Ruth Lea: Expect muddle, not masterplans, as turmoil in the eurozone turns toxic

The FTSE 100 was down by nine per cent in the week as a wave of pessimism and fear about the economic outlook panicked the financial markets. Bank shares were especially hard hit.

Commentators are increasingly talking about a rerun of the autumn 2008 financial crisis, which was triggered by the Lehmans collapse and led to the deepest recession since the Second World War.

Hopefully, a repeat of the worst of the 2008 crisis can be avoided this time.

Policymakers are, in some ways, more prepared than they were then and the banks are better capitalised. But, given the recent, dangerous developments in Italy, nothing can be guaranteed.

There has been a stream of disappointing economic news in recent weeks on both sides of the Atlantic.

Growth has almost flat-lined in Britain since autumn last year, even the well-performing economies in the eurozone, including Germany, are showing signs of slowing and recent data out of the USA have been very disappointing.

But what makes this economic news so toxic for the markets is the seeming inability of the eurozone’s politicians to get control of Europe’s mounting debt crisis and evidence of a dysfunctional government in the USA, which part contributed to last Friday’s downgrading of US government debt by one of the ratings agencies.

At least, after an unseemly squabble, President Obama and the recalcitrant Republican-led House of Representatives did manage to patch up their differences and agree to increase America’s “debt ceiling” – even if it was at the last minute.

It is more the sight of many of the eurozone’s politicians heading for their holidays as markets burn that makes people nervous.

The crisis in the eurozone is far the most serious threat to economic recovery. Worryingly, the government debt problems that initially affected Greece, Ireland and Portugal have now been transmitted to the much bigger economies of Spain and Italy.

To get some sense of proportion Greece, Portugal and Ireland together account for about 6 per cent of eurozone GDP. Spain accounts for nearly 12 per cent and Italy about 17 per cent.

In addition, Italy’s total government debt is the third biggest in the world after the US and Japan, reflecting years of overspending. It amounts to an eye-watering €1.8 trillion, over 120 per cent of GDP.

Greece (twice), Ireland and Portugal have, of course, been bailed out when it became obvious they were unable to fully repay their debts.

As the debt crisis hits Spain and Italy, then fears that they will also be unable to fully repay their debts, and will also need to be bailed out, become only too real.

This is an awesome prospect as the EU bailout fund, the European Financial Stability Facility, is probably far too small to cope with Spain (possibly) and Italy (certainly).

Under these circumstances, no one can be surprised that the markets take the view that the eurozone simply does not have the firepower to cope with the potential costs of the current crisis.

More fundamentally, they question whether the bickering eurozone politicians prone to muddling through can ever come up with a permanent “solution” to the endemic problems of the eurozone. And, of course, they are selling the government debt of Spain and Italy in alarming quantities.

But what should the eurozone leaders do to solve the euro’s problems?

Before answering that question, it is important to emphasise just how dysfunctional the euro is.

Some of us were also sceptical that a currency union comprising such disparate economies as Greece and Germany and Italy and Finland would ever “work” without a strong centralised economic government in the first place.

So it has proved to be. The economics of the eurozone are simply pulling the currency union apart. The northern countries are performing relatively well while the southern ones struggle to grow, partly because of the austerity packages imposed upon them, which makes their debt problems even more intractable.

There are really only two basic options for a “permanent solution” to the travails of the eurozone.

The first is the development of a fully-fledged economic government, with eurozone bonds, a eurozone Treasury which can dictate tax and spending terms to the member states and large enough fiscal transfers from the better off north to the less well off south (including Ireland).

Politically, this would seem to be a non-starter. Germany and fellow “northerners” would baulk at the costs involved and the southern countries would surely find the loss of their sovereignty unacceptable.

The second is an orderly division of the eurozone into, say, two currencies: a northern euro comprising Germany and economic allies and a southern euro for the rest. But the politics could prove intractable.

So we’re left with muddling through until there is a crisis and what then? We can only speculate. Perhaps some countries, say Greece, will simply leave. Perhaps the whole edifice will completely break up. We shall see. * ruth Lea is an economic advisor to the Arbuthnot Banking Group.