The governor of The Bank of England in announcing recently another round of quantative easing said that he feared there might be an economic slowdown worse than in the 1930s. He may have been exaggerating in order to justify the bank’s decision to print more money at a time when inflation in Britain is running at around five percent or double the bank’s target.

The economic situation is grim. British consumers are facing wage freezes, increases in energy bills (gas, electricity and gasoline) and rising food prices. Rises in unemployment seem inevitable and living standards are likely to fall further. Borrowers such as those with variable interest mortgages are cushioned by ultra low interest rates while savers and those on fixed incomes are being clobbered.

The British government, determined that Britain must limit its indebtedness and keep its borrowing costs under control, is sticking to its planned cuts in public expenditure and refuse to reduce taxes to stimulate consumer spending. So far British sovereign debt has avoided a downgrade. But if the government’s target of eliminating the deficit within the life time of the current parliament is to be attained the country must return soon to growth. Growth will, however, be difficult to achieve without a fiscal stimulus.

As one measure to promote growth the government is considering measures to extend lending to small and medium sized businesses. The banks which are currently being forced to increase their capital ratios are understandably reluctant to make loans which might become non-performing and will be looking for some kind of guarantee from either the Treasury or the Bank of England. They are also concerned that a European tax on financial transactions would undermine London’s position as the pre-eminent financial centre in Europe.

The British economy cannot be isolated from the economies of the United States and the rest of Europe. In the U.S., Republicans with an eye on the next presidential election are playing a dangerous game over economic policies, while some Democrats are toying with protectionist measures which could if unchecked lead to greatly increased trade friction which would damage U.S. competitiveness.

The other countries in the European Union are now Britain’s most important market. While Britain remains outside the euro zone, it is very much in Britain’s interest that the euro should remain healthy. This cannot currently be guaranteed. The most immediate problem remains Greek sovereign debt. Despite help from the European Central Bank, the International Monetary Fund and other euro-zone countries, Greece is finding it difficult to pay its way and a Greek default looks increasingly likely unless the 17 countries using the euro are willing to increase significantly standby facilities.

Many Greeks are bitterly opposed to the austerity measures which have been forced on their government by the European Union and the IMF, and many observers think that a halving of Greece’s national debt will somehow have to be made if bankruptcy is to be avoided. Many Greeks would prefer Greece to default on its international obligations, leave the euro and re-establish the drachma as the national currency. But the treaty establishing the euro contains no provisions for a member country to leave. Even if drachma notes and coins could be prepared in secret, which is unlikely, Greeks would try to retain their balances in euros rather than move into a currency which would inevitably be devalued. Greece would face a serious threat of inflation and social instability.

Greece is not the only weak member of the euro zone. Ireland and Portugal have had to be rescued and while their position is stable for the moment their economies could be further destabilized if there was a Greek default.

The Italian government has been forced to take austerity measures to bring its debts under control, but Italian Prime Minister Silvio Berlusconi seems more intent on shoring up his dubious private affairs than on tackling his county’s troubles.

Spain has the worst unemployment in Europe. Its vast property bubble has burst and many of its banks are in trouble. The Socialist Party looks likely to lose the election due this autumn.

In many of the countries north of the Mediterranean periphery there is much anger over the demand that they should bail out their southern neighbors. Greece is depicted as a country with too many bureaucrats who retire too young and where paying taxes is easily avoided.

German public opinion has been particularly critical of a Greek bailout, but there is significant opposition in the Netherlands, Finland and Slovakia to increasing the funds available for weaker euro-zone countries. As any increase in these funds requires the approval of all 17 countries using the euro, and as the German constitutional court could veto action by the German government, the way forward is not simple.

A Greek default — apart from its serious implications for Greece — would pose heavy burdens on European banks that hold Greek government debt. Already Dexia, a largely Belgian bank, has had to be rescued. French and German bank have major exposures to Greek debt. British banks would also need additional help in the event of a default. This, and the effect which any Greek default might have on the European single market and in particular on Europe as a market for British exports, has induced the British government to press European governments, particularly those of France and Germany, to hasten the establishment of an adequate safety net for euro-zone countries and European banks. There is a feeling among many British politicians that French President Nicolas Sarkozy and German Chancellor Angela Merkel have not yet shown sufficient leadership or sense of urgency in tackling the euro-zone crisis.

It seems probable that the only way in the longer term of ensuring monetary stability in the euro zone is the establishment of a much closer and effective structure governing the way in which euro-zone budgets are drawn up and taxes imposed. This implies moving towards a more federal structure, but this would require significant treaty changes which would have to be ratified by all participating countries. Euro-skepticism is no longer mainly a British phenomenon.

Hugh Cortazzi served as Britain’s ambassador to Japan from 1980-1984.

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