Economic freedom and growth: the case of the Celtic tiger.
Powell, Benjamin
Ireland was one of Europe's poorest countries for more than
two centuries. Yet, during the 1990s, Ireland achieved a remarkable rate
of economic growth. By the end of the decade, its GDP per capita stood
at $25,500 (in terms of purchasing power parity), higher than both the
United Kingdom at $22,300, and Germany at $23,500 (Economist
Intelligence Unit [EIU] 2000: 25). In 1987, Ireland's GDP per
capita was only 63 percent of the United Kingdom's (The Economist
1997). As Figure 1 shows, almost all of the catching up occurred in a
little over a decade. From 1990 through 1995, Ireland's GDP
increased at an average rate of 5.14 percent per year, and from 1996
through 2000, GDP increased at an average rate of 9.66 percent
(International Monetary Fund 2001).
[FIGURE 1 OMITTED]
Most theories of economic growth can be dismissed as an explanation
for the rapid growth of the Irish economy. The thesis of this paper is
that no one particular policy is responsible for Ireland's dramatic
economic growth. Rather, a general tendency of many policies to increase
economic freedom has caused Ireland's economy to grow rapidly.
The first section of this paper looks at general policies and
economic growth in Ireland from 1950 to 1973. The second section
examines Ireland's experience with Keynesian policies and a fiscal
crisis in the 1973-87 period. The third section considers the policies
used to correct the fiscal crisis and achieve the dynamic growth that
occurred from 1987 through 2000. The policies in the above periods are
explained more broadly in the context of economic freedom and its
relationship to economic growth in the fourth section. Other possible
explanations of Irish economic growth are briefly explored. The paper
ends with conclusions that can be drawn from Ireland's experience.
Early Prospects for Growth, 1950-73
The Irish Republic had a dismal record of economic growth before
1960. At the dawn of the 20th century Ireland had a relatively high GDP
per capita, but it declined markedly vis-a-vis the rest of northwestern
Europe up until 1960. During the 1950s, the policy stance of successive
governments was that of protectionism. Exports as a proportion of GDP
were only 39. percent, with more than 75 percent of those exports going
to the United Kingdom (Considine and O'Leary 1999: 117). The high
level of government interference in trade and the other parts of the
economy caused dismal economic performance. In the 1950s, average growth
rates were only 2 percent, far below the postwar European average (EIU
2000: 5). That dismal performance was reflected in massive emigration that reduced Ireland's population by one-seventh in the 1950s
(Jacobsen 1994: 68).
The Irish government slowly shifted away from highly protectionist
policies in the 1960s and began to pursue a strategy of export-led
growth (Considine and O'Leary 1999: 117). Unilateral tariff cuts in
1964 and again in 1965, as well as the Anglo-Irish Trade Agreement in
1965 that swapped duty-free access of Irish manufactures to Britain for
progressive annual 10 percent reductions in Irish tariffs, were
particularly beneficial policies that helped make Ireland more
attractive to foreign investors (Jacobsen 1994: 81).
Trade liberalization during the 1960s fueled Ireland's
economic growth. Output expanded at an average annual rate of 4.2
percent, nearly double that achieved in the 1950s (EIU 2000: 5). Still,
there was a great deal of state intervention in the economy during this
time, and while the growth was much higher than the 1950s, it is not
nearly as remarkable as the growth Ireland has experienced since 1990.
During the decade of the 1960s, the rest of Europe was also experiencing
about 4 percent GDP growth. Ireland's freer trade policies merely
allowed it to cash in on the generally good growth rates the rest of
Europe was experiencing. Ireland made no progress converging to the rest
of Europe's standard of living; in fact, it actually fell slightly,
from 66 percent of the EU 12 average in 1960 to 64 percent in 1973
(Considine and O'Leary 1999: 117).
Keynesian Policies and Fiscal Mismanagement, 1973-86
In the early 1970s, Ireland made further advances in trade
liberalization and joined the European Economic Community in 1973. For
the most part, however, the period from 1973 until 1986 was
characterized by Keynesian policies that led to a fiscal crisis.
