In the closing weeks of 2010, the government got a vote of confidence from two quite different sources that its policies are on the right track. First, the Office of Budget Responsibility endorsed the view that its deficit-reduction policy should have the desired fiscal effect without derailing growth. Second, chaos in the eurozone confirmed that Gordon Brown’s decision to keep the UK out of the single currency was the right one and that George Osborne’s plan to act early and decisively on the UK’s budget deficit was also correct.
Although not of our making, the fallout from the crisis affecting a number of eurozone countries will not leave the UK unscathed. The countries in the firing line last year were Greece and the Republic of Ireland: Portugal, Spain and even Italy are possible candidates for bailout activity in 2011. Each country’s problems involve a slightly different combination of large deficits, big debts, bad banks and poor growth prospects, but the net result is the same. A loss of confidence in a country’s finances creates market uncertainty, which pushes up the costs of borrowing and makes the debt servicing issue even more acute. For Greece and Ireland, that concluded with other countries stepping in to help the national governments.
The key word is contagion: the fear that markets will move from country to country until the resources to help the ailing states are exhausted. Greece and Ireland were manageable, as would be Portugal. But the collapse of Spain, twice as large as the other three combined, could threaten the viability of the eurozone. All the vulnerable countries are in the single currency area, but it is not the currency itself that has caused the problems. It was, for example, the Irish government’s decision to guarantee 100 percent of bank deposits – effectively ‘nationalising’ the debts of the banks – which brought on its crisis.
But the flawed structure of the eurozone sets a timebomb that has been ticking away since 1999. Although member states surrendered control of their monetary policy (interest rates) on adopting the single currency, they retained control of fiscal policy, subject to the constraint that a deficit cannot exceed three percent of GDP. Evidently, this condition has been weakly enforced even for the major countries, and has been almost ignored by some of the smaller members. To give up fiscal policy implies a degree of economic integration and loss of sovereignty most countries would find unacceptable, but without it, a currency union will only be as effective as its least fiscally rigorous and most profligate member.
The day of reckoning has arrived. Debt has become so expensive in some countries it threatens economic stability, and perhaps the social fabric and democratic process as well. Neither devaluation to restore competitiveness nor default on the debt is an option for the threatened eurozone governments. So, since there is no mechanism for expelling recalcitrant members of the union, some collective action is needed by the other members. The terms of the ‘rescues’ so far are not especially generous and will put a strain on growth prospects, employment and living standards in the recipient countries – but until such time as Germany can enforce more stringent fiscal discipline on the other members, that is all that is available.
Although a semi-detached member, all this matters to the UK. For a country that needs to export its way to growth and rebalance its economy, the fact that our combined sales to the fast-growing markets of Brazil, Russia, India and China amount to less than our exports to the Republic of Ireland is a chastening thought. Some 55 percent of British exports are to the European Union: we need a strong Europe if we are to make the most of our competitive exchange rate. George Osborne’s contribution to the Irish bailout makes economic sense from the UK’s perspective and his decision to act on the budget deficit sooner rather than later also looks to be the right one.
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