One of the more interesting 'fights' going on in the euro zone is that between what is economically 'required' and the invariably messy outcome of politics. Mind you, this isn't something exclusive to the euro zone but happens almost anywhere. Few countries are ruled by 'economist-King's.' and even the latter are not infallible.
But in the euro zone, additional levels of political complexity are added by the super-national level.
The euro was created on economically rather dubious grounds. While there are certain economic advantages (it can be seen as a natural conclusion of the Single Market, the elimination of currency crisis, the creation of euro zone wide price transparency and the elimination of cross-border transaction cost), the risks have always been known as well.
These are that the euro zone isn't likely to constitute an 'optimum currency area.' There isn't a central budget that automatically redistributes from the boom to the bust areas like the Federal budget does in the US. There isn't the required level of labor mobility (allowing people to move from high unemployment areas to low unemployment areas) and wages and prices are insufficiently flexible (especially downwards).
There is a one size fits nobody monetary policy, and countries have given up control over their interest and exchange rates, both important adjustment mechanisms in the face of economic shocks (especially if these shocks are 'asymmetrical,' that is, the incidence of these shocks impacts different areas quite differently, requiring adjustment).
What's more, the euro has unleashed perverse capital flows that were first seen as benign. Capital flew from the center to the periphery and this was deemed to lead to convergence, that is, reduce the levels of income and wealth in the euro zone. This indeed happened until the financial crisis, but it wasn't the benign development many thought it was, quite the contrary.
The capital inflows in the periphery created credit and housing bubbles (Spain, Ireland) and put countries to sleep with regard to any necessary adjustment in their public finances and/or trade balance (Greece, Portugal, Italy) as they could suddenly borrow at much lower interest rates as a result of their euro membership.
But this was only temporary. The capital flows first came to a halt and have now reversed, ravaging the euro zone periphery. The point is, if you have your money in a Spanish or Portuguese bank as a deposit (or bond), or sovereign bond, you can considerably reduce your risk by moving your money to a German bank and/or sovereign without incurring any exchange rate risk or cost.
And this is happening on a sufficient enough scale to create the all to real possibility of a self-fulfilling prophesy. This is why, despite a very expansionary monetary stance of the ECB, the money supply is actually contracting in much of the periphery and there is a credit crunch going on there, and investors (but for their national banks) run away from their sovereign bonds.
Clearly this economic rationale is now so perverse that nobody in his right mind would propose a common currency if it wasn't there already, at least not one with the flawed design mechanics of the present one. But we're stuck with it because unwinding the present arrangement is too costly and risky.
But the euro was always more of a political project. Most of the political rationale lies in a political trade-off between the German and French elite. Germany, fresh from German reunification, wanted to anchor itself firmer within Europe, and the French were tired of the Bundesbank dictating their every monetary move.
In fact, even those who were aware of the economic shortcomings of the euro (that are now too painful to watch) argued at the time that introducing the euro anyway would be a great lever to remedy them, using the euro as a force for additional economic and political integration.
How has that played out? Well, economically the Germans are the undisputed winners of the euro, although it remains to be seen whether that can last. They saw their competitiveness shoot up vis-a-vis other euro area members when the latter got all those capital inflows and got lax on the reform side.
The French, however are still under diktats from Frankfurt and Berlin, not to mention the Italians. The latter were on the French side at the outset of the euro, trying to achieve more monetary independence.
But now one could say that Frankfurt has even been instrumental in the overthrow of an Italian government and something of a policy dictate. From a democratic point of view, this is extremely awkward, even if it's easy to make a convincing case that the Monti government is an order of magnitude better than the previous one.
Change is in the air
While the whole euro project has been seen as something of the europhile elites, now that it is (rightly) associated with unmitigated disaster there is a considerable backlash growing. Merkel (echoing Helmut Kohl) has warned that without European integration, peace and stability cannot be guaranteed.
But too much integration (especially with a half baked design like the euro) could very well be instrumental in producing centrifugal forces, rather than cementing peace and stability in Europe. While we're not anywhere near what happened to Yugoslavia (an artificially amalgam of different peoples under central authority), centrifugal forces are clearly becoming visible.
With governments in Italy and Greece overturned, the one in the Netherlands fallen on an austerity package, and elections in Greece and France this weekend, there are signs that the electorate is turning away from the German austerity dictate. In a way this is helpful, as too much emphasis on austerity has undermined economic growth and has a dubious effect on achieving sustainability of public finances.
