Will 2010 be worse than 2009 for Ireland? Most mainstream economists believe that the economy will stabilise next year, and I hope they are right. But there are many reasons to be worried.

The biggest issue is that we are caught in a downward spiral where prices are falling.

On top of this, the already over-valued exchange rate is rising, and so is unemployment. Monetary policy – the mechanism whereby lower interest rates are passed on to the average person – is broken, because the banks are in tatters. As the top brass of AIB made clear during the week, the banks are in serious retrenchment mode – with or without Nama.

This retrenchment is called ‘deleveraging’ in economics. What it means is that, over time, the banks will be taking money out of the economy, not putting it back in. For many people, this probably means the banks calling in their loans now, having been rolling over interest and putting things on the long finger for the past year. All this has changed in the past few weeks, with the banks getting more aggressive.

In the boom, the banks blew their balance sheets by borrowing abroad in the short term to finance their long-term mortgage lending here. The foreign lenders pulled the plug on this short-term financing last year, and the ECB moved to make up the shortfall. But, as evidenced by the wrap on the knuckles Greece received last week, the ECB is now thinking of ways to unwind these loans to delinquent banking systems.

The government must be hoping for another off-balance-sheet deal with the ECB in order to avoid a massive new credit contraction here. For the next 24 months at least, banks will have to cutback lending and raise deposits to make sure that they have enough capital. This means less, not more, credit in the economy.

So we have less credit available and taxes are on the rise, which means that we have less income to spend, even if we had the inclination. And, of course, government spending will be reduced, adding to the overall deflationary impact on the economy. In such an environment, where is economic growth going to come from?

Some commentators are saying that this tough budget – if that is what it turns out to be – will have an effect on the economy and personal spending similar to that of the Ray MacSharry budgets of the 1980s.

By this, they mean that, if the public sees the government getting to grips with the situation, we will conclude that the worst is over and this will prompt us to bring forward spending which we had been postponing because we were afraid things were spinning out of control.

In addition, traditional economics suggest that, when the country is in difficulty, we see huge capital flight, and that this capital is just waiting for the signal to come back in. We can usually gauge this pent-up capital idea because interest rates rise rapidly in a crisis to reflect the capital leaving Ireland.

The problem in this country is that the opposite has occurred. Interest rates have fallen so far in the crisis, but are likely to rise next year because the ECB will tighten rates as Europe recovers, leaving a heavily indebted Ireland in the doldrums.

Therefore, the idea that we will get an interest rate bonus from any government contraction doesn’t stand up to much analysis.

Some balanced budget fetishists argue that, if serious moves are made towards balancing the budgets now, people who have been saving because they are afraid of higher taxes, will see that higher taxes are off the agenda and thus will bring forward spending.

This theory is called ‘expansionary fiscal contraction’ and was first observed in Denmark in the mid-1980s.However, though not particularly persuasive because it has only been witnessed once, it is only likely in the case of massive contraction.

If we had a huge one-off budget, we might achieve the idea that people would say, okay, the problem has been fixed and the risk of future higher taxation has disappeared. But, of course, we have not chosen the massive cuts strategy. Our strategy is going to be based on four years of budget contraction.

So what’s going to be the likely outcome of this policy?

The balance of economic evidence is that Ireland is in a cul-de-sac, and that we are running out of options. We aren’t spending, because we think that prices will be lower tomorrow than today. Why spend today when you will get a better bargain next week or the week after?

This is the classic depression economics dilemma. The more the government cuts now, the more the economy contracts. When you take out a euro of government spending at a time when we’re not spending or investing, the effect is to make the situation worse.

Growth will not re-emerge, and so we get involved in a brutal campaign to grind down wages and prices in an economy that is already weak. The multiplier effect of cutting spending now will exacerbate the problem, and we will try to regain competitiveness by confrontation with the unions.

Already, we have seen just how hard it has been to get concessions from the union side, simply because the unions don’t think it’s fair that their members take the pain of a crisis caused by political and financial errors.

What is it going to be like when it finally dawns on people that, to regain competitiveness, Ireland might need wage cuts of up to 25 per cent to allow us to sell our goods profitably abroad? We are only getting a taster of things to come and, given this government’s inability to make a decision, the prospect for 2010 doesn’t look good.

If we can’t get wages and prices down dramatically, then we will fail the Newry Test. This is whether an item can be bought more cheaply in Newry than it can in Dundalk. Only when we pass the Newry Test will it be possible to suggest that Ireland is becoming competitive. When do you think that will happen? As long as we fail the Newry Test, the business model in the Republic is not working.

So if we can’t or don’t want to do a Ryanair on the economy (by this, I mean get the costs structure right down),then we risk the prospect of becoming a client state of the ECB. The productive marrow of the country will be hollowed out by an overvalued exchange rate and high costs, leaving manufacturing dead in the water.

We will have a large civil service, paid for by transfers from the ECB, because the Nama bonds are redeemable at the ECB and the resulting cash can be used to buy government debt.

While we remain in the euro, we will always have the comfort that they will not entertain a default in Ireland, so we can play games with the EU, cutting a little bit here and there to escape dramatic sanction, but never being serious about anything.

We will retain what remains of the multinational sector and a few big protected industries. Maybe this is the long game for some of the top union members.

This is how a once-vibrant country turns into a vassal state – and, more importantly, this is how the insiders protect themselves against the outsiders in a crisis. All the while, house prices continue to fall, defaults increase across the board, and the prospect of a Nama mark 2 and 3 emerges, facilitated by some other sweetheart deal with the ECB.

You couldn’t make this stuff up!

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