The European sovereign debt problem that began with Greece has entered a new phase. In addition to the ruling party’s defeat in polls Greece held May 6, Nicholas Sarkozy, who helped champion fiscal austerity as the cure for the crisis, was replaced as French president by Francois Hollande, a Socialist who has called for greater emphasis on growth.
These two election results are threatening to create a new split in economic policy among the eurozone governments and have raised the spectre of Greece exiting the common currency.
An informal summit of EU leaders held in Brussels on May 23 — the first one attended by Hollande — failed to come up with a clear response to the situation.
German Chancellor Angela Merkel made it clear that while she wants Greece to remain in the eurozone, Athens must meet the terms it agreed to under the international bailout plan. Peter Norman, Sweden’s financial markets minister, stated that his country is “well prepared” for the possibility of a Greek exit.
The euro is now back on its way down. Its value, which stood above ¥110 in early April, is already below ¥100 and has fallen from 1.50 to 1.25 against the U.S. dollar. Yields on Greece’s 10-year euro-denominated government bonds have topped 30 percent, while the interest rate gap between Germany (1.262 percent as of Thursday) and France (2.473 percent) has expanded.
European Central Bank chief Mario Draghi has said it will be difficult to issue jointly backed EU debt under such circumstances.
History shows that states typically accumulate mountains of debt by alternating between fiscal rehabilitation efforts and austerity measures. Without painful reforms to the real economy, governments essentially have to fill their budget deficits with borrowings, thereby putting off fiscal reform.
If the Greek re-election set for June 17 results in a sea change against austerity, the likelihood of a Greek exit will increase even further.
Exiting the unified currency will force Greece to revive the drachma, her national currency. Then the government will try to set a low exchange rate to promote exports and lure foreign tourists.
On the other hand, the termination of European Union and ECB support money will throw the Greek economy into chaos, with inflation likely due to the high oil prices. The purchasing power of wage-earning Greeks will plunge and living standards will decline. Wage increases in the absence of a rise in productivity will only accelerate the inflation spiral. And through this process, economic distortions that are often hard to resolve through democratic political means will be corrected by market forces.
This is one of the advantages of a market economy that you don’t see in a socialist system.
The chaos might then spread to the other members, with more departures from the common currency a distinct possibility. This would no doubt lead to global economic disruptions. There are already reports of people in some countries making huge withdrawals from bank deposits due to concerns that their banks could go bankrupt.
For Japan, which has the largest debt to GDP ratio in the world, this is not somebody else’s problem. The major credit rating agencies are already beginning to downgrade Japanese government bonds.
Political leaders in a democracy often find it hard to ask voters in an election year to accept austerity and find it easier to cater to what the electorate wants. Winston Churchill once said, “Democracy is the worst form of government, except for all those other forms that have been tried from time to time.”
The degree of a democracy’s deficiencies reflects the maturity level of a country’s voters. As we consider responses to the public debt problem, we need to first recognize that such deficiencies exist.
Teruhiko Mano is an international economic analyst.