Elections Clear Path for Euro Zone Break-Up

Member states within the euro zone cannot run independent monetary policy. They cannot depreciate a national currency. They cannot depend on a central bank backstop. Nor can they run sufficiently countercyclical fiscal policy to deal with a large downturn. These are the policy tools that euro zone members have given up to benefit from the single currency due to a perceived free rider problem when the Maastricht Treaty was formulated. Without some kind of a countervailing supranational fiscal agent or sovereign risk pooling, this arrangement invariably means some sort of crisis will arise when the unharmonised economies of the euro zone result in large enough current account imbalances. Put simply, the euro zone is made for crisis. It is designed to fail.

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Europe Edges Closer to the Endgame
By Edward Harrison

Harrison has been spot on with his outlook for Europe over the past couple years. Considering elections from this past weekend, he poses two questions:

1. Do these election results change the commitment to membership in the euro? If so, by whom and of whom?
2. Do these election results change the commitment to the institutional framework and the specific economic policy guidelines used to support the euro? If so, by whom?

Harrison answered no and yes, respectively, although his explanations are less definitive. With the risk of going against a proven expert, I think the answers are actually yes and no.

The election results in Greece have changed their commitment to membership in the Euro. Trying to put together a coalition government is proving nearly impossible and another election will likely take place in mid-June. Before then Greece will have to decide on whether or not to make interest payments on outstanding bonds and may find itself short on payroll funding if the next bailout tranche is not released. Considering that a majority of the elected parties are anti-bailout, the odds of these issues being resolved smoothly appears slim. Greek voters have finally endured enough pain that previously radical parties are garnering significant support. It’s hard to foresee Greece remaining in the Euro for too much longer.  

France has not changed its commitment to membership in the Euro and despite all of the “pro-growth” talk, I don’t think the commitment to the institutional framework will shift much either. As I showed in The Austerity Experiment Failed Without Really Starting, France has actually increased government spending by several percent in the past few years. Deficit reduction in France in 2011 was largely due to a sizable increase in tax revenues. Francois Hollande has already outlined his plans to raise taxes on the wealthy, while maintaining a goal of balancing the budget in 2017. With these goals in mind, I think France will maintain its current spending path and continue to work at lowering the deficit from the revenue side. As for holding public debt below 60% of GDP, in my opinion that remains a talking point on which no country actively worries about compliance. Overall the rhetoric and specific economic policies will probably change to some degree but the aggregate effect of these changes on planned budget deficits and public debt will be minimal.  

These election results have already spooked financial markets, sending yields on PIIGS sovereign debt higher again. Although hope remains that the ECB will enact another round of LTRO, Spanish banks may no longer hold any eligible collateral for the program. As countries continue to reduce exposure across borders, the potential for exit grows. Aside from a massive transfer in funds from northern Europe (primarily Germany) to the PIIGS (primarily Spain), the underlying economic problems will continue to worsen. The road may still be long but the path towards a break-up is looking clearer.