Will the Euro Zone Go Up in Smoke?

Celebrating French President Francois Hollande’s victory earlier this month. Bertrand Guay / AFP-Getty Images

Barring a miracle, Greece is hurtling toward a destination that is not even supposed to exist: bankrupt, and outside the euro zone. And if Greece is kicked out the door, the political as well as economic staying power of other debt-plagued members of the euro zone will be tested hard—possibly to destruction.

Mayday calls are sounding from Athens to Madrid, from Rome and even Amsterdam, with France’s Nicolas Sarkozy the latest of a dozen political leaders to be washed overboard since the euro zone hit rough seas. Europe’s slow-motion crisis has abruptly reached the point where deals cannot be fudged or decisions postponed. The whole business has become exceedingly complicated and technical because Europe’s leaders, since the beginning of the crisis, have taken only incremental steps without considering the big picture. And, further, they have left public opinion out of the equation, seldom if ever explaining what is at stake and how reforms will bring rewards. This has had consequences for political stability that they should have foreseen.

Alexis Tsipras, the young firebrand whose radical left Syriza movement came from nowhere to win second place in Greece’s recent parliamentary elections on a platform of “can’t pay, won’t pay,” has overturned the cart of rotten apples that passes for the Greek political establishment. But that in turn could upset the rest of Europe, particularly if, as looks probable, Syriza comes first in the next round of elections on June 17 and forms a hard-left anti-bailout coalition government. The miracle Tsipras promises is that Greece can tear up the “usurious” March pact that made the European Union–International Monetary Fund €130 billion bailout for Greece, the second in two years, contingent on deep spending cuts and structural reforms—and yet still keep the euro. Accusing German Chancellor Angela Merkel of playing poker with people’s lives, he insists that when push comes to shove, even Berlin will balk at the risks to the very survival of the euro zone if Greece exits. The Greeks have the “ultimate weapon,” he boasts: however devastating the financial chaos might be for them outside the euro, the very prospect of Greece hobbling back to the drachma could engender such a massive loss of confidence throughout the euro zone that it would unravel the single currency.

Tsipras is putting Greece itself at dauntingly big risk. He may conceivably be right that EU governments are bluffing when they insist that nothing in the Greek bailout deal can be renegotiated. Its current terms doom Greece to an ever deeper depression that will leave the wretched country still more deeply mired in debt. And the trumpeted deal is already unraveling on the markets: the new Greek bonds issued after private investors took a 75 percent haircut a mere two months ago are trading at distress levels already, showing 21 percent yields on 10-year debt. Tweaking the bailout terms could postpone the day of a default that seems inevitable, in the hope that by then the rest of the euro zone would be less vulnerable to contamination. In addition, there is the awkward fact that there is no “legal” way to kick Greece out of the euro. Because the euro is, by law, the currency of the EU and membership is theoretically irrevocable, there is no exit clause in the EU treaties.

But tweaking is one thing: Syriza’s demand to cancel the deal outright, halt debt repayments, and reverse pension and salary cuts is another matter altogether. There is already considerable EU exasperation that Greece has loaded pain on private citizens while failing to actually sack a single one of its 790,000 civil servants, a pampered multitude. If the Greeks do elect a Syriza-led government, they may rapidly find out whether a chaotic default, return to the drachma, and devaluation does in fact offer eventual escape from the debt trap they find intolerable. What Tsipras sees as calling Europe’s bluff looks to Greece’s German paymasters like atrocious blackmail.

And that, only a few months ago, would have been that: what Angela Merkel said, went—with Sarkozy’s publicly unflinching if privately somewhat frustrated support. No longer. For two years, Merkel has doggedly kept her hand stuck in the European dyke, proclaiming even as the cracks widened that, provided everyone manned the pumps round the clock, the dam was structurally sound enough to withstand the rising waters. All that was needed was the courage to undertake deep structural reforms, as Germany did in the 1990s. Abruptly, she finds herself swimming for her life. German financial clout is as great as ever, but it risks finding itself back in the position where Charles de Gaulle liked to describe it: that of a doughty German workhorse controlled by a French rider. From many European quarters, but most critically from France and even in Germany itself, Merkel’s tough disciplinary regime for Europe is finding fewer and fewer takers.

