Dr. Tom McDonnell:

I thank the Cathaoirleach, members and staff of the committee for the invitation to appear today. I am co-director of the Nevin Economic Research Institute, NERI, and am grateful for the opportunity to present the institute's views on tariffs. While the final landing point of the US tariffs is uncertain, the minimum we can expect is 10% on most goods. There is a very significant possibility of higher rates, potentially varying by sector and potentially including services, depending on how the EU responds to the US provocations.

In attempting to understand how events might play out, we first need to understand the motivation of the US Administration. In essence, alongside its value as a bargaining tool and lever for political pressure, the Administration has four arguments justifying tariffs. First, tariffs will lower import prices, before tariffs are counted of course, thereby shifting the cost onto foreign producers. This will improve the US terms of trade in a welfare-improving way for the US. Second, tariffs would lead to a relocation of manufacturing production to the US, which would boost domestic employment and the quality of that employment. Third, tariff revenues would allow the US Administration, as we have already seen, to reduce taxes in other areas, including taxes on income, corporate profits and billionaires, for example. Fourth, tariff revenues will reduce trade deficits with foreign countries, which is something the US perceives, correctly or not, as a security issue.

It is important to emphasise that tariffs are not an inherently left-wing or right-wing policy. They are supported by many progressives, for example, Bernie Sanders, in the US. Whether a tariff or industrial subsidy is progressive or not, depends on the role it plays in the overall development strategy. It can legitimately be used to counterbalance imperfect competition or where a country has lost ground in global competition. However, as it happens, the likely impacts are very different from those anticipated by the US Administration. Economic theory, which is contested, broadly suggests that import tariffs have a number of economic transmissions to which I have pointed in the appendix and that the outcome will include weaker domestic and trade partner GDP, potential improvements to the trade balance which are conditional on exchange rate movements and, ultimately, weaker average productivity in both countries as markets shift away from the most productive exporting firms to less productive domestic firms.

In addition, empirical studies consistently reveal negative impacts from tariffs. Based on the empirical literature, we can expect that prices will increase in the US, economic output and productivity will fall on both sides and unemployment and inequality will rise in the tariff-imposing country because it is a regressive tax on imported goods. There will be a decline in real incomes and aggregate demand. Unemployment will also rise in the countries facing the tariff because there is a reduction in external demand. Global value chains will start to fragment, which creates all sorts of distortions. Supply costs will be disrupted, as will trade flows, and exports and imports will both shrink. There will also be a slowdown in business investment because of the uncertain nature of the tariffs. We see that they are changing every week and even if there is an agreement in August, they are still very much open to being changed on a monthly or quarterly basis. This means that businesses hold off on investments. There is an abeyance, which will be bad for productivity in the medium term and employment in the short term.

A further issue is the extent to which there are diverted exports from other tariff-hit countries. If, for example, China is not able to sell its goods to the US, it might divert them, albeit at a lower price, to places like the EU, which could cause issues within EU markets. Overall, protectionism is expected to distort production and resource allocation, erode competitiveness and, ultimately, generate welfare losses on both sides. These effects are magnified if the affected countries retaliate. Effectively, if we do the same thing, the same effects happen to us. It is important to note in passing that the trade union related economists network, or TUREC network, of which NERI is a member, used the NIGEM model and found very similar results. Higher inflation, declining domestic demand, falling imports and exports were all anticipated, with reciprocal tariffs making things worse.

In order to understand why these negative effects happen, we can think in terms of four shocks. The first shock of course is the direct impact of the tariffs themselves. This means distortions to existing supply chains, shifts in demand, lower average productivity and job losses over the medium term. The second tariff shock that cascades from the first is the inflation effect. Specifically, the higher prices which research indicates will ultimately be borne by US consumers will reduce their purchasing power and reduce imports into the US even further. In addition, this could cause a monetary policy shock within the US, that is, higher prices will cause an increase in interest rates and that will have a further negative effect on GDP and employment. It is worth noting that these things do not happen instantly. They tend to happen over months, quarters and even years.

