Working Paper 16 Economic Freedom and Growth: The Case of the Celtic Tiger * BENJAMIN POWELL Abstract Ireland had low rates of economic growth prior to the 1990s and then it achieved rapid rates of economic growth, converging and passing Europe’s per capita income level. This paper traces the policies of the Irish government from the 1950s to present and relates these policies to the degree of economic freedom in Ireland. We find that as economic freedom increased, Ireland grew more rapidly. Specifically, the reforms made following Ireland’s fiscal crisis in the mid-80s, that slashed the government’s role in the economy, changed the institutional environment that entrepreneurs operate in. The government made credible commitments not to inflate or run large budget deficits, while continuing to cut tax rates following the initial reforms. We find that the “Celtic Tiger’s” growth was achieved by reducing the government’s involvement in the economy and freeing private entrepreneurs and investors to pursue their own self interest. * Benjamin Powell (M.A., George Mason University) is a Social Change Fellow at the Mercatus Center and PhD candidate in economics at George Mason University. He has been a visiting fellow at the American Institute for Economic Research. The ideas presented in this research are the author’s and do not represent official positions of the Mercatus Center at George Mason University. Economic Freedom and Growth: The Case of the Celtic Tiger∗ Benjamin Powell Department of Economics George Mason University And Social Change Fellow Mercatus Center 8261 White Pine Dr. Manassas Park VA 20111 [email protected] PAPER ABSTRACT Ireland had low rates of economic growth prior to the 1990s and then it achieved rapid rates of economic growth, converging and passing Europe’s per capita income level. This paper traces the policies of the Irish government from the 1950s to present and relates these policies to the degree of economic freedom in Ireland. We find that as economic freedom increased, Ireland grew more rapidly. Specifically, the reforms made following Ireland’s fiscal crisis in the mid 80s, that slashed the government’s role in the economy, changed the institutional environment that entrepreneurs operate in. The government made credible commitments not to inflate or run large budget deficits, while continuing to cut tax rates following the initial reforms. We find that the “Celtic Tiger’s” growth was achieved by reducing the government’s involvement in the economy and freeing private entrepreneurs and investors to pursue their own self interest. WORKING ∗ I would like to thank 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 earlier drafts. I would also like to thank the Mercatus Center and the American Institute for Economic Research for financial support. Any remaining errors are my responsibility. 1 Ireland was one of Europe’s poorest count PAPER achieved a remarkable rate of economic growth the decade, its GDP per capita stood at Kingdom at 22,300 and Germany at 23,500 (Econo 2000: 25). Almost all of the catching up occurred in just over a decade (See Figure 1). In 1987 Ireland’s GDP per capita was only (Economist 5/17/97). From 1990 through 1995 Ire rate of 5.14 percent per year 1996 through 2000 GDP increased even more rapidly at an average rate of 9.66 percent ries for over two centuries. Ireland (International Financial 25,500 (US$PPP), higher than both the United achieved during the 199 35,000 (International Financial St mist Intelligence Unit Report [EIU] 63 percent of the United Kingdom’s 30,000 Statistics Yearbook 2001). 0s. By the end of WORKING25,000 land’s GDP increased at an average GERMANY 20,000 IRELAND Ireland's Per Capita GDP Convergence UNITED KINGDOM atistics Yearbook 2001). From UNITED STATES 15,000 EU15 Figure 1 Per Capita GDP (PPP) 1995 Dollars 10,000 5,000 - 1970 1971 Source: OECD Annual National Accounts- Comparative Tables 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 2 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 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 the dramatic economic growth of Ireland, but instead 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 1950-1973. The second section examines Ireland’s experience with Keynesian policies and a fiscal crisis in the period between 1973-1987. We then look at the policies 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 economicPAPER growth in the fourth section. Then other possible explanations of Irish economic growth are briefly explored. The paper ends with conclusions that can be drawn from Ireland’s experience. 1950-73 Early Prospects for Growth The Irish Republic had a dismal record of economic growth before 1960. At the turn of the century Ireland had a relatively high GDP per capita but it declined markedly vis- à-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 32 percent, with over 75 percent of these exports going to the UK (Considine andWORKING O’Leary 1999: 117). The high level of government interference in trade and the other parts of the economy caused dismal economic performance during the 50s. Average growth rates during the 1950s were only 2 percent - far below the post war 3 European average (EIU 2000: 5). The poor economic performance of the 50s was reflected in the massive emigration, which over the course of the 1950s, subtracted one- seventh of Ireland’s total population (Jacobsen 1994: 68). During the 1960s the policy stance of the Irish government shifted away from highly protectionist policies. That is not to say that Ireland embraced the full principles of laissez faire. Jacobsen notes, “In the 1960s Irish administrators squeamishly made way – minimal way – for a planning system designed to operate ‘only to the degree that it is compatible with the market’” (Jacobsen 1994: 70). Mostly what they made way for was 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, which swapped duty-free access of Irish manufactures to PAPERBritain for progressive annual 10 percent reductions in Irish tariffs, were particularly beneficial policies. These and other free trade policies helped to make Ireland more attractive to foreign investors (Jacobsen 1994: 81). The freer trade policies in Ireland, during the 1960s, helped it to achieve higher levels of economic growth. During the 60s, Ireland had an average output expansion of 4.2 percent, just about double that achieved in the 50s (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 60s, the rest of Europe was also experiencingWORKING about 4 percent GDP growth. Ireland’s relative opening of its economy 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 4 living, during the 60s; 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). 1973-86 Keynesian Policies and Fiscal Mismanagement In the early 1970s Ireland made further advances in trade liberalization, like joining the European Economic Community in 1973. For the most part, however, the period from 1973 until 1986 was characterized by Keynesian macro economic 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. This policy did not help to revive the Irish economy. The expansionary fiscal policies had the effect of puttingPAPER 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 deficit (Honohan 1999: 76). After 1977, the government engaged in a even more unsustainable fiscal expansion causing public sector borrowing to rise from 10 to 17 percent of GNP despite increased taxation (Honohan 1999: 76). All categories of government spending were 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). TheWORKING government’s interest payments also increased during this time. International interest rates were at an all time high, and in addition, because of Ireland’s accumulated debt, lenders required a high risk premium on Irish debt. This resulted in interest rates in 5 Ireland that were 15 percent higher than in Germany (Considine and O’Leary 1999: 118).