Gavin McCrone: Nowhere to shelter in stormy eurozone

It will not be easily resolved. The demonstration was not only in Madrid, but in all of Spain's leading cities. Although it was timed for the period leading up to the local and regional elections, it continued night and day for many days afterwards. The demonstrators were encamped in tents in the Plaza del Sol and the atmosphere seemed to be more that of carnival than confrontation. It reminded me more of the Paris demonstrations in 1968, though not on the same scale and without the water cannon and flying cobblestones, than of anything in the UK.

It was not clear what the many disparate groups of demonstrators were trying to achieve, but there was undoubtedly serious discontent. The major underlying reason for discontent was undoubtedly the high rate of unemployment coupled with the harsh austerity measures made necessary by the financial crisis. Unemployment in Spain has been high for some years but in this recession it has risen to more than 20 per cent of the workforce, and is claimed to be more than 40 per cent for those under 25. It was, therefore, not surprising that, in the regional and local elections the socialist party, which forms the national government, was severely punished. If these results are indicative of next year's general election, the government will be swept from power by the conservative Partido Popular.

Coupled with the problems in Greece, which are by no means resolved, in Ireland and in Portugal, the Spanish situation raises major questions about the future of the eurozone. In each of these countries there are important differences in the cause of the crisis. In Greece, under the previous government, there was serious misreporting of the true economic situation such that, had the statistics been accurate, the country would not have satisfied the tests for entry to the eurozone. In Ireland, despite the government's budget surplus and low national debt before the crisis, a massive debt-fuelled housing boom led to a spectacular collapse. In rescuing the banks the government took on a debt burden that overwhelmed its finances. In Portugal flagging growth, a relatively high government deficit and national debt coupled with failure to adopt necessary austerity measures in time, caused the markets to lose confidence.In Spain the government, as in Ireland, had a budget surplus before the crisis. But also, as in Ireland, there was a major construction boom fuelled by ever rising levels of private indebtedness. When this collapsed, unemployment rose and the overhang of private debt caused individuals to cut back drastically on their expenditure. The result was that the government's tax revenue fell sharply. Hopefully Spain can escape the need to seek a bail-out from the European Union and International Monetary Fund, which the other three countries have been forced into. Its government has adopted all the measures necessary to avoid this. But that will depend on the markets, the rating agencies and those willing to buy bonds, whether speculators or long-term investors.

Clearly the eurozone is in serious trouble. It is now clear that the monetary union project was too ambitious; to a large extent it was a triumph of politics over economics. Had they not been members of the monetary union, Greece, Ireland, Portugal and Spain would not have avoided the crisis - after all the UK has suffered severely from it too. There would probably have been a lot of speculative pressure on their currencies. But being in the monetary union exacerbated the problem, at least for Ireland and Spain, because it gave them low interest rates, lower than they would have had otherwise, adding fuel to the boom. Moreover, when the crisis came, monetary union meant the safety valve of currency adjustment was no longer available to them.

The case for monetary union was, of course, not just political. There are great advantages in having one currency, if the appropriate conditions are satisfied. It is a great convenience to people travelling between member states and trade between them flows more easily. Indeed, it could be convincingly argued that, if the single European market was to be durable, it needed a single currency, so that the destabilising effects of speculative currency movements, often unrelated to the economic strength of members, were avoided.

But to succeed monetary union should from the start have had mechanisms for inter-country transfer of funds to enable support to be given to member states that found themselves in temporary difficulty. The measures hurriedly put together over the last year are an attempt to deal with that, but a full fiscal transfer union has so far been unacceptable to Germany and the other creditor countries of northern Europe.

More important than this is the need for member countries to be able to keep their unit labour costs broadly in line with each other so as to maintain their competitive position. This has not happened in Europe since the start of monetary union. As a result of pressure on wages and increased productivity, unit labour costs in Germany have risen very little since 1999, whereas in Greece, Ireland, Spain, Portugal and Italy, they have risen by about 30 per cent.It is no wonder then that Germany has a large balance of payments surplus and that the other countries have deficits.

So what is likely to happen now? The most acute problem is in Greece. Attempts are being made to patch things up with further loans. But the interest rate on ten-year Greek bonds has risen to some 16 per cent, making further borrowing by the government unaffordable. Clearly the market considers a default likely. According to the UK's National Institute of Economic and Social Research, the measures so far taken by Greece have brought the government's budget into primary balance, which means that the remaining substantial deficit is the result only of the interest it has to pay on its very high national debt. The cost of this, however, is about 24 per cent of GDP, according to the IMF.

In this situation, if I were a Greek, I would see attractions in a default. It would wipe out, or at least substantially reduce, a burden which is going to cause misery for many years to come. But the consequences would be major. Greece would almost certainly have to leave the monetary union. That could improve its competitiveness at a stroke but give rise to inflationary pressure. Investors in Greek bonds, not only in Greece but throughout Europe, including many banks and pension funds, would lose money, causing serious problems in other countries which might require a new round of support for banks. It would take a long time for markets to settle and enable the Greek government to borrow again at reasonable rates.

What of the other countries? A Greek default would greatly increase the pressure on them. None of them yet has a primary budget in balance, so further loans are essential to them to finance current borrowing. Default by any of them would make it very difficult for their governments to borrow on terms that were affordable. Leaving the eurozone would not be an easy solution either. Apart from being messy and technically complicated, it would almost certainly involve default, as the outstanding national debt, which is in euros, would be an even greater burden for a country with a depreciated national currency.

But the present situation is unsustainable, because of the burden it is imposing on national taxpayers, and the social cost in unemployment. A possible solution would be to pool, say, half the national debt of all eurozone countries. This would involve this debt being backed by the eurozone as a whole. It would be strongly resisted by the creditor countries in northern Europe but it would immediately cut borrowing costs for the countries in difficulty and give time to get their budgets into balance and improve the competitive position of their economies. A more radical plan by the EU is now clearly necessary and maybe a Greek default would be the catalyst to bring this about.