth. This theory also leaves room for unexpected shocks, such as a decrease in FDI or downturn in the US economy to have an impact on the economy, which in light of recent events, would seem to be more accurate. The regional boom theory will now be examined in more detail. A regional economy differs from a national economy in that there is free movement of labour in and out of the region (Barry 2002a). Krugman (1997) has suggested that Ireland be treated as such a regional economy due to the fact that it exhibits many of the features of a small region of a larger economy rather than a larger independent nation. Ireland is a small, extremely open economy and before the adoption of the Euro, had a currency that was mostly pegged to another. With the free movement of labour, wages are determined by those of the larger region, rather than within the country itself and job numbers are based on labour demand rather than labour supply determining job creation based on wages (Krugman, 1997). Also, adjustment to exogenous shocks will be dealt with differently by a country in a regional economy versus a sovereign country. If a shock occurs to the labour market in an open economy, labour will simply leave, rather than a wage adjustment occurring and new industrie s arising, as in a closed economy. Krugman argues in favour of the regional boom hypothesis because of the large increase in the export economy and the increase in jobs in the services sector as a result. The majority of the increase in exports during the Celtic Tiger was in foreign-owned companies. Barry (2002b) examines Irelands economic performance and the factors that lead to convergence compared to the other peripheral EU countries of Spain, Portugal and Greece. Ireland, unlike the other countries, failed to reach EU average levels of growth until much later. Unlike previously argued by Ó Grà ¡da and ORourke, Barry finds that this was not in fact due to macroeconomic policies, as all four countries had similar practices and in fact, Ireland was the most export oriented country of the group, as shown in Table 1. Barry finds the main difference between Ireland and the rest is actually in labour market operations. Ireland experienced high unemployment, high emigration and increased wages from the 1960s to the late 1980s. The relatively high wages meant domestically owned labour-intensive firms were unable to compete with foreign-owned firms as high levels of FDI, particularly in the manufacturing sector, started to enter the economy. Thus, Barrys findings seem to support the regional boom hypothesis with exports and FDI playing a key role in explaining Irish growth. Table 1: Exports of goods and services as a percentage of GDP Barry (1999) argues that in order to achieve high levels of growth in a regional economy, a nation needs to be internationally competitive in the non-agricultural sector, as increased capital in an agriculturally based economy will lead to more emigration. He argues that industrialisation policy is crucial, whereas proponents of the convergence theory, including Ó Grà ¡da consider this a distortion with Ireland merely switching from import-substitution industrialisation to export-substitution industrialisation (Ó Grà ¡da, 2002, p. 8). However, others, such as Barros and Cabral (2000) and Fumagalli (1999) suggest that in order to industrialise, such a distortion is necessary. Hill et al (2005) consider both theories and come to the conclusion that perhaps it cannot be explained solely by one theory, but rather a combination of the two. They argue that the necessary conditions for convergence were in place by the 1970s, but that Ireland suffered as a result of poor policy practices from 1973-1986 and global economic downturn. However, this is not sufficient to explain the economic growth fully and thus, Hill et al also incorporate the regional perspective. Labour and capital inflows were as equally important as sound policies in Irelands growth. Ireland was able to attract foreign investment, create more and higher quality jobs and as a result, the levels of labour force participation increased. They cite increases in employment and job creation as extremely important in the Irish case, which implies a larger role for government than in convergence theory. Government needs to do more than just maintain proper fiscal policy and must ensure there is a compet itive environment for business. Ó Grà ¡da (2002) also considers the regional boom hypothesis, but finds it overly optimistic for proposing that high growth rates could be sustained without sustained increases in labour. However, both Barry (2002c) and Dascher (2000) develop a model of a regional boom economy with Irelands specifications and find that labour inflows will decline as infrastructure and housing become more congested. Yet, growth can still continue without more labour if sufficient stocks are maintained and there are no negative exogenous shocks to the larger regional economy. The regional boom theory also suggests that just because Ireland has caught