Following the first oil shock in 1973 and continuing through the second
oil shock in 1979, Ireland tried to boost aggregate demand through
increased government expenditures--a policy that failed to revive the
Irish economy.
The expansionary fiscal policies had the effect of putting the
government in poor fiscal condition. The government had run substantial
deficits, associated with the first oil shock, mostly for the purpose of
financing capital accumulation up until 1977, which caused a ballooning
current-account deficit (Honohan 1999:76). After 1977, the government
engaged in an even more unsustainable fiscal expansion causing
public-sector borrowing to rise from 10 percent of GNP to 17 percent,
despite increased taxation. All categories of government spending increased between 1977 and 1981: wages and salaries increased due to
national pay agreements; public bodies took on more staff to try to
reduce unemployment; transfer payments increased; and an ambitious
program of public infrastructure expansion caused capital spending to
increase (Honohan 1999: 76). Interest payments also increased during
this time. International interest rates were at an all-time high, and
lenders required Ireland to pay a high risk premium. Interest rates in
Ireland were 15 percent higher than in Germany (Considine and
O'Leary 1999: 118).
The government reacted, in the early 1980s, by increasing taxes on
labor and consumption to try to reduce the budget deficit. Although the
primary deficit was cut in half, the debt-to-GDP ratio continued to
climb, and by 1984 further tax increases were not seen as a viable
solution to Ireland's fiscal situation (Lane 2000). The level of
accumulated debt was 116 percent of GDP by 1986 (Considine and
O'Leary 1999: 119). High levels of government debt, interest
payments, and expenditures put the Irish government in a precarious
fiscal position.
Ireland's economic growth during this time period was as
dismal as its fiscal condition. Ireland averaged 1.9 percent expansion
of GDP per year between 1973 and 1986 (Considine and O'Leary 1999:
111). Although that low growth rate was the same as during the 1950s,
the difference was that the rest of Europe also grew slowly.
Consequently, Ireland remained at about two-thirds the level of GDP per
capita of the European Union. There was one sector of the Irish economy
that did do relatively well during the 1973-86 period. Because of
Ireland's increasing openness to trade, foreign-owned firms
continued to expand, increasing their employment by 25 percent
(Considine and O'Leary 1999: 119).
Unleashing the Tiger, 1987-2000
A radical policy shift was needed because of Ireland's fiscal
crisis. The newly elected prime minister, Charles Haughey, had not
followed a policy of limited government while previously in office
(1979-82). In fact, his big spending policies played a part in creating
the crisis (The Economist 1988). Prior to the 1987 reforms, Haughey and
the incoming Fianna Fail government had campaigned on a populist
platform against cutting public spending. It was the urgency of the
fiscal crisis, not an ideological shift, that caused policy to change in
Ireland. As Lane (2000: 317) notes, "The fiscal adjustment program
was broadly based and non-ideological. Rather, there was a wide
consensus that drastic action was the only option, with the alternative
being a full-scale debt crisis requiring external intervention from the
IMF or EU." Haughey himself said, "The policies which we have
adopted are dictated entirely by the fiscal and economic realities, I
wish to state categorically that they are not being undertaken for any
ideological reason or political motives" but because they are
"dictated by the sheer necessity of economic survival"
(Jacobsen 1994: 177). Even the main opposition party supported
Haughey's reforms (Lane 2000).
Since Ireland was a member of the European Monetary System (EMS),
and had just successfully cut back its rate of inflation from 19.6
percent in 1981 to 4.6 percent in 1986, monetizing the debt through
inflation was not a viable option (Lane 2000). Tax increases had already
failed to resolve the crisis in the early 1980s. With both inflation and
tax increases ruled out, reducing government expenditures was
Ireland's only option to resolve its fiscal crisis.
