The Economy: Britain’s European dilemma and why the country needs to take a lead

The past few months have witnessed growing economic turmoil in Europe and Britain is suffering from the knock-on effects, writes Lord Eatwell, chief economic adviser to CMI

The relentless character of the growing crisis was evident in the behaviour of the markets over the last few weeks. In mid-June the euro fell sharply against the dollar and bond markets were under pressure because, so said the commentators, Spain was taking insufficiently austere measures to reduce the country’s budget deficit. The Spanish government responded with a swingeing package of expenditure cuts. The markets fell yet further. Why? Because of fear of the recession that the cuts might precipitate!

Need for resolution

It is in Britain’s fundamental economic interests that the difficulties in the Eurozone are resolved. 

First, the economic health of our economy is inextricably tied to the economic health of the rest of the European Union. It is obviously in our interest that those to whom we sell over 60 per cent of our exports should be prosperous, providing a growing market for British goods. But perhaps of even greater importance is the financial stability of Europe. If the Eurozone were to collapse the resultant financial apocalypse would engulf us all.

Second, it has become evident over the past few weeks that the economic institutions of the European Union in general and of the Eurozone in particular require fundamental reform. Without major changes to the institutions of monetary and fiscal management the persistent weakness of the past decade will persist, and we will all be buffeted by recurrent storms.

The need for reform is the third reason why we in Britain have such pressing concerns. The necessary reforms will require a new treaty to strengthen European institutions, a treaty that will require Britain’s active participation.

Fears of default

The shape of necessary reforms has been defined by the emerging difficulties of the past few months. The mis-management of the Greek economy, exacerbated by the collapse of world trade and hence the collapse of shipping revenues, led to cumulative severe pressures on the bond sales necessary to fund the government deficit. Since Greek government bonds are denominated in euros, investors faced no currency risk. However, they did face increasing fears of default.

The reaction in European capitals was to initiate a protracted, indecisive debate on raising the funds for a Greek “bail-out” – funding vigorously resisted in the main bail-out state, Germany. As vague pronouncements were piled on indecision the fear of default increased so that when the 40 billion euro “bail-out” was at last agreed it proved inadequate against the tide of default pessimism.

The incompetent handling of the Greek crisis stands in stark contrast to the rapid and effective measures taken by the US government in the Mexican crisis of December 1994. In the latter case investors in Mexican government tesosbonos faced a complex mix of currency risk and default risk. Yet the $50 billion package assembled by the Clinton administration in a few days, predominantly in the form of guarantees, stemmed the run and rapidly restored confidence. As Alan Greenspan recounts in his autobiography: “Mexico ended up using only a fraction of the credit. The minute confidence was restored, it paid the money back – the United States actually profited $500 million on the deal” (The Age of Turbulence, p159).

European paralysis

If a credible Eurozone institution had guaranteed Greek bonds at the outset the immediate crisis would be over, at negligible cost.
In the face of continued European paralysis it took a telephone call from President Obama to avert disaster, if only temporarily. At last a 750 billion euro guarantee fund has been established, with the assistance of the IMF. But delay has fed the flames of volatility and it is now not clear that this sum will be enough.

A more damaging sequence of events would be difficult to imagine.
But worse is to follow. Having at last chosen to follow a sensible guarantee strategy, the Eurozone governments, led by Germany, plan to resuscitate the growth and stability pact – an Orwellian label if ever there was one, for a policy that brought neither growth nor stability.

The Eurozone has been gripped by deficit hysteria, with all governments being forced to commit to massive precipitate cuts in public expenditure. The path to recovery is to be paved by unemployment and bankruptcy.
It is becoming increasingly likely that the Eurozone will suffer a prolonged stagnation, not unlike the Japanese “lost decade” of the 1990s. That would be very bad news for Britain.  A reassessment of economic policies and institutions is necessary throughout Europe. Britain should be taking a lead.

Lord Eatwell is Professor of Financial Policy at Cambridge University

Article published in the September issue of Professional Manager

Home  |   Subscribe   |   Advertise   |   Book Reviews   |   Previous Content