Greece and the Last Gasp of European Fiscal Sanity

Beleaguered country on its way out of the euro-zone?

[](/sites/default/files/uploads/2012/05/EUROPE-articleLarge.gif)Voters across Europe have spoken in the last week and the message they have sent has upended the fragile consensus that budget cuts and fiscal discipline would bring the continent back from the brink of debt Armageddon.

In national elections in Greece and France, as well as local elections in Germany and Italy, voters turned out governments that backed so-called “austerity” programs that would have brought a measure of sanity back to budgeting and debt management, while electing socialist politicians who promised that economic problems could be solved by implementing “growth” policies – policies that include massive new spending, tax increases on the “rich,” and a rollback of budget cuts.

Greece appears to be a nation in full denial, rejecting the coalition that negotiated a bailout package worth 180 billion euros that would have kept the nation in the euro zone, and embracing a radical socialist party that wants to scuttle the deal. French voters had other problems with former President Nicholas Sarkozy, but it was primarily his tepid attempts to reform labor laws and the education system that led to his downfall in the May 6 election.

President-elect Francois Hollande has promised to restore what Sarkozy cut, while making it clear that he wants to “renegotiate” the carefully crafted “fiscal compact” that sets budget and deficit guidelines for the entire euro zone. The compact was the work of German Chancellor Angela Merkel and Sarkozy – “Merkozy” as the duo was referred to in the European press. The defeat of Sarkozy calls into question the France-Germany relationship, which is largely responsible for keeping the EU from disintegrating in these last two years of crisis, as the leaders of the two largest economies in Europe successfully navigated the panics that almost tore the euro zone apart.

In Spain, where one in four workers are unemployed, the government has come under massive pressure from the left to change course from the painful medicine of cutting services and firing government employees and embrace massive increases in spending. Prime Minister Mariano Rajoy is determined to stick with his budget cutting and deficit reduction. Madrid announced this weekend that it may take over the finances of an entire region because the local government may not be able to meet his deficit targets. He has also vowed to clean up Spain’s tottering banking sector, taking over Bankia, the country’s largest mortgage lender, just this week.

But for all of Rajoy’s cutting, it is likely he will not meet his deficit target for the year. Instead of a projected deficit of 5.3% of GDP, Spain is likely to see a 6.4% shortfall. This is down from 8.3% last year, but is not likely to appease investors in Spanish debt who will demand a premium that may lead to even more financing problems for the country. Ten year notes ballooned to over 6% this past week – an unsustainable level that would set off a ruinous debt spiral of increased deficits due to costlier debt servicing, which would panic investors even more, leading to higher interest rates on bonds to finance the debt.

Spain’s economy is expected to contract almost 2% this year, with anemic growth projected for 2013. With budget cuts just beginning to bite and no growth in sight to bring the unemployment rate down significantly, the future is not bright for Rajoy’s efforts. Hundreds of thousands took to the streets on Saturday in Spain’s major cities to protest against Rajoy’s efforts to bring Spain’s fiscal crisis under control. It is doubtful, given what we’ve seen across Europe this past week, whether he can hold together the consensus to continue his austerity program.

Spain may flirt with disaster in the coming months, but the spotlight this past week was on France, and especially Greece, where national elections have unleashed the socialist left and promise to bring the euro zone back into a full fledged crisis sooner rather than later.

The election of Francois Hollande in France – the first socialist to win the presidency since Mitterand 16 years ago – has had the immediate effect of breaking the alliance between Merkel and Sarkozy that proved to be the linchpin that held the EU together during the worst of the sovereign debt crisis. Their partnership produced several measures that will allow the European Central Bank more leeway in dealing with future crisis while their collaboration on the EU fiscal compact has tied the economies of the EU together in a way never before attempted.

Hollande will travel to Berlin for a meet and greet with Merkel after he is sworn in later this week. His election means that France will perform an about-face on attempting to bring the budget under control and reverse Sarkozy’s labor law reform, making it once again virtually impossible to fire anyone. Hollande has promised to pay for any new spending he proposes, but he plans to do it by eliminating tax breaks for business and raising taxes on “the rich.” He plans a “75% tax rate on income above 1 million euros a year and a 45 percent upper tax rate for those earning over 150,000 euros. He would limit executive pay at state-owned companies to 20 times the lowest wage, cut the presidential salary by 30 percent and index the country’s minimum wage to economic growth.”

His plans call for 20 billion euros in new spending over five years, and he wants to “hire 60,000 more educators over his term and 1,000 police a year, and create 150,000 state-aided jobs to tackle youth unemployment.” He says his tax hikes will bring in an extra 29 billion euros while limiting the growth of government spending to 1.1% a year.

And the French voters bought it all. Unfortunately for Hollande, wealthy Frenchmen are already making plans to leave the country and avoid the socialist penalty for being successful.

It is Hollande’s demand that the EU fiscal compact be “renegotiated” where he will clash with Merkel. He wants to include provisions for “jobs and growth” in the compact, which sets strict guidelines for the budgets of member states, as well as deficit targets that must be met. Merkel has already said she has no intention of reopening negotiations on the pact, and their meeting this week will no doubt be much frostier than her consultations with Sarkozy.

Given the near certainty that Greece will exit the euro zone in the coming months, can the two leaders cooperate in inoculating the rest of Europe from the contagion of a Greek default? Thankfully, Merkozy worked to strengthen the European Central bank against such an eventuality by creating a 700 billion euro emergency fund to shore up shaky banks and loosening restrictions on the ECB’s ability to buy government bonds. These measures should see the EU through a Greek default, but it is an open question whether further erosion in Spain or France can be so easily dealt with.

Meanwhile, Greece is in chaos. The radical socialist Alexis Tsipras, whose SYRIZA party finished a surprising second in the May 6 elections, has forcefully declined to participate in a coalition government with the traditional socialist party PASOK and the New Democracy party who negotiated the bailout deal with the EU and IMF last March. Tsipras campaigned on an anti-austerity, anti-bailout platform, referring to the painstakingly negotiated agreement with the EU, IMF, and ECB (the “troika”) as “blackmail.” He rejects the idea that Greece will exit the euro, believing that the troika is bluffing when they say there will be no bailout if Greece rejects the deficit targets and budget cuts to which the previous government agreed.

Tsipras’ obstinacy has led to a crisis as there is no way a governing coalition can be formed. Together, PASOK and New Democracy won only 40% of the seats in parliament. Most of the smaller parties also ran on an anti-bailout, anti-austerity platform and appear unwilling to join the mainstream parties in walking the plank to save Greece from default.

Greek President Karolos Papoulias has called for a meeting on Monday of the top three parties but Tsipras has already rejected the idea saying, “They’re asking for accomplices to austerity. We can’t take part in this crime.”

Tsipras has good reason to torpedo the talks. Polls show SYRIZA is likely to win an outright majority if negotiations fail and new elections are called for next month. But Tsipras may have overplayed his hand. His suggestion that the private bank accounts of Greek citizens should be used to support the Greek economy, as well as his total disregard for the possibility of default might scare enough voters that they would return to their traditional loyalties, voting for PASOK and New Democracy next month.

Although the EU has been planning for a default by Greece, the shock of a member state leaving the euro zone will probably not help shaky banks, or government bond sales going forward. And the complex nature of Greece returning to the drachma as currency has many unknowns to which the EU will have to cope.

But if Greek voters prefer default and even more chaos to an austerity program with at least the promise of emerging from economic stagnation some day, they may give Tsipras what he wants – a majority of radical socialists for a government and economic pain that will make austerity look good by comparison.

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