EU must take a stand united behind Greece

THE crisis in Greece is set to make 2010 the year in which the European Monetary Union (EMU) is put to its most serious test. Nor should we be thinking that, because the UK is not in the eurozone, it is of no concern. Europe takes the largest part of our trade, so what happens affects our ability to get out of the recession.

I have always supported the European Union. By ending the rivalry between nations and removing barriers to trade, it has delivered a longer period of peace on our continent and greater prosperity than before. But I had reservations about EMU. It is not difficult to understand why so many Europeans were keen: the creation of the Single Market in 1992 would be less likely to result in abolition of barriers to trade if the competitive position of member states' economies was changing as a result of movements in currency exchange rates. To cope with Britain and Denmark, the two countries that had opt-outs, was all very well, but widespread changes in currency values would be difficult. The single currency was therefore the coping stone on the creation of the single market.

The adoption of the euro went smoothly and was technically a great success. But the problem with a monetary union is that member states have to remain competitive by ensuring that inflation rates are broadly comparable. If this cannot be achieved, exports of those countries with higher inflation become uncompetitive, their balance of payments will deteriorate and tax revenues will fall as unemployment rises. It takes several years for this to become apparent. Devaluation, the normal remedy, is no longer an option when national currencies have been abolished, and the only course is to reducE inflation by slowing economic growth and allowing unemployment to rise. This process may prove socially and politically unacceptable.

Since the euro was adopted, Germany, with very low inflation, has improved its competitive position within the eurozone and now has a large export surplus; several other countries, notably the so-called "Club Med" countries and Ireland, have had higher inflation and are in trade deficit. This is the crux of the present problem but it was disguised for a while by easy credit.

In the case of Greece, it is now admitted that previous governments falsified their statistics. The annual public sector deficit, forecast to be around 6 per cent of GDP for 2010, is now expected to be over 12 per cent, and national debt, at 125 per cent of GDP, is the highest in Europe. A large proportion of this debt is short-term and falls to be refinanced in the year ahead. Demand for Greek government bonds, though denominated in euros, has fallen through fear of default and interest rates are now some 4 per cent above those on German bonds.

What is to be done? A Greek default on its sovereign debt would have catastrophic consequences. Banks all over Europe, including the UK, hold large quantities of Greek bonds. Individuals and pension funds would lose their savings and the heat on other countries with large deficits, such as Spain, Portugal and possibly Ireland, would become intense.

In my view Greece should never have joined the eurozone. What we know now suggests it never met the entry criteria. But to leave the monetary union in a crisis, when the national currency is no longer in circulation, would be traumatic. The debt is denominated in euros and would be a greater burden if it had to be repaid in depreciated drachma. The speculators would then turn their attention to other eurozone members, trying to force the weakest into a similar crisis.

The only sensible course is for the eurozone to support Greece. This is what the EU heads of government appear to have decided. But, if this is to work, that support will have to be much more explicit than was apparent in the communiqu issued after their meeting on Thursday. One can understand the reluctance of taxpayers to take on foreign debt.

But in reality such support could be almost costless, if the whole eurozone stands behind Greece. Rather than individual member states, it could be done by the EU as a whole, which, under Article 122 of the Lisbon Treaty, now has substantial borrowing powers. There would then have to be firm and unavoidably painful action to ensure that Greece's debt was rescheduled, that the country's finances were sorted out and that its repayments were met.

But none of this removes the underlying problem of the deteriorating competitive position of the eurozone's peripheral countries and Germany's export surplus. Restoring this balance would require the deficit countries to carry through difficult structural reforms and reduce their inflation to very low levels. At the same time, Germany needs to boost its consumption rather than its exports, as it seems to be aiming to do as a means of getting out of recession. Either way it will take time and, for the deficit countries, cause severe social and political strain. The more the burden of adjustment falls on them, rather than by boosting consumption in Germany, the longer the eurozone will remain depressed and the more difficult it will be for the UK to recover.