John McTernan: Deeper Irish cuts could test country to destruction

On 7 December, the Irish government will publish another budget which will take €6 billion (5bn) out of public spending through spending cuts or tax increases. This comes on top of savage reductions already made.

There's an obvious objection to this strategy - it is unlikely to make the government any more popular than they already are. Fianna Fail is likely to see its majority cut to two if, as expected, it loses a by-election that will be held on 25 November. Extraordinarily, this seat - in Donegal - has been kept vacant for nearly a year and a half, the government only holding a by-election after being ordered to by the courts.

With a further three by-elections pending, the government's majority looks under real threat - they nearly lost control earlier this year when the volcanic ash cloud from Iceland stranded government ministers abroad and their paper majority disappeared. If self-preservation wasn't sufficient incentive, there's something profoundly wrong with the economics.

A recent BBC report captures it brilliantly. It says: "Investors fear the budget cuts are likely to worsen the country's already deep recession, leading to further losses to the government via falling tax revenues and higher benefit payments."

That seems straightforward, yet as the BBC correspondent Joe Lynam comments: "Ireland doesn't need to ask the markets for money until next year. But bond traders are not convinced it can cut its deficit by enough by then and have pushed the cost of borrowing to unsustainable levels (8.3 per cent). Dublin had hoped that by slashing spending and raising taxes in the forthcoming budget, it would show resolve and in doing so drive down the cost of borrowing on the bond market. That hope is now dashed."

This is the unsustainable paradox of modern politics. The very banking system that brought the world economy to its knees - and in Ireland's case led to a massive government bank bail-out - is asserting that it is back in control. No matter that the Irish economy is unsustainably close to locking itself into a downward spiral - house values, for instance, have fallen by more than half since 2008, radically devaluing the assets owned by the banks now taken over by the Irish state. What, then, are Ireland's options?

First, they could - as the Financial Times's Wolfgang Munchau has been arguing - get bondholders to share some of the cost of the bank bail out.Why, he asks, should taxpayers take all the pain? He notes that default - of any sort - is currently anathema in Europe: "The European political establishment recoils so much at the idea of default, it is willing to accept extreme hardship. Just look at Latvia. But Latvian brutalism is not going to be realistic for Ireland. Brian Lenihan, the Irish finance minister, might wish to ponder whether his monumentally unfair taxpayer bail-out is what will ultimately 'bring down Ireland'."

And, if not Ireland, then maybe the Irish government if the by-elections go as polls predict. For the first time in Irish history the Irish Labour Party are far and away the most popular party - their critique of banks from an early stage in the global financial crisis resonating with voters.

Currently, it seems, that Ireland is exploring the option of accessing finance from the European Financial Stability Fund (EFSF). Sums of up to €100bn are being discussed in the press - and so vehemently denied that anyone who understands governments can't help but feel the rumours must be true. But can Ireland really afford to go down this route?

Estimates of the interest that the EFSF would charge put rates as high as 8 per cent - broadly the same as bond markets are charging the Irish government, and which are driving the emergency budget in December.

Is there another way? There's one, almost unthinkable option - rejoin the United Kingdom. Implausible at the moment, but think of the advantages. The Good Friday Agreement has already established an array of cross-border institutions. Not just north-south ones to bind Northern Ireland and Ireland closer together, but also east-west ones that link Ireland with England, Scotland and Wales. And the UK itself has not merely embraced devolution, but that settlement is itself evolving with new powers on the horizon for the Welsh Assembly and the Scottish Parliament. In addition, it's a system based on variable geometry which could arguably allow another Parliament with yet a different set of powers.

Of course, this is just a thought experiment. It is highly unlikely that this could ever happen. But financial crisis does change minds dramatically. The Depression eventually forced Newfoundland into Canada, after 50 years of equal status with Canada or Australia. And the financial crash has Iceland seeking European Union membership - with the consequence that adoption of the Common Fisheries Policy will finally settle the Cod War in Europe's favour.

The real question is how high a cost will people be willing to continue to pay for independence? There is, for sure, a bottom line. At the moment the Irish government thinks that it can go further and deeper in cuts. That proposition will be tested to destruction shortly. Whichever way the country turns, the Celtic Tiger has been humbled.

Greater integration of the Irish economy and its tax, spend and welfare system into a larger one is undoubtedly the answer.The eurozone is fitfully adapting itself to address the problems faced by Greece, Portugal and Ireland - and it will be tough for all countries to handle.

This is by far a more likely outcome than a re-union - but never say never. There are many more twists left in this tale - though sadly the least likely is one that would see the bankers pay the price for the disaster rather than punters. Maybe electoral upheaval in Ireland will force the pace on that too.