Irish Economic Growth - Case Study Example

Name: Student ID: Title: Date: “Irish Economic Growth” According to Robert Solow, economic growth will require an increase in per capital income, and political and social institutions necessary to support an expansion of the national economy (Solow 1957). It also requires people in that particular country to produce goods and services at higher rates. In addition to increase per capital income, it also includes changes in the structure of the economy. These changes are characterized by industrial sector growth and a decline in agriculture share of GDP (Gross Domestic Product) as well as changes in employment opportunities, rural to urban migration and population growth (Solow and Temin 1978). Basic Economic Growth Model According to Solow Growth Model, the primary factors of economic growth are labor and capital. At a national level, production function can be represented by the formula Y= F (K, L) where Y represent output, and L and K represent labor and capital respectively. An Increase in Y (output) depends on increase in L (labor supply) through population growth and increase in K (capital stock) through investment (Solow and Temin 1978). In addition, capital investment will depend on savings while labor supply will be based on demographics. When labor and capital increase, economy will grow (Solow 1957). In Ireland (The Celtic Tiger) case period of the mid- to late 1990s saw the Ireland economy having a double-digit GDP growth” (Honohan 2009), which was driven by industrial policies that was able to boast exports and large-scale foreign direct investment into the country. Ireland GDP growth dipped during the economic slowdown, but averaged roughly 5 per cent annually between 2004 and 2007, which was the best performance among the European Union (EU) 15 member states. During the same period, Irish economy was able to generate approximately 90,000 new jobs yearly and attracted over 250,000 foreign workers, mostly from the new European Union (EU) member states (Honohan and Walsh 2002). In an unavoidable foreign workers influx into Ireland, the construction sector contributed to approximately one-quarter of these new jobs. However, during the economic recession in 2008, Irish economy started experiencing a slowdown. The property and mortgage market collapsed, pilling pressure on the financial institutions and banks, which they invested portion of their loan in real estate. This, in turn, had a negative effect on the government’s finances because of reduced revenue raised from tax on property and value-added tax transactions (Honohan 2009). Solow (Neoclassical) Growth Model According to Neoclassical Growth Model, Output (Y) can be expanded in one of three ways: (1) increase in labor, (2) increase in capital, or (3) increases through fixed and equal portions of capital and labor. According to Solow (1957), technological change in a country is seen as increasing productivity. Neoclassical Model function showed increasing knowledge or technology as labor supplementing and increasing output. Solow (1957) further argues technology development in a country is exogenous or independent of the model in two forms: Human capital (improved healthcare, education workers skills, etc) and mechanical (improved machinery, computer, etc). Part of Irish economic growth has been attributed to globalization which enabled the country to move from the periphery towards the centre of the new global economy. At the moment, Ireland is the second largest exporter of packaged computers programs or software after the US. At the moment, top ten pharmaceutical companies and twelve of top twenty electronic companies have factories in Ireland. From not having any major export industries, Ireland economy has provided a platform for major high-tech companies that are competing in the EU market (Honohan and Walsh 2002). The workforce found in Ireland is highly skilled, while cost-competiveness in companies has improved. For example, business cost including private rents, energy, services, office rents, labor and construction have all become more competitive. Both electricity and gas prices are below the European Union (EU) average, while the cost of living in the country has fallen as compared to other European Union (EU) member states. The European Union (EU) has forecasted that from 2007 to 2012, the labor cost in Ireland will improve 13 per cent relative to European Union (EU) average at 27 per cent. This improvement in labor cost has been key in securing new Foreign Direct Investment (FDI) for the country’s economy and has continue focusing on improvement in this essential (Lane 2000). In Solow growth model, where there is absence or little barriers to capital mobility, an increase in the savings rate in a country should translate into higher investment