The euro faces its moment of truth

Is it the Greek parliament, which critically votes on a further package of austerity measures this week? Or will it be the demos, in mass street protests and general strikes? Greece’s austerity plan is just not credible in the face of mass civil resistance.

Last Thursday evening, EU leaders meeting in Brussels insisted that Greece fills a further ¤5.5 billion (£4.9bn) “black hole” in its austerity plan and that the main opposition party, New Democracy, backs the whole package as a condition of the next ¤12bn instalment of the first ¤110bn bail-out. The opposition announced last week that it will not support the new austerity plan and has pledged to vote against it in Tuesday’s crucial vote. Greece needs the ¤12bn tranche by 15 July or it goes into default.

The relief that greeted the conclusion of the EU summit on Friday is highly conditional, both on Greek compliance and acquiescence by all 17 eurozone member states who are putting up the money. UK Prime Minister David Cameron claimed a victory in heading off German pressure for a UK contribution. But how watertight will this prove to be? And will the private sector lenders to Greece accept a “voluntary” restructuring of their loans and interest payments?

By widespread admission in Brussels, Europe is facing its most serious financial crisis since the failure of Credit-Anstalt bank in 1931 – the trigger event that pushed Europe and the world into the Great Depression. We are perilously close to a similar trigger point over the coming weeks.

Greece has already passed a point of no return. This is what has triggered the need for a second bail-out package of ¤120bn. By the end of this year, its government will owe more than 150 per cent of the country’s annual output. By 2016, even with huge public spending cuts, its additional gross borrowing needs will be scraping ¤350bn, and its debt to GDP ratio will still be at 146 per cent. With these sorts of numbers, most observers believe default is just a matter of time.

So much for the drains. Now for the radiators. Other European banks and governments are heavily into Greek debt. According to the Bank for International Settlements, Italian banks hold $2.3bn (£1.4bn) of Greek debt and UK lenders are in for $3.4bn.

That looks manageable, if only the numbers stopped there. But factor in French holdings of $15bn of Greek bonds, German banks’ exposure of $23bn, the European Central Bank’s ¤47bn worth of holdings of Greek bonds, and cross-country exposures were a sovereign bondholder exodus to strike at Ireland and Portugal, and the capital at risk becomes colossal.

Whichever way events turn, there are now massive dangers. If the EU/International Monetary Fund emergency package is seen to be rejected and a default triggered, banks and governments across Europe and the western world would be severely affected: the “second Lehman” would be unleashed, a crisis with the capacity to engulf us all.

But if a second bail-out goes ahead, this is by no means the end of the matter. How can Greece survive in the face of doubts expressed by almost every economist over its ability to honour its mountainous debt obligations under the most stringent austerity measures ever imposed on a modern economy? Greece is as good as a goner, whether its parliament votes “yes” or “no” this week.

And when Greece defaults, it would almost certainly have knock-on effects on Portugal and Ireland as bond investors scramble for the exits. Not far behind would be Spain, whose potential debts are larger than the three countries’ impaired sovereign debts combined.

In that scenario Britain could not hope to stand aside as an unaffected observer but would be in severe trouble as its export markets weakened and its banks buckled under the weight of their substantial exposures to these countries. All told, the UK is reckoned to have almost ¤1 trillion (£892bn) at risk were a Greek default to spark a chain reaction in Ireland, Portugal and Spain. The idea that we are clear of all this is a dangerously complacent delusion.

Why do we not just let Greece default and leave the euro? A growing number now see this as the least worse option. But in Brussels this is the option to be avoided at all costs.

The first and last concern of eurozone ministers is to protect the single currency from this existential threat. Once one country leaves, the price of government bonds across the eurozone will fall (and yields rise) to reflect the risk that other stricken members may opt to leave. One of the key justifications for the eurozone project – the promise it held out of lower sovereign debt costs and bond yield convergence with Germany, its strongest member – would collapse.

The survival of the single currency through this crisis is now seen to lie in a decisive, epochal shift towards a single tax and fiscal regime across the zone, and the acceptance of fiscal transfers. Indeed, the central flaw of the single currency project from the outset was the denial of a common economic policy; that currency union was impossible without a large measure of political union.

Now this moment of truth has struck. A Europe of fiscal transfers – better-off members helping out weaker members in trouble – is now at hand.

But keen though officials in Brussels may be to seize this moment, voters in the more prosperous areas of northern Europe show no sign at all of warming to it. Germany in particular has deep misgivings over its participation in a Greek bail-out. It has gone through a decade of tough labour market reforms and productivity improvements to see the benefits of a more competitive economy and an export surge. Why should it now sacrifice these gains?

Thus, from almost every angle, the crisis now facing Europe is acute. From this perspective, the meetings of eurozone and Greek government officials between now and the end of July to resolve the crisis is akin to walking through a minefield: one misstep could trigger a conflagration. The best that can be hoped for is a set of interim emergency arrangements that will somehow keep sovereign bondholders in line and the Greek demos on board.

It may all look like a desperate deferral of the inevitable: a playing for time in the hope that the problem will become more manageable. Unfortunately, there is no sign of an economic uplift strong enough to relieve the pressure and supply some sort of longer-term solution.

We are thus on course for the most expensive bail-out ever mounted to stave off a nuclear chain reaction engulfing Europe’s banks and governments. The UK is going to be hit, however much the government protests its determination not to be sucked in.

At key turning points in European history there is no such thing as Olympian detachment, nor has there ever been. Debt and debt default is a virus that leaps borders. And it is debt default that now threatens all of Europe.