On December 31st, 1998, the pound will die and with it will pass what many would regard as an important symbol of Irish nationhood and economic independence. Some will lament the passing of the currency but for many its demise will be welcomed as another important step in the journey to becoming a modern European state. From an economic perspective, the Republic's experience with its own currency has been a pretty mixed one, at times disastrous, at times successful, but never easy. Under the new currency regime, currency management will not be an issue for the Irish authorities, as we will become part of a currency bloc that will compete on the world stage with the mighty dollar and the somewhat less mighty yen.
The Irish pound's experience as an independent currency dates back to 1979 when it became a founding member of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). At the beginning of December, 1978, the British government announced that it would not be participating in the ERM and just 10 days later the Irish government bravely announced that the Irish pound would be joining the system regardless of the British stance.
The EMS commenced operations on March 13th, 1979, and the pound became a fully paid up member from the beginning and, most importantly, participated in its exchange rate mechanism. This decision was quite historic as it signalled the end of the 153-year-old currency union between Britain and the Republic. This decision to break the link with sterling in 1979 was not too difficult from an Irish perspective, as the link with the British unit had not been a particularly fulfilling experience. Management of the British economy had operated on a pretty dubious footing from time to time and this created its own problems for the Irish economy.
Independent management of the domestic economy had been rendered pretty difficult. It was against this uncertain background that the Irish authorities decided to enter the ERM without Britain. It was hoped that participation in the ERM and the establishment of a formal link with the deutschmark would achieve greater exchange rate stability for the Irish pound, lower interest rates and inflation, and an improved growth performance. The failure to achieve these objectives before 1979 was attributed to the sterling link. After the ERM commenced operations, the pound initially maintained its relationship with sterling, while still remaining within the 2.25 per cent permissible band of fluctuation within the ERM. This lasted for just a few weeks.
The pressures mounted very quickly as sterling soared on the back of its oil status. Finally on March 30th the game ended when the authorities were obliged to allow the Irish currency diverge from sterling, thereby formally bringing the one-for-one relationship to an end. The early years of ERM membership could not be described as successful for the Republic. The reality was that the currency had established a formal link with a group of currencies that accounted for less than one-third of total trade, while the currency that accounted for 40 per cent of our trade remained outside. Consequently, the pound experienced considerable difficulties as a direct result of the vagaries of sterling. Furthermore, the exchange rate commitment was not backed up by credible policies. The Exchequer borrowing requirement (EBR) reached 15.7 per cent of gross national product (GNP) in 1981 and it remained in double digits until 1986, and the balance of payment was in double digits for the first four years of membership. As a result of these factors, the pound was unilaterally devalued by 3.5 per cent in 1983 and 8 per cent in 1986. The latter was the biggest ERM devaluation since the inception of the system and highlighted the ongoing difficulties posed by sterling.
Up until 1987, the Republic's ERM performance was poor and lacked market credibility, with the result that we failed to derive the promised benefits - interest rates remained well above German levels. This changed in 1987 when the newly-elected government was given the scope to correct the imbalances in the public finances and for the first time official policy appeared to be consistent with the exchange rate commitment. In 1992, the old bogeyman, sterling, returned to the scene with a vengeance and wreaked havoc on the Irish pound.
Britain eventually joined the ERM in October 1990, just as the impact of German reunification was starting to be felt. Reunification was a severe shock to the system and the refusal of other countries to countenance a unilateral revaluation of the deutschmark to reflect Germany's changed circumstances eventually resulted in a serious currency crisis. Britain had joined at a central rate of DM2.95 which subsequently proved too high and after enduring the economic pain associated with an overvalued currency and German inspired interest rates that were far too high for Britain, Norman Lamont was eventually forced to take sterling out of the ERM on September 16th 1992.
Sterling immediately fell heavily on the exchanges and in the space of five weeks the Irish pound appreciated by 16 per cent against sterling. The markets immediately and correctly concluded that the pound would have to be devalued within the ERM to restore competitiveness against sterling. Thus started a very difficult period for the Irish economy during which interest rates were taken to extraordinary heights to fend off devaluation. However, after much pain the authorities were forced to accept the inevitable, and the currency was devalued by 10 per cent on January 30th, 1993. The problems for the ERM did not end there, and eventually in August of that year, all currencies except the deutschmark and guilder adopted 15 per cent bands of fluctuation around unchanged central parities.
The Irish economy did very well in the wider bands and was able to ride two horses, in the sense that it had enough flexibility to maintain competitive levels against sterling and the ERM currencies. However, sterling's strength in 1997 resulted in the pound trading close to its permissible ERM ceiling and this gave rise to considerable speculation about revaluation as EMU loomed closer. Eventually, the authorities were forced to re-value the punt's central rate by 3 per cent in March 1998 and the new central parity of DM2.4833 was chosen as the EMU entry rate.
In overall terms, the pound's experience as an independent currency was fraught with difficulty, with sterling typically the root cause of the problems. Whether strong or weak, sterling posed its own difficulties for the State's economy. Unfortunately, as we stand on the brink of EMU, the spectre of sterling still looms over the Irish economy. The Republic can have no guarantees about how sterling will relate to the euro and in the absence of exchange rate adjustment options, the economy will remain subject to the vagaries of what is a very volatile and unpredictable unit. This will be one of the biggest challenges for the Irish authorities in an EMU context.
Jim Power is chief economist at Bank of Ireland Group Treasury
