ECONOMICS:YOU DON'T hear much mention of the sterling/Irish pound exchange rate these days. That's mainly because the Irish pound no longer exists. Still, even if it has only a notional status, the sterling/Irish pound exchange rate hasn't gone away and, after sterling's precipitate decline of recent months, it may yet come back to haunt us.
For most of the five years prior to the last year, the sterling/euro exchange rate traded within a few whiskers of £0.68. Over the past 12 months or so, however, it has been seriously on the move. Earlier this week it came within touching distance of £0.82, representing a 20 per cent-plus depreciation of sterling since last September.
If the Irish pound still existed, it would now be trading at around £1.04 sterling. The last time our currency was this strong against sterling was in 1996. Given the outlook for the UK economy and interest rates, further sterling weakness seems likely. Another 5-6 per cent decline would see the Irish economy facing the kind of sterling exchange rate that was previously endured during the currency crisis of 1992-93.
Of course, a lot has changed since those dark says. Ireland's dependence on the UK as a trading partner has diminished, while a substantial portion of our trade with the UK is denominated in our currency (the euro) rather than sterling, which should soften the blow, at least in the short run. Still, the challenge of coping with a relatively sudden 20-25 per cent currency appreciation against what remains our single most important trading partner (the UK accounts for 25 per cent of Ireland's merchandise trade) is a daunting one and poses a serious threat to a large number of jobs.
The last time we faced this sort of threat, the financial markets responded by pushing up Irish interest rates to intolerable levels. (How many people remember overnight inter-bank rates in Dublin of over 100 per cent, or mortgage rates of 15 per cent?)
Fortunately, membership of the euro zone means such an outcome cannot recur this time. The obverse side of the coin is that, having given up our own currency, devaluation is no longer available as an option to us.
How critical a loss is the devaluation option? Well, it depends on how domestic costs, wages in particular, respond to the challenge. The reason devaluations work is because they result in a fall in the real exchange rate (or a gain in competitiveness). If they did not produce this result - in other words, if domestic costs rose immediately by the full amount of the nominal exchange rate change - the exercise would be pointless.
The question at this juncture for the Irish economy is whether a fall in the real exchange rate can be brought about in the absence of the devaluation option. The answer is that it can be (at least theoretically), but it is a very painful process: it requires a cut in domestic costs or, at least, a much slower rate of increase in domestic costs than is occurring in the rest of the world, which effectively amounts to the same thing when trading partners' costs are increasing very slowly.
In other words, a country without an independent currency can emulate the effects of a devaluation by reducing wages. This sounds like a very tall order, and it is. A somewhat less tall order and, by extension, a somewhat less efficacious means of bringing about the desired real exchange rate adjustment or competitiveness gain, would be to freeze wages.
As such, this can be thought of as a compromise solution, although it too typically generates plenty of resistance from workers and their unions, as we are witnessing at the moment in the context of the talks on a national pay agreement.
Painting the picture of the damage that will be wreaked on output and jobs if costs are not capped or cut is part of what needs to be done to break down this resistance. But there is another critical element. The UK accounts for one-third of all merchandise imports into Ireland. Accordingly, the euro's strength against sterling should convert into substantial price reductions across a wide range of imported items, processed foods and other consumer goods in particular. The Government and its agencies should spare no effort in ensuring that this in fact occurs. This is the logical quid pro quo for sacrifices on the wage front.
It is worth noting in all of this that we actually run a (merchandise) trade deficit with the UK. What this suggests is that the Irish economy is potentially a net beneficiary from sterling weakness: the gains from cheaper imports potentially exceed the losses suffered by exporters.
In essence the challenge is to harness the gains on the import side in a way that ensures that the difficulties experienced by exporters do not lead to reductions in output and employment.
• Jim O'Leary is a Senior Fellow of the Department of Economics, Finance and Accounting in NUI-Maynooth. He can be contacted at jim.oleary@nuim.ie