up to average EU levels, it does not mean that further growth cannot be achieved as convergence theory would suggest. Indeed, if Ireland could continue attracting FDI and supplying labour, growth should still be able to continue, despite convergence already being attained. Blanchard (2002) comments on Honohan and Walshs 2002 paper and argues that convergence theory is not the appropriate model to describe Irelands growth, but rather endogenous growth theory is. Instead of the Solow model which has diminishing returns to capital, he suggests the AK model of economic growth is more appropriate, where output and capital accumulation move together because of consistently increasing employment levels. Thus, the economy will move towards producing more capital intensive goods. This is similar to the regional boom perspective where increases in labour and capital will stimulate each other to create more growth than would be possible in a national economy. The regional boom theory, unlike convergence theory, allows for negative exogenous shocks to affect growth. For example, a downturn in the global economy or a withdrawal of FDI in favour of Central and Eastern European countries, would significantly impact the Irish economy. However, convergence theory would consider these to be temporary shocks and since no policy changes have been made, they should not affect growth. Conversely, the regional boom theory allows for the possibility that these could be permanent shocks with tremendous negative effects, including even a return to pre-Celtic Tiger levels of unemployment and emigration and the undoing of the catch-up. Overall, both perspectives offer valid reasons to explain Irelands economic growth however, in view of the recent financial crisis and Irelands sharp economic decline, it may be more appropriate to view the progress of the 1990s in terms of a regional boom. While Ireland had relatively similar policies to Greece, Spain and Portugal, it did not catch up with European averages in the 1960s like the others did. Thus it seems perhaps more suitable to view Ireland in terms of part of a regional economy tied to the UK for that time period and again connected to the US during its boom years starting in the late 1980s. This theory also suggests that industrialisation strategy, creating an export-based economy and attracting FDI are the key factors for growth, rather than just appropriate macroeconomic policies. Both of these theories can provide useful lessons for other developing countries seeking to follow in Irelands footsteps of rapid economic growth. Lessons from Ireland for other countries There are many papers discussing the Irish economic boom, its causes and what lessons can be learned for other countries seeking to achieve such rapid economic growth. Acs, et al (2007) examine whether the Irish miracle could be duplicated in Hungary. The paper focuses specifically on the impact of FDI and how it affects entrepreneurial activity. While they find significant differences between the two, the results do suggest several policy outcomes based on the Irish experience that Hungary could implement, including boosting human capital, improving the quality of FDI and encouraging more enterprise development. Andreosso-OCallaghan and Lenihan (2005) focus on economic policy and whether Ireland can provide a good example of economic development for NMS, with particular regard to developing small and medium sized enterprises (SMEs). They find that Ireland does indeed supply a useful model for others to follow. Developing the growth of SMEs is important for overall economic growth and it was a key focus of Irish industrial policy, particularly after 1993. Andreosso-OCallaghan and Lenihan suggest that adopting Irish policies, such as dedicated development agencies, and proactively evaluating industrial policies, would help SMEs grow in NMS. However, they also warn of the dangers of relying too heavily on FDI as some would suggest Ireland has done. Hill et al (2005) examine the Irish experience in great detail, beginning with considering whether convergence theory or regional boom is more appropriate. They then recognize that for a small, open economy to develop and create quality jobs, the country needs to be competitive in the following four areas: context for firm strategy and rivalry, demand conditions, factor (input) conditions and related and supporting industries (Hill et al, 2005, 5). There are also corresponding policy initiatives for each of the four areas: tax policy, educational system, regional economy and institutions and consumer protection laws. They then analyse these four areas for Ireland and how policymakers have performed. The economic conditions and performance of Arizona in the United States is then compared to Ireland, to see what lessons Arizona could learn and if they could replicate Irelands growth. The results show that Arizona shares some similar characteristics with Ireland and thus has some opport unities for similar growth. Bailey et al (2009) examine industrial policy