Gavin McCrone: Europe's 2011 will be one of fiscal pain

IF 2010 turned out less bad than many forecasts suggested, few people will shed a tear at its passing. But will 2011 be any better? The cloud that hangs over the economy is the crisis in the eurozone. The bail-outs of Greece and now Ireland show how serious this is and most commentators expect further problems ahead. Will there be a need for further bail-outs? Portugal seems to be the present focus of attention, then Spain perhaps, even Italy? If one country goes the contagion spreads, as international speculators, having made money at one country's expense, shift their attention to others. While the UK, as a non-eurozone member, is not expected to be in the firing line, it could be greatly affected by the outcome.

The European Union had no mechanisms in place to deal with these crises. It has them now but there is widespread doubt about their adequacy. Many people argue that for a monetary union such as the eurozone to succeed, it must be accompanied if not by political union, at least by many elements of fiscal union.

This is something that those critics of Calman, who advocate fiscal independence for Scotland while remaining in the UK, need to ponder more than they have apparently done so far.

The immediate causes of the crisis differ in each of the countries under threat. In Greece it was the state of the government's finances, but in Ireland and in Spain government finances were in surplus before the credit crunch and national debt was less than in most other countries.

The problem has arisen because unsustainable construction booms led, in the case of Ireland, to the collapse of the banks and, in Spain, to unsustainable debt in local banks and municipalities. It is government decisions to underwrite such debt that turn what was a private sector problem into a public sector one.

The eurozone's response to the crisis has been to set up the European Financial Stability Facility (EFSF). This is funded by up to €440 billion in loans guaranteed by all eurozone members, €60 billion from the EU itself and a further €250 billion from the International Monetary Fund making a total of €750 billion available.

While this is adequate to bail out Ireland and Portugal, it is not thought sufficient should Spain or Italy need help. The EFSF is a temporary facility to last till 2013 and will then, provided member states approve, be replaced by a more permanent European Stability Mechanism (ESM).This will be able to provide emergency funding, subject to tough fiscal adjustment by the applicant state, but if the country's debt position is judged unsustainable, it would be required to negotiate with its creditors to restructure its debt. This "haircut" of creditors, a condition insisted on by Germany, has unsettled markets and given rise to criticism.

The question, however, is whether countries will be able to cope with the amount of debt being loaded on to them both by the crisis and by the EFSF bail-outs. All of these have to be repaid, and in Ireland's case, where the UK is also involved, at a rate of interest of 5.8 per cent, substantially above what it cost the EFSF or the UK to borrow the funds on the market. The countries being supported may be able to service the additional debt if economic growth recovers.

But with the savage cuts being imposed to restore balance in their budgets this seems rather unlikely. If in the end it turns out that the burden of debt is too great, there would be a danger of an even more serious crisis leading to default. This is why Angela Merkel has insisted on debt restructuring as part of the longer term measures to be introduced after 2013.

My own view is that, if that is at all likely, it would be better to face the issue now. Those who have invested in the bonds of banks took an element of risk in doing so and should not expect the taxpayer to provide a guarantee for 100 per cent of their investment.

Such restructuring of debt played an important part in ending the 1980s financial crisis in Latin America under the 1987 Brady plan. And I am convinced that if the eurozone countries now in difficulty are not to face many years of austerity, unemployment and poor economic growth, something similar needs to be done in Europe.

But the process would be painful. There is much investment by banks and other financial institutions such as pension funds of the stronger eurozone countries in the government and private sector debt of the weaker ones, so that the pain would be felt across all countries.

But neither bail-outs nor stricter conditions for fiscal rectitude are enough to prevent similar problems arising in future. As Ireland and Spain demonstrate, the problem was not caused by government financial indebtedness but by excessive debt in the private sector which, when the crash came, caused a sharp downturn in the economy and then became a public liability.

If this is to be prevented in future there will have to be not only stricter fiscal rules for the eurozone but a mechanism to control asset bubbles in the private sector. In particular this applies to housing and credit card debt. It would involve a degree policy harmonisation, of mutual oversight and intrusion into each other's affairs that some countries will find hard to accept.

But even this does not get to the heart of the problem.For the eurozone to work satisfactorily, countries must keep broadly competitive one with another. This they have so far proved unable to do.

Whereas Germany, since the start of the euro, has improved its productivity so that its costs have risen only slightly since 1999, Greece, Ireland, Portugal, Spain and Italy have all been subject to a much greater increase in costs, thereby making their goods less competitive (see chart, left). The result is that Germany has a large current account surplus on its balance of payments, while the other countries have varying amounts of deficit.

In the absence of monetary union the Germany currency would have risen in value and that of the others fallen, which would itself have helped to correct the imbalance. Within monetary union this cannot happen and the only way that the adjustment can take place is either by Germany allowing its costs to rise or the other countries cutting theirs.

Germany will resist the former and for the other countries the latter process will be extremely painful, involving, as it is likely to do, long years of austerity, low growth and unemployment. All these countries can expect to pay a high price in labour and political unrest.

Will the eurozone survive all this? A great deal is at stake here and the outcome will have a major effect on our economy, since all of the European countries, whether in the eurozone or not, are highly interdependent. Despite the present problems, the euro has brought substantial benefits to those countries that joined, and it should be remembered that the pre-euro Europe also had currency crises that were a threat to the creation of the single European market.

But the strong leadership that this crisis demands is unfortunately not evident at present. In its absence I expect the eurozone to survive but it will be a case of muddling through. Maybe the final outcome will be a more clearly defined two tier Europe with the countries of the eurozone pooling more of their economic sovereignty and those outside, like Britain, Denmark and Sweden, even less likely to seek membership.

• Gavin McCrone was formerly chief economist at the Scottish Office