German reunification delayed the arrival of the Celtic Tiger

At the end of the 1980s, after a miserable decade of fiscal retrenchment, the clouds began to lift on the Irish economy. While emigration peaked in 1989, there were already many signs that Ireland was returning to growth.

The squeeze on the public finances in the 1980s had arisen from unwise expansionary budgets in the late 1970s. The outcome left Ireland very indebted with high unemployment. However, with a favourable external climate, and the fiscal adjustment almost complete as the 1980s drew to a close, Ireland’s output grew by an average of more than 5 per cent a year in 1989 and 1990.

Then, at the end of 1989, the Berlin Wall fell, followed by German reunification – something few people had expected to see happen in our lifetimes. However, because the collapse of the East German regime was unanticipated, the (West) German government did not have a plan to deal with the situation. So a solution to the challenges of unification had to be worked out very rapidly.

The decision the German government took was to immediately integrate East Germany into a unified German economy. This proved feasible because the population of East Germany was only a quarter of West Germany. If it had been much larger, given the disparity in output levels between East and West, absorption would have proved very difficult.

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As it was, the adjustment proved both painful for many in East Germany and costly for those in the former West Germany. A large number of East German public servants, who were ill-equipped for the new world or who were tainted by the old regime, were let go. In addition, many inefficient factories closed, so unemployment rose dramatically across East Germany. West Germans had to pay to absorb the much poorer east and invest in its inferior infrastructure.

Borrowing programme

So the German government embarked on a huge infrastructure programme financed by borrowing. This dramatic rise in German public expenditure resulted in inflationary pressures. Therefore the Bundesbank, committed to maintaining a low inflation rate, raised interest rates by 2.5 percentage points to choke off price rises.

However, Ireland, alongside the UK and other EU countries, were members of the European Monetary System (EMS). This meant that when German interest rates rose, they also rose across the EMS, including in Ireland. While higher interest rates were appropriate for the German economy, they were most unwelcome for the rest of Europe.

While recent German fiscal policy has been inappropriately tight, its negative effects have been offset

A 1991 ESRI study showed that the German interest rate rise would have a serious impact on the then very indebted Irish economy. As indeed transpired: our growth over the years 1991-1993 fell to less than 3 per cent a year. Other studies have confirmed that the rise in interest rates at that time led to much lower growth for the UK and France. As these export markets for Ireland faltered, a reduction in demand for our products aggravated the direct effects of higher interest rates on the fortunes of the Irish economy.

With the benefit of hindsight, it is clear that the non-German members of the EMS should have escaped from the straitjacket of this particular monetary arrangement and set their own interest rates. Instead, it was the financial markets, rather than decisions of sovereign governments, that forced the necessary adjustments. As a result, the UK crashed out of the EMS in September 1992. The humiliation of this outcome had a permanent scarring effect on perceptions of EU institutions in the UK.

Different approach

This experience in 1992 influenced the approach of EMS members to the development of the Economic and Monetary Union (EMU). Now the European Central Bank (ECB) sets interest rates to manage inflation across the euro zone, rather than inflation in any one country like Germany. Although German inflation is significantly higher than elsewhere in the Euro zone, this is outweighed by low inflation rates elsewhere.

So, over the past few years the ECB has maintained negative interest rates, and under Mario Draghi has pursued a monetary stimulus. So while German fiscal policy in recent years has been inappropriately tight, its negative effects have been offset to a degree by ECB monetary policies. While not ideal, it is a much more satisfactory situation for Ireland than that of the early 1990s.

If we had had EMU in the early 1990s, German reunification would not have caused such a sharp increase in EU interest rates and Irish and EU growth would not have been choked off as much as it was: the Celtic Tiger would have happened three years earlier than it did.