Hamish McRae: It's the clash of the EU titans: political will vs financial maths. What next?

Economic View

Yes, but what about the economics? The clash in Europe between political will and financial mathematics continues, and Britain last week was caught in the crossfire.

Actually that may be no bad thing.

In political terms it might seem tricky to be in a minority of one in Europe, though it is a situation in which we have found ourselves before and in much more difficult circumstances. But in economic terms there was no alternative. Look at the hard numbers and you can see very quickly why a more distant relationship with Europe may turn out to be in British self-interest. You can also see why Europe very much needs the British market.

Some numbers explain why. The Office for National Statistics produces a study of the country's balance of payments each year, popularly known as the "Pink Book" because of the colour of its cover. Last year's tally is just out. It showed that we have a current-account deficit of a bit less than £40bn. Within that total there was a deficit of nearly £100bn on trade in goods, for we import vastly more physical stuff than we export. But that was offset by a surplus of nearly £60bn in services. The UK remains the second-largest exporter of services in the world, after the US.

That story, that we use a surplus on services to cover much of our deficit in goods, is well-known. Much less well-known is the extent to which the UK has a deficit in its trade with Europe, offset in part by a surplus in trade with the US and Australasia. As you can see from the main graph, Europe sells £66bn more goods and services to the UK than it buys from us. (Germany alone has a surplus of more than €€20bn with the UK.) By contrast, the Americas buy £35bn more from us than they sell to us and, as you can see, we do well with Australia and New Zealand too. So you could say that while Europe matters to us as an export market – of course it does – we matter much more to them.

Now look at earnings from financial services. It depends a bit on how you measure it, whether, say, you include fees earned from London lawyers on international business as well as purely financial earnings, but the headline surplus on trade in financial services is shown in the right-hand graph. As you can see, the City had another bad year last year with the surplus down to "only" £32bn, against a peak of £42bn in 2008. But that is in a bad year, and it is still more than the surplus in 2005 or 2006. The City's surplus covers roughly one-third of the country's trade deficit. So the idea that Germany and France should use the EU to tax this British export industry is as absurd as us getting the EU to put a special tax on, say, the German luxury-car business.

So that is why we are where we are. What happens next?

You should never underrate political will. The fiscal compact that is being developed over the next few months will buy some time – particularly since it will be coupled with some more firepower in the support funds, including cash from the IMF, and, crucially, by the ECB being prepared to help countries fund their deficits, if necessary by printing the money. But this latest summit is the seventh of the eurozone crisis, and, according to Saxo Bank, the 17th financial crisis meeting. There will be many more.

The core problem is not a lack of fiscal discipline that this compact is designed to tackle. Governments all over Europe are already racing to bring in yet more stringent budget packages. A compact might help on a five-year view by helping them to re-establish a reputation for fiscal probity, though cynics would ask why such a compact should succeed where the Stability and Growth Pact failed.

But the problem is that the weaker governments cannot finance deficits at an acceptable rate. The rates they would have to pay, 5.5 to 7 per cent for Italy, would be too high for the countries to bear. (Mind you, looking on the bright side, the yield on Greek debt hit 49 per cent on Friday – form an orderly queue to buy.)

More loans – from the EU, the IMF, the Chinese, whoever – simply postpone the problem, and not for long. Indeed they make the default even larger and more painful when it occurs. As Mervyn King put it, the problem is one of solvency, not liquidity, which is about as close as any central banker could come to admitting that more sovereign defaults are inevitable.

But a default only cuts debts; it does not restore competitiveness. Only devaluation could do that. It may well be that years of austerity will come first but a break-up of the eurozone is a large enough possibility that Europe's firms are already making contingency plans in a way that would have been unthinkable even three months ago.

That leads to the question: would an early realignment of Europe's currencies, either by splitting the eurozone into north and south blocs or by allowing some countries to leave, be such a bad outcome?

The conventional view, mouthed by every mainstream politician and most economists is that a eurozone break-up would be a disaster. All sorts of calculations have been made about Europe losing 10 per cent, 20 per cent, whatever, of its GDP. Intuitively this feels wrong. Experience of other currency-zone break-ups suggests there would be short-term costs, but there would also be longer-term benefits. The break-up of the rouble zone in the early 1990s after the Soviet Union collapse did lead to massive disruption across Eastern Europe before output recovered. But the structure of those economies had to be transformed; it was not just that they had an uncompetitive exchange rate. The gradual break-up of the sterling area brought clear benefits to the countries that left, including, probably, Ireland. (Ireland did devalue in 1979 when it broke its sterling link, but initially only by about 5 per cent.)

What is beyond doubt is that we are heading further into unknown territory. There may well be a couple of weeks of relative calm as markets digest what Europe is doing, or trying to do. But come the New Year the challenges will mount again. Can Italy and Spain raise money from the markets on acceptable terms? And if not, what will emerge from the next crisis summit – and the ones to follow?

Turkey is a terrific success story, so maybe it's not so bad on Europe's fringes

So what is life like on the fringe of Europe, if that is where we might be a-heading? A visit to Istanbul last week was profoundly uplifting – and not just because it is such a stunning city in a stunning location. From an economic perspective Turkey has been a huge success story. Growth this year is expected to decline to, wait for it, 7.5 per cent, after 9 per cent in 2010. The economy is slowing and will undoubtedly be further hit by the eurozone crisis, with estimates of between 5 per cent and 2 per cent growth next year. Unemployment, while too high at 9.2 per cent, is still below the eurozone average, and most impressive of all, government debt has been stable at around 50 per cent of GDP right through the recession. In 2001 it was over 100 per cent of GDP – amazing what decent growth coupled with devaluation can do.

Turkey has other advantages aside from currency flexibility, in particular a young and increasingly well-educated workforce. Back in the 1960s fertility rates were around six babies per mother, the same as India, and that cohort is of course still in the workforce. Now the fertility rate has fallen to a little above replacement rate, 2.1 babies per mother – still higher than anywhere in the EU, and the flow of young graduates is great for ambitious businesses.

Population growth and the potential for further productivity increases mean that the economy is projected by the Goldman Sachs Brics model to become the 12th-largest in the world by 2030. Turkey should by then have an economy about the size of Italy's, though its larger population will still have lower living standards than people in Western Europe.

There are, inevitably, social and political tensions, and no one should minimise those. But from an economic perspective Turkey is a massive success story, an example to the EU, and a great place to escape the pre-Christmas blues of Britain.

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