The third and fourth shocks, which can happen much more quickly, are linked to uncertainty and loss of confidence. The erratic, inconsistent and unreliable behaviour of the current US Administration is obviously causing significant uncertainty. That uncertainty mixed with higher than expected inflation ends up causing a term premium on US Treasury bonds. The interest rates required on the bonds goes up and that means the cost of servicing US debt goes up. In addition, the cost of corporate credit goes up because there is more uncertainty. Banks do not like uncertainty when they are lending, which means what they demand from businesses goes up. All of this is bad for investment. The IMF estimates that uncertainty shocks could double the negative effect of direct tariff rate shocks, with investment plans in abeyance. The fourth shock, a loss of confidence, can have a number of impacts. The most obvious is an increase in precautionary saving because people are worried they might lost their jobs. This means a decline in household consumption and business investment. These confidence effects are non-linear. It is not simply a case of a little bit less spending and a little bit less investment. At some stage, we reach tipping points. A full-blown trade war could precipitate a shock, an abrupt loss of confidence in the US or the EU, leading to a recession which, in turn, would further damage exports.

How does this all play out for Ireland? As everyone knows, Ireland is one of the most highly globalised economies in the world. It has very significant two-way linkages with the US economy and is itself the most exposed economy to tariffs within the EU, relative to its size. We have one of the largest trade surpluses with the US in the entire world. The €72 billion in goods exported to the US last year was the second largest in the EU, despite our minuscule population. Germany had the highest. Ireland's exposure to the US was illustrated fully in the first quarter of this year by the surge in pharmaceutical exports just to get ahead of the tariffs. This caused an enormous shock to our GDP, which is so large it affects data for the EU as a whole, despite our small population.

As members know, the US is the top export destination for the EU, with a massive goods exports surplus of close to €200 billion. On the other hand, there is a services deficit on the other side. Germany, Italy and Ireland have the largest surpluses, which explains their very cautious or dovish attitude. Other countries that are less exposed are able to be more hawkish. It is noted that most of the Irish exports are from US companies selling into other US companies. We know about the €58 billion last year concentrated in pharma and chemicals and it will probably be higher again this year, notwithstanding the tariffs. The US makes up more than half of extra EU exports from Ireland, which is more than double any other EU country.

What does this all mean? It means that the proposed tariff increases and potential reciprocal escalation are a potentially game-changing threat to the Irish economic model. Tariffs reduce trade and disproportionately affect small open economies, which Ireland is, and the uncertainty around the timing, scale and extent of tariffs will slow investment location decisions until such time as there is greater policy clarity, which may not come until 2027.

As we know, the large trade surplus specific to the pharmaceutical sector makes it a particular target for the Trump Administration, albeit one that it is not quite clear or sure how to deal with. While it is possible that jobs could be moved to the US in order to circumvent tariffs, the practicalities of this are not particularly feasible in the short term because of the nature of the product. Relocating pharmaceutical plants to the US could take five to ten years, and hopefully the tariffs will be long gone by then. It is a highly specialised sector with complex supply chains that needs a skilled workforce and so forth. What is more realistic is the loss of future foreign direct investment and slower employment growth. In addition, multinationals may choose to shift their intra-company payments, that is, transfer pricing, between different parts of the same company to reduce their tariff exposure. They would charge a lower price, which would mean there is a smaller tariff on it, but that means the corporate profits are made in the United States instead of being made in Ireland, which obviously would affect corporate tax receipts. Overall, pharma companies may shift some production to the US over the medium term in order to serve that market, but moving production makes it more difficult to serve the EU market. In my view, the uncertainty over whether tariffs will outlast the Trump Presidency or 2027 might reasonably induce those companies to take a wait-and-see approach.

When it comes to tariffs it is important to understand that all goods will react differently to a tariff regime. Inelastic, non-price sensitive, essential goods, where you cannot get something else, for example, a different type of drug because you need that type of drug to live, or whatever might be the case, and items with limited substitutes, such as many pharma goods and medical instruments, are unlikely to see much reduction in export volume in the short run, whereas elastic or very price-sensitive goods, which are also non-essential, with easy substitutes, such as dairy, butter, beef and alcohol, are likely to see much more significant reductions in their export volumes and in the prices producers can obtain. Therefore, that means short-term job losses are more likely in food and drink than in pharma and this is where we expect them to occur.

In addition, an escalation of a trade war would further expose our economy. If a different tariff obtains in Northern Ireland or Scotland than in the Republic of Ireland, this would create a competitive disadvantage, for example, for whiskey produced here. They do not care in the US if "Irish whiskey" comes from the North or the Republic. That is obviously a challenge south of the Border.

