It happens like this. The election result in Greece means pro-austerity parties lack the parliamentary support and the moral authority to govern. Demands from Athens for the tough bailout conditions to be softened are turned down flat by the International Monetary Fund, the European Central Bank and the European Commission.
Political impasse in Greece leads to a second general election being called for next month. Angela Merkel makes it clear the next tranche of cash to keep Greek banks and the Greek state solvent will not be given unless the plan is adhered to in full. The strains on the single currency become intolerable; Greece leaves the euro and defaults, starting the process by which monetary union unravels.
In May 2010, when David Cameron and Nick Clegg were negotiating the terms of their coalition agreement and Greece received its first package of financial support, the idea that Europe was about to be gripped by a crisis that would put monetary union in peril was ridiculed. On Monday, as the euro fell on the foreign exchanges, the Greek stock market plunged and investors piled into the safe haven of German bunds, it no longer seems quite so far-fetched.
The jittery mood in the markets reflects the fear that the turmoil of the past five years – the sub-prime crisis, the near-death experience of the banks, the deepest slump since the Great Depression, the sovereign debt crisis – is about to reach a climax over the coming months with a battle for the euro’s very survival.
For two years, Europe has been force-fed a diet of unrelenting austerity. The crisis began in the private sector – in over-leveraged banks and wild financial speculation – but such was its impact on consumer spending, investment and trade that governments have seen their public finances dive deep into the red. Spending cuts have been imposed, pensions have been made less generous, and taxes have gone up. The policy has been an economic disaster. Growth has collapsed, unemployment has soared and – unsurprisingly – budget deficits have been much bigger than forecast. Election results from France and Greece show that it has also been a political disaster: voters have decisively rejected Euro-sadism and made it clear they want their politicians to chart a different course. Democracy has trumped austerity.
In the fantasy world of policymakers in Brussels, the eurozone would fast-track to full fiscal union, but there is no realistic chance of this happening any time soon. Nor does there seem much prospect of ameliorating austerity with a growth strategy that would give the more vulnerable countries a fighting chance of meeting the currently unrealistic deficit reduction targets.
Hollande may be talking about “a new start” but his slogan finds no real echo in Berlin, where the German government was insisting that the weekend elections change nothing of substance. To be sure, Merkel emphasised the need for growth in her message of congratulation to the new French president but while the rhetoric may change the German policy stance promises to be unflinching.
Greece, according to Merkel, must grind its way through its structural adjustment programme; France must adhere to the fiscal compact thrashed out late last year; there will be no Eurobonds to transfer resources from rich to poor parts of the eurozone, and no extension of the European Central Bank’s remit so that it can emulate the quantitative easing programmes of the Federal Reserve and the Bank of England.
The deep problems of monetary union are encapsulated in this tension. The eurozone is a currency union not a federal state, which means it lacks a single finance minister calling the shots and a centralised budget like that in the US or the UK. Germany is by far the biggest and most powerful nation in the eurozone, and, while committed to keeping the single currency alive, takes a conservative approach to monetary and fiscal policy. Over the past two years, it has been able to impose this approach on Europe’s governments but not on their voters, who have thrown out incumbent governments whenever they have had the opportunity.
Forecasting what is likely to happen in financial markets is a mug’s game, but it’s a fair bet that the next few weeks will not be pretty. Fears that the election of François Hollande as the new French president will lead to a rift between anti-austerity Paris and pro-austerity Berlin is one concern. Yet Hollande’s deficit reduction plan is not significantly different from that proposed by Nicolas Sarkozy, and it is likely that once he gets his feet under the table at the Elysée Palace, Hollande will soft pedal on some of his more controversial policies. While it is still early days, there was no knee-jerk sell off in French bondson Monday, reflecting the feeling that Merkel and Hollande will settle their differences to keep the Berlin-Paris axis strong.
A bigger immediate threat is that a Greek exit from the euro – rated as a 50-75% probability by Citigroup – will have a domino effect on Portugal, Spain and Italy.
Jason Conibear, director of foreign exchange firm Cambridge Mercantile, said the euro was currently as attractive to investors as a toxic derivative during the sub-prime crisis: “There’s every chance the euro will go into freefall in the weeks ahead against all the major currencies. Investors are waking up to the fact that the once-ridiculous notion the euro could collapse is increasingly the most likely outcome.”
On past form, the response of Europe’s policymakers will be to muddle through, to kick the can down the road to play for time. But that is no longer a realistic option.
Europe is heading deeper into a double-dip recession, the banks are on life support, and there is nothing resembling a Plan B as opposition to austerity stiffens. As Tristan Cooper, sovereign debt analyst at Fidelity Worldwide Investments, noted: “The irresistible force of German austerity has clashed with the immovable object of Greek popular resistance.” There is now a stark choice. Unless the terms of Greece’s bailout are made less onerous, it is heading for the euro exit door. The warning signs for the commission, the ECB and the IMF are there: sow the wind and you will reap the whirlwind.