ECONOMICS:The full weight of a loss of Irish competitiveness on foreign markets will now fall on the domestic economy

Since joining the euro in 1999, domestic consumer prices have risen by almost one-third, faster than in all of the major countries with which Ireland trades.

In addition to outsprinting competitor countries in the inflation race, Ireland's trade-weighted exchange rate has risen by more than 10 per cent in nominal terms since 1999, due principally to the recent weakness of sterling and the dollar against the euro.

As a result, Ireland's real exchange rate - the nominal trade-weighted exchange rate adjusted for Ireland's inflationary excesses relative to trade rivals - has appreciated by 23.3 per cent since euro entry. More tellingly, the real exchange rate has risen by 21.7 per cent since 2002.

This appreciation of the real exchange rate constitutes a clear and present danger to Ireland's future competitiveness on foreign markets.

The cumulative rise in the Irish consumer price level amounted to 31.4 per cent in the eight years to 2007. Euro zone prices rose by 18.8 per cent on average over the same period while, in Britain, consumer price inflation was contained to 13.2 per cent.

Comparisons of inflation performance are shown in Table 1, where price trends are measured by the Harmonised Index of Consumer Prices (HICP), which excludes mortgage interest.

Most of the inflationary damage was inflicted in the early years of Ireland's euro membership due to excessive demand growth at the height of the boom.

Ireland's inflation rate fell back towards the euro zone average in 2004 and 2005, but since then it has again accelerated away from the average.

The inflationary surge in the Irish economy between 1999 and 2002 should have caused a steep deterioration in Irish price competitiveness.

However, two factors intervened to offset competitive losses. First, Irish productivity growth surpassed the rate of output growth per person in competitor countries during these years.

Second, the euro took a decided turn for the worse against sterling and the dollar in the years immediately after its launch.

As can be seen from Table 2, against sterling, the euro fell from £0.66 in 1999 to £0.61 a year later. Similarly, against the dollar, the euro declined from $1.07 in 1999 to $0.90 in 2001.

Uniquely among members of the euro zone, Ireland's two principal foreign markets lie outside the euro zone. Together, the US and Britain purchase almost two-fifths of Ireland's merchandise exports.

Thus, in the early years of its life, the euro's weakness cushioned the loss of Irish competitiveness in the British and US markets. Despite Ireland's inflationary excesses, there was virtually no appreciation in the real exchange rate between 1999 and 2002, as shown in Table 2.

From 2003 onwards, the euro began to strengthen. However, until very recently, the material exchange rate changes were confined to the dollar. While the dollar dived, sterling appeared to be shadowing the euro. But, in the second half of last year, all changed utterly. Sterling went into free fall. Since last June, the euro exchange rate against sterling has risen from £0.6740 to £0.7440, or by 10 per cent.

Britain is, by some distance, the most important foreign market for indigenous Irish enterprises. Sterling's precipitous fall presents exporters to Britain with unpalatable choices. They can maintain their sterling prices in an effort to retain market share, but at the expense of much-diminished profitability.

Alternatively, they can seek to raise sterling prices in the hope of maintaining sales revenues in euro terms but at the risk of losing market share to British competitors. Of course, they can mix both approaches but, no matter what way the sterling exchange rate shock is sliced, it means lower sales and weaker profits for indigenous Irish exporters selling to the British market.

Nor is this squeeze on export sales and profits likely to abate in the near term. Foreign exchange markets are already discounting future cuts in US and British interest rates and, if recession tightens its grip on either economy, the easing of monetary policy in both countries is likely to be more pronounced than in the euro zone.

An imminent recovery in either sterling or the dollar is thus unlikely.

Moreover, Irish policymakers enjoy fewer degrees of freedom in dealing with this problem than in the past. During the 1980s and into the 1990s, currency depreciations and two outright devaluations of the Irish pound - in 1986 and 1993 - were used to offset competitive losses induced by excessive inflation. As a member of a single currency, recourse to devaluation is no longer possible.

As a result, the full weight of the required adjustment to real competitive losses now falls on the domestic economy. With monetary policy already exported to the European Central Bank and the Budget for 2008 squared away, that leaves only incomes policies. However, it is politically unrealistic and socially unfair to expect that the full weight of adjustment required by a steep appreciation of the real exchange rate should be shouldered by labour. The unfortunate consequence is that the only other option is externally-induced deflation.