Ten years on, the eurozone must beware of Greeks bearing debts

Europe's leaders have plenty to fret about. The Czech Government, which holds the EU presidency, has collapsed. The European Commission is battling against the protectionist instincts of some states. And in the run-up to the G20 summit, America is whingeing that European governments are not spending enough to boost demand.

So few leaders are focusing on a below-the-radar threat to Europe's long-term stability - the risk that the euro could splinter.

The economic crisis has highlighted the benefits of euro membership, which has sheltered countries from the currency swings that destabilised the likes of Iceland and Hungary. Furthermore, the euro has stimulated trade and investment between the nations that use it. But the downturn is also exposing flaws in the currency union launched ten years ago.

When a country joins the euro it loses the freedom to devalue its currency. This can be punishing for countries whose economies are too sluggish or inflexible to adjust to unforeseen events. This is the case with Southern Europe and the markets sniff trouble. They worry that some members may be unable to service their debt and stay in the euro.

Because Greece is seen as a greater credit risk, the gap between the rate of interest that Athens must pay to borrow and that paid by Germany widened earlier this year to 2.5 per cent. Italy, Spain and Portugal are also paying much more. The Irish Republic pays 2.8 per cent more than Germany.

These countries face two problems, which the crisis is making worse. First, government borrowing is out of control, increasing the risk of default. Greek government debt will soon pass 100 per cent of GDP while Italian debt is about 115 per cent.

Second, Greece, Italy, Spain and Portugal have long-term economic weaknesses. Their overregulated economies discourage innovation and efficiency. Their universities are of poor quality and too little is spent on R&D. They are too dependent on low-tech industries that cannot compete with Asia; but powerful trade unions have pushed up wages. Since 1999 wages in manufacturing, adjusted for productivity growth, have risen by 36 per cent in Italy, 27 per cent in Spain and 14 per cent in Greece. Over the same period they fell by 12 per cent in Germany.

Partly because of this declining competitiveness, current account deficits have grown - to 8 per cent in Spain, 11 per cent in Portugal and 13.5 per cent in Greece. The recession is preventing them from cutting their deficits by exporting more; only a big fall in consumption can shrink them.

Ireland is somewhat better off, with a flexible economy that encourages foreign investment. But financial markets worry about Ireland having to spend huge amounts on bank bailouts, and it faces the deepest recession in the eurozone. Ireland is lucky enough to have a fairly strong state. Public sector employees have accepted wage cuts. The political system in Greece - arguably the weakest link in the eurozone - is fragile (Greece only qualified to join in 2001, after its Government fiddled key economic statistics). It is recovering from riots in December and a farmers' strike in January. The fear of street protests has deterred politicians from taking serious steps to bring order to its public finances or to shake up its sluggish economy.

If Greece's leaders refuse to act, investors will eventually become very reluctant to lend it money. The option of defaulting, leaving the euro and devaluing a new drachma might appeal. It would make exports more competitive. But Greece - or any other eurozone country in trouble - is unlikely to pursue such a course, for two reasons.

First, few Greeks would want to leave the euro, and not only because it is a symbol of economic and political modernity. Even a discussion about leaving would cause huge dislocation. People would sell Greek assets, on the assumption that the new currency would sink, and stop lending to Greek companies. If the Government did decide to leave the euro, it would need perhaps a year to negotiate the divorce. And when the new currency lost value, Greek companies and citizens would strain to service their euro debts.

Second, Greece's partners would rather bail it out than see it leave the euro. If Greece contemplated leaving, the financial markets would speculate against other potential quitters; Italy or Ireland, for example, could find that credit dried up. Last month Peer Steinbrück, Germany's Finance Minister, attempted to calm the markets by saying that “in reality the other states would have to rescue those running into difficulty”.

EU treaties are designed to deter governments from profligacy: they make no provision for assisting a eurozone country in trouble, but do include the so-called no bailout rule. However, this could be circumvented. If the EU itself could not lend to Greece, a group of member states would. Officials in London say that Britain would contribute, as it has an interest in preventing chaos in the eurozone. But neither the Germans - who would provide the lion's share of any bailout - nor anyone else would want to hand over cash without strict conditions. Greece would have to implement painful spending cuts and structural reforms. Is the Greek political system robust enough to swallow such bitter medicine? There would surely be huge demonstrations against austerity and perhaps calls to quit the euro.

European officials are discussing how a bailout might work. Many argue that the EU should run the rescue operation, excluding the IMF. That would be a mistake. The IMF has a reputation for objectivity and is experienced at setting conditions. If the EU tried to set them there would be a risk of political horse-trading - and of it becoming hated in the country being rescued. The EU should lend the money but bring in the IMF for the conditions. If Europe's leaders want to ensure that the euro endures for another ten years, they need to move swiftly to work out the rules for aiding countries in trouble.