June 23, 2006

June 23, 2006 | Backgrounder on Democracy and Human Rights

How Ireland Became the Celtic Tiger

In just over a generation, Ireland has evolved from one of the poorest countries in Western Europe to one of the most successful. It has reversed the persistent emigration of its best and brightest and achieved an enviable reputation as a thriving, knowledge-driven economy.

As a result of sustained efforts over many years, the past of declining population, poor living standards, and economic stagnation has been left behind. Ireland now has the second highest gross domestic product (GDP) per capita within the European Union (after Luxembourg), one-third higher than the EU-25[1] average, and has achieved exceptional growth. (See Chart 1.)

One of the biggest successes of the Irish economy has been new job creation. From 1990 to 2005, employment soared from 1.1 million to 1.9 million. (See Chart 2.) Economic growth, more Jobs, and rising living standards meant the resolution of the emigration problem, which had bedeviled Ireland for generations.

The population increased by almost 15 percent from 1996 to 2005 in a striking reversal of previous trends. In one year alone (July 2004-June 2005), employment increased by 5 percent. Ireland is now seen as the land of opportunity by many workers from the 10 newest EU member states. Its unemployment rate of 4.4 percent is less than half the EU average. Public budgets are in balance, and foreign investment was equivalent to 17 percent of GDP in 2003.

Ireland achieved this success through a combination of sensible policies and pragmatism. At the heart of these policies was a belief in economic openness to global markets, low tax rates, and investment in education. While economic success over the past 15 years can be ascribed to a range of domestic and international factors, it was not a fluke. Ireland has long had, and intends to sustain, low tax rates to attract investment. Its current 12.5 percent corporate tax rate evolved from the zero rate on export sales in the 1950s and the 10 percent rate on manufacturing and some internationally traded services introduced in 1980.

Ireland's transformation was national in scope, with individuals, businesses, institutions, and government sharing the same ambition. It involved parents deciding that their children would have choices that they did not have and would not be forced to leave their home communities because of economic necessity. Political decisions were driven and sustained by the public will for success. There were some deviations from sensible policies at times, but through the many difficult years, the threads of consistent development can be seen. This paper explains how the transformation occurred.

Economic Nationalism

For a generation after achieving independence from the United Kingdom in 1922, Ireland sought to be economically self-sufficient. It relied on small-scale agriculture, exporting primary produce to the U.K. market and manufacturing mainly for the home market of less than 3 million people. trade barriers such as high Tariffs and a policy of import substitution sought to make this reliance on economic nationalism successful. Inevitably, it failed.

Ireland's population was just short of 3 million people when the new state was established in 1922. It fell marginally each decade thereafter until the 1950s, when 400,000 people (one-seventh of the population) emigrated in a single decade. (See Chart 3.) There could be no clearer evidence of the failure of economic policies and opportunities and of the inadequate fulfillment of national aspirations.

By the mid-1950s, it was clear that economic nationalism was not sustainable. The stagnation and emigration, and the despondency they caused, were in stark contrast to other, fast-recovering economies of postwar Europe. As a result, radical policy change was introduced, and the previous protectionism was abandoned in favor of openness, driven by the need for progress from an intolerable position that offered few prospects for economic success.

The policy changes were drawn together in Economic Development, an official paper published in 1958 that overturned much previous policy thinking by advocating free trade, foreign investment, productive (rather than mainly social) investment, and growth rather than fiscal restraint as the prime objective of economic management.[2] In 1956, to spur business development, tax relief on profits from export sales from Ireland was offered for the first time. In 1958, all controls on foreign ownership of businesses were lifted.

In the early 1960s, Ireland unilaterally lowered its import Tariffs and started to negotiate a free trade agreement with the U.K. This agreement was concluded in 1965, and Ireland joined the General Agreement on Tariffs and trade in 1967. In 1961, Ireland expressed its ambition to join the European Economic Community (EEC), which had been founded by the six member states in the previous decade. The U.K. had the same ambition, but this was thwarted by a French veto for some years, and Ireland's application did not proceed. The U.K., Ireland, and Denmark finally joined the EEC in 1973.

These policy changes were facilitated by a transition from the generation that had won independence (although Sean Lemass, the political leader who made the most changes in a few years, was himself part of that generation) and by Ken Whitaker, the young and forward-looking head of the civil service, who led the Department of Finance from 1956 to 1969. Whitaker was the primary author of Economic Development.