in which a country will have higher return to capital. According to Solow (1957), some variables may affect both investment and savings. In Ireland case, foreign direct investment (FDI) was also another factor which has remained very active. In fact, in 2010 foreign direct investment was the best performance in 7 years, and this trend has continued so far in 2011. Recent survey has confirmed this, many of foreign projected that have been initiated in Ireland, which is an increase by 15 per cent in 2010. Over the years, there has been an upward trend in number of organizations or companies that investing in Ireland; in particular in the customer support and software sectors as well as in medical devices. Also, existing organizations investors operating in Ireland have continued to diversify and expand their services or operations. Among those companies or organizations investing in Ireland for the first time in 2010 were: Telefonica, Dun & Bradstreet, Warner Chicott, Electronic Arts, LinkedIn, Riot Games, Spencer Stuart, Webroot, Aspect Software and Streamserve. Foreign direct investment (FDI) has still remained key growth driver in the Irish economy. In 2011, FDI accounts for over 75 per cent of the total Irish exports. Currently, the number of foreign companies operating in Ireland has reached 960 and employing over 138,000 employees. Also, there are over 50 per cent of the world’s leading banks and financial services have their operations in Ireland. The activities that are being carried out by these organizations are also moving towards higher value-added services such as development and innovation (RD &I) and research. For example, in 2010 IBM’s decision to locate its 440 million pound smarter cities project in Ireland. The country has also built a critical mass of companies in a number of important industries such as internet services, pharmaceuticals and financial services, which in turn it has made the country’s economy be an attractive for further investment in these industries. Its corporate tax for domestic and foreign firms stands at 12.5 per cent. Which is below the EU average and has been the cornerstone of Ireland’s industrial policy since mid-1960s. This has able to attract high-value inward investment. Many businesses also find Ireland to be a suitable place to manufacture for the European market, since it is inside the European Union (EU) area and uses the euro. Other factors for the country’s attractiveness include a transparent judicial system; cooperative labor relations; strong intellectual property protection; political stability; flexibility and quality of the English-speaking work force; and pro-business government policies (Lane 2000). One cause of Irish economy collapse was easy credit, which was occasioned, by the euro. Before joining the EU, Ireland central bank could regulate credit. By joining the EU, meant the government surrendered this privilege of controlling interest rates to the European Central Bank (ECB), which has the responsibility of setting one policy for all EU member states. The ECB’s rates favored Germany and France but were too low for Ireland. Moreover, interest rates pushed the government bonds down to lower German levels. These interest rates were halved overnight from 6 per cent to 3 per cent. High interest rates on the part of Ireland could have helped the country from avoiding asset bubble developing. The effect of lower interest rates will encourage easier borrowing, and the prices houses will rise at a rate which the economy of a country could support. Because the demand for houses in Germany and France was low, the interest rate for Euro has to be set at a lower level. “Low interest rates had a negative effect on the Irish property market. In 2006 construction sector was 23 per cent of the country’s GDP, and a fifty of the workforce were employed in the construction industry” (Kelly 2009). After the collapse of the housing market, in 2007, ‘credit crunch’ hit Ireland. Many Irish defaulted on their mortgages repayment. Many of these liabilities slipped into negative equity in the housing market. Where the value of houses was less than the debt owned against the houses. And due to financial risk associated with housing market, many financial institutions and banks in Ireland stopped lending to each other and to people buying houses. The banks in Ireland were the main leaders to the Irish housing market. When the prices for houses crashed the banks in Ireland were left with enormous levels of bad debt. The collapse of Irish economy was also contributed by reduce investment in Information Technology (IT) industry in the world (Kelly 2009). In the late 90s, the industry had over-expanded while the stock market equity declined vigorously; Ireland was a major player in IT industry accounting to 50 per cent of all packaged