Luck of the Irish: Will they say yes or no to austerity?

Today's Irish referendum might not decide Europe's future – or even necessarily Ireland's – but in many ways it will be a test of the German-led principles that have governed the continent's crisis response.

The vote will decide whether Ireland will accept the European Fiscal Compact, a treaty designed to enforce tough fiscal rules among the 17 countries with the euro as their currency (it is also signed by 25 of the 27 European Union countries). The treaty would force governments to be far more tight-fisted: While current EU rules forbid deficits from rising above 3 per cent of gross domestic product (GDP), they have largely been ignored, even by Germany. The treaty would limit deficits to 0.5 per cent of GDP, and force countries to make this national law.

Even though an Irish "no" vote wouldn't veto the treaty – which only requires the assent of 12 of the 17 euro zone states – it would be a dramatic message of rejection of the German-led austerity agenda by a country that has long been prized for its fiscal discipline. And the effects on the Irish economy are hard to predict.

All of Ireland's major political parties – Fine Gael and Labour, who govern in a coalition, and the opposition Fianna Fail – are backing a Yes vote. The no campaign is led by the resurgent Sinn Fein, whose left-wing nationalist policies (and reputation as the former political branch of the now-defunct Irish Republican Army in Northern Ireland) leave a bad taste in many voters' mouths.

The arguments on both sides are compelling – both from a Europe-wide perspective and from an internal Irish perspective. Here's a guide to the campaign.

The Irish case for yes:

Ireland's government argues that the treaty will guarantee a stable recovery, will reassure investors that Ireland is a safe place, thus allowing Ireland to return to the bond market next year, and will give Ireland credibility in international political circles, thus allowing it to negotiate better terms in the future.

In particular, Dublin officials point to the large number of multinational corporations in Ireland – a third of Irish jobs are with foreign firms – and warn that a "no" vote would scare away such employment-generating investment.

So far, Ireland has been exemplary in its austerity – since 2008, it has slashed €25-billion from its budget, and has received six positive reviews from the International Monetary Fund. Given those sacrifices and the financial credibility they have generated, the yes side argues, why blow it all away for a treaty rejection that won't actually change anything? After all, Ireland will suffer severe cuts to government services whether or not the treaty is in force.

And a no vote could be very dangerous, because Ireland is on the verge of another crisis: Since May, yields on Irish bonds have risen to a nearly unaffordable 6.25 per cent as investors stay away from Dublin government debt amid fears that a Greek collapse or exit will damage Ireland.

"We would expect there would be a sharp selloff of Irish government votes if there's a no vote," Owen Callen of Dublin's Danske Markets told said in a TV interview. So a no vote could erase all the gains of the past four years and push Ireland into its worst crisis yet.

Without the treaty, Ireland would not be able to borrow from Europe's rescue fund, the European Stability Mechanism. Markets would almost certainly reject Irish debt, leaving Ireland with very few sources of credit – and thus making a default or collapse much more likely.

On top of this, yes supporters note that the no campaign is largely backed by Sinn Fein, and more moderate voters might not want to give the resurgent far-left party a major victory.

The Irish case for no:

Ireland is being punished for good behaviour, the no side points out. Irish governments have been lean, low-spending and transparent institutions; even at the peak of the boom, they didn't build up debt or spending. Its crisis wasn't caused by waste or public-sector excesses, but by a real-estate bubble that has seen property prices fall by 56 per cent, causing a cascade of bank failures and expensive bailouts.

Yet today, Ireland suffers from 14.5 per cent unemployment, and conditions appear to be deteriorating. Ireland's borrowing costs are higher than those in less-austere countries such as Spain and Italy. No economic growth is projected for 2012, and prospects don't look good for 2013. If four years of Europe's most intensive austerity policies haven't improved conditions in Ireland, the argument goes, then how will even more severe austerity?

By signing the treaty, the no side says, Ireland will send a message to Berlin and Brussels that a purely debt-cutting approach to the crisis isn't working. That message has received a strong backing from newly-elected French president Francois Hollande, from the Dutch parliament, and from other sources. On Wednesday, the Nobel Prize-winning economist Paul Krugman joined that campaign.

"At this point the Germans need to face the reality that this cannot work and that the Irish, who've been such good soldiers in this crisis, if even the Irish say no then that would actually send a helpful message," Mr. Krugman told the BBC on Wednesday. "The whole intellectual framework has been tested to destruction in the euro zone."

Ireland would theoretically be denied access to the European Stability Mechanism, but in the event of a serious crisis, Europe would probably step in. If it didn't, Ireland could still rely for credit upon the International Monetary Fund, which has been a strong backer of Ireland's recovery plans.

The European case for an Irish yes:

Anything that could raise the risk of an Irish default would be disastrous for Europe. Ireland's debt levels are many times higher than Greece: British banks hold an estimated €180-billion in Irish debt, and Germans another €150-billion.

If Ireland's economy isn't kept in reasonable shape, a large-scale debt default would do serious damage to the euro itself – not to mention British and German banks.

As such, a no vote could place Europe's largest economies in jeopardy, spreading investor fear of debt contagion and Irish collapse, and destabilizing the entire economic recovery.

Not only that, a lack of euro zone unanimity around the treaty – and the philosophy behind it – could damage the stability mechanism, forcing compromises. If Ireland were granted special exemptions from the treaty's terms, why should Greece or Spain have to abide by its extremely strict rules.

"It will create stability in the euro zone," Prime Minister Enda Kenny said in a TV address on Wednesday – and only with that continent-wide stability, he said, can Ireland return to job growth.

The European case for an Irish no:

Many European leaders and economists believe that the German insistence on austerity is pushing the continent's economies in the wrong direction, and that a period of growth and inflation is needed to build up demand, start tax revenues flowing and create the productive conditions in which debt can be repaid.

Theoretically, Europe could punish Ireland, even forcing it into default, for failing to ratify the treaty. But to do that would send a stark message to other countries: If you play by the rules and impose austerity, you'll still be hurt – so why bother participating?

"If the EU's star pupil were to be consigned to the disaster zone of default in response to an exercise in democracy such as a referendum," asks John O'Brennan of the National University of Ireland, "how could other debt-ridden states be convinced of the value of implementing austerity policies?"

As such, the argument goes, an Irish rejection would show that the austerity agenda is not working, and would create an opening for an alternative approach.