In order to bring Ireland's budget under control, health
expenditures were cut 6 percent, education 7 percent, agricultural
spending fell 18 percent, roads and housing were down 11 percent, and
the military budget was cut 7 percent. Foras Forbatha, an environmental
watchdog, was abolished as were the National Social Services Board, the
Health Education Bureau, and the Regional Development Organizations.
Through early retirement and other incentives, public sector employment
was voluntarily cut by nearly 10,000 jobs (Jacobsen 1994: 177-78).
After cutting government spending in 1987, a budget was set for
1988, which had the biggest spending cuts Ireland had seen in 30 years.
Current spending was reduced by 3 percent and capital spending was cut
by 16 percent (The Economist 1988: 9). The reductions in government
spending got Ireland out of its fiscal crisis. The primary deficit was
eliminated in 1987, and the debt-to-GDP ratio started falling sharply
from its 1986 peak. By the end of 1990, government debt was less than
100 percent of GDP (Honohan 1999: 81).
Although the reductions in government spending were made to solve
the fiscal crisis and not as an attempt to achieve a more economically
liberal state, over the course of a few years, they did have the effect
of reducing the size of the government's role in the economy.
Government noninterest spending declined, from a high of about 55
percent of GNP in 1985, to about 41 percent of GNP by 1990 (Honohan
1999: 80).
With the size of government in the economy reduced, the
macroeconomic environment stabilized, and the free trade policies that
had existed for decades, Ireland's economy began growing at a rate
of 4 percent by 1989 (Jacobsen 1994: 181). That level of growth was
impressive compared with the 1.9 percent growth between 1973 and 1986,
when the government had been pursuing activist fiscal policies. However,
the 4 percent growth is not nearly as remarkable as the
"tiger" growth experienced in the late 1990s. The government
made further policy changes in the 1990-95 period, which helped to bring
about the higher rate of growth.
Once Ireland resolved its fiscal problems, there was the
possibility that it could begin engaging in reckless expansionary fiscal
policies again. The signing of the Maastricht Treaty in 1992 helped to
make Ireland's commitment to sound fiscal policies more credible
and permanent. The treaty required members to maintain fiscal deficits
below 3 percent of GDP and set a target of a 60 percent debt-to-GDP
ratio by the start of the Economic and Monetary Union in 1999. Those
provisions constrained Ireland's ability to issue debt in order to
expand government spending.
Inflation is another option to finance an expansion of government
spending. Ireland has been a member of the EMS from the outset in March
1979. There is a fixed exchange rate between the Irish currency and the
other EMS members, limiting Ireland's ability to pursue an
expansionary monetary policy and inflation. With the exception of an
early bout of high inflation through 1984, Ireland's annual rate of
change in the CPI was less than 5 percent in all but two years up to
1995, and inflation averaged only 1.9 percent from 1995 through 1999.
With commitments limiting the government's ability to fund
increased spending through inflation or debt issue, increased taxation
is the only other available method. Traditionally, it has been harder to
increase government spending through taxation, because it is a more
obvious burden to voters. This reality has helped to assure investors
that the government is not likely to engage in another dramatic increase
in spending.
High levels of taxation were already in place in Ireland before
either monetary or debt policy was constrained. Ireland had top marginal
tax rates as high as 80 percent in 1975 and 65 percent in 1985. During
the 1990s both personal and corporate tax rates decreased dramatically,
and tariff rates continued to decline. In 1989 the standard income tax
rate was lowered from 35 percent to 32 percent, and the top marginal
rate was lowered from 58 percent to 56 percent (Jacobsen 1994: 182). The
standard rate was down to 24 percent and the top down to 46 percent by
2000. Those rates were further reduced for 2001 to 22 percent and 44
percent, respectively (EIU 2000: 28). (1) Although Ireland has had
relatively free trade for a long time, the mean tariff rate continued to
decline from 7.5 percent in 1985 to 6.9 percent in 1999.
