Essentially membership of the Euro involves:
- Single Currency
- Single Monetary policy - interest rate set by the ECB.
This loss of monetary policy and exchange rate policy is not a problem if the Eurozone is an optimal currency area and the economies grow at the same rate. But, there is increasingly a divergence between different areas of the Eurozone - roughly a north - south split. The north (France and Germany) could recover strongly - this will cause ECB to put up interest rates and the Euro to appreciate.
But, in the south, deflationary pressures make recovery very difficult for the likes of Portugal, Greece and Italy. Also, the south have a much worse fiscal position.
This is the dilemma of the Eurozone - ideally, the south would have low interest rates, quantitative easing and a depreciation. But, the north doesn't. The ECB have great belief in their own powers and the necessity of the Euro project. But, this is not a dilemma which will easily go away.
Problem of Public Sector Debt.
One of the supposed Maastrict criteria of Euro membership was that countries should limit public sector debt to 60% of GDP. However, the recession and profligate fiscal policies have prevented this.
Greece has a public sector debt of 120pc of GDP this year. S&P says it will reach 138pc by 2012.
The solution is of course to implement deflationary fiscal policy - higher taxes and cuts in spending. But, when your economy is in recession this will lead to an even bigger fall in output.
Deflationary fiscal policy is OK, so long as you have something to offset it - a devaluation in exchange rate or looser monetary policy. But, Greece doesn't have this. Greece will be implementing the painful part but without the relief.
For example, in the coming years, the UK will need to tackle its fiscal deficit - this will be difficult given our anaemic growth prospects - but, at least we will be able to benefit from monetary policy as loose as we want and a weak currency. If we had to reduce our deficit with a very strong pound, higher interest rates and deflation - it would be a disaster.
The outlook for the Greek economy is very grim.
Already, they are facing deflationary pressure - making the effective real interest rates high and increasing the debt repayment burden.
They can't devalue and are suffering from a hefty loss of competitiveness.
The only policy tools available to increase competitiveness are the prospect of nominal wage cuts - not political popular - and of doubtful economic value. (cut wages and people spend less)
In fact, the most viable economic option Greece has at the moment, is to leave the Euro, devalue the currency, pursue looser monetary policy and reduce the structural deficit.
Of course, the other option is for the stronger Northern Euro members to have a massive bailout of the indebted south. But, the idea of German taxpayers bailing out profligate Greeks and Italians may test even the most ardent European idealist....