in both the Celtic Tiger and East Asian Tiger countries to see what potential lessons African nations could learn. They focus primarily on the Irish experience and provide several reasons why Ireland is a better example for Africa, including that most African countries, like Ireland are small and open, Ireland had a more corporatist experience than in East Asia, and that in some East Asian countries the rights of trade unions were suppressed. Bailey et al take a holistic approach to analysing Irish industrial policy, instead of focusing solely on policies that promote just FDI, or developing SMEs or Research and Development (RD), and then apply it to Africa. They find that Africa can learn from the policy examples and mistakes of Ireland and East Asia. In another paper, Bailey et al (2008) examine and compare the Irish and Hungarian experience, with particular focus on industrial policy and then determine what lessons other Central and Eastern European nations could learn. Hungary is selected as a comparison because it has closely followed the Irish model and has been cited by others, including the World Bank and the OECD, as a potential example for other developing countries (Fink, 2006). Like previously mentioned, Bailey et al implement a holistic approach to industrial policy. They assess both countries policies and find that attracting FDI has had the most significant impact on growth. However, they find that there are limitations to FDI based growth and thus emphasize the need to also develop domestic industry. Fortin (2000) discusses and analyses the characteristics and causes of the Irish economic boom. It is divided into two main sections, a long-term productivity boom and a short-term employment boom. Key lessons as well as appropriate policies for other countries, particularly Canada, are identified based on the Irish experience. These include encouraging free trade and investment, industrial and tax policy conducive to business and ensuring high levels of education. Fortin examines Canadas recent economic performance and discusses what changes Canada can implement based on these lessons from Ireland. Although not all Irish policy is applicable, Canada can emulate the policies of fiscal discipline, openness and free trade. Hansen (2006) examines the Irish determinants of growth individually and assesses whether Latvia could repeat Irish success. The approach is more holistic and based on the methodology of Mancur Olson (1996) and Hansen states that this approach could be applied to any of the other New Member States of the EU. The results show that Latvia has already implemented many of the same policies that contributed to the Irish boom. Other factors are considered to be specific to Ireland, and consequently unable to be replicated. Overall, Hansen suggests that Latvia cannot adopt much more from Ireland and goes so far as to suggest the Irish case is no miracle as others have proposed, but rather a combination of sound policy, timing and a bit of luck (2006, 13). With the exception of Hansen (2006) and Fortin (2000), most of the literature on Irish growth and lessons for other countries focuses on specific determinants or policies rather than taking a holistic approach. Therefore, this paper seeks to follow this example and examine the Irish boom in detail and then apply it to country. The individual determinants of Irish growth will now be examined in more detail. The Irish Experience Macroeconomic Stability Convergence theory cites effective policy as an instrumental part of economic growth and indeed Irelands failure to catch up until recently has been attributed to this. In the immediate post-War period, much of Western Europe began to recover and experienced economic growth. However, in the 1950s, Ireland still relied heavily on agriculture, had high levels of emigration and protectionist policies. In the 1960s, the economic conditions began to turn around, with better macroeconomic policies being adopted. As Honohan and Walsh (2002) state, these include pegging the exchange rates to the British pound, managing a reasonable balance of payments deficit, conservative fiscal policy of borrowing only to finance public capital investment and relatively low tax rates. Previous protectionism was dropped and foreign direct investment was encouraged through grants and tax exemptions. Ireland entered into the Anglo-Irish Free Trade Area Agreement in 1965 and also decided to apply for membershi p in the European Economic Community (EEC), hence opening itself up for more trade. It would seem that during the 1960s Ireland was poised to catch up with the rest. However, in the 1970s, with the global oil crisis and inappropriate policy response, Ireland was unable to capitalise on the progress made in the previous decade. In an attempt to recover from the crisis quickly, expansionary practices were pursued, which caused real wages to escalate and crowded out productive growth. Consequently, in 1987 there was public debt in excess of 130%, an unemployment rate of about 16%, inflation