It was not just sceptics of the idea of a single currency like me who warned that the currency could be damaged or even destroyed if each euro member country could borrow as much as it liked in the common currency. The founders seemed to know this.
When they set it up they said a country could not join if it had already borrowed too much, or if its running deficit was too high. Unfortunately, they shelved this wisdom, allowing the politicians to put economies into the scheme that were nowhere near meeting the requirements. They then allowed them to go on borrowing too much after entry.
History tells us that successful currency unions require political unions to back them up. The German currency union worked because it went hand in hand with building a united Germany. The French led Latin currency union and the Scandinavian currency union of the nineteenth century did not. They were broken apart by too much state borrowing at the time of the First World War.
The reason a currency union needs a political union is simple. The centre has to have some way of stopping parts of the union from borrowing too much in the common currency at the common interest rate. If some borrow too much they are free riders on the backs of the more prudent areas.
If they go on borrowing too much they undermine the credit rating of the whole area, and force up the cost of borrowing for the prudent parts. To achieve discipline, the centre also needs to send subsidies and payments to the poorer parts, to compensate them for their inability to devalue to price themselves back into a competitive position.
Today the single currency system is suffering from the double stresses of too much borrowing by countries such as Greece and Portugal, who have spent too much and raised too little in tax, and from the need of countries like Ireland to bail out their overstretched banking systems. The low interest rate in the single currency prior to the credit crunch allowed Irish, Spanish and other banks to over-extend credit leaving a difficult case of over-indebtedness by banks within the euro area.
So what should be done? Lending these countries more is not the answer. You do not get out of a debt crisis by borrowing more. You get out of a debt crisis by spending less, or by raising more revenue, or by selling assets to cut the amount you need to borrow. The EU and IMF seems to think if they lend countries such as Greece and Portugal more money, it will buy them time to make the changes they need to make. Instead, it has delayed effective action and put more money at risk. The Greek first package of Spring 2010 had to be renegotiated in the autumn. Less than a year after the first loan the talk is of much larger sums being lent to Greece to keep her going.
Greece is now in a nasty downward spiral. Its economy is declining, so tax revenues are not improving as needed, whilst social expenditures are going up to pay for all the unemployment.
Meanwhile, the market says Greece needs to pay 15-25pc interest to borrow money, depending on the length of the loan. These rates are penal and mean Greece is, to all intent, no longer able to borrow any more, other than through a special subsidised deal from the EU or IMF. Some say Greece needs to spend more public money – all borrowed – to act as a stimulus. This is absurd. Greece has enjoyed endless public sector stimuli, so called, ending in this debt disaster. You can hardly say spending more has boosted the economy when it has led to such an international collapse of confidence and the end to market borrowing.
Extra public spending paid for by taxes is not stimulatory, as for every amount the state spends the private sector is unable to spend as they have to pay the tax. If the money is borrowed, for every sum the state spends, the private sector can spend less as it has to lend the money.
Research shows that successful recoveries usually come from private sector led growth which requires monetary stimulus, with access to sensible amounts of borrowing by the private sector. Often tax cuts are needed to boost enterprise. Spending more money in the state sector is often accompanied by poor economic performance. Greece and Portugal would recover more quickly if they left the euro, devalued, and then made credit available for private sector led growth. If they stay in the euro, they will have to cut and cut again, to reduce their deficits to an acceptable level. Recovery is made more difficult because the monetary policy of the union and the value of the currency will be set for stronger areas, leaving them squeezed.
If, like Greece, you transfer too many resources from the private sector into a low productivity public sector you get a worse performing economy. Greece either has to earn more or spend less.
John Redwood is a former Conservative cabinet minister and now chairs the investment committee of Evercore Pan-Asset Capital Management