Hamish McRae: A terminal eurozone illness is more likely than a sudden death

Economic Life: The conventional wisdom at the moment is that a disorderly default by Greece would be a disaster. I am not sure that is right

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The Independent Online

When central banks want to make an impact they act in concert. They have the power to pump money into the financial system almost without limit: to provide short-term liquidity to the world's banks. I suggested last week in this paper that there might have to be concerted action by the central banks on these lines but they would only do so if it were absolutely necessary. It seems that the pressures on the banks as a result of Europe's sovereign debt crisis have become so severe that yesterday five of them did so: the Federal Reserve, the European Central Bank, the Swiss National Bank and the Bank of Japan gave three-month loans to the banks to make sure they could function through the rest of this year.

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This is classic text-book stuff: what every student on a first-year money and banking course learns about central banking and what has happened many times over the past couple of centuries. The good news is that the banks have done what they have to do; the bad news is that the situation was so dire that they had to do it.

Pumping liquidity into the markets is a short-term fix, for it does nothing to affect the solvency of the banks, or the ability of Greece to pay its debts, or indeed of the eurozone to survive in the medium term. All of this remains in the air. However, I do keep on being asked what will happen to the euro, so a bit of clarification might be helpful.

Greece will default within the next few months but will stay in the eurozone for the time being; and the eurozone itself will break up in somewhere between five and 10 years' time.

Now, of course, that is only a best guess of the likely sequence and it may be quite wrong. Things are happening very fast at the moment, witness the central bank action yesterday. They have been brought to a head by the fact that the Greek government cannot pay its bills, but of far deeper origin. It is always possible that events that seem some way off suddenly become closer. Nevertheless, it seems to me that a drawn-out but ultimately terminal illness is more likely than sudden death.

If this is right, then all the guff that were Greece to be allowed to default, it would be the end of the euro and were that to happen it would in turn be the end of the European Union, is plain wrong. Default is one thing, the future structure and membership of the eurozone is another, and the future of the EU is something else again. It is quite right that our government should have contingency plans for the end of the euro and indeed the end of the EU. But that does not mean the former outcome is immediate or the latter probable.

The really interesting issue is whether events can and will be controlled. The conventional wisdom at the moment is that a disorderly default by Greece would be a disaster. I am not sure that is right. It might actually be better for the country to default now, in the next few days, and get the news out of the way. There would be a great deal of picking up of pieces, including the need for support of several European banks that hold too much Greek debt. But the news would be out in the open and there is no automatic need to expel the country from the euro.

There is obviously the question of whether the fear of default would then switch to Portugal and Ireland but the situation in both countries is quite different. Ireland seems to have turned the corner, with exports doing very well indeed. Portugal's problem is slow growth rather than excessive public indebtedness. As for Spain and Italy, and indeed France, they all face longer-term problems but bank debts apart, are not directly affected by what happens in Greece. And at least everything will be in the open.

By contrast, a controlled default means many more months of confusion and deceit. There is confusion because different politicians, even within the same government, say different things: for example, does Germany want Greece to default or not? And there is deceit because they feel they have to proclaim that, for example, the major French banks are sound when they are self-evidently having trouble funding themselves.

So the central bank action yesterday has bought a little time but only that. It helps the banks directly and as a result helps protect the European economy from a financial squeeze as the banks' inability to fund themselves translates into their cutting their lending to business. Whether Europe continues with its present slow growth or does slip back into recession will turn on more general matters of confidence.

It is important to recognise right now that the European economy, despite all that has been thrown at it, is still growing. You can see the pattern in the top graph, with industrial production swinging much more markedly than overall output, but now at least according to these Goldman Sachs projections, the outlook is for both remaining in positive territory. It would be perfectly normal after the sharp bounce in output for it to fall back below the line. As you can see there have been several periods since the early 1990s recession when industrial production has gone negative. It is just because we have become so traumatised by the huge dip in 2009 that any weakness now sends the shivers down people's spines: could this be 2008 all over again, with Greece fulfilling the role of Lehman Brothers?

I think the answer to that is no, not because Greece can struggle through, which it can't, but because we have more experience of how to cope.

The bottom two graphs surely confirm that judgement about Greece. As you can see the yield on Greek government debt has shot up yet again and apparently even at these levels that are very few buyers. If you think that Greek debt is worth about half its face value that would probably be about right, for country defaults over the past 30 years have tended to see write-downs in the 40-60 per cent region. But writing down existing debt does not solve the revenue problem, and as you can see from the right-hand graph the monthly running deficit this year is even worse than it was last year. Ground is being lost, not gained.

But consider this. It is surely improbable that one default from one relatively small country that happens to have adopted the euro as its currency can destroy the currency itself. If that were so, the currency cannot be well based. What would destroy the euro would be were several countries, including Spain and Italy, to leave. That seems to me to be several years off. As for the end of the euro being the end of the EU, the EU and its earlier incarnations has been running for more than 50 years, while the euro little more than 10. If for some three-quarters of its life this community of nations managed without a single currency it should surely be possible to manage again.