EU fooling itself there's firewall around result of Greece's drama

German Chancellor Angela Merkel. Photo / Getty Images

We know from memoirs and a torrent of leaks that Europe's creditor bloc came frighteningly close to ejecting Greece from the euro in early 2012.

Former US Treasury Secretary Tim Geithner has described the mood at a G7 conclave in Canada vividly. "The Europeans came into that meeting basically saying: 'We're going to teach the Greeks a lesson. They are really terrible. They lied to us, and we're going to crush them'," he said.

"I just made very clear right then: if you want to be tough on them, that's fine, but you have to make sure that you're not going to allow the crisis to spread beyond Greece."

German chancellor Angela Merkel did later retreat but only once it was clear from stress in the bond markets that Italy and Spain would be swept away in the ensuing panic, setting off a crisis across the economic and monetary union (EMU).

The prevailing view in Berlin and even Brussels is that no such risk exists today: Europe has since created a ring of firewalls; debtor states have been knocked into shape by their EMU drill sergeants.

The democratic drama unfolding in Greece this month is a local matter. If Syriza rebels win power on January 25 and repudiate the EU-IMF Troika Memorandum immediately, Greece alone will suffer the consequences.

"I believe monetary union can today handle a Greek exit," said Michael Huther, head of Germany's IW institute. "The knock-on effects would be limited. There's been institutional progress such as the banking union. Europe is far less easily blackmailed than it was three years ago."

This loosely is the "German view", summed up pithily by Berenberg's Holger Schmieding: "We're looking at a Greece problem, the euro crisis is over. I don't expect markets to seriously contest the contagion defences of Europe."

It sounds plausible. Bond yields in Italy, Spain and Portugal touched a record low this week. Yet it rests on the overarching assumption that the Merkel plan of austerity and "internal devaluation" has succeeded. An army of critics retort that the underlying picture is blacker by the day.

Europe's rescue apparatus is not what it seems. The banking union belies its name; it's just a supervision union. Each EMU state bears the burden for rescuing its own lenders. Europe's leaders never delivered on their promise to "break the vicious circle between banks and sovereigns".

The political facts are that the anti-euro Front National leads in France, the neo-Marxist Podemos movement is leading in Spain, and all three opposition parties in Italy are now hostile to monetary union.

The creditor core has destroyed the political unity of EMU by pushing its contractionary agenda too far, and imposing an "asymmetric adjustment" that forces deficit states alone to close the intra-EMU gap rather than surplus states.

"The conflict over austerity is politically explosive as it's becoming a conflict between Germany and Italy," says Joschka Fischer, Germany's former Foreign Minister.

Such political damage would be unforgivable even if EMU crisis strategy were defensible on economic grounds, but it is not. Mass unemployment - 43 per cent for youth in Italy and 54 per cent in Spain - erodes skills. Youth is pure gold for ageing societies. It is being wasted.

Hysteresis effects will reduce the long-term growth rate of these economies, outweighing any of the alleged gains from "reforms", a euphemism for wage cuts.

Spain's car factories may be working day and night again after slashing wages by 27 per cent, exporting vehicles at a record pace, but this is a displacement effect within EMU at the cost of France and Italy. It pushes the currency bloc as a whole further into a deflationary vortex.

The eurozone recovery that was proclaimed a year ago never happened. Barely out of double-dip recession, it is flirting with a third, even as America roars ahead at a growth rate of 5 per cent . "I completely underweighted the possibility they would flail around for three years," said Geithner. Make that five years.

Not only has EMU strategy managed to trump the Great Depression - leaving output below its prior peak six years on - but it has brought about deflation, proving self-defeating even on its minimalist objective of containing debt.

Italy's debt ratio has spiked from 116 per cent to 133 per cent of GDP in three years despite a primary surplus, simply because nominal GDP has failed to keep pace with interest costs. Alarm in Rome is palpable.

The Bank of Italy warns any further drift towards deflation could have "extremely grave consequences".

The underlying debt dynamics of the eurozone are still deteriorating. All that has changed since July 2012 is the European Central Bank (ECB) being allowed to act as a lender of last resort; or, at least, markets believe so.

Whether this belief would survive an expulsion of Greece from the euro is an open question.

As matters stand, the ECB's backstop plan for Italian and Spanish debt cannot legally be activated. The German constitutional court has ruled that it "manifestly violates" the EU treaties and is probably ultra vires, implying that the Bundesbank may not take part.

The case was referred to the European Court as a courtesy. Its adjutant-general will issue an opinion on January 14 but it has no legal standing. The judges won't rule for months. When they do, they cannot safely ignore the prior findings of the irascible German court.

Nor can the ECB safely ignore German objections to quantitative easing, unless it is willing to test the limits of German popular consent for the euro. There is talk of a half-baked compromise where each EMU central bank buys only the bonds of its own country, creating a fresh vicious circle. Such is the determination to avoid any pooling of debt or sharing of risk.

The eurozone is not an inch closer to fiscal union. There is an array of "two-packs" and "six-packs" and other measures to police sinners, capped by a Fiscal Compact of staggering folly, yet nothing has been done to place monetary union on viable foundations.

Should EMU leaders choose to cut off liquidity support for the Greek banking system - forcing a return to the drachma - they might find that their contagion defences are a fiction.

Everyone's tired of Greece's agony. It's precisely when you are most tired that your judgment fails you.