Analysis: Britain in eye of storm as Greeks prepare to reject austerity

IT is increasingly likely that Greece will exit the eurozone in the coming weeks, if not days. The election results demonstrated that the Greek public is unwilling to endorse EU-imposed austerity policies in exchange for the on-going financial support needed to fund public spending.

There is little prospect of a new election changing this. The direction of travel is clear. The immediate impact would be felt in Greece. The domestic banking system would all but collapse as the government defaulted on remaining debt and capital flight ensued as depositors sought to re-invest their euro savings abroad. The new currency would depreciate massively serving to push up the costs of the imports on which Greece is heavily reliant.

Inflation would rise with a risk that Greece would enter a ruinous period of hyper-inflation. Over the longer term the combination of debt default and a competitive exchange rate would promote economic recovery in Greece.

But Greece would need to undertake precisely the types of structural adjustments that are proving so unpopular at the moment. So economic recovery is far from certain.

Outside of Greece the direct impact of eurozone exit would be serious but, in itself, not disastrous. Banks holding Greek debt – including in the UK – would incur losses, although on a scale unlikely to compromise their viability.

Much more serious is the effect Greek exit will have in other heavily indebted eurozone countries (such as Spain): the feared contagion effect. If domestic political pressure rose in those countries and forced them to follow Greece out of the eurozone and default on their debts, the costs of government borrowing will rise almost certainly forcing some to seek a (further) bailout from the EU and IMF.

There is little doubt that the UK banks can weather the financial storm if Greece exits the eurozone and defaults on its debts. It is much less certain our banking system – and those of other EU countries – can cope if any of the larger indebted countries (Spain or Italy) decide that leaving the eurozone. Addressing the on-going sovereign debt crisis, and reducing the likelihood of a potentially disastrous contagion effect being triggered by a Greek exit, requires EU member states to commit themselves immediately to a credible growth strategy. Otherwise, they face the prospect of being trapped in a viscous circle of austerity-induced recession.

Much is riding on the persuasive power of president Hollande in his discussions with chancellor Merkel. Under the contagion scenario the UK economy is very firmly in the eye of the storm. Britain cannot escape the obligation that now rests on its shoulders to champion and support, by its policies, just such a strategy.

• Drew Scott is Professor of European Union Studies at Edinburgh University and Co-Director Europa Institute.