Economics: Despite being in broad agreement on a range of major issues, EMU and fiscal policy continue to be a major bone of contention to our economists.

Despite a reputation for near pathological discord, mainstream economists are in broad agreement on a wide range of issues: the desirability of competition; the need for wage moderation; the advisability of non-distortionary taxes; the imperative of low inflation, to name a few. However, there are two issues on which Irish economists are deeply, if not ideologically, divided: EMU, and fiscal policy.

There are two camps on each issue. On EMU, there are those (including this writer) who thought it a mistake for Ireland to join when it did (i.e. in the middle of an economic boom, and without the UK) and, of course, there are those who considered it the right thing to do.

As for fiscal policy, there are those (again including this writer), who consider that varying the size of the Government's budget balance has little effect on demand in the Irish economy, and there are those who think that such actions have sizeable effects.

Actually, where one stands on one issue is a reasonably reliable predictor of where one stands on the other. Those economists who argued against Ireland joining EMU in 1999, tended to be those who are sceptical about fiscal policy as a demand management tool. Indeed, their fiscal scepticism contributed to their doubts about the wisdom of EMU membership.

Their argument was that, by joining EMU, we were giving up two tools of macroeconomic management - the exchange rate and interest rates - and retaining a third - fiscal policy - which theory suggested was extremely blunt and/or history suggested was systematically abused or misused by politicians. On the other hand, those who advocated Ireland's participation in EMU tended to be those who think fiscal policy is effective.

They accept that EMU membership permanently rules out the use of the exchange rate and/or interest rates as instruments for stabilising the economy, but argue that it enhances the role of fiscal policy.

To some extent, this is an argument based on coherent - albeit, in the eyes of the fiscal sceptics, largely irrelevant - theoretical reasoning. But it sometimes seems to be an argument based on necessity, as in: if we can't resort to the exchange rate or interest rates to stabilise demand, fiscal policy had better work.

The ideological divide also manifests itself in the apportionment of responsibility for what has happened in the Irish economy over the past couple of years.

According to the euro enthusiasts, a significant measure of blame for the acceleration of inflation, the loss of competitiveness and the associated downturn in activity, lies with the failure to pursue the correct fiscal policies in the later boom years.

Given the stimulus that was coming from other sources in this period, they claim that fiscal policy should and could have been deployed as a countervailing force.

According to the alternative school of thought (to which this writer subscribes), the europhile position is not only misguided in its belief in the effectiveness of fiscal policy, but also seriously flawed in its perspective.

The point is that membership of EMU has not only diminished Ireland's ability to respond to economic shocks, but has itself been the source of substantial shocks to the Irish economy. In other words, the membership and non-membership scenarios do not differ simply in terms of the range of stabilisation instruments at Ireland's disposal, but also and more profoundly in terms of the sources and extent of instability.

The most obvious source of instability is the exchange rate. Because of the euro's protracted weakness against sterling and the dollar throughout the first three years of EMU, Ireland's trade-weighted exchange rate fell sharply over the period. This imparted a substantial and wholly unwarranted stimulus to an economy that was already enjoying rapid output and employment growth, with predictable consequences for inflation and the cost structure.

More recently, of course, the euro has reversed its earlier losses and Ireland's trade-weighted exchange rate has risen sharply, this time with predictable consequences in terms of damaged competitiveness and output and job losses.

A less obvious, but no less important source of instability is interest rates. While the Irish economy boomed in the first few years of EMU, the rest of the euro zone languished in a near-stagnant state and the ECB lowered interest rates.

The resultant stimulus, however inappropriate from an Irish point of view, was greatly amplified by the fact that inflation was accelerating at the time (thanks to the sharp currency depreciation), and so real interest rates - the measure of interest rates that matters most in economic analysis - turned negative.

This has had predictable consequences for credit growth, mortgage lending in particular, and for asset prices, especially house prices.

While the Irish economy is now enduring the rigours of a destabilising turnaround in the exchange rate, it has so far been spared the consequences of a turnaround in ECB interest rates. The behaviour of real interest rates is quite another matter however. CPI inflation has decelerated steeply since the start of the year and real interest rates have risen as a result. We may yet be some distance from positive real deposit rates, but many key lending rates are now back in positive territory in real terms.

Moreover, if inflation decelerates significantly further, which is more likely than not, real interest rates in Ireland will rise significantly from current levels.

This increase in real interest rates will have an impact on the economy that will not be trivial and may be substantial. It will exacerbate, perhaps greatly, the deflationary effects of an appreciating exchange rate.

Moreover, the greater the extent of exchange rate appreciation, the more it is that Irish real interest rates are likely to rise. Needless to say, fiscal policy cannot be expected to deliver us from the unpleasant consequences of all this.

Jim O'Leary is currently lecturing in economics at NUI-Maynooth. He can be contacted at jim.oleary@maynooth.ie