Hamish McRae: Will the sun ever shine again on the eurozone's Club Med?

Economic Life

Contagion. That is the fear. The past few days have quite suddenly brought home to us all that the crisis over the Greek debt position will hang over the European economy and beyond for the next couple of years at least. There will, on the balance of probability, be some sort of patch for Greece, because if there isn't, the damage to the eurozone will be huge. But this is not just something about the future of the Eurozone. It is about the attitudes by investors to sovereign risk, and as a consequence of that, about the pace at which governments everywhere will be forced to fix their finances.

I happen to be writing this from Spain, whose debt was downgraded by one agency on Wednesday and where the headline in the newspaper El Pais read: "El contagio griego rebaja la nota de solvencia de la deuda espanola." You do not need to read Spanish to understand it. The solvency of the country is on the line. Now I think that Spain may scramble through, though I worry about the solidity of the Spanish banking system given its loans for property development and I worry very much about the impact on Spanish people, given that unemployment is nudging 20 per cent. But the broader point here is that, as and when Greece is bailed out on some sort of terms, the focus will switch to the rest of the eurozone's Club Med, and specifically to Portugal, Spain and Italy.

The question is very simple: most investors ask "Will I get my money back on the date at which the loan falls due?" It is not: "Will I get my money back sooner or later?" Nor is it: "Will I get most of my money back?" For some investors it may be: "What premium do I need to compensate for the possibility that I may not get my money back?" For most though, it makes more sense to lend to a credit-worthy country such as Germany rather than chase the extra return. People like to sleep o'nights.

All this has been made worse by the sub-prime crisis. Investors were told that the complex yet AAA-rated products they were sold were indeed sound investments, just as they were told a few weeks ago that the European Union had agreed a plan to bail out Greece. They now know they were lied to by the bankers on the former and, shall we say, somewhat misled by the politicians on the latter. So there is a trust deficit.

The unfortunate parallel is with the collapse of Lehman Brothers. If Greece is equivalent to smaller Bear Sterns, which was indeed rescued by the US authorities, which country is equivalent to the much larger Lehman Brothers, which wasn't? I don't think I want to go into that because the consequences of a default by a larger eurozone economy don't bear thinking about.

So what will happen? It is very difficult because those of us who could not believe the US authorities would be so stupid as to let a major investment bank go under have been proved wrong. This is simply because all economic history demonstrates that the costs of propping up major institutions are less than the costs of letting them go. The fact that propping up is unpalatable is irrelevant; it is cheaper. I cannot believe, given this, that Greece will be allowed to default. But monetary authorities and politicians alike make mistakes.

Sure, developing and emerging countries do periodically default. We have experience of that in Russia, Argentina and many others. But established developed countries do not, or at least have not since the Second World War. The shock of a default by Greece would be vastly greater than that of Argentina.

So on the balance of probability the most likely outcome, I think, is that this will be patched up. There will be a sequential series of measures rolling across southern Europe, with a mixture of additional loans from the eurozone members and the International Monetary Fund, coupled with new and tighter fiscal plans. As a result, the eurozone will be stitched together for the time being. But there will be costs.

One of these will be a rise in interest rate payments. You can see some estimates from Capital Economics for that in the first graph. So the funds available for other forms of government spending will be correspondingly less. Government debts as a percentage of GDP will climb towards or above 100 per cent of GDP, a level which seems to curb economic growth. So growth will be lower than it otherwise would have been.

Beyond that, we have to factor in further policy changes, voluntary or forced, on the part of governments not just in the eurozone but everywhere. I think all governments will discover that the gradual progressive tightening of fiscal policy, as envisaged for example by all three parties here, simply will not be possible. They will have to move faster. They will have to do so not to preserve AAA ratings or anything so mechanical. They will have to do so because the rise in long-term interest rates if they don't move swiftly will more than offset the mathematical fiscal boost from additional borrowing.

If this is right, then what is happening in Greece and the other Club Med economies is of profound importance. Concerns about the solvency of sovereign states have replaced worries about the solvency of financial institutions. We have got over the sub-prime crisis, more or less. Now we have, or may if handled badly, a sovereign debt crisis. From the latter, no indebted country is immune, including certainly the UK and indeed also the US.

The better news is that a cyclical recovery is in place, even in inherently slow-growing regions. The third graph simply shows the relationship in the European Union between sentiment and GDP growth. The recovery in Europe and the UK has so far been disappointing but the turn in sentiment is really encouraging and a couple of years of decent growth seem in store.

The great issue that the Club Med plight highlights is the extent to which this coming growth period must be used to get all debts – government in the first instance but also corporate and personal – under control before the next downturn strikes. It is plausible, given the sequence of the past 30 years, that there will be another recession some time between 2016 and 2020. That is the window. I happen to think that this next downturn will be the one in which the eurozone breaks up, not this one. The reason is that the political will to hold things together will be greater than the economic forces pushing it apart. Eventually economics will win, but not yet. But that is just a view. Much more important than the future of the eurozone is the future of the sovereign debts.

Come back to home. I don't think the UK will default on its debts, nor devalue further to reduce their real value. But the window to fix them may be narrower than our politicians appreciate, as our fellow EU members to the south have suddenly discovered.