Europe’s economic struggles are a consistent drag on American growth. A eurozone breakup, in chaos and acrimony, could be a Lehman-like shock of incalculable damage.
For years, the stronger European economies have managed to bump along from challenge to challenge — providing bailouts to the improvident in exchange for fiscal restraint and reform, while reassuring credit markets in an elaborate confidence game. But the fundamental problem has never been resolved. Europe is a monetary union without being a fiscal union. Germany has become the continent’s rich uncle, vouching for the credit and covering the debts of distant relations without authority over their spending habits.
German patience with this arrangement is now being tested by Greece. It would be possible for Europe to maintain Greece — just 2 percent of the continent’s economy — as a permanent dependent. Greece could default within the euro zone and have much of its debt written off.
But Greece is a living, breathing moral hazard. What message would it send to Italy, Spain, Ireland and Portugal — all undertaking difficult austerity programs — if the European Union provided special treatment to its least trustworthy member? Many Germans believe that Greece entered the E.U. in the first place on the basis of false economic figures. Should German taxpayers now assume permanent responsibility for a political system apparently incapable of responsibility? The birthplace of democracy seems to lack a working one.
So Europe seems to be preparing for the departure of Greece from the euro — kicking the dependent out of the house to live on his own. For many months, German and French banks have been quietly offloading Greek liabilities. European finance ministries are beginning to plan for an event with no legal precedent or procedure.
The Greek return to a devalued drachma would probably not be disastrous (except for the Greeks), so long as the damage is containable. Credit markets — having tested Greek political will and found it wanting — would press Portugal, Italy and Spain. Any sign of weakness would push their borrowing costs to astronomical, unsustainable levels. The trick will be for the E.U. to construct a firewall of long-term confidence — a reasonable conviction among investors that other economies are on a responsible, sustainable path.
This task is complicated. Portugal, Italy and Spain are making tough, painful fiscal reforms and reducing their structural deficits. They gain part of their national identity from responsible membership in the European project and don’t want to be relegated to the category of Greece. But their governments may be facing a decade of depressing, unrewarded austerity. Eventually, markets don’t judge intentions but likely political outcomes. Will the political systems of vulnerable European nations be able to maintain responsible fiscal policies through a long slog without disruptive political backlash? Austerity may be necessary — but is it politically sustainable?
Probably not without help. As they engage in rigorous structural reforms, Italy, Spain and others are looking for greater transfers at Europe’s federal level to cushion their austerity. They seek, in essence, a deal: In exchange for surrendering a portion of their fiscal sovereignty, they want Germany to put up more money for expansionary investment. Germany already does some transfers through the European Financial Stability Facility and other outlets. But it has resisted the issuing of euro bonds by the European Central Bank. There are a variety of proposals on the table to help diminish that opposition.
So the survival of the euro is possible, but it requires the working of an immensely complicated machine. The jamming of any gear could immobilize it. Will German voters continue to accept the role of easing austerity in other countries? Recent electoral reverses must worry German Chancellor Angela Merkel. Will the new French president, Francois Hollande, mix his own country’s message of responsibility? Will street unrest in vulnerable countries — or future electoral victories by anti-austerity parties — derail reform?
Europe’s economic future does not only depend on objective economic conditions, such as the number of BMWs and Fiats produced and sold. It depends on the confidence of markets in the future political choices of politicians and voters. Europe has managed to muddle along from crisis to crisis. But the probability of managing all these sequential crises adequately is diminishing.
For those inclined to pity the Europeans, it is worth recalling that the U.S. fiscal reckoning is delayed but not dissimilar. Economics is eventually politics — and our politics is hardly a model.