The standard corporate tax rate fell from 40 percent in 1996 to 24
percent by 2000 (EIU 2000: 29). There is also a special 10 percent
corporate taxation rate for manufacturing companies and companies
involved in internationally traded services, or located in Dublin's
International Financial Services Centre or in the Shannon duty-free zone
(EIU 2000: 29). Ireland came under pressure from the European Commission
to eliminate the special 10 percent corporate tax. In an agreement with
the EC, Ireland promised to raise the special 10 percent rate, however,
it will also lower the standard rate. In 2003 the standard rate will be
lowered to 12.5 percent, and the 10 percent rate will not be offered to
new firms. Some firms, who are currently eligible, will keep the 10
percent rate until 2005 or 2010. Overall, this change should be
beneficial to Ireland's economy because it will almost cut in half
the standard corporate tax rate and eliminate the bias to particular
industries and areas that the special 10 percent rate created.
Because of the many decreases in tax rates and the growth of the
Irish economy, Ireland now enjoys a lower tax burden than any other EU
country except Luxembourg. Ireland's total tax revenue in 1999,
(including social security receipts) was 31 percent of GDP, much lower
than the EU average of 46 percent (EIU 2000: 28).
During the period from 1987 through 2000 Ireland closed and
surpassed the living standard differential with the rest of Europe.
There was strong growth in the early part of the 1990s and remarkable
"tiger" growth in the late 1990s when GDP growth averaged more
than 9 percent from 1996 through 2000. The policies undertaken during
that time were not the sole cause of the growth that has taken place.
Rather, they are better viewed as the final missing piece, which when
finally put in place, allowed the broader cause of economic growth to
take hold.
Economic Freedom and Growth in Ireland
Government actions that hinder people's ability to engage in
mutually beneficial exchanges limit the standard of living that the
people are able to achieve. Restrictions on international trade and
domestic regulations interfere with some mutually beneficial trades.
Taxes and inflation take wealth away from citizens that could have been
used to make trades to increase their well being. Legal security and the
rule of law give people the confidence that when they undertake
long-term projects for mutual benefit, the government or other citizens
will not be able to arbitrarily seize their increased wealth. While an
imperfect measure, per capita GDP roughly reflects the standard of
living. As Ireland increased economic freedom, per capita GDP rose.
Holcombe (1998) provides a theory of the relation between
entrepreneurship and economic growth, in which the entrepreneur is the
endogenous engine of economic growth. (2) According to Holcombe, when
entrepreneurs take advantage of profit opportunities, they create new
entrepreneurial opportunities that others can act upon. In this way,
entrepreneurship creates an environment that makes more entrepreneurship
possible. Since the Kirznerian entrepreneur (see Kirzner 1973) is alert
to profit opportunities that satisfy consumer desires, the more
entrepreneurship there is, the more consumer desires are satisfied, and
the more growth will result. The Kirznerian entrepreneur is also
omnipresent; hence, the institutional environment in which he operates
must be considered to explain differences in economic growth. According
to Holcombe (1998: 58-59),
When entrepreneurship is seen as the engine of growth, the emphasis
shifts toward the creation of an environment within which
opportunities for entrepreneurial activity are created, and
successful entrepreneurship is rewarded. Human and physical capital
remain inputs into the production process, to be sure, but by
themselves they do not create economic growth. Rather, an
institutional environment that encourages entrepreneurship attracts
human and physical capital, which is why investment and growth are
correlated. When the key role of entrepreneurship is taken into
account, it is apparent that emphasis should be placed on market
institutions rather than production function inputs.
Harper (1998) examines the institutional conditions for
entrepreneurship. His central thesis is that the more freedom people
have, the more likely they are to hold internal locus-of-control
beliefs, and the more acute will be their alertness to profit
opportunities. That increased alertness leads to more entrepreneurial
activity.
Combining Holcombe (1998) and Harper (1998), we have a theoretical
argument for why increases in economic freedom provide an institutional
environment that promotes more entrepreneurship, and how more
entrepreneurship functions as an endogenous source of growth. Their
argument is consistent with empirical investigations into the
relationship between economic freedom and growth.