Ultimately, whether tariffs are unilateral and set at 10%, reciprocal or escalatory, they will lead to higher levels of inflation. This could induce central banks to slow or reverse interest rate cuts, which would be a mistake. In addition, they will lead to reduced scope for multinationals to make profits in Ireland, and might ultimately lead to slower rates of foreign direct investment and lower employment levels as well as lower corporation tax and income tax revenues. The silver lining is the higher revenue from the tariffs themselves.

I am sure the committee knows already about the research done earlier this year by the ESRI and the Department of Finance. It looks like the tariffs will be reciprocal in nature. They will be at least 10%, and they are potentially likely to last for four years. In that outcome, we are looking at modified domestic demand falling by 1.3% and consumption by 2.4%, while prices rise by 0.2% and Government debt rising by 0.9%. Employment would fall by close to 2% relative to the baseline. If we imagine that employment was due to increase by 1.5% each year for the next four years, it would instead fall to about 4% instead of 6%. According to the analysis, we are not talking about job losses, per se, as would appear in the data; we are talking about slower employment growth, albeit to the tune of about 50,000 fewer new jobs.

That is also borne out by results from the Aston school. Béla Galgóczi estimates that a 20% tariff on EU goods exports would put 750,000 EU jobs at risk, most of them in manufacturing. Countries like Germany would be particularly badly hit.

In terms of the policy response, there is not necessarily agreement between economists as to what one ought to do in terms of whether the EU should respond. A trade economist would simply say tariffs are bad for business and the economy, just do not respond and de-escalate the situation as much as possible so as to prevent the extension of tariffs to services, including indirectly via the anti-coercion instrument. Ireland is very much exposed.

On the other hand, a behavioural economist or game theorist, if you will, who plays the game more strategically, might suggest going toe to toe with the Trump Administration in the short run, in order to get a better deal. In other words, the hope is that the US is badly hit and that there is a Trump recession which, in a way, discredits tariffs as a policy and over the medium term leads to the ending of tariffs as a policy tool being used by the United States.

It is true that the EU has clout due to its market size but we also have greater dependence on the US, which puts us in a weaker position than China. While a TACO - Trump always chickens out - strategy that assumes Trump will back down is understandable, it is obviously very risky and it could induce a global recession. Were this to happen, and were it deemed to be temporary, then an EU-wide response to preserve productive capacity akin to a scaled down Covid response such as, for example, SURE - support to mitigate unemployment risks in an emergency - at the EU level and an expansion of the European globalisation fund, EGF, would be appropriate. Ideally, such a response would be sector-specific. In our case, food and drink would be a good example. If done, we would argue that it ought to be tied to social conditionality with broadened social sectoral dialogues and sectoral task forces for the affected sectors. In addition, monetary and fiscal policy would need to be proactive and supportive. However, such a response can only be a temporary holding position.

We would argue that what governments should not do is use a crisis that affects specific industries, often exporting industries, to rush towards what we call a low-road competitiveness agenda that undermines workers' rights or environmental rights. Such an approach is a developmental dead end in the long term for the Irish economy. NERI has been working on an alternative policy suite, our new economic model, which we would be happy to discuss with the committee either now or at a later date.

In short, reciprocal tariffs will damage the EU and Irish economies but there may be strategic advantages to responding in kind. If retaliation is the decision, then my personal view is that a general approach is preferable to a targeted one. Ultimately, any deal with this US Administration is unlikely to be superior to that offered to the UK, which was a blanket 10% tariff on goods exports. Crucially, we should take the approach that we are willing to respond in kind if the US changes its behaviour. If Congress re-exerts control of trade policy, we should signal to it that we are willing to immediately end tariffs on our side if it is willing to do so in order to de-escalate at the earliest opportunity.

A related point, which perhaps has not been in the discussion in Ireland or at EU level to a great extent, is industrial policy.

It is important to understand that over the past ten years, China's vertical industrial policy has proven much more successful, for example, in terms of the green revolution, than the EU's horizontal industrial policy. As a result, a reassessment of our strategy at European and domestic level is required. In addition, we should realign our trade policy with countries in the global south in order to develop a new trade policy framework.

I will finish on that. There is a final point about our over-reliance on US capital and US multinationals and the need to evolve our model, but I am way over time,. I will be happy to take any questions.