Could this week produce a turning point in Europe's long, Sisyphean battle against the debt-and-banking crisis that has been ravaging it for the last two-and-a-half years? This coming Sunday, France will likely vote for Francois Hollande, a pro-Keynesian Socialist, as its new president. In Greece, on the same day, parliamentary elections will produce a hammer blow to the existing two-party system and will significantly increase the strength of the anti-Europeans on the far left and the extreme right. These elections will be held in the context of a continuously worsening economic picture in the continent, which has convinced almost everyone-with the crucial exception of the Germans-that the current recipe of one-size-fits-all austerity is leading to catastrophe and needs to be modified before it causes irreparable harm.
The woes of Spain and the Netherlands, which have been the focus of concern in the last few days, illustrate the depth and breadth of the eurozone's problems, and the failure of existing policies to tackle them. In Spain, a conservative government was elected last November with 46 percent of the vote, on exactly the platform endorsed by Berlin and Brussels: harsh austerity and structural reform, especially in the labor market, to bring down unemployment and jumpstart growth. A few weeks ago, the government produced a budget amounting to a massive fiscal adjustment of 27 billion euros for 2012, in order to bring down the deficit this year from 8.5 percent of GDP to 5.3 percent (a slowing economy had meant it had overshot its 2011 deficit target by 2.5 percent). Economists argued that the government underestimated the dynamic effects of the cuts on growth and that, in fact, achieving a 3.2 percent reduction the deficit-to-GDP ratio could require double the amount of austerity measures.
With Spanish bond yields steadily creeping up, last Thursday Standard & Poor's became the first rating agency to downgrade Spain below an A rating (two notches, to BBB+). The agency cited concerns about the deficit, the banking system, still suffering from the effects of the great real estate bubble, and weak economic prospects. On the next day, unemployment figures for the first quarter of 2012 were released: the unemployment rate has reached a socially explosive 24.4 percent (up from 22.9 in the last quarter of 2011). Among those under 25, it has climbed to 52 percent.
Someone might argue that this is further proof of the inability of the European South to adjust to the stringent demands of the currency union. This would ignore the fact that Spain's crisis was brought on by private sector excesses (the aforementioned bubble) and that before 2008, the country was a model of fiscal probity (budget surplus of 1.9 percent of GDP, net debt 27 percent of GDP in 2007). It would also ignore the troubles of those northern paragons of fiscal virtue, the Dutch, whose government collapsed on April 23 after failing to secure support for an 14-billion-euro austerity package aimed at bringing the country's deficit down from 4.6 percent of GDP this year to 3 percent next year. The caretaker government that will lead the Netherlands to an early election in September has tentatively agreed since then to a large package of spending cuts to be implemented before then, but already opposition parties are questioning parts of it and saying it may be challenged by the next government. Meanwhile Fitch is threatening the Netherlands with a loss of its prized AAA credit rating, as Standard & Poor's did last January. This would lead to a rise in the cost of borrowing not only for the country but also for the EFSF, Europe's rescue fund, which depends on guarantees from the dwindling number of AAA-rated eurozone members for its high credit rating.
Faced with this increasingly bleak situation, European officials absurdly insist that the problem is insufficient commitment by member-states to lowering deficit ratios, no matter what the economic cost. But even if bond markets themselves have behaved erratically in the recent past in response to government fiscal policies (IMF chief economist Olivier Blanchard has spoken of their "schizophrenic" demands for immediate fiscal retrenchment combined with worries about slowing growth caused by the cuts), it is now clear that their main concern is the contracting effect of austerity, all across Europe. A quick overview of the European real economy shows that eight eurozone countries-Spain, Greece (for the fifth straight year), Portugal, Ireland, Italy, the Netherlands, Belgium, and Slovenia-are now in recession. Outside the eurozone, recently published figures for the first quarter of 2012 show that the UK has dipped back into recession, along with Denmark and the Czech Republic, whose government was also nearly brought down last week because of opposition to austerity measures. Even mighty Germany saw its GDP shrink in the fourth quarter of 2011, for the first time since 2009.
Francois Hollande has long made it clear that he will not be the obedient junior partner to Angela Merkel that Nicolas Sarkozy has been. In particular, he has issued calls for a renegotiation of the fiscal compact agreed by 25 out of 27 EU members earlier this year, to make it more growth-friendly. He has insisted that without a supplementary package of pro-growth measures, he will refuse to ratify it. the German chancellor insists that the pact is not negotiable, but Hollande claims to have support for his approach from many European governments, including conservative ones. As he stated in a television appearance last Thursday: "It is not for Germany to decide for the rest of Europe." Even internally, Merkel cannot ratify the fiscal compact without support from the SPD, which, emboldened by Hollande, is demanding a stimulus program for weaker European economies as the price for its support. The fact that Mario Draghi himself, the head of the arch-conservative European Central Bank, spoke, after the first round of voting in France and the resignation of the Dutch prime minister, of the need for a "growth compact" to complement the agreement to tighten fiscal rules is a signal that the eurozone may, finally, be moving in a different direction.
This is not to underestimate the task facing Hollande and the European pro-growth alliance he hopes to lead. A party man without previous governmental experience, he is expected to goad the notoriously stubborn Merkel into a U-turn that, to be meaningful, will need to go beyond a relaxation of the pace of fiscal adjustment. Countries with strong public finances and high competitiveness will need to embrace stimulative short-run policies, which will increase consumption, allow the troubled countries of the periphery to export more and improve growths prospect throughout the continent. They will also have to accept some form of a joint guarantee of the debt of eurozone member-states, to put to bed once and for all market fears about a break up of the euro. The French Socialist must, at the same time, deal with deficits and structural sclerosis at home, the latter an area he has shown little inclination to tackle. It is a tall order but, as things stand, its success may be the eurozone's last chance.
