Hamish McRae: Europe has been scarred – and the pain will spread

Economic Studies
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The Independent Online

What is happening in Europe is about money, of course, but in the past few days it has become clear how much it is also about power. The next stage? Well, it could be about the whole European social model.

It is just a year since Greece received its package of financial support from the EU and the International Monetary Fund. That support has failed in its aim to rehabilitate the country so that it could borrow again from the markets. The markets are shut. In theory it could borrow at 15 per cent but of course it cannot afford that and, were it to try, no one would lend it the money anyway. The markets are similarly shut for Ireland and Portugal, though the notional borrowing rates are somewhat lower. So these countries simply cannot pay their bills without help. The governments are not really in charge anymore.

You can see this right now in Greece. It has said it will bring forward the sale of some state-owned enterprises, its telecommunications and power companies and its port authority. That may be enough to persuade the EU and IMF inspectors, who are in Athens this week, to sign off on the bailout's next instalment of €12bn. If they don't, Greece may have to stop paying its creditors (that is not me saying that, it is the country's finance minister, George Papaconstantinou}. And if that were to happen, would the debt simply be restructured so that Greece had more time to pay? Not so, according to Christian Noyer, head of the Bank of France and a member of the European Central Bank board. "There's no solution possible [for Greece other than its austerity programme]," he told reporters in Paris yesterday. "Restructuring is not a solution, it's a horror story." It would leave the nation shut out of financing for years.

You see the point. The Greek government may have the electorate's mandate but it does not set policy. That is being determined, somewhat incoherently it must be said, in Brussels, Berlin, Frankfurt and Washington. Power has gone. Many developing countries have found themselves in similar positions when they cannot pay their debts, and even the UK ceded authority to the IMF when it had to accept an IMF loan in 1976. But the scale of the power shift is bigger in that three European countries already find themselves in this position and others may well follow. Both Italy and Belgium have recently found their credit ratings deteriorating as rating agencies have warned of possible downgrades.

What next? We are just starting to see the level of public debt become a constraint on Europe more generally, witness concerns about Italy and Belgium, where there is no immediate funding problem but high debt to GDP ratios. It is quite possible that in the next few years all developed countries will find their national finances examined much more closely. How big are the public pension fund obligations? How much public investment has been pushed off the balance sheet in public/private partnership and other arrangements? And since some European countries face a particularly adverse demographic outlook, to what extent will a smaller workforce be able to pay the taxes to service the debt?

At the moment we have a two-tier situation in the bond markets. Most developed countries can borrow very cheaply, while a few can't borrow at all. This makes no sense. Ireland could borrow cheaply four years ago when it did not need to; now it can't when it does. This flip from easy money to the reverse represents a market failure and a lot of people have lost a lot of money as a result. So it is reasonable to expect investors being asked to lend to a country for, say, 30 years, to do due diligence about the likely tax base of the country in a generation and the implications of that for its current policies.

We are not there yet. The bond markets are still in a post-emergency mode, fuelled by money being pumped into the system by the central banks. But what is happening in Europe is a scarring experience and as normality returns expect all countries to have their public finances put under much greater scrutiny. Europe, with its high debt levels, high public spending and ageing populations, is particularly vulnerable – though maybe Japan hits the wall first.

Professor Vito Tanzi, a former minister for the economy and finance in Italy and for many years head of fiscal affairs at the IMF, was in London this week, speaking at a Politeia lecture. The core of his thesis was that the state would be so constrained by these forces that it would inevitably play a smaller role in the future than it does at present. A century ago government accounted for 10 to 15 per cent of GDP. Now, in Europe at least, it is typically between 40 to 50 per cent. He was not suggesting we would go back to the levels of a century ago, but we might head back to, say, 30 per cent of GDP. If he is right, and I personally believe he is, then what is happening in the fringe Eurozone countries gives us a feel for something much bigger to come.







What Plan B would really involve



A footnote on all this came yesterday in the UK's public borrowing figures for the first month of the financial year. They were much worse than expected, actually the highest ever for April at just under £10bn. I take three messages from this. First, cuts in public spending have yet to happen so blaming any apparent economic slowdown on them makes no sense at all. Second, the key in the months ahead will be tax revenues. If they hold up we are OK; if not we are in big trouble. Third, we may well find ourselves moving to Plan B, which is Plan A but carried out a bit more slowly.



h.mcrae@independent.co.uk

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