Hamish McRae: If only Greece and its fellow laggards could devalue now

Economic Life: More investors cannot see quite how the weaker governments can dig their way out

Well those voters on the Continent have certainly spoiled the party, haven't they? It has taken a few days for the results of last weekend's elections to feed through into the mood of the markets but gradually the long-standing doubts about the sustainability of the euro and the wider prospects for the European economy have been pushed centre stage again. The markets have duly lurched downwards.

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But what is going on? It is not just that the markets realise they will have to contend with a French president that says he hates them, though if you substitute the word "savers" for "markets", you can see how ugly that sounds. The job of markets, after all, is simply to allocate savers' funds. Nor is it just the near-inevitability that Greece will be unable to meet its fiscal targets, nor the probability it will leave the euro sooner rather than later. It is inherently improbable that a country which accounts for less than one-quarter of one per cent of world GDP should destabilise the entire eurozone, which accounts for 18 per cent of world GDP.

So it can't just be this. It must be something else. There are, I think, a couple of other concerns that have been brought into focus by the continued turmoil. The first and perhaps most important is the realisation that the scale of the cost adjustment that individual members of the eurozone will have to make is almost unthinkably huge, and that it will be almost impossible to manage without devaluations. The second is as long-term interest rates start to rise around the world, perhaps the start of a 30-year bear market in bonds, the pressure on European governments will be particularly intense. More and more investors cannot see quite how the weaker European governments can ever dig their way out. A word about each.

The top graph shows some calculations by Goldman Sachs about the extent to which the fringe European countries' costs are out of line with the core. This is the extent to which they have to cut their money wages and other costs to regain competitiveness, or, were they able to devalue, the scale of devaluation they would need. As you can see Greece is not in the worst position; that is Portugal. But note too that Spain and France need to cut costs too by the order of 20 per cent. Ireland, intriguingly, is OK, while Germany is over-competitive by some 10 per cent, at least in European terms.

These are just one set of calculations but as a rough guide to the sort of adjustment that countries need to make they are a decent starting point. Put it this way: were Greece to leave the euro, it would need a devaluation of around 30 per cent, maybe a bit more, to give it the competitive advantage it would need to get people back to work. My own view, for what it is worth, is that this would be the least bad outcome for Greece because devaluation is the fastest way to regain competitiveness and the country indeed needs to boost employment fast. It also needs to make structural changes to this economy but those are far easier to do in a climate of growth than a climate of austerity.

I cannot think of any country in recent history that has made a similar cut in its costs by what might be called conventional austerity, reducing money wages and other means. Ireland has come the closest but it has benefited from an export sector that was always pretty competitive and by softening the social burden of job losses by emigration.

But Greece aside, note how other countries need to adjust too. Countries can live for a long time with an uncompetitive exchange rate, longer in fact than they can with an inappropriate interest rate, but it does create distortions. The pound was some 20 per cent overvalued from 1997 through to 2007 and that period was associated with de-industrialisation. Then sterling fell sharply, which was associated with relatively high inflation, but may have laid the base for a modest manufacturing recovery. Now, with the pound having climbed back a little, we are probably about right. But the gap between France and Germany is huge and that will be a drag on France for many years to come. The headwind will be increased by the fact that France has to borrow much more expensively than Germany, a gap that is likely to increase.

The whole European debt problem becomes even more alarming were long-term rates to turn up. This is a huge subject and it is impossible to do more than flag it up here. My point is simply that we have had a generation of falling long-term interest rates worldwide. That period, starting in the late 1970s, followed a 30-year period of rising nominal interest rates. In real terms, rates are negative in the US, UK and Germany. Historically, that is an anomaly that has never lasted very long. So if France had to pay even five per cent to service its national debt instead of three per cent (and 10-year Spanish debt went over six per cent yesterday) it would require much more austerity than the country is experiencing at the moment. German 10-year bonds, by contrast, are trading at close to 1.5 per cent.

The paradox here is that the eurozone not doing that badly. It may or may not be technically back in recession when the figures are released next week, but the current activity indicator developed by Goldman Sachs suggests the region is growing, albeit slowly, as the bottom graph shows. Germany has had another good quarter and France seems to be growing decently.

So it is important to temper concern about the internal imbalances within Europe with a recognition that parts of the European economy are quite strong. The sad thing is that a mechanism that was supposed to help integrate the European economy, the single currency, has had the effect of pushing it apart.