The Transition to Openness

More open markets spurred improved economic performance in the 1960s, compared to the previous decade. Annual average growth in national income-both GDP and gross national product (GNP)-was 4.2 percent. The Industrial Development Authority (IDA) sought out new modern industry overseas, which benefited from the attractions of abundant English-speaking and low-cost labor and the exemption from corporation tax of all profits from exports. Pfizer, which established its first plant in 1969, was one of over 350 overseas companies that set up in Ireland by 1970.

However, this progress did not initially spur employment or stop emigration. In fact it came at a price: Many companies that had been set up in earlier years to serve the small closed national market were uncompetitive in the face of free trade. Moreover, Ireland still depended heavily on agriculture, which had low output and income levels, and the migration of people from the land was greater than job creation in new businesses. As a result, there was no net increase in employment in the 1960s, and net emigration from the country continued, although at a lower rate than in the 1950s.

The role of the state also increased during the 1960s. Public expenditure grew from 32 percent of GNP in 1960 to 42 percent in 1973. Social services and education, in particular, expanded with the state. The Organisation for Economic Co-operation and Development (OECD) sponsored an influential report on education in Ireland, Investment in Education, which was published in 1965. This report emphasized that education was key to the future of Ireland's society and economy. Although not directly recommended in the report, beginning in 1967, the state paid for all secondary schooling and transportation to school. This measure resulted in a rapid rise in the level of education attained by the younger population.

Attempts were made to adjust to the new openness. The National Industrial and Economic Council, comprising government, business, and other interests, discussed the challenges of restructuring industry now faced with free-trade competition. Underlying the extensive processes of consultation and engagement was a clear commitment to change, even if that change had inevitable problems and costs.

With hindsight, the path to openness was irreversible, although it may not always have seemed so at the time. The establishment of the first (state-owned) television service in 1960 quickly facilitated debate on, and sometimes a questioning of, long-established societal norms and values. The country, which had been introspective and highly sensitized by its history, now began to see the possibilities that others enjoyed.

Joining Europe and Going Forward

When Ireland joined the EEC in 1973, its confidence and sense of its own status grew. Now it could deal with large and successful states as a partner, no longer burdened by its colonial history. Business now had free access to a much larger market, and exports could be diversified away from dependence on the U.K. Moreover, through the EEC's Common Agricultural Policy, agriculture gained from access to wider markets at good prices. An improvement in Ireland's living standards and prospects lifted spirits.

The 1970s reversed past trends. For the first time since independence, the population increased, rising by 15 percent for the decade. National income increased at a sustained annual rate of about 4 percent. Unlike previous decades, employment increased by about 1 percent per year, although a large part of this increase was in the state sector, contributing to financing problems in subsequent years.

The IDA played a central role in the new drive for success. While still funded by the state, the IDA was established in 1970 with its own board, staff, and operating freedoms, separate from the Department of Industry and Commerce of which it had been a part. It was the first dedicated state agency in the world to undertake a massive and sustained campaign to establish a modern manufacturing base by attracting large-scale foreign investment.

The IDA adopted pragmatic, business-like, focused marketing methods. The key decision was to focus on companies that represented the future-high technology, high output, and high skills. The main targets included the computer industry, pharmaceuticals, and medical technology, followed by international services. Soon investments were won from leading companies, including Amdahl, Baxter Travenol, Digital, Merck Sharpe, Wang, and Warner Lambert. All of these companies were persuaded of the value of using Ireland as an export platform to serve Europe and other markets. By 1975, more than 450 foreign-owned industrial projects, covering a wide range of manufacturing sectors, accounted for two-thirds of Ireland's total industrial output.

While the new multinational companies brought success, many older indigenous businesses had considerable difficulty in adjusting to the new open trading conditions. An apparent dichotomy in the performance of new and old, foreign and Irish companies would be the subject of debate and some policy reassessment in the following years.

The 1970s also saw a rapid expansion in public (state) expenditure on social welfare, health and education, housing, telecommunications and other infrastructure, and administrative services. Public-sector employment represented a third of the total workforce by 1980, partly because Jobs were created to deal with rising unemployment, which stood at 9 percent of the workforce in 1977.

All of this happened against a backdrop of high inflation, which averaged 13.6 percent per year from 1971 to 1980 and was driven partly by international factors such as oil crises and partly by domestic demand and an expansionary fiscal policy. Public budget deficits and high public borrowing were features of the latter years of the decade, creating the basis for the crises that erupted in the 1980s.