level around 9.5%, high interest rates and there was an average growth rate of 3.2% during the 1980s (Hansen, 2006). All of these elements were not conducive to economic growth and as a result, Ireland faced a severe recession. Accordingly, it became evident that economic policy changes needed to be made and the general election of 1987 heralded the beginning of a more stable macroeconomic policy. The new government, employers and trade unions developed a social partnership known as the Programme for National Recovery to reach an agreement on wages, taxes, and other social welfare improvements. The government offered lower income tax rates in exchange for wage moderation by the trade unions. As a result, the labour market became more competitive and effective and more employment opportunities were created in both the services and manufacturing sectors. Fiscal Policy Fiscal policy from the 1970s to late 1980s was quite varied and went from being expansionary in 1977, to taxing and spending in 1981 and then to cost-cutting in 1987. These changes coincided with different governments in power and corresponding different policy goals. It was not until 1987 that appropriate fiscal policy was adopted for the economic situation and as a result, stabilisation began to occur. The government focused on reducing the budget deficit, which had reached levels between 6.1% and 8.2% of GNP between 1978-1987 and the debt to GNP ratio was a massive 131.4% in 1987 (Leddin and OLeary, 1991). By the end of 2001, the debt to GNP ratio was only 38% (Honohan and Walsh, 2002). Government spending also decreased from about 46% of GNP in 1987 to 37.2% already in 1991 (Leddin and OLeary, 1991). (For graphs see H and W). In addition to cutting spending and reducing the debt, the government cut tax rates. Comparing 2001 and 1985, the top income tax rates decreased from 65% to 42%, corporate tax rates fell from 50% to 16%, capital gains tax was reduced from 60% to 20% and capital acquisitions tax fell from 55% to 20% (Honohan and Walsh, 2002). From the 1960s until 1981, Ireland has a 0% tax rate on export profits. However, such low tax rates drew complaints from other EU members and, as a result, Ireland was forced to raise it to 10% in 1981. This preferential corporate tax rate was put in place for profits in the manufacturing sector, internationally traded services, and activities in the Dublin based International Financial Services Centre (IFSC). Again, due to complaints, Ireland agreed to raise rates to 12.5% in 2003 for manufacturing and internationally traded services and in 2005 for IFSC activities. It is generally recognized that such low corporate tax rates were instrumental in attracting inte rnational companies to conduct business in Ireland. Gropp and Kostial (2000) estimated that if Ireland had increased corporate tax rates to the EU average from 1990-1997, there would have been a loss of more than 1.3% of GDP per year in net FDI and a 0.8% loss of GDP in revenue. As a result of Irelands success, lowering of corporate tax rates has also been adopted by other countries, perhaps most significantly, Germany, who reduced their tax rate from 40% in 2000 to 25% in 2001 (Walsh, 2000). Despite this, it is also important to note that the effect of low corporate tax rates on attracting FDI may be distorted as a result of transfer pricing. This means that foreign-owned companies may use pricing adjustments to allocate a larger share of their profits to their Irish operations and thus pay less taxes. This may be responsible for the large gap between GDP and GNP in Ireland during the 1990s. In 1998, GDP surpassed GNP by 14.3%, well higher than any other country in the OECD (Walsh, 2000). However, Walsh also states that the effects of transfer pricing on the measurement of economic growth should not be exaggerated (2000: 225). Generally, GNP is used to measure the performance of the Irish economic boom because of the high levels of FDI. Overall, corporate tax rates have played an important role in attracting FDI, which in turn has been a significant factor in Irelands growth and will be examined more fully below. Monetary Policy Ireland decided to join the European Monetary System (EMS) and an adjustable peg system in 1978 and end its parity with the pound sterling in 1979. Although the decision was made more for political rather than economic reasons, there were definite economic implications. Throughout the period of EMS, many exchange rate readjustments occurred and for most of them the Irish pound was devalued against the German Deutschmark, which allowed Ireland to gain wage competitiveness. Overall, though, Irish membership in the EMS was not as successful as hoped and served to increase uncertainty and discourage anti-inflationary practices. However, joining EMS laid the groundwork for signing the Maastricht Treaty in 1992 and thus the agreement to join the European Monetary Union (EMU). As a result of joining EMU and giving up their independent currency, Ireland experienced a onetime decrease in interest rates.