A significant factor boosting Irish economic activity (and inflation) in the early years of the Economic and Monetary Union (EMU), and indeed the two-year period leading up to the arrival of the single currency, was currency depreciation.
Between the end of 1996 and the end of 1998, the value of the Irish pound declined by 8 per cent on a trade-weighted basis as the currency was positioned for a "competitive" euro entry rate.
In the 2½ years following the birth of the euro, the new unit fell by almost 30 per cent against the dollar and by 15 per cent against sterling. Weighted by reference to the distribution of Ireland's international trade, the depreciation over this period was about 12.5 per cent.
Together with the loss of value sustained by the Irish pound over the previous two years, this meant the Irish economy experienced a near-20 per cent currency depreciation between end 1996 and mid-2001.
The euro bottomed out in mid-2001 and has been gaining ground since then. Its upward trajectory has become notably steeper over the past six months.
It has regained all the ground previously lost against sterling and almost all the ground previously lost against the dollar. From an Irish perspective (that is, weighted on the basis of Ireland's trade patterns), the appreciation that has occurred from mid-2001 to date has amounted to about 14 per cent.
In other words, about three-quarters of the currency depreciation that the Irish economy experienced between 1996 and 2001 has been reversed at this stage.
The sterling/Irish pound rate, for example, which was trading above parity in late 1996 and had fallen to a notional 76p by mid-2001 is now back up to a notional 91p.
Of course, the recent appreciation of the euro has come at a time when costs and prices in Ireland have been inflating at a substantially faster rate than in our main trading partners.
The measure that combines nominal exchange rate movements with movements in relative prices is called the real exchange rate. It is a crude but useful barometer of competitiveness.
The latest available Central Bank estimates of the real exchange rate point to a 12 per cent deterioration in competitiveness between mid-2001 and the end of last year.
Almost certainly there has been a further deterioration amounting to six to eight percentage points since then.
Some commentators are inclined to play down the significance of the real exchange rate appreciation or competitiveness deterioration that we have sustained over the past two years on the grounds that our currency was seriously undervalued and Irish producers were excessively competitive two years ago.
There is some truth in this: there is no question that, from an Irish point of view, the value of the euro was inappropriately low between 1999 and 2001. There is, therefore, a sense in which Irish producers enjoyed an unwarranted degree of competitiveness at that point. However, it is unrealistic to think that competitiveness is something that can be stockpiled. "Surplus" competitiveness cannot really be stashed away in the good times and then drawn down when things (like exchange rates) turn adverse.
Instead, what happens is this. Favourable exchange rate movements, such as those experienced by Ireland between 1996 and 2001, tend to get used up by some combination of output and employment gains on the one hand and cost increases on the other.
That combination will be more heavily weighted in the direction of output and employment gains the further away from full capacity the economy is operating.
As the Irish economy approached its capacity limits towards the end of the Celtic Tiger period, however, the currency depreciation was increasingly reflected in cost increases.
The point is that the protracted currency depreciation experienced by Ireland between 1996 and 2001 left a legacy, not in the shape of a big reservoir of untapped competitiveness that is now available to be drawn upon, but in the shape of levels of output and employment higher than would otherwise have been attained and a cost structure higher than would otherwise have come about.
Viewed this way, there are two paths available to the economy in adjusting to the new realities of the foreign exchange market.
Either a cost structure consistent with the much higher exchange rate is put in place or significant reductions in output and employment will occur.
The more resistance there is to cost control the more the outcome will be marked by lost output and job cuts. Unfortunately, the evidence to date points in the latter direction.
Even as exchange rates are running against us, our costs of production continue to increase faster than our competitors' costs. What might be charitably described as a "countercyclical" public sector pay policy obviously aggravates the problem. It also strips Government sermons on competitiveness of any moral authority they might otherwise have. Nor is the economy likely to be baled out by a renewed fall in the euro. I don't hold myself out as having any great authority (moral or otherwise) when it comes to exchange rate forecasts, but I am prepared to offer the view that the euro is more likely to rise further than fall from current levels. In the first instance, most estimates of its long run equilibrium value are in a range ($1.03-$1.45) which its current spot rate of $1.15 is closer to the bottom than the top of.
Second, there is little evidence that the European Central Bank (ECB) considers the euro to be overvalued at present. Indeed, the estimates of the euro's equilibrium value just cited come from research conducted by ECB staff. It may be inferred from this that the ECB will not be wading in to try reversing the euro's rise anytime soon. By contrast, an inference that can reasonably be drawn from recent Fed statements is that it is happy to see a further decline in the dollar.
Jim O'Leary is lecturing in economics at NUI-Maynooth. He can be contacted at jim.oleary@may.ie