Crises Accumulate

Unsolved, the underlying economic problems of the 1970s rolled over into the 1980s, producing disappointment. The causes were the return of high unemployment, emigration, steady worsening of the public finances, and the seeming inability of any government to manage the nation's affairs and find a solution to the worsening situation. The atmosphere of the 1980s was more redolent of the dark years of the 1950s than of the optimism that had permeated the two decades in between.

The feeling of failure was exacerbated by the waves of emigration of young people, just as in a generation earlier. Whole classes of university graduates would frequently leave the country. There was a disheartening drain of human capital. A net 200,000 people left from 1981 to 1990. In the worst years, more than 1 percent of the country's population fled. This was not what the policies of the previous 25 years had been designed to achieve. What had gone wrong?

A number of internal and external factors were conspiring to slow down progress and undermine confidence. Global conditions were weaker after the oil shocks of the 1970s. The momentum from EEC entry had faded. Persistent inflation averaged close to 11 percent per year between 1981 and 1986. Jobs created by new foreign investment, while substantial, were inadequate to employ the growing workforce and counter the failure rate of older businesses.

Attempts at government intervention proved to be no better. Continued increases in public spending, tax increases, and deficit financing through borrowing soured the investment climate and failed to raise employment while increasing the drag on the underperforming economy.

Between 1980 and 1986, total government expenditure grew from 54 percent to 62 percent of GNP, and public debt increased from 87 percent to 120 percent of GNP while annual budget deficits exceeded 10 percent of GNP. Over one-third of all tax revenue (over 90 percent of income tax revenue) was being used to service this debt. Meanwhile, the economic dependency ratio rose to 2.3 persons per person employed in 1985, and unemployment stood at 15 percent.

While the IDA continued to attract foreign investors (IBM, Lotus, Microsoft, and Bausch & Lomb, among many others) into the 1980s, some high-profile failures of recent investments raised questions about this strategy. In particular, a specially commissioned investigation by Telesis on behalf of the National Economic and Social Council (NESC) raised some troubling issues.[3]

Telesis found that the value of inward investments tended to be overstated-employment prospects were too often exaggerated at a time of high unemployment-and that promised linkages to the domestic economy were frequently weak. It also criticized what it saw as an excessive attention to overseas companies relative to indigenous businesses. While initially stung, the IDA responded well to the report and increased its attention to Irish-owned industry.

The political parties were not successfully addressing the gathering gloom. Fianna Fail, the opposition party since 1982, won the general election in 1987. When in government in the late 1970s, Fianna Fail had been largely responsible for the excessive and misguided public spending. This time, however, the party tried a different path. On election to government in 1987, they surprised many, including their own supporters, with a program of severe cuts in expenditure accompanied by some novel consensus-building and developmental measures. Within a few years, these steps began to show dividends, helped by a coincidence of other factors.[4]

Recovery and Success

Smaller government became part of the road to success. There was surprise with the first moves to cut spending severely across a range of programs and abolish a number of government agencies. These steps were strongly criticized initially, especially when they seemed to affect (state-provided) health and social services, but the depth of the budgetary crisis allowed the momentum to be sustained. The government was assisted by a consensus that had been built in the NESC, comprising business, farming, trade union, and social interest> groups. The main opposition party, whose leader had been minister for finance before the election, also supported any measures that restored fiscal discipline.

A second element of the new government's action plan was moderate wage increases in return for modest reductions in direct income taxes, in effect allowing take-home pay to increase more than the pay raise granted by employers. This three-year Program for National Recovery involved government itself, employers, unions, and farmers. This helped to break the spiral of inflationary wage increases and ensured industrial peace. The program also served to create agreement on the nature of the crisis facing the state and on steps needed to deal with it. The wider benefits of consensus on development priorities and the shared efforts involved to achieve national goals proved to be of lasting value, and similar national partnership agreements have been put in place repeatedly up to 2005.

While cutting back on spending, the government took steps to promote business investment. A notable example was the adoption of a proposal to create the International Financial Services Centre (IFSC) in the old Docklands area of Dublin. The successful development of the IFSC shows the strength of cooperation between business interests and all parts of the state system that is such a strong characteristic of Ireland.

Development steps in financial services and other sectors were assisted by a series of investments in telecommunications from the 1980s onward, although the sector remained largely state-owned until the late 1990s. Late entry to heavy investment in this sector ultimately served Ireland well in that it provided the most advanced and comprehensive digital network in Europe (much as the relevance of the education system was also greater as a result of its late expansion).

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