http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/6...

Euroland's revolt has begun. Greece has become the first country on the distressed fringes of Europe's monetary union to defy Brussels and reject the Dark Age leech-cure of wage deflation.

While premier George Papandreou offered pro forma assurances at Friday's EU summit that Greece would not default on its €298bn (£268bn) debt, his words to reporters afterwards had a different flavour.

"Salaried workers will not pay for this situation: we will not proceed with wage freezes or cuts. We did not come to power to tear down the social state," he said.

Were we to believe that a country in the grip anarchist riots and prey to hard-Left unions would risk its democracy to please Brussels?

Mr Papandreou has good reason to throw the gauntlet at Europe's feet. Greece is being told to adopt an IMF-style austerity package, without the devaluation so central to IMF plans. The prescription is ruinous and patently self-defeating. Public debt is already 113pc of GDP. The Commission says it will reach 125pc by late 2010. It may top 140pc by 2012.

If Greece were to impose the draconian pay cuts under way in Ireland (5pc for lower state workers, rising to 20pc for bosses), it would deepen depression and cause tax revenues to collapse further. It is already too late for such crude policies. Greece is past the tipping point of a compound debt spiral.

Ireland may just pull it off. It starts with lower debt. It has flexible labour markets, and has shown a Scandinavian discipline. Mr Papandreou faces circumstances more akin to those of Argentine leaders in 2001, when they tried to cut wages in the mistaken belief that ditching the dollar-peg would prove calamitous. Buenos Aires erupted in riots. The police lost control, killing 27 people. President De la Rua was rescued from the Casa Rosada by an air force helicopter. The peg collapsed, setting in train the biggest sovereign default in history.

Economists waited for the sky to fall. It refused to do so. Argentina achieved Chinese growth for half a decade: 8.8pc in 2003, 9pc in 2004, 9.2pc in 2005, 8.5pc in 2006, and 8.7pc in 2007.

London bankers were soon lining up to lend money (our pension funds?) to the Argentine state – despite the 70pc haircut suffered by earlier creditors.

In theory, Greece could do the same: restore its currency, devalue, pass a law switching internal euro debt into drachmas, and "restructure" foreign contracts. This is the "kitchen-sink" option. Such action would allow Greece to break out of its death loop.

Bondholders would scream, but then they should have delved deeper into the inner workings of EMU. RBS said the UK and Ireland have most exposure, with 23pc of Greek debt between them (mostly for global clients). The French hold 11pc, Italians 6pc.

Remember, Athens holds the whip hand over Brussels, not the other way round. Greek exit from EMU would be dangerous. Quite apart from the instant contagion effects across Club Med and Eastern Europe, it would puncture the aura of manifest destiny that has driven EU integration for half a century.

I don't wish to suggest that Mr Papandreou – an EU insider – is thinking in quite such terms. Full membership of the EU system is imperative for a country dangling off the bottom of Balkans, all too close to its Seljuk nemesis. But Mr Papandreou cannot comply with the EU's deflation diktat.

No doubt, EU institutions will rustle up a rescue. RBS says action by the European Central Bank may be "days away". While the ECB may not bail out states, it may buy Greek bonds in the open market. EU states may club together to keep Greece afloat with loans for a while. That solves nothing. It increases Greece's debt, drawing out the agony. What Greece needs – unless it leaves EMU – is a permanent subsidy from the North. Spain and Portugal will need help too.

The danger point for Greece will come when the Pfennig drops in Berlin that EMU divergence between North and South
has widened to such a point that the system will break up unless: either Germany tolerates inflation of 4pc or 5pc to prevent Club Med tipping into debt deflation; or it pays welfare transfers to the South (not loans) equal to East German subsidies after reunification.

Before we blame Greece for making a hash of the euro, let us not forget how we got here. EMU lured Club Med into a trap. Interest rates were too low for Greece, Portugal, Spain, and Ireland, causing them all to be engulfed in a destructive property and wage boom.

The ECB was complicit. It breached its inflation and M3 money target repeatedly in order to nurse Germany through slump. ECB rates were 2pc until December 2005. This was poison for overheating Southern states.

The deeper truth that few in Euroland are willing to discuss is that EMU is inherently dysfunctional – for Greece, for Germany, for everybody.