There is vast amount of literature linking economic freedom to
growth and measures of well being. Studies by Scully (1988 and 1992),
Barro (1991), Barro and Sala-I-Martin (1995), Knack and Keefer (1995),
Knack (1996), Keefer and Knack (1997) all show that measures of
well-defined property rights, public policies that do not attenuate property rights, and the rule of law tend to generate economic growth.
Gwartney, Holcombe, and Lawson (1998) found a strong and persistent
negative relationship between government expenditures and growth of GDP
for both OECD countries and a larger set of 60 nations around the world.
They estimate that a 10 percent increase in government expenditures as a
share of GDP results in approximately a 1 percentage point reduction in
GDP growth. Using the Fraser and Heritage indexes of economic freedom,
Norton (1998) found that strong property rights tend to reduce
deprivation of the world's poorest people while weak property
rights tend to amplify deprivation of the world's poorest people.
Grubel (1998) also used the Fraser Institute's index of economic
freedom to find that economic freedom is associated with superior
performance in income levels, income growth, unemployment rates, and
human development. All of those findings are consistent with
Holcombe's entrepreneurial theory of endogenous growth and
Harper's theory of institutional conditions conducive to
entrepreneurship. That theoretical structure and those empirical
regularities are also consistent with Ireland's economic freedom
and growth.
Some aspects of economic freedom have been present in Ireland for a
long time. During times when gains in economic freedom occurred, growth
improved. The rapid growth of the "Celtic tiger" only occurred
once all aspects of economic freedom were largely respected at the same
time.
After the protectionist decade of the 1950s, when economic growth
averaged only 2 percent a year, the 1960s saw the liberalization of
trade policy, which increased economic freedom and growth improved,
averaging 4.2 percent over the course of the decade. The 1970s saw
further advances in the liberalization of international trade, but, at
the same time, the government was engaging in Keynesian interventionist
fiscal policies that interfered with citizen's economic freedom.
Growth stagnated in Ireland as well as in the rest of Europe. During the
early 1980s, high inflation, fiscal instability, a high level of
government spending, and high taxation all limited economic
freedom--resulting in an average growth rate of only 1.9 percent from
1973 to 1986. The contraction in the level of government spending, in
response to the fiscal crisis, increased economic freedom and growth
resumed. During the 1990s further tax reductions and credible
commitments not to engage in a reckless expansion of government spending
continued to increase economic freedom. Never before have all of the
components of economic freedom been present simultaneously in Ireland.
When all aspects of economic freedom were respected in Ireland, the
synergy between the components allowed the dynamic growth that occurred
in the late 1990s.
The above description of economic policies that increased and
decreased economic freedom is broadly reflected in the Fraser
Institute's 2002 index of economic freedom. Ireland was the 13th
freest country in the world, in 1970, and had an overall summary rating
of 6.7. The rating had fallen to 5.8 in 1975 and by 1985 it had
increased to 6.2. By 1990, when Ireland's economic growth began to
pick up, Ireland's score had increased to 6.7. When Ireland was
experiencing its rapid "tiger" growth, in 1995, it was the
world's 5th freest economy, and in 2000 it was the 7th freest
economy, achieving scores of 8.2 and 8.1, respectively. From 1985 to
2000, Ireland improved its score on all five of the freedom index's
broad categories (Gwartney and Lawson 2002).
Figure 2 plots Ireland's five-year average growth rates and
its overall freedom scores from 1970 through 2000. The figure shows
Ireland's growth was strongest when its freedom scores had the most
dramatic improvements.
[FIGURE 2 OMITTED]
Other Possible Explanations of Ireland's Growth Considered
There are a number of other possible explanations for
Ireland's dramatic economic growth. One explanation is that the
neoclassical growth model predicts convergence, so Ireland's
economic growth should be expected. Another explanation is transfer
payments from the EU have caused economic growth in Ireland. Other
explanations focus on foreign direct investment (FDI) or economies of
agglomeration as the source of Ireland's growth. Finally, some have
even suggested that the dramatic growth is only an illusion in the GDP
account. All of those explanations are either incorrect or incomplete.
