Catching Up with the Leaders: The Irish Hare

Olivier Blanchard:

This paper is wise and informative and contains two important warnings:

—Beware of numbers, especially in a small economy with a large export-import sector, low taxation of profits, and transfer pricing.

—Beware of monocausal explanations. No single factor, whether it be the low taxation of foreign firms, the subsidies from the European Union, the increase in the level of education, or the expansionary effects of fiscal consolidation—to cite just some of the theories floating about in the literature—can account for the Irish boom.

But the paper goes too far in declaring that what is at work is a simple, run-of-the-mill catch-up story. The authors undersell their country's performance: perhaps proximity has bred excessive contempt. After reading their paper and digesting the evidence, I have three main reactions:

—From a greater distance, but still looking carefully at the numbers, the Irish economic performance of the last fifteen years does look quite miraculous, especially when one looks not only at productivity but also at employment.

—The proximate cause appears easy to identify, namely, wage moderation leading to lower costs, higher profits, and large increases in labor and capital.

—The very strong effects of this wage moderation suggest, however, unusual mechanisms at work. In an economy such as Ireland, which is open to trade, capital flows, and, most important, labor flows, wage explosions can kill, but wage moderation can work miracles. The latter is what has happened in Ireland over the last fifteen years. Let me develop each of these themes in turn.

Ireland's performance.

The authors are obviously right to point out that the profits generated by foreign firms may reflect little else than creative transfer pricing in response to low profit tax rates in Ireland. The question is how much this affects the numbers for aggregate output and productivity growth. I believe the impression given by the paper is a bit misleading. The correction is far from negligible, but even after the correction the performance of output and of implied productivity remains impressive.

To explore the issue, I went back to the data set for the Irish business sector maintained by the OECD. (That database, unfortunately, has been discontinued, and therefore the series depicted in the figures below stop in 1997, missing some of the most impressive years of the Irish boom.) I considered three alternative series for output. The first is business sector GDP. The second is business sector GDP net of all profits repatriated by foreign firms; the implicit assumption is that these profits represent only transfer pricing, not value added. Because this correction may be too strong, I constructed a third series, business sector GDP minus half of the profits repatriated by foreign firms.

The upper panel of my figure 1 plots the logarithms of these three series from 1971 to 1997. Each series is normalized to zero in 1971, so that the scale gives the proportional increase in each series since 1971. The differences among the three series (13 percent between the highest and the lowest in 1997) are clearly visible, but they hardly change the general conclusion: output growth has been very rapid, especially since the mid-1980s.

The lower panel of figure 1 plots the logarithms of the three productivity series implied by each of the three measures of output. Again the visual impression is clear: the treatment of repatriated profits makes a difference, but in all three cases the productivity performance remains strong. This is especially apparent since the mid-1980s: productivity growth averages 4.2 percent annually from 1985 to 1997, for example, when unadjusted output is used, and a still-high 3.4 percent when output net of repatriated profits is used. (The difference between these numbers and those in the authors' figure 14 must derive in large part from the fact that I look only at the business sector here.)

Looking at productivity growth alone, however, misses the other part of the Irish miracle, namely, employment growth. Since 1985, employment has increased at an average annual rate of 2.7 percent, obviously a