Merkel and Sarkozy, or “Merkozy,” were a decidedly odd couple. Sarkozy’s vaunted enthusiasm for reform evaporated as the French economy faltered, while his appetite increased for burden sharing—notably through persuading Germany to sink funds into Eurobonds that effectively would pool euro-zone debt. For Merkel, anything approaching a “transfer union” was—and is—anathema: better a crippling European recession (from which Germany is not suffering) than tying Germany’s currency to the whims of more profligate cultures. But the Merkozy couple was determined never to fall out. By contrast, the joke making the Paris rounds as it became likely that François Hollande would send Sarkozy packing was that a new packaging of the two names would have to be found. The favorite was not Merlande, but the more pungent Merde, which began to hit the fan within hours of the final count.

Hollande has directly challenged Germany’s vision for the euro zone, unblushingly setting up a false dichotomy between “austerity”—for which read, balancing the accounts—and “growth.” His demand to renegotiate and water down Merkel’s cherished fiscal pact, which goes beyond deficit cutting to impose a fiscal straitjacket throughout Europe that would limit spending regardless of economic cycles, may yet be quietly converted into a carefully vague communiqué on the desirability of growth. But the pact’s passage not only in the French but also the Italian Parliament is now in some doubt.

Hollande’s anti-austerity rhetoric has already sparked a war of words across the Rhine. Volker Kauder, the parliamentary leader of the Christian Democrats, observed that “Germany is not here to finance French election promises.” To which Hollande’s spokesman, Benoit Hamon, shot back, “We didn’t have an election to get a European president called Mrs. Merkel who has the power to decide everyone else’s fate.” Welcome to the new Europe—split right at the core.

Hollande’s election without doubt changes the European political equation—perhaps for the better, if he can really pull France out of the economic doldrums while making good on his somewhat implausible pledge to slice €24 billion from spending in time to cut next year’s budget deficit to 3 percent. But his election will certainly be for the worse if it fuels populist protests against unquestionably necessary reforms to labor markets and closed-shop privileges. His campaign alone may have contributed to the anti-bailout vote in Greece.

Merkel’s command of this new equation is diminished. Across Europe, recession is reigniting hostility to Germany. Even at home, her personal popularity endures but her party is in trouble, and its trouncing in North Rhine–Westphalia last week in favor of a Social Democrat who pledged to go easy on the state’s formidable debts has emboldened the Social Democratic Party to demand a German—yes, German—softening of the famous fiscal pact. France has allies as well in the European Commission, not least because Brussels has a big bid in to increase its own notoriously ill-spent budget. José Manuel Barroso, the commission president, expressed himself delighted at “the new momentum that is clearly building in our member states to kick-start the stalled engine of growth.” What both Barroso and Italian Prime Minister Mario Monti mean by reemphasizing growth is investment coupled with deeper structural reform. Hollande, by contrast, plans to boost France’s already massively high state spending, hiring 60,000 extra teachers and subsidizing 150,000 “jobs for the future” on the back of sharply steeper taxes. In his lexicon, “liberalization” is a dirty word.

The deeper the recession bites, the more isolated Merkel will be. Last week’s spring forecast by the European Commission anticipates a 0.3 percent contraction in 2012 in the 17 countries using the euro, and only 1 percent growth next year. The pain in Spain, where half of the under-25 labor force has no job, could rapidly get much worse if the Mariano Rajoy government fails, as it may, to convincingly plug the terrifying bad debt holes in the country’s banks.

The euro, which was supposed to promote greater competitiveness through economic convergence, transparent markets, and political cohesion has instead achieved the remarkable feat of destabilizing each of its members in a different way—and setting them increasingly at loggerheads. Euro-zone countries are caught in a trap: unable to devalue their way out of trouble, or adjust interest rates, they can hold down the cost of borrowing only by convincing markets through spending cuts, tax increases, and reforms that their public finances are coming under control. Yet this becomes self-defeating if markets start believing that, in the process, their gross national product is shrinking and thus so is their ability to pay those same debts.

The urgent challenge for Hollande and Merkel is to marry those tough reforms to economic revival. That will certainly involve European Central Bank interest-rate cuts and an expanded money supply, whatever the risks of inflation. It may yet require more German money, but Hollande is hardly the man best placed to convince Merkel of that. As Mervyn King, governor of the Bank of England, observed last week, “the euro area is tearing itself apart without any obvious solution.” And there is almost nothing Britain, or even America, can do to dilute the toxic impact on the wider global economy.

Rosemary Righter is an associate editor at The Times of London.