It only takes a cursory glance at the global press to see how the recent European elections have been viewed:

I don’t really have to translate der Spiegel to get the message across but it says: Why Greece must now leave the Euro.

Wow. So France elected a “dangerous” Socialist and Greece is going to leave the Euro. Not only that, the markets apparently believe that the sky is falling as well: (links here)

To summarize broadly the narrative that has come out of the press in the past week: European voters have rejected austerity, now the end (of the Euro) is near.

I want to go beyond that narrative though, there’s much more behind this “democracy interferes with a solution to the European crisis” than is being reported.

So lets start with the election of Socialist François Hollande. The Economist is a publication I hold dear most of the time; usually their articles promote a mostly centrist, albeit pro-globalization view. But there are so many problems with the Op-Ed piece on Hollande that I struggle to find merit in any of it. They malign him for not seeking to trim the size of the French state, while admitting that he seeks a balanced budget. And while they say that he “gets one big thing right” with his criticism of German-let austerity they posit that he isn’t doing it for the right reasons, as if intentions make a difference in modern electoral politics. (I’ll go into more detail on the German austerity program but to avoid being redundant here’s a relink a blog I wrote about it earlier). So The Economist was alarmed by the prospect of Hollande winning, what about the markets?

As you can see yields on French 10-year government bonds initially dropped before rising later in the trading week. But even at its current peak French bonds are still more highly valued than they were for most of the end of Nicolas Sarkozy’s term, a less “dangerous” candidate.

But while Hollande’s ascension might have drawn criticism of The Economist, Greece’s electoral result was far less conclusive. While people viewed the Socialists rise with ambivalence, almost everyone has taken the Greek result as a sign of the volatility. From the BBC:

New Democracy was awarded 50 additional seats for coming in first place, but no party won even 20% of the popular vote in this election. It should also be noted that only PASOK and New Democracy supported continuing the bailout-induced austerity program. After four separate attempts to form a coalition, the parties gave up and planned a new election on June 17th. Current polls have the left wing anti-austerity party Syriza coming in first place with 22% of the vote.

While the potential for a Greek government that opposes austerity has rattled the markets, people should be equally concerned over what the response could be from Germany. Angela Merkel telephoned the interim leader of Greece and was reported to have suggested Greece should hold a referendum on its Euro membership, though Germany denies this was proposed. Greece would not be alone in seeing voters reject austerity: Italian local elections also saw supporters of austerity get voted out. And while not facing an election, Spain’s prime minister Mariano Rajoy said that the country would breach the deficit targets imposed by the so-called Fiscal Pact led by Germany.

I’d like to expand the often cited “fiscal pact” for a moment here. The EU treaty now called the fiscal pact was signed at the beginning of March 2011, it stipulates that signing nations must not run a budget deficit of more than 3% of GDP or they will be fined. The fiscal pact has been maligned by many (Joseph Stiglitz even called it a suicide pact) but the treaty was enacted in order to fix a real problem inside the Eurozone.

Unlike the United States, where both our currency (monetary policy) and the national budget (fiscal policy) is set by the federal government, the EU only has direct control over the currency (the Euro). This causes many complications, of these the most well understood has been a competitiveness problem in certain European countries. Countries like Italy and Spain gave up a competitive advantage when they joined the Euro by giving up their cheaper local currencies. A way of offsetting this was to lower the borrowing costs for new members to help eliminate the competitiveness problem without devaluing the Euro currency itself. The problem now is that 10 years after the creation of the Euro, the competitiveness gap still exists.

This is not unique to Europe; in the US we also have a competitiveness gap between US states. Poorer US states like Kentucky, Mississippi, and West Virginia take in much more than they pay into the IRS, while states like California get considerably less back. This translates into long term transfers of wealth from competitive parts of the country to less competitive ones; Europe lacks this redistributive mechanism. At the same time, because the federal government issues bonds on behalf of all 50 states, the fiscal insolvency of one state (say California) is not exposed to the wrath of the markets. In other words, the risk between US states is mutualized by the federal government. Europe currently lacks both of these tools to stymie the crisis.

This brings us back to issue of democracy and the European economic crisis. While some countries have voted in opposition to the austerity drive, German voters have their own reservations on many proposed solutions to the crisis. According to a poll in November 2011, 79% of Germans oppose a European Bond that would combine sovereign debt from Germany with other Euro members. Germans are similarly opposed to any inflation outside of what they view as acceptable. A poll from an insurance company (R+V) asked Germans what their most pressing fear was: last year inflation topped the list with 63% of respondents listing it. These views have been reflected by German policymakers  as Finance Minister Wolfgang Schaeuble denied that Greek bailouts would result in any transfer union in Europe. German opposition to inflationary policy at the ECB has also been pronounced. While some of this stubbornness has changed over time, policymakers still have an obligation to follow the wishes of their citizens or face potential defeat in elections.

Right now the “strategy” to resolve the Eurozone competitiveness problem involves cutting deficits across the EU and relying on “internal devaluation” caused by austerity and falling prices in the most troubled economies (Greece, Ireland, Portugal, Spain, Italy). Unfortunately this process takes a very long time and has put many of the troubled economies into recession. This process is also complicated by German opposition to inflation, as higher inflation in Germany would help make the troubled periphery more competitive.

In the end, the problems affecting the Eurozone will probably require a combination of both austerity measures over time in some countries as well as some form of debt mutualization and fiscal transfers to less competitive countries. This is, of course, just to stymie the medium to long term imbalances facing the Eurozone. In the short term the EU has very dire questions to answer: is the current strategy sustainable, can the Eurozone survive a Greek exit, would it be worth it to tolerate countries rejecting austerity if the alternative was a disorderly departure from the single currency? Above all, can the Euro survive the challenge democracy presents to resolving its many problems?

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