GloboTrends

Euro membership, Inflation, Interest rates – effect on development, bubbles & bust

In recent weeks, we have seen Ireland thrust to the forefront of European fiscal crisis.  Why?  What has happened?  Here is the 5 minute overview of the problem…

• see our GloboTrends Wiki for a deeper analysis here

A Brief History:

When Ireland joined the Eurozone, they gave up control over the interest rates.   During the ealy 2000′s, while inflation rates were relatively low across Europe (see chart below), the ECB was able to keep interest rates also relatively low.   This should be a good thing, but at the same time, a fast-growing economy like that of Ireland probably needed higher interest rates.   Slow growth in Germany meant that low interest rates were needed to spur growth, but booming growth in Ireland meant that higher interest rates were needed to slow it down.  The fundamental weakness (one of them) of the Eurozone is that “one-size-fits-all” interest rate policy of the ECB might not be appropriate for economies with different business cycles (one up while the other is down).   The trouble for a country like Ireland was that without higher rates, the economy was sure to overheat.    Another trouble was that Irish investors (especially Irish BANKS) could borrow money at cheap interest rates in continental Europe and invest at higher (expected) rates of return in Ireland (a “carry trade” or interest rate arbitrage).    Investors benefited with a fixed exchange rate, since there was no fear of currency devaluation and so the international borrowing seemed “risk free”.   Since money seemed easy, it flowed… and created asset  bubbles (especially in real estate).  All was good…. but, then came the housing bubble burst of 2007 and the fiscal deficit crisis of 2010….

Irish Fears:  Why Ireland doesn’t want a bailout from the EU / IMF:

The biggest fear that Ireland has is that by accepting a bailout from the EU / IMF, they would need to raise taxes.  The Irish are especially sensitive to threats that Ireland may need to raise corporate tax rates as a condition for accepting EU money.  This is sensitive stuff.   Ireland previously rejected the Lisbon Treaty because of fears that the EU would force them to raise corporate taxes (goal of the EU to harmonize tax rates across the union).   Back then, Ireland won a concession from the other members of the EU to specifically get an exemption, thus “guaranteeing” Ireland’s independent tax policy.    The agreement says that nothing in Lisbon treaty would result in “any change of any kind, for any member state, to the extent or operation of the competence of the EU in relation to taxation”.  Pretty clear stuff.  But the loophole is that if Ireland were to go begging to the EU for funds, they may be asked to “voluntarily” make adjustments to the tax structure in order to receive more funds.  This prospect has the Irish press nervous.

The Irish development model (Celtic Tiger): i.e. What Ireland doesn’t want to give up!

The cornerstone of Irish industrial policy has been = low corporate tax rates.  This is one of the fundamental reasons that many international companies have used Ireland as a headquarters for their European operations.   This started with US technology firms who looked to Ireland in the late 1980′s – early 1990′s.  Example:  Intel semiconductors arrived in 1989, with other multinationals following soon thereafter.

Ireland was attractive because:

1. English speaking workforce
2. Well educated
3. Young population (compared to European competitors)
4. Free trade zone with Europe – as barriers came down in 1992
5. Grants from the state
6. Low corporate income tax of 12.5%  (very low compared to the rest of the EU or the US — “Excluding exemptions, the average corporate tax rate in the EU is 23%; the U.S.’s corporate rate is 35%.¹ )

The Irish fear now is that by accepting EU (or IMF) money, they will be “forced” to raise taxes (and not just focus on cutting costs).  Outsiders argue that something must be done to raise revenues for the budget to balance.  Irish counter that growth is needed and to raise corporate tax rates would be the equivalent of shooting themselves in the foot.   Irish argue that FDI, growth, jobs, exports… all of these factors are needed to grow out of this mess, and that low-corporate tax rates MUST remain in order for that to happen.    Only time will tell how this will play out…

Related articles

• see our GloboTrends Wiki for a deeper analysis here

• Excellent article here from the Economist.com  http://www.economist.com/node/17522578 “Ireland has been in trouble before. In the late 1980s the economy was sickly. Public debt was close to 120% of GDP. High tax rates choked growth yet did not produce enough revenue to finance a generous welfare state. High inflation and interest rates deterred investment. The young and educated went abroad. Ireland seemed doomed to be western Europe’s straggler: “The poorest of the rich” was the title of a 1988 survey by The Economist….Yet from this adversity sprang the Celtic tiger, Europe’s unlikely answer to the fast-growing economies of Asia. … Read more from The Economist here
• Irish Grasp at EU, IMF Lifeline (online.wsj.com)
• Irish head toward bailout; Portugal next in line? (seattletimes.nwsource.com)
• Ireland take hardline stance on corporate tax as bailout talks begin – The Guardian (news.google.com)