Dear Prudence, won’t you open up your eyes?

If one accepts the definition of insanity as doing the same thing over and over again, and expecting different results, then surely re-doubling belt-tightening austerity, and expecting growth, is economic lunacy?

The only part of the Irish economy that is growing in any meaningful sense is our record-breaking trade surplus. Overall, the economy can only grow if this is enough to offset the opposing contractionary forces of fiscal austerity and inconspicuous consumption.

The advent of the Fiscal Advisory Council (FAC), made up of 5 highly esteemed economists, is a welcome development, and one would hope that it evolves to fulfil a role similar to the highly respected, non-partisan Congressional Budget Office in the US. Their most recent assessment of Ireland’s economic prospects is undoubtedly correct: the risks to economic growth forecasts are skewed to the downside.

Writing in the Irish Times on April 4th, Dan O’Brien, Economics Editor, knocked down the straw man of a ‘zero austerity’ approach, but no credible commentator is seriously proposing this. The country is in administration, and our creditors call the shots. The debate centres on whether we should wield the axe harder and faster, and how the pain should be shared.

In framing forthcoming budgets, the Irish government faces a binding constraint set by our official lenders: to bring the deficit down to 7.5% of GDP in 2013, 5.1% in 2014, and 2.9% in 2015. How these targets are achieved is subject to negotiation, but they must be met, as things stand.

There is no question of this being an easy task, while a much more aggressive schedule, as the FAC, O’Brien and some others propose, could well cement continued recession. The IMF has repeatedly warned that this is as much as our economy can take, and that chasing our tail with ever-more austerity could be counter-productive.

Some argue that more aggressive austerity would boost credibility with financial markets, but any seasoned market-watcher can see quite clearly that schizophrenia now reigns. Markets, a vast collection of independent but interdependent players, don’t know have a clear idea of what they want.

Yes, delivering up-front austerity may send a ‘credible’ signal – and the tougher the measures on citizens the better. Markets also understand, however, that the debt burden is made up of a denominator, GDP, as well as the numerator, debt. Markets care about both sides of this equation. They react negatively if austerity targets are not met, but also when growth falls short.

On April 6th, O’Brien followed up with an article heralding the Baltic approach, viewed by some fiscal fundamentalists as a model to follow: if only Ireland could accelerate austerity, as the Baltic countries were forced to do, we could bring back the boom.

There are some critical distinctions that render this comparison meaningless, however. The Irish economy of today is neither comparable to the Irish economy of the late 1980s nor to the Baltic economies of today.

Estonia, the most developed of the Baltics, is today only half as wealthy as Ireland, measured by GDP per capita. Just as Irish living standards converged rapidly to, then surpassed, the European average in the 1990s, so one would expect the Baltics to now grow faster than Ireland, all else being equal. This is borne out by the OECD estimates of potential GDP growth, which is 2.5% higher in Estonia than in Ireland for both 2012 and 2013.

Incidentally, this is also the reason why Ireland will not again sustainably see the convergence rates of growth of the 1990s, and why bringing down our Debt-to-GDP ratio will be far more challenging this time around.

Even if the Baltics were not on a convergence path, they would still be expected to grow faster than their EU neighbours, simply because they were so badly hit by the financial crisis, far worse even than Ireland. Ireland, Lithuania, Estonia, and Latvia suffered peak-to-trough falls in GDP of 10.1%, 14.8%, 17.4% and 20.7% respectively.

The further they fall, the faster they climb because there is so much more slack in their economies, and because they have lost so much of their potential GDP. In part, the Baltics are making up for lost growth as they regain the convergence path.

There is a school of thought that argues that beatings should continue until morale improves, that we should up the dose of austerity just to be on the safe side. The truth is that economists are at a loss to predict the effect of ever-more more austerity when the output gap – a measure of how actual economic output compares to potential – is as wide as it is in Ireland today.

We are dealing with known unknowns, and staying on the safe side probably means sticking to the IMF’s advice. Our belt has no more holes, and tightening above and beyond what is absolutely necessary could turn a crash diet into a futile hunger strike.

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