Each will be considered in turn.
One alternative explanation is that there has not been a
"Celtic tiger." As The Economist (1997: 21) reported, "Is
it too good to be true? Yes a few critics say: it was all done with
smoke mirrors and money from Brussels." One argument is that
Ireland's GDP is much higher than GNP because of the amount of
profits that foreign-owned companies send back to their owners overseas.
The high GDP numbers, therefore, do not necessarily translate into
wealth for the Irish citizens. Yet, The Economist also notes that
"Ireland's GNP has been growing nearly as quickly as its
GDP." The dramatic economic growth in the 1990s is not only evident
from the increases in both GDP and GNP but also in other statistics. For
example, by 1995 life expectancy at birth was 78.6 years for women and
73 years for men, up from 75.6 and 70.1, respectively in 1980-82 (EIU
2000: 17). The economic growth is also translating into more material
goods for the Irish population. For example, between 1992 and 1999, the
number of cars registered in Ireland increased by 40 percent (EIU 2000:
19). Perhaps the strongest indications that economic growth actually
occurred in Ireland are the immigration statistics. Ireland has
typically experienced emigration, however the trend reversed itself in
the 1990s. Between 1996 and 1999, there was an average annual increase
in the population of 1.1 percent--higher than the population growth rate
of any other EU country during that time. In the 12 months leading up to
April of 1998, Ireland had 47,500 immigrants arrive, the most immigrants
Ireland had recorded up to that time (EIU 2000: 15). Regardless of any
difficulties with measurement of GDP or GNP, all statistics point to a
dramatic improvement in the Irish economy during the 1990s.
Both theoretical and empirical evidence show that EU subsidies have
not been a major cause of Ireland's economic growth. The
difficulties of economic calculation and public choice problems present
theoretical reasons why transfers to the Irish government cannot be a
major cause of growth.
The government needs some method to calculate which projects have
the most potential, if a transfer to the Irish government from the EU is
going to be used to create the greatest possible growth. When a
businessman faces this problem he looks at expected profits and then
uses profit-and-loss accounting to evaluate his decisions ex post to
make corrections. The government does not have that method of
calculation available to it (Mises 1944, 1949). It is true that when
Ireland receives subsidies from the EU and spends the money on new
projects there will be an increase in measured GDP. However, the
government has no way to evaluate whether the project was the
citizens' highest valued use of the EU transfer or if the project
was valued at all. The GDP that is created is not necessarily wealth
enhancing. It may actually retard growth by directing scarce resources
to government projects that could have been better used by private
entrepreneurs if the government had not bid the resources away.
Agricultural subsidies are one component of EU transfers and are an
example of how well-meaning transfers can get in the way of economic
development. McMahon (2000: 89-90) notes that, "These [subsidies]
boost rural incomes but have little impact on investment and may retard
economic adjustment by keeping rural populations artificially
high." The subsidies change the marginal incentives for farmers,
making them more likely to stay on their farms, instead of migrating to
the cities. In this way, the subsidies hinder the process of moving
resources to their most highly valued use. As long as people are
subsidized to stay in particular professions, Ireland will not fully
exploit its comparative advantage in the international division of
labor. This depresses incomes and slows growth.
Public choice theory points to another problem with the argument
that EU transfers have caused massive growth. Why would government
officials ever allocate the resources to the most growth-enhancing
project even if they were able to calculate? Entrepreneurs direct
resources to the highest valued projects because they have a property
right in the profits from the investment. Government officials have no
such residual claim. They can benefit more by giving the transfers to
projects that benefit their political supporters, instead of directing
them to the most growth-enhancing projects. That strategy would impose a
dispersed opportunity cost on the rest of society, while creating a
concentrated benefit for special interest groups (Olson 1965). Unless
the political process perfectly disciplines elected officials and
bureaucrats for not allocating EU transfers to the most growth-enhancing
projects, they will not have incentives to do so. Since voters have
incentives to remain rationally ignorant, there is little reason to
believe they do perfectly discipline public officials.
