In the debate prior to joining EMU, all commentators were agreed that prudence in wage agreements would be critical to ensure the Republic could enjoy stable growth within the constraints imposed by a single currency. Yet it is remarkable that the EMU dimension has been generally ignored during the current media discussion concerning the next round of national pay agreements.
In conditions of low unemployment and high productivity growth, it is clear that significant pay improvements are feasible in many sectors of the economy. However, the advent of EMU means that it has never been more important to guard against excessive wage growth. The case for prudence in wage agreements under a single currency can be simply put. Prior to EMU, devaluation was available as a policy option to restore competitiveness if wage rates grew too rapidly compared to productivity. In a currency union, there is no such "escape clause": a loss of competitiveness will translate into an increase in unemployment, net emigration and a decline in labour force participation.
Since union leaders are undoubtedly aware of the policy restriction imposed by EMU, it might be imagined that wage claims will be suitably moderated. However, the the single currency creates an opposing effect that may lead to more aggressive union behaviour.
When the Republic still exercised some effective control over its monetary policy, the national union leadership knew that excessive wage claims were self-defeating: the inflationary impact would lead to higher interest rates and exchange rate depreciation. Workers' real living standards would quickly suffer and their employment prospects deteriorate.
Now that monetary policy is determined in Frankfurt and reflects only broad European conditions, the links between domestic wage growth, interest rates and inflation are greatly weakened. Aggressive wage claims will have no effect on the level of interest rates, which are now outside domestic control. The sensitivity of the consumer inflation rate to domestic pay increases is also significantly diminished, now acting only via the non-tradables components of the consumer price index. In the private sector, unions still retain a powerful incentive to avoid excessive wage claims: in many industries, a loss of competitiveness can quickly translate into a relocation of activities from the Republic to other European regions.
Rather, the main concern is with respect to public-sector pay. In the public sector, there is no direct threat of foreign competition, removing an important discipline on wage growth. Under EMU, it seems that the basic conflict of interest between private and public-sector workers is stronger than under the previous pay agreements negotiated under the old exchange rate regime. This makes negotiating a useful new national pay agreement that spans the private and public sectors all the more unlikely.
The Government's role is crucial in ensuring that the economy successfully meets the challenges posed by EMU membership. First, even if no new private sector pay agreement is achieved, it is imperative to devise a public-sector pay scheme that avoids overshooting. A new public-sector pay deal must acknowledge differences in labour shortages across regions and sectors. For instance, the Government and unions should address the reality that the cost of living is substantially higher in the Dublin metropolitan area than in other regions in the State.
It is not at all clear why public-sector workers in other areas should be paid the same as their Dublin-based colleagues, since the same cash income delivers a much lower material standard of living for the latter group. A new deal must also extract meaningful productivity improvements in exchange for pay increases: if public-sector pay is to track patterns in the private sector, similar efforts to improve productivity growth should be required.
Indirect pay increases such as regrading, seniority increments, early retirement schemes, a shorter working week and other improvements in ancillary benefits should be fully costed and integrated into the overall pay package.
Finally, structural problems such as the manipulation of overtime agreements in some parts of the public sector should also be corrected.
Second, the loss of monetary control means that fiscal policy is now the only macroeconomic tool available to the Government if there is an economic downturn. EMU has the benefit that fiscal policy is more effective inside a currency union: the positive effects of fiscal expansion will not be choked off by an appreciation of the nominal exchange rate.
To allow room for manoeuvre, the Government must accumulate sufficiently large surpluses during the current boom to avoid inappropriate fiscal tightening during a future slump. In particular, we may come to regret excessive tax cuts during the current period if they must be painfully reversed during the next recession.
Dr Philip Lane is an economist in Trinity College Dublin
