In the year ahead, the exchange rate question will rarely be far from the headlines. If we are to have a referendum -- which, according to the Finance Minister, will be a vote on whether we are in or out of the euro -- we should get our heads around what the exchange rate does, what having your own exchange rate allows you to do and why that might be a valuable alternative for Ireland.
At the moment, the central plank of Irish economic policy, backed by the IMF and the EU, is something called "internal devaluation" and the logic of it goes like this: Ireland is uncompetitive and needs to export its way out of the recession. As we don't have an exchange rate that can fall, we need to grind down wages over a period of years so that Irish industry can be competitive again.
At the same time as we are forcing down wages, we must also reduce government expenditure, because we can't afford to pay for it. As the government deficit at the start of the IMF bailout programme was 14pc of GNP and we need to get the deficit down to 3pc, we will reduce spending by 11pc of GNP over the next two or three years.
Therefore, government spending will be reduced dramatically. But if the government is not spending, who is?
We should be, but we are not because we are worried about the future, so we are saving. Who is spending the missing 11pc of our income which has just been taken out of the Irish economy? Now here is where our policy gets a bit hopeful to say the least because in order for our economy to stay just as it is, foreigners need to massively increase their buying of Irish goods.
But why would they do this? Have Irish goods become dramatically cheaper so that they have become dramatically better value?
The theory of "internal devaluation" says that the Irish economy and workforce are so flexible that we will all take dramatic paycuts, this will drive down wages and we will become competitive this way. Because we have no exchange rate and are members of the euro, we will devalue by canabalising our own wages -- but according to the present policy, even at these much lower wages we will be able to service the huge debts built up in the credit bubble. How is that possible? Well, it is not.
But before we explain why debt dynamics at lower wages makes servicing old debt impossible, let's examine the first bit of the theory which says that Irish wages have fallen dramatically and will continue to do so. Let us examine the evidence that Irish workers -- or any workers for that matter -- accept reductions in their wages as the theory says.
Look at the cartoon. It shows wages in Ireland, Iceland and Latvia. Ireland and Latvia are in the euro (well, Latvia has a fixed exchange rate with the euro). We are both locked in austerity programmes, and we are supposed to be devaluing internally. The other chart shows Icelandic wages measured in euro. Iceland has its own currency, the kroner.
What the chart in the cartoon reveals is that Irish and Latvian wages have remained more or less the same since 2008 against our competitors. In contrast, Icelandic wages against its competitors have fallen dramatically. Iceland has become dramatically more competitive vis-a-vis Ireland and Latvia because it devalued its currency dramatically in 2008/09.
Iceland in one sharp devaluation has achieved what Ireland and Latvia are supposed to achieve over years of grinding down wages. If we are supposed to achieve Icelandic levels of wage competitiveness, we will have to shrink the economy over the next few years. By having their own currency the Icelandics did in a few weeks what we have been trying -- unsucessfully -- to do over four years.
Having its own exchange rate allows a country to adjust quickly. Yes, living standards when measured in euro fall, but that has to happen in both the Irish and the Icelandic case. The question is how do you achieve this and are you giving your people a chance?
There is a reason why no economy in the world has ever emerged from a recession like ours without changing its exchange rate. The reason is that it simply can't be done. There is no evidence anywhere, ever, that shows that a country can operate a successful "internal devaluation" -- particularly an economy carrying as much debt as we have.
So if it can't be done, what are we trying to do? And more to the point, what is the cost of this lunacy? Look at the chart again. Much is made of the "flexibility" of the Irish labour force. But the flexibility is not in wages but in levels of unemployment. The Irish labour market adjusts alright, but the adjustment comes not in falling wages but in rising unemployment and emigration. This is what we don't want to happen, yet this is what the policy is leading to.
So those getting paid too much in Ireland still get paid too much, yet the people who feel the real cost of the "internal devaluation" are those who lose their jobs because rather than cut wages, employers cut staff.
When people are laid off, it is very difficult to get a new job because no one is spending in the economy. The government is not spending and the people are not spending. But what about the the much heralded export-led growth which postulates that foreigners will buy loads of Irish goods, more than compensating for the fall in domestic spending?
Well it doesn't happen, partly because Irish wages don't fall as we can see in the chart, so Irish goods are no more competitive than they were a few years ago. Yes, exports have risen, but nowhere near enough to offset the local contraction. This is why unemployment has trebled in three years and why emigration is running at over 1,000 people a week. It is not that the policy of internal devaluation is not working, it can't work. It has never worked anywhere, ever.
Yet the really strange thing is that it is billed as being mainstream economic thinking. It is not mainstream economics, it is highly radical. What is mainstream and proven is the power of devaluations. Yet those recommending the course of action that mainstream economics tells us to do are labelled radicals.
Language will be very important in a referendum year and you will notice that the Irish and European economic establishment will deploy language to paint those who support the country returning to its own currency as extreme. The truth is that what is extreme is following a policy which has never worked anywhere and the cost of which is mass unemployment and mass emigration. Now that is truly radical.