Bill Jamieson: Contagion at risk of spreading as eurozone markets fall

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HERE'S a sentence I thought I'd never write. Give thanks for Gordon Brown. Sing his praises, shower him with gifts and scatter his path with rose petals. For, had it not been for Brown, Britain would now be a member of the European single currency – and a whisker away from the financial rigor mortis now spreading across Greece, Portugal and Spain.

It was in June 2003 that Chancellor Gordon Brown produced the crushing verdict of his five economic tests for joining the euro. The analysis, running to 1,738 pages, was presented in five hefty tomes and it was these that Brown pressed firmly down like suffocating cushions on the euro-eager face of his Prime Minister.

The case for entry failed on four counts

and Britain stayed out – and thus has avoided, for now, the crises that have befallen debt-laden member states. How ironic to recall that there was no greater apologist at the time for our membership than one Peter, now Lord, Mandelson, Minister of Business and All He Surveys, who now appears to have amnesia.

Membership would have been akin to entrapping the UK economy in a leaden tomb. Britain's sky-high budget deficit puts it in the same debtors' league as Greece, whose shortfall is just fractionally ahead of the UK's at 12.7 per cent. But Greece and the Club Med countries no longer have the flexibility to devalue and give their export industries a fighting chance –they are trapped.

For the same reason, Ireland's budget crisis has been deep and immediate, giving the government no option but to put in place a programme of severe spending reductions, wage cuts and redundancies. Britain at least has had the luxury of a temporary deferment while the economy strengthens. But time here looks to be running out.

Over the past few weeks, pressure has piled up on the Greek government to get a grip of its finances and put a deficit-reduction plan into action. Unfortunately, given the country's unreliable statistics and over-optimistic projections, its tough budget plans have struggled to gain credibility. Over the past week the yield on 10-year Greek bonds leapt to 7.2 per cent, around 4 per cent higher than German yields. Its stock market also slumped on fears of a deflationary recession. The fact that Greece must raise ?54 billion this year, or risk defaulting, is wearing heavily on sentiment.

Fears that other eurozone economies are in budget trouble have sparked sharp falls in continental markets. The Portuguese, Spanish and Greek markets were hardest hit as investor fears undermined confidence in their economies and the ability of their governments to tackle the deficit problem. On Thursday the euro tumbled to its lowest level against the dollar in eight months.

Major labour and political unrest could now lie ahead. On Friday, nerves were tested further when Portuguese opposition parties defeated a government austerity plan and allowed the country's regions to rack up even more debt.

Portugal's 2009 deficit is expected to hit a record 9.3 per cent of GDP. The government had pledged to bring the deficit to below the 3 percent limit for eurozone countries by 2013, by cutting government jobs, freezing civil servants' pay and curbing other spending.

Spain has also been hit. It has a budget deficit equivalent to 11.4 per cent of GDP and unemployment of 20 per cent. Last Thursday its stock market plunged 6 per cent. It has an austerity plan to narrow the budget deficit by ?50bn over four years and to raise the retirement age.

Can the euro ride out this storm? And what are the risks of the UK being hit by another financial meltdown weeks ahead of an election? Julian Callow, economist at Barclays Capital, believes the EU may need to invoke emergency powers under Article 122 to halt the contagion, issuing an EU guarantee for Greek debt. "If not contained", he warns, "this could result in a Lehman-style tsunami spreading across much of the EU."

The European Commission is petrified at the prospect of a Greek debt default, not least because of the risk of contagion to other eurozone countries. It has thus signalled that it will provide Greece with emergency support to prevent it from defaulting on its debt as a last resort. However, this runs counter to the Maastricht Treaty's "no bail-out" clause which was intended to protect the interests of "good behaviour" governments and avoid a moral hazard problem.

The Commission now expects Athens to impose tough targets on its public finances to qualify for this support. The documents give Athens a four-month deadline to impose a stringent regime of budget cuts and financial reforms. This, says Ruth Lea, economist at Arbuthnot Banking Group, leaves Greece with "two very unpalatable choices" – big structural fiscal tightening "all too likely to lead to a deep recession and possible social unrest", or exit from the eurozone. However, the latter would almost certainly spark a massive capital exodus and force up interest rates to crippling levels – a cure worse than the disease.

The likelihood is that the Commission will see to it that Greece stays in, while it puts in longer-term plans for tighter budget control and surveillance – effectively accelerating the drive to fiscal and political union. As this was one of the major objections to UK membership, it would kill the euro project stone dead in Britain while creating major concerns in Germany and the northern European eurozone members opposed to fiscal transfers from strong to weak countries. But that is just what the bail-out of Greece implies and, indeed, it is hard to see any system of monetary union working without machinery for such transfers being in place.

As for the UK's current position, there is every danger that apprehensive bond market investors will give the UK debt markets a wide berth until they see evidence of real, practical measures being taken to tackle a budget deficit on course for 178bn this financial year. Compounding all this are the first steps being taken by central banks to end monetary easing, thus making it more critical than ever that governments enforce deficit reduction measures to win confidence.

Pledges of chastity tomorrow will not do. The sharp falls in European markets are a warning that a new financial tsunami could strike, with devastating consequences.