The presence of EU funds retards growth in another way as well.
Baumol (1990) argues that while the total supply of entrepreneurs varies
among societies, the productive contribution of the society's
entrepreneurial activities varies much more because of their allocation
between productive activities, such as innovation, and unproductive
activities, such as rent seeking. The presence of EU funds creates a
rent for Irish entrepreneurs to seek. This will cause some
entrepreneurs, who were previously engaging in productive and innovative
activity, to engage in rent seeking instead. This rent seeking wastes
both physical and human resources that could have been used to satisfy
consumer demands and increase economic growth.
There is no sound theoretical case for viewing EU structural funds
as the cause of Ireland's economic growth. Government officials
have no way to know what investment projects will generate the most
growth and, even if they did, they have little incentive to undertake
them.
Empirically, if EU transfers were a major cause for Ireland's
growth, we would expect Ireland's growth to be highest when it was
receiving the greatest transfers. Figure 3 demonstrates that this is not
the case, and that growth rates and net transfers as a percent of GDP
have actually moved in opposite directions during Ireland's rapid
growth. Ireland began receiving subsidies after joining the European
community in 1973. Net receipts from the EU averaged 3.03 percent of GDP
during the period of rapid growth from 1995 through 2000, but during the
low growth period, from 1973 through 1986, they averaged 3.99 percent of
GDP (Department of Finance 2002). In absolute terms, net receipts were
at about the same level in 2001 as they were in 1985. In 1985
Ireland's net receipts were 1,162.3 million euros and in 2001 they
were 1,268.8 million euros. Throughout the 1990s, Ireland's
payments to the EU budget steadily increased from 359.2 million euros in
1990 to 1,527.1 million euros in 2000. Yet, in 2000, the receipts in
from the EU are 2,488.8 million euros, less than the 1991 level of 2,798
million euros. Ireland's growth rates have increased, while net
funds from the EU remained relatively constant and have shrunk in
proportion to Ireland's economy.
[FIGURE 3 OMITTED]
If the subsides were really the cause of Ireland's growth, we
would also expect other poor countries in the EU, who receive subsidies,
to have a high rates of economic growth. EU Structural and Cohesion
Funds represented 4 percent of Greek, 2.3 percent of Spanish, and 3.8
percent of Portuguese GDP (Paliginis 2000). None of those countries
achieved anywhere near the rate of growth the Irish economy experienced.
Greece averaged 2.2 percent GDP growth, Spain averaged 2.5 percent GDP
growth, and Portugal averaged 2.6 percent GDP growth, from 1990 through
2000 (Clarke and Capponi 2001: 14-15).
Ireland's growth also cannot be explained by the neoclassical
convergence that a Solow growth model would predict. That model
predicted Irish convergence incorrectly for more than 100 years. Even
during the 1960s, when Ireland's economy had a high rate of growth,
it still was not converging on the standard of living of other European
nations. It was actually losing ground. All of Ireland's
convergence occurred in a 13-year time span, from 1987 through 2000. The
Economist (1997: 22)was wrong when it reported, "There is more to
it than the surge since 1987. Ireland has been catching up for decades.
... In many ways the dreadful years between 1980 and 1987 were more
unusual than the supposedly miraculous ones since 1990." Ireland
had not done any catching up before 1987. In 1960 the Irish Republic had
a GDP per capita that was 66 percent of the EU average, and in 1986 it
had actually decreased to 65 percent of the average (Considine and
O'Leary 1999). There had been some growth during that time but it
was less than the EU experienced. The model needs to explain why Ireland
converged only after 1987 and why it converged so rapidly.