software sold in EU market. Sept/11 attacks and foot and mouth disease damaged Ireland’s agricultural and tourism sectors, deterring British and America tourists. Several companies moved their operations to China and Eastern Europe because of a rise in insurance premiums, wage costs, and a general reduction in economic competitiveness (Kelly 2009). What is to be done In the Irish economy? A similar situation happened in Iceland in 2008, but the government allowed financial institutions and banks to default. The results in Iceland were much better in term of recovery. Although it was unfortunate that some people lost their savings in banks and financial institutions, most of these looses were made by wealthy speculators. This should be the case in banks and financial institutions in Ireland. Banks and financial institutions should be allowed to go to the wall, although this move will have repercussions such as will prevent companies from investing in the country. There is no medium or long term guarantee of success to bailout; this has been the way forward for Iceland, which is now emerging from financial recession (Acemoglu and Angrist 2000). As a country must be consistent and active supporters of investment and free international trade. Contemporary research has shown that a determined outward orientation will diffuse domestic economy and accelerates technological innovation, allows specialization to take place by guarantees access to international markets, procuring the relevant economies of scale, and strengthens the competitiveness of domestic companies or organization by subjecting them to stimulating international competition. Example Ireland could take are work with other countries to find internationally-acceptable ground rules for international trade (Murphy, Riddell and Romer 1998). Education is another measure Irish government can use to reverse the trend of economic slowdown. The government should invest in secondary and post-secondary education. There is evidence on the impact of the level of education on labor productivity and quality, and on both person and aggregated wages (Acemoglu and Angrist 2000). Skilled workers in Ireland will play an important role in the implementation and development of new technologies. Education in Ireland can also be used as a weapon against the rising inequality in the knowledge-intensive economy (Murphy, Riddell and Romer 1998). Irish government should reform its education and training policies. For example, “Portugal and Spain are using the crisis as an opportunity to strengthen reforms to training policies or higher education institutions” (Murphy, Riddell and Romer 1998). Also, these reforms in education will be required to adapt to the emerging needs of a post-crisis society. The crisis has accelerated new structural changes: new sectors have appeared while the old ones have faded away; new work organizations have been introduced; thus there is a need for new skills in the country. As demonstrated in the OECD Innovation Strategy, attitudes and entrepreneurial skills, creativity, risk-taking behavior, etc (Murphy, Riddell and Romer 1998). References Acemoglu, D, and Josh A. (2000). ″How Large Are the Social Returns to Education? Evidence from Compulsory Schooling Laws″, in B. Bernanke and J. Rotemberg (eds.), NBER Macroeconomics Annual 2000.Cambridge, MA: MIT Press. Akerlof, G. A., William T. D, and George L. (2000). ″Near-Rational Wage and Price Setting and the Long-Run Phillips Curve″, Brookings Papers on Economic Activity 1, pp. 1-44. Honohan, P. (2009). “Resolving Ireland’s Banking Crisis,” Economic and Social Review, 40 (2), 207 – 231. Honohan, P. and Walsh, B. (2002). “Catching Up with the Leaders: The Irish Hare,” Brookings Papers on Economic Activity 33:1-78. Lane, P. (2000). “Disinflation, Switching Nominal Anchors and Twin Crises: The Irish Experience.” Journal of Policy Reform 3: 301–26. Kelly, M. (2009). “The Irish Credit Bubble,” working paper 09/32, School of Economics, University College, Dublin, December. McMahon, F. (2000) Road to Growth, How Lagging Economies Become Prosperous. Halifax, N.S.: Atlantic Institute for Market Studies. Murphy, K. M., Craig Riddell, W., and Paul M. R. (1998). ″Wages, Skills, and Technology in the United States and Canada″, in E. Helpman (ed.), General Purpose Technologies and Economic Growth (Cambridge, MA: MIT Press). Solow, R. M. (1957). Technical change and the aggregate production function. Review of Economics and Statistics 39,pp 312-20 Solow, R. M., and Temin, P. (1978). Introduction: The inputs for growth. In The Cambridge Economic History of Europe, vol VII: The Industrial Economies: Capital, Labour, and Enterprise. Cambridge: Cambridge University Press. Ross, S. (2009). The Bankers: How the Banks Brought Ireland to its Knees, Penguin Press, Ireland. Read More