There seems to be quite a revolt from diverse electorates and politicians against the German austerity diktat, but to what this amounts remains very much to be seen. Even ECB president Mario Draghi called for a 'growth compact,' but too much can be read into that:
"We've had a fiscal compact," he said. "What is most present in my mind now is to have a growth compact. I think that's what we have to have." He didn't elaborate. [Bloomberg]
It doesn't look like he wants countries to abandon their austerity drive just yet, so the best interpretation is probably something along the lines of structural reforms that improve the supply side of economies, which would be welcome but in the short-term, no miracles can be expected of these.
We would be quite surprised if he supports Hollande's (the French presidential candidate most likely to win next week's election) call for a renegotiation of the 'fiscal compact,' that limits country's structural budget deficit to 1% of GDP. Merkel has already ruled that out, but a classic EU 'fudge' might very well happen in which reality on the ground doesn't quite reflect the letter of the treaty, and these targets will be treated as 'soft'. This won't be a surprise at all, after all, the Stability Pact was also fudged with Germany as its first violator.
While one could argue that elections in Spain and Portugal were still clearly providing a mandate for austerity, the mood seems to be definitely swinging as austerity has only added to the economic misery and electorates are growing tired of it. If Hollande gets elected in France, it will be to a considerable extent on an anti-austerity ticket and a similar development is possible in Greece.
In the Netherlands, which is also experiencing a recession (largely the result of a soft housing market) the Government fell on a proposed austerity package when the populist Freedom Party of Geert Wilders didn't want to sign up to "dictates from Brussels."
In Brussels itself, the European Commission has grabbed the initiative and proposed a rather whopping 7% increase of the EU budget, but this is a very hard sell as countries embarking on austerity at home in the name of the Stability Pact or the 'Fiscal Compact' to avoid sanctions from Brussels are not likely to embrace increased spending from Brussels.
The IMF was (apart from private economists like Krugman) one of the first to warn that countries can overdo it on the austerity front. The combination of deep cuts into public spending, big tax hikes, and no offsetting monetary stimulus or depreciation of the currency in economies already in deep recession is likely to lead economies into more trouble.
But before the anti-austerity camp starts celebrating, remember that the margins are very small and even politically not everything is what it seems. Monti was installed as Italian PM under heavy pressure from Frankfurt, Brussels and Berlin. He subsequently embarked on a big austerity project and his popularity shot up to stratospheric heights, only for it to come down to earth when he embarked on structural reforms, the type of what a 'growth compact' would consists off, labor market reforms, increasing the pension age, liberating markets, etc..
The Spanish and Portuguese governments were elected on an austerity platform, and while the Dutch government fell on a proposed austerity package, the two parties that made up the government quickly cobbled a classic Dutch compromise with some opposition parties in record time. The one socialist opposition party that didn't vote in favor of this lost 5 seats in the polls.
So whether the revolt against austerity has legs remains very much to be seen and the margins are very small anyway. With the periphery bleeding capital and their banks being about the only buyers of their own sovereign debt anything can trigger a sovereign debt crisis in a moment.
Christina Romer has it about right, we feel. Under normal circumstances, if countries had their own currency, the situation would be difficult but by no means as dire as it is today. But given the circumstance where they effectively borrow in a foreign currency, are plagued by capital outflows and their own banks being the buyers of last resort of their debt, the peripheral public finances are in a bind and there isn't much room for any additional spending.
The most what they could do is what Romer suggested, that is, backloading the austerity measures:
to pass the needed budget measures now, but to phase in the actual tax increases and spending cuts only gradually [Christina Romer, see previous link]
She goes on to describe a few historical examples of backloading, like the US social security reform in 1983, or Sweden's budget reforms in 1995.
If this would be accompanied by a more expansionary stance of the ECB (we have long argued that the only area in the world where QE would make a real difference is in the euro area, as it could prevent the perverse capital flows from the periphery to the center if the ECB would function as lender of last resort and back the peripheral debt).
But this is probably too much to ask of the ECB, and the fiscal margins in the euro zone are too small. Luckily, much of the population seems to understand the latter, which is why the Spanish and Portuguese governments were elected, Monti still is very popular in Italy, and the Dutch socialist were punished in a poll for not backing an austerity package.
Only in Greece is austerity so tainted that there is a risk of a wholesale rejection by the electorate. But in Greece, the margins for error are simply non-existent, there the demands of the euro and those of democracy are fighting a battle to the end. The outcome could determine Europe's future.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.