Knack (1996) found empirical evidence of strong convergence in per
capita incomes among nations with institutions--namely, secure private
property rights--conducive to saving, investing, and producing. That
form of conditional convergence, with the introduction of free-market
institutions, is much more plausible in Ireland's case than
neoclassical convergence. Ireland did experience increases in economic
freedom just prior to and during its remarkable growth. The extent that
it was conditional convergence that drove growth, as opposed to just
adopting the appropriate institutions, is not clear. The fact that the
Irish economy has not slowed since achieving convergence casts doubt on
the importance of even conditional convergence and instead points to the
adoption of market-friendly institutions as the source of growth. Once
Ireland had converged with the EU and United Kingdom's standard of
living, it achieved record growth of 11.5 percent during 2000 (EIU 2001:
11). While convergence conditional on an institutional environment of
secure private property rights is more consistent with Ireland's
experience than neoclassical convergence, both fail to explain
Ireland's rapid growth in the last few years of the 1990s and in
2000.
FDI and economies of agglomeration are two explanations of
Ireland's growth that do have some merit but that are incomplete by
themselves. FDI has certainly played a role in Ireland's growth.
America alone had $10 billion ($3,000 per capita) invested in Ireland by
1994, and by 1997 foreign-owned firms were said to account for 30
percent of the economy and nearly 40 percent of exports (The Economist
1997: 22). Economies of agglomeration, where like firms try to locate
near each other to take advantage of positive externalities, have also
helped. Ireland has had particular success in attracting industrial
developments with large numbers of high tech and manufacturing companies
that benefit from being near each other. The relevant question is, Why
did massive FDI, which has spurred economies of agglomeration, not occur
sooner? What changed in Ireland were the institutional conditions that
attracted FDI. The FDI and economies of agglomeration are an indication
of institutional factors favorable to economic growth, not the cause of
the growth.
The interesting question to ask is, What gives rise to favorable
conditions that allow growth to occur? This article has maintained that
it is the institutional framework that hinders or helps the market
achieve economic growth. The key institutional factor is the degree of
economic freedom enjoyed by the people.
Conclusion
In May 1997, The Economist stated, "How much longer the Irish
formula will deliver such striking success is difficult to say....
Ireland grew quickly for more than 30 years because it had a lot of
catching up to do, and because policy and circumstances conspired to let
it happen. Success of that kind, impressive and unusual though it may
be, contains the seeds of its own demise." The article concluded by
saying, "If Ireland has another decade as successful as the last
one, it will be a miracle economy indeed" (The Economist 1997: 24).
The fact is Ireland had not been catching up for 30 years; it
accomplished its catching up in 13 years. Rapid rates of growth have
continued to be recorded since converging with Europe's standard of
living. The neoclassical growth model does not account for
Ireland's success. Rather, rapid growth has been driven by
increases in economic freedom. As long as Ireland continues to pursue
policies that increase economic freedom, the Irish "miracle"
is likely to continue.
(1) The social partnership agreement between government, employer
federations, and labor unions has played a role in the continued tax
reductions and low inflation. The agreements began in 1987 and have been
continually renewed with minor revisions since. Those agreements have
effectively turned unions into a force lobbying for reductions in taxes
and inflation. Lane (2000) notes that the unions promised wage
moderation, partly compensated by a reduction in labor taxes and with
the implicit promise that the government would maintain price stability.
McMahon (2000) argues the holding down of wage rates by these agreements
was important for making Ireland more competitive in attracting
companies which resulted in growth. It is important to remember though,
that the wage constraint on the part of the unions was not so much a
sacrifice by workers to attract business, as it was the unions forcing a
reduction in taxes to compensate the workers, so their real after-tax
wage could still increase, while attracting more businesses and creating
more jobs.
(2) For a survey of the endogenous growth literature that Holcombe
is incorporating his theory into and contrasting his theory with, see
Romer (1994).
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Benjamin Powell is a Ph.D. candidate in Economics at George Mason
University and a Social Change Fellow at the Mercatus Center. He thanks
Peter Boettke, Christopher Coyne, Todd Zywicki, the participants at the
Association of Private Enterprise Education conference in Cancun 2002,
the participants at the Mercatus Center "brown bag" series,
and an anonymous referee, for helpful suggestions on earlier drafts. He
also thanks the Mercatus Center and the American Institute for Economic
Research for financial support.