No incentive to be good in eurozone

The most urgent challenge for the European Union is the plight of its new member states in central and eastern Europe hit hardest by the economic crisis. Outside the safety net of the eurozone, several have faced the full force of speculation against their frail currencies. Hungary, Latvia and Romania had no choice but to run for emergency loans from the International Monetary Fund and Brussels institutions.

But what of those inside the eurozone that have got into fiscal disarray? For them, a bail-out is not an option: it is specifically banned by the treaty that set up the euro. In theory, at least, they are on their own.

They may have the protection of the single currency, but they have to pay a price for it: they cannot use devaluation as a cushion, as the UK has done by allowing sterling to slump by 30 per cent. They only have the tools of painful deflation to get their internal and external accounts in order.

Greece and Ireland are the two countries most exposed. Both are peripheral economies in the eurozone, facing the full force of the recession. Both have yawning trade and budget deficits. Both have to pay much the same penalty for borrowing in international bond markets, nearly 3 percentage points above the cost of German bunds.

Yet there the similarities end.

One country – Greece – is in virtual denial that it has any problem. The government has introduced a couple of temporary measures to reduce its deficit, including a one-year public sector pay freeze.

It blames the markets for exaggerating its difficulties. It has done nothing to tackle a chronic problem of tax evasion.

Ireland, on the other hand, admits the economy has "fallen off a cliff", in the words of Brian Lenihan, the finance minister.

He is set to introduce an emergency budget on April 7 to reduce the deficit by €4.5bn ($6.1bn, £4.2bn), on top of €2bn already cut in January. That is about 2 per cent of gross domestic product, and it will surely hurt.

The contrasting reactions show just how little fiscal co-ordination there is inside the eurozone, and how much there needs to be.

Take Greece. In a land where mythology has a special magic, a new myth has been born: that the flourishing black market, estimated at 30 per cent of GDP, will somehow protect the economy from the full force of the crisis.

It is true that a black market underestimates real incomes, and may provide loans through informal channels, helping borrowers escape the credit crunch.

In Greece, the use of post-dated cheques is an important part of the underground economy.

But the credit crunch is not Greece's main problem. The real reason for the high cost of borrowing is the failure of successive governments to reform the public sector and its finances.

Government debt is almost 100 per cent of GDP, and the budget deficit has not sunk below the 3 per cent ceiling required of eurozone members since Greece joined the single currency.

Failure to curb tax evasion, and the corruption which allows it, is a direct cause of the budget deficit. Far from being an economic saviour, the black market is its bane.

Ireland's plight is very different. It has one of the lowest national debts in Europe – down to 30 per cent of GDP in 2007, and lower still if you take the national pension reserve fund into account.

But the bursting of Ireland's property bubble – a direct consequence of excess credit pumped out by the banks – has caused a collapse in tax revenues. The budget has gone from a balance in 2007, to a deficit of 8 per cent of GDP last year, and a forecast 12 per cent in 2009, before Mr Lenihan wields his axe in April.

Tax revenues fell faster than GDP because the government had used the one-off surge in stamp duty on property sales to cut income taxes before the last election.

Revenues from property sales have vanished, but the income tax cut remains.

The problem has been compounded by the devaluation of sterling. It has not only undermined exports, but caused a surge of cross-border shopping in Northern Ireland, and a consequent drop of value added tax receipts.

Dublin has decided to take a painful cure. In Athens, they have opted for inaction. Both pay the same penalty in the bond market. So why bother to be good?