Greece must exit the eurozone

Uncontrolled break-up of the eurozone awaits if Europe's leaders remain committed to their dream of solidarity

José Manuel Barroso sings the Kinks. By far the strangest story of the weekend was news that the president of the European commission has taken to quoting Ray Davies, the quintessential English bard, in his speeches. Barroso burst into song in Brussels last week with his rendition of Village Green Preservation Society, complete with its references to Desperate Dan and strawberry jam, to make a point about emissions trading.

This is a trend to be encouraged. With the crisis in Greece threatening the stability of the euro area, we could have...
Jean-Claude Trichet belting out the lyrics to Where Have All the Good Times Gone. As he sits in Athens wondering when the International Monetary Fund is going to deliver another bailout, George Papandreou might be tempted to hum a few lines of Tired of Waiting for You. We can only wonder what Davies – the chronicler of the quirky and the offbeat, of steam trains and little men in suburbia – would make of the euro, the great modernist project, with its strict rules and straight lines.

Not that it can be doubted that the architects of the single currency had the best intentions. They believed monetary union would boost trade, make commerce simpler, smooth out the differences between the economies of member states. It would make Europe safe and sound.

Here's the position. Monetary union was designed as a one-size-fits-all economic policy for countries that were broadly similar in their make-up. It was accepted that if they were not alike, the loss of flexibility caused by ceding control of exchange rates and interest rates would result in a gulf opening up between the strong and weak countries.

So there were tests – the famous Maastricht criteria – to show that there was a suitable level of convergence between member states. These were neither comprehensive nor stringent enough, and were in any case circumvented by those countries that had problems with inflation and budgets but still wanted to be part of the club.

Window dressing

The Maastricht criteria were really economic window dressing for a politically motivated concept, and politics decreed that there should be as many members of the euro area as possible. Perhaps five or six countries were in a fit state to cope with the rigours of the euro; 11 – including Greece, Portugal, Italy, Ireland and Spain – were founder members.

Predictably, life's now not so happy in their Shangri-La. The one-size-fits-all interest rate proved to be one size fits nobody: too high for the slow-growing countries and too low for those struggling to control their costs. On the weaker fringes of the euro area, low interest rates fuelled excessive borrowing and real estate bubbles.

Monetary union did not lead to convergence; rather it exacerbated existing differences. A heavy price is being paid for failing to try out the idea of a single currency in a hard core of countries where economic performance was broadly similar. The failure to make the single currency work with a wider group of countries means that the attempt to muddle through has reached the end of its natural life. No country is prepared to have a pan-European taxman take all their dough, so full political union is not on the agenda. That means there are really only two logical ways forward. Either there needs to be a plan B in which the euro area is pared back to a group that includes Germany, France, Austria, the Netherlands and perhaps a couple of other countries, or there will be an uncontrolled break-up with dire consequences.

Europe's leaders have no plan B. They see no need for it because they are still committed to plan A – the European dream of fraternity and solidarity. This must be defended at all costs, even if it means permanent austerity for Greece, Ireland, Spain, Portugal and any other country that can't cut the mustard.

Seen from the perspective of rational Euro Man, Greece has to deflate because neither of the other two options open to it – devaluation or default – is conceivable. Devaluation means leaving the euro area, and almost certainly setting off a domino effect through the single currency. That would be the end of the Project. Default means that the banks and governments that are exposed to Greece would suffer losses, risking a repeat of the 2008 crisis that brought the global financial system to the brink of collapse. The European Central Bank will not countenance the idea of default. That just leaves deflation, and lots of it, as a way of putting the Greek economy back on track and ensuring the single currency remains intact.

Crackpot

This is a crackpot idea for two reasons. First, it runs counter to the basic principles of democracy; the Greek people are clearly not in the mood to bear the spending cuts, the reductions in wages and the sweeping privatisation being demanded of them by the European Union and the IMF as the price of a fresh bailout.

Second, deflation has already made Greece's debt problem worse and more deflation will make it worse still. It is worth spelling out exactly why this is so. The public finances of a country are made up of two components – the annual current budget and the stock of national debt. The national debt is simply the total of all the previous budget deficits or surpluses and is measured as a percentage of overall output. As an example, the UK ran a budget deficit of about £140bn last year, pushing up national debt to just over £900bn. The output of the economy was just short of £1.5tn so the national debt is about 60% of GDP.

In Greece's case, the position is much more serious. At the end of 2010 its national debt was in excess of 140% of GDP. The interest payments on that debt are colossal, and will become ruinous if the national debt continues to rise. But to stabilise Greek debt at 140% of GDP, the country has to run a very large budget surplus once interest payments are stripped out. Charles Dumas at Lombard Street Research calculates that this so-called primary budget surplus has to be in the 7-10% of GDP range. To illustrate the scale of that challenge, in 2010 Greece appears to have run a primary budget deficit of at least 4% of GDP.

Running a primary budget surplus requires revenues from taxes to be higher than government spending. What then are the chances of Greece running a primary budget deficit of 7-10% of GDP if subjected to further austerity measures? None whatsoever, which is why either default or devaluation – and perhaps both – seem increasingly likely.

These are not good options for Greece, either, because there are no good options for Greece. But it is clearly not going to deflate its way to solvency. Providing a second, or even a third or fourth, bailout cannot disguise the fact that monetary union is fundamentally flawed, with zero chance that the weaker members can become as competitive as those at the core. In his discussions with European leaders this week, Barroso may be tempted to raise spirits with the Kinks' Better Things. Who'll Be the Next in Line or Dead End Street would be wiser choices.

guardian