When Ireland joined the ERM in 1979, hoping for currency stability, the immediate result was a fall in the exchange rate. Within two years the pound had fallen to 74p sterling. History seems to be repeating itself as the EMU, the latest attempt to achieve currency stability in Europe, has also put skids under the Irish pound. Still, the 4 per cent fall in the trade-weighted average value of the Irish pound since April of this year has merely undone a nominal and real appreciation which had been under way since the previous low point in 1993.
Thus, although the fall against sterling has been sharp, it has not really brought the average value of the Irish pound to an unduly low level.
Indeed, the Irish pound is about 12 per cent above its central parity against the deutschmark. If, as is being widely suggested, these central parities were to be used as the entry rate for EMU, then the Irish pound would have to fall by that amount sometime between now and the start of 1999. Of course, sterling might weaken too (forward foreign exchange rates imply that it will) in which case the depreciation of the Irish pound against sterling would not be so great.
A further depreciation would certainly not be welcome if we were expecting to go on as at present with a kind of managed exchange rate float. But we are in a novel situation, preparing our currency for extinction. In this situation, our policy instincts can mislead. Though a further depreciation will lead to some compensating rise in prices and upward pressure on wages (potentially destabilising Partnership 2000), there is little risk of an inflationary psychology taking over, if we are using the euro from 1999. The likely source of excessive wage demands is much more on the real side - workers wanting a greater share of the Celtic Tiger prosperity - than on the nominal side -
workers looking to shield themselves from exaggerated fears of continuing inflation.
Depreciating when the balance of payments is strong and the labour market tightening is certainly odd, but not likely to be damaging in the context of a currency nearing the end of its life. Indeed, all EMU participants have an incentive to enter the regime at a lower currency rate to ensure adequate wage and price competitiveness in the early stages of the new regime. The inflation risks for any one country of such a strategy are unusually low, while the competitiveness gain is no lower than usual.
By contrast, entering at a higher DM rate - close to the present market rate
- would have the advantage of avoiding the modest jump in the general level of prices to which I referred. But it would effectively pass up the opportunity to slightly undervalue the currency on entry. When one recognises the unique nature of the end-game now being played in our currency policy it is easy to be persuaded that this is an inferior option.
It is even harder to defend the suggestion that the Irish pound should be realigned upwards now to ensure that the entry rate is high. With sterling unusually strong at present, it would be gratuitously risky to unnecessarily lock ourselves in to a high DM parity at entry. A sharp sterling decline between now and end 1998 would, to say the least, remove any desire for the high
DM entry rate into which it is proposed we should lock ourselves by means of this realignment. That would clearly be an unforced error, an own goal.
It has to be said that the continued strength of sterling means that neither of the major entry rate options at present being discussed are particularly attractive, though the low is clearly better than the high. The problem is going to become acute if we are forced to declare a pre-announced entry rate.
We can surely do better. The previous discussion of the various options conveys two main messages. First, the weaker tone that has been given to the Irish pound (in trade-weighted terms) is no bad thing in the context of the end-game;
but a further sharp fall would not help further, and could be somewhat destabilising. Ideally we would enter the system no weaker in trade-weighted terms, but if we have to pre-announce an entry rate against the DM we become subject to the vicissitudes of future sterling movements.
As a way out of this dilemma a simple safety valve could be introduced into the pre-announced entry rate formula for Ireland. The purpose of the safety valve would be to prevent a pre-announced DM entry rate from resulting in a plunge against sterling, while protecting against a sharp fall in sterling between now and the beginning of 1999. A number of alternatives are possible, but the most transparent would be a floor against sterling at entry. Thus, with the agreement of our partners (which would surely be forthcoming), if we have to pre-announce an entry rate for Ireland it could be: the DM parity of 2.41, or the equivalent of (say) 87p sterling, whichever is the higher. By imposing this sterling floor, we prevent a further sharp depreciation of the Irish pound against sterling, without exposing ourselves to the risk that we might have to enter at too high a rate against sterling.
While inclusion of such a sterling floor in our pre-announced entry rate would highlight the very real problems that we have with such divergent movements of sterling and other EU currencies, these are problems that will not go away when the euro arrives. We should not worsen them by an unwarranted realignment.
