The Coming Eurozone Austerity Battle

Recent elections in France and Greece pose significant challenges to the strict economic austerity policies Germany has called for in response to the eurozone sovereign debt crisis. Still, Germany has resolutely rebuffed any efforts to alter the European fiscal compact agreed to late last year, explains CFR’s Sebastian Mallaby. "There’s a battle coming up between Hollande and his European partners as to quite what a growth agenda might mean," he says. At the same time, the political situation in Greece is "more potentially cataclysmic in its consequences," Mallaby argues, because it could not only signal a Greek exit from the eurozone, but also undermine European financial institutions and facilitate further sovereign debt contagion.

Voters in Greece rejected the country’s mainstream political parties, and, by extension, the latest EU-IMF bailout. In France, voters elected François Hollande to implement pro-growth policies in a worsening economic climate. What are the implications of these recent elections on EU efforts to resolve the eurozone debt crisis?

In the case of France, what François Hollande has done by defeating [current President Nicolas] Sarkozy is basically to put on the agenda a "growth pact." The question is how to define that rebalancing of European policies away from the austerity formula that has driven it so far. The problem is that there are three competing definitions of what Hollande’s growth agenda might mean for Europe. There’s a kind of [ECB President] Mario Draghi version of this, which is that the growth pact should involve the kinds of structural reforms for the labor market and so forth that have already been put in place in Italy and Spain. The problem with that is that although it drives better growth in the longer term, in the short term, labor market reform means firms can fire people more easily, and those structural reforms actually will drive a reduction in employment and demand in the short term and make recession worse. There is a different version of what a growth pact might mean and one that François Hollande is more keen on, and that is ideally to relax the austerity pact--the fiscal responsibility pact, as [German] Chancellor [Angela] Merkel called it. But Germany has rejected that option. So there’s a battle coming up between Hollande and his European partners as to quite what a growth agenda might mean.

The Greek election is much more potentially cataclysmic in its consequences, because what Greek voters did on the weekend was to reject the two political parties that have provided stability for Greece for the past two generations: the sort of center left [Socialist Pasok party] and center right [New Democracy party], which were the two parties that supported working with the European Union partners and with the IMF to reform the budget, reform the economy, and try to gradually work Greece’s way out of the debt crisis. Those two parties between them got just under one-third of the vote. It was a really dramatic rejection of the policy of working with the outside partners and tolerating austerity.

Meanwhile, the extremes from the left and the right got two-thirds of the vote, and in particular, the new rising leftist [Syriza] party headed by Alexis Tsipras. He is very blunt in saying that the result of the election means that budget cuts are now politically illegitimate because they’ve been rejected by the polls. The problem is, Greece has a big deficit, and if it won’t try to deliver on the cuts that it’s promised to the outside funders--the European partners and the IMF--those partners will turn the taps off in terms of the aid promised two months ago. And if that were to happen, Greece [could] start printing its own money--IOUs--which would circulate in parallel with the euro. Most people would see that as a first step toward the fall of the euro in Greece, and it would trigger a collapse in the business framework to transact with any Greek company, and essentially drag the economy into a death spiral. We’re on a real collision course.

What steps can the EU take to prepare for a Greek exit from the eurozone?

The good news is that they’ve already restructured--basically a controlled default--on privately held government debt, so there isn’t going to be much of a shock to private holders of Greek sovereign debt because they’ve already taken the hit. That takes off the table one form of contagion out of Greece and into the rest of Europe. The problem is that there are other channels of contagion that still exist. One is that private Greek companies have borrowed from other European lenders, including from French banks--such that if private Greek companies stop paying back, maybe because the country’s left the euro or it’s gone into an even worse recession than it’s in already, the hit to French bank capital would be very significant, and the French government would have to recapitalize French banks. That could drive the French debt-to-GDP ratio toward the sort of really bad levels faced by Italy.

So that’s one channel of contagion, and the other one is psychological: If Greece really gets into terrible trouble and Greek creditors in Greek banks realize that they have these euros that they’ve saved up and they’ve put in a Greek bank, that could be actually changed into some revived drachma, I think the effect on Portuguese savers who have their money in Portuguese banks, or on Spanish savers who have their money in Spanish banks, could be quite bad--and you might start to see a bank run developing across peripheral Europe.

To come back to France, what are the kinds of growth measures endorsed by Hollande that Germany might be willing to accept?

The most obvious compromise is to accept a beefing-up of infrastructure investment, channeled through the European Investment Bank, and possibly through other European Commission funding. That would allow Hollande to go back to his electorate and say, "I promised you that we would do something on the growth side, and now we’ve done it." In numbers, its actual quantitative effect on the contraction that’s happening in the economy of all the debt-stricken countries is not going to be enough to turn it around.

So austerity is likely to continue to be the main European policy response?

Well, I think to get out of austerity, you either have to relax or set aside the recently agreed European fiscal pact, and that is something that Chancellor Merkel has rejected. In other words, getting to a relaxation of austerity would be to partially neutralize government debt in Europe--and there’s always proposals on the table to have a European-wide sovereign bond, which would give Spain and Italy the ability to borrow money while piggybacking off the credit rating of the whole eurozone. That could reduce the cost of funding and therefore to take some pressure off the budget.

But is Merkel also unlikely to accept a eurobond?

That’s certainly the position now. The big judgment at the back of all these discussions of Europe is whether one thinks the grim dynamics of debt and deflation are going to win, or if they will ultimately be trumped by the political forces, the weight of blood and history. If one accepts that the central achievement of German leaders since 1945 has been a) to reunify Germany, and b) to place Germany in the context of a union of peaceful democracies, it takes a lot for [Merkel] to want to be the chancellor who undid sixty years of integration.

The German economic miracle has been based on export performance, which in turn was based on an undervalued euro relative to how competitive German companies are. You’d quickly lose that export-driven German economic miracle if you had the deutschmark, because the deutschmark would appreciate just like the Swiss franc has appreciated--choke off that engine of growth. Germany has both self-interested economic reasons as well as grand, historical, German-destiny reasons to try to get itself out of this box: that you have to have austerity and everybody has to do labor market reform. The experience of the last year or so is that when you really get to the cliff, the Germans do not want to jump off. That’s the drama we’re watching: will they in the end jump off or allow others to jump off? I give it slightly higher odds that Germany’s perception of its own self-interest is ultimately to put eurozone cohesion above a stated commitment to not having the eurobonds, sticking with austerity, and so on.

Lastly, what are some of the parallels between what’s happening in Europe and the U.S. economic situation? How does the U.S. fit into this debate over austerity versus growth?

It’s a comparison that is often made, but rather glibly. The U.S. federal debt-to-GDP ratio is rising and uncomfortably high--around 73 percent right now--but it’s not like Italy, which is around 100 [percent], and Greece, which is above that. Nor is the [United States] as uncompetitive as some of these peripheral European economies. Most crucially of all, the U.S. has its own central bank and a flexible currency, and that makes the U.S. position so very different to that of any of these crisis-afflicted economies. When you’ve got your own currency and it can drift downward, that can be a way of correcting a problem with your competitiveness and boosting growth through exports. Ultimately, if you have your own central bank, you will monetize your debt; in other words, you will print money to fuel your deficit before you’ll default. The U.S. has serious budget challenges, which it will have to grapple with after the election at the end of the year, because that’s when the Bush tax cuts are due to expire; that’s when we hit the debt ceiling again; that’s when the automatic spending cuts agreed to last year in the sequester kick in. And there will be some fascinating brinkmanship around that. But it really ain’t Europe.