Bracing for a Hit from Europe

It may be the peak of vacation season in Europe, but the continent’s fiscal crisis has not taken a break. Last week, Wolfgang Schäuble, the powerful German finance minister, took time out from his holiday to have a sit-down with his American counterpart, Tim Geithner, in the North Sea island of Sylt. The last-minute meeting was organized at Geithner’s request. Less than a hundred days from the U.S. presidential election, it highlighted—as if more evidence were necessary—the Obama administration’s concern about how developments in the Eurozone could affect the vote come November 6.

The crisis calendar between now and then is certainly packed; if a week is a long time in politics, three months is an eternity in economics. Below, the Prospect sketches out a road-map of the pitfalls ahead.

Greece

We start, unsurprisingly, in Greece. The recently elected coalition government there is putting the final touches on a new austerity program—a condition for its second bailout. The program calls for 11.6 billion euros' worth (or 5 percent of GDP's worth) of spending cuts for 2013-2014. The measures, which include new wage, pension, and benefit cuts; a rise in the retirement age; and the closure of hospitals and university departments are already causing serious friction within the governing coalition. For a country already in its fifth year of recession and with a 23 percent unemployment rate, that’s no surprise.

Evangelos Venizelos, the former finance minister and the leader of the center-left PASOK party, has expressed reservations about the strategy adopted by prime minister Antonis Samaras and finance minister Yannis Stournaras. Even though Venizelos played a central role in negotiating the second bailout a few months ago, he now argues that the spending cuts must be spread out over a four-year period (2013-2016) to prevent the economy from collapsing. In contrast, Samaras and Stournaras argue—and have prevailed, for now—that the comprehensive package of cuts must first be presented to regain international credibility. Once that is done, they say, there can be negotiations for the country to be given more time, which also means more funding from its official creditors—something Northern Europeans are at present unwilling to grant.

Representatives of the troika of creditors (The European Union, the European Central Bank, and the International Monetary Fund) will return to Greece on August 27 to assess the latest austerity package. Their assessment will be presented at a meeting of Eurozone finance ministers, either on September 3 or (more likely) on the 14th of the month. A positive assessment will lead to the release of a massive, 31 billion-euro installment of the second bailout, critical for recapitalizing Greece’s banks and for repaying the government’s debt of over six billion euros to private creditors. A negative evaluation would leave the Greek government and the banking sector without funds, potentially triggering the country’s exit from the euro within weeks. Aside from the chaos that this would lead to in the country itself, it would cause a panicked flight from euro risk in the markets and pile the pressure on Spain and Italy, the elephants in the European room.

The European Stability Mechanism

But Greece is not the only dark cloud on the horizon. On September 12, Germany’s Constitutional Court will decide whether to issue a temporary injunction against the European Stability Mechanism (ESM)—the new, permanent bailout fund that was meant to have replaced its predecessor, the European Financial Stability Facility (EFSF)—and against the fiscal compact imposing tighter pan-European control of the national budgets of 25 of the 27 members of the EU. The German parliament approved both the ESM and the fiscal compact with a two-thirds majority. It is widely expected that the judges will reject the temporary injunction, a decision tantamount to a final approval. After all, while insisting on the rights of the Bundestag and setting a number of caveats, they have not blocked any of the major moves towards further European integration in the last few years (the Lisbon Treaty, the first Greek bailout, and the EFSF). But some analysts warn that the court may demand a referendum for the two treaties to be ratified, thus further delaying their activation and, by extension, the institutional reform necessary for the Eurozone to offer a meaningful policy response to its existing challenges.

Elections in the Netherlands

On the same date that Germany’s top judges will issue their verdict, early parliamentary elections will be held in the Netherlands. The Netherlands is one of only four countries in the common currency area that retains a AAA credit rating, and it is closely aligned with Germany in opposing debt mutualization in the Eurozone. Dutch voters, in an economy on the verge of recession and facing severe spending cuts to bring the budget deficit into line with European rules, are proving receptive to the anti-austerity message of the Socialist party, which polls favor to come out on top. They are also receptive to the xenophobic populism of Geert Wilders, who plays on frustrations about taxpayers’ money going to support welfare benefits for immigrants and bailouts for debt-ridden Southern Europeans. Coalition negotiations, always time-consuming, are expected to be particularly complicated on this occasion. If the new government is even more opposed to bailouts than the previous one, the efforts to protect Spain and Italy from the doubts of the bond markets will become all the greater.

Spain and Italy

This brings us to the biggest shadow hanging over Europe, and the world economy, over the next few months: the fate of the big two of the European South. The prospect of a full sovereign bailout of the Spanish government now seems increasingly likely, if not imminent. A lot will depend on what the ECB is able to do in the next few weeks to bring down Spain’s borrowing costs, which have often exceeded 7 percent for ten-year bonds over the past month. The bank’s president, Mario Draghi, caused a short-lived euphoria in the markets when he stated in late July that "the ECB is ready to do whatever it takes to preserve the euro—and believe me, it will be enough." But last week, he said that a bond-buying program to bring down Spanish yields will only come after Madrid makes a formal request for assistance (and the same goes for Italy). Such a request comes with conditions that are tantamount to partial loss of fiscal sovereignty, which Spain’s prime minister Mariano Rajoy is desperate to avoid.

If Rajoy relents—as he has seemed more likely to in recent days—this will allow the EFSF to buy Spanish bonds in the primary market, after imposing terms. This in turn will give Draghi the political cover he needs with the Bank’s more conservative members, above all the German Bundesbank, to intervene in the secondary market and keep Spanish yields down to acceptable levels. A strong ECB intervention, it is hoped, will convince investors that it means business, and this will keep Rome’s borrowing costs below the danger zone, though the Spanish recipe could, in theory, be applied to Italy’s even larger bond market as well. Failure to do what is necessary for Spain and Italy would lead to solvency crises in the two Mediterranean giants and would in due course spell the end of the euro.

The European drama, then, is likely to climax repeatedly in the next few weeks and months. The White House will no doubt keep following it obsessively, and will make frantic phone calls when things threaten to get out of hand. At least until November 6.

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