Versailles on the Lethe

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The Europeans are determined to take care of their own; or to discipline their own, depending on your view. But the degree of pain and denial that Germany and France are demanding of Greece is of a level that neither government would inflict on their own citizens. The German Chancellor and French President would be voted out of office if they dared.

“The best solution [to the Greek situation] without any doubt is that Greece meets its obligations and that the markets believe these commitments will be implemented”, said German Chancellor Angela Merkel following the European Union (EU) summit on Thursday. The EU summiteers offered Greece solidarity but no cash and no loan guarantees.

Northern European public opinion is against funding Greek profligacy with taxpayer euros. Successive Greek governments used the low interest rates provided by the ECB and euro membership to buy an economic boom the cost of which is now due. Greece will have great difficulty rolling its debt in the spring without external guarantees or ruinous interest charges. It has not helped the Athenian position that it cheated to enter the euro in 2001 and hid the size of its deficit from its European Monetary Union (EMU) partners under the previous government.

“Greece has to help itself; we want to help Greece do it”. “That we help to convince the population [of Greece] of the necessity of solid fiscal policy”, declared German Finance Minister Wolfgang Schaueble in an interview with the German paper Frankfurter Rundschau. By help, Mr. Schaueble means that drastic spending cuts are “the logical and inevitable consequence” of the country’s financial dilemma. The Greek population is expected to understand and acquiesce.

But Greece is only the most outstanding example of a problem that is shared by several less wealthy and less prudent EMU members, including Spain, Portugal, Ireland and Italy, and is to some degree inherent in the unified currency structure.

The EMU experiment, one monetary policy and one interest rate, for sixteen capitals, with uncoordinated fiscal and tax policies and elected governments with very different financial traditions, that answer not to a federal authority but to their own voters, is wholly dependant on the prudence and financial good sense of the individual capitals. The EMU lacks any credible enforcement mechanisms for ensuring fiscal discipline from its members.

The writers of the Maastricht Treaty thought that the unified currency would be self-enforcing. They expected that fiscal congruence would evolve from the requirements of the convergence criteria that set eligibility for euro membership and that had demanded a high standard of fiscal and deficit performance of the joining countries. That has not happened. The countries which had been used to borrowing and then devaluing to maintain competitiveness, Italy, Greece, Spain and Portugal, have remained as they were. The pact has not taught fiscal prudence.

What might be said of the Greek voters’ penchant for squeezing benefits and pay from their government, may also be said, if somewhat less so, of Italy, Spain and Portugal, and in fact Germany and France themselves. Though the protests and street riots in Athens last year had little to do with finance and there have not been any related to the current crisis perhaps the voters should not be overly tried.

Yet it is not apparent that any voter in Greece, as an example or the EMU would want to return to the pre-euro world of cross borders currency wars. Whatever the volatility and disruptions from the current situation, it still compares favorably to the financial and economic turmoil that the old free floating and ERM regimes suffered. It may seem that the EMU is at risk, but it is not. It is doubtful that anyone in Europe, in government or without, would want to return to the world of competitive devaluations, currency change at every national boundary, wildly fluctuating exchange rates and defensive overnight interest rates of 50% or 100% deployed against currency speculators.

One thing that should have been learned over the past three years is the reach of unintended financial consequences. If it applies to Lehman, then surely it applies to the finances of an entire national economy. If Greece is shut out of the sovereign debt markets, what will the consequences be for the continent’s banking system, linked throughout the European Union to banks in France ($76 billion of exposure), Switzerland ($64 billion), and Germany ($43 billion)? And these are only the most direct links. The ramifications of asset downgrades can spread very quickly, from bank to bank and country to country. No political leader, especially not in the EMU could survive the consequences that would spring from the default of a euro member.

But unintended consequences can be political as well. If Germany and France insist on inflicting extended economic pain on several members of the EMU, what damage may they do to the political popularity of the entire project? Germany and France need to consider if they want to be seen as the enforcers of austerity on Greece?

Three years is a very long time in politics. Whatever solution is forthcoming from the EU, the chance that Greece will maintain its ‘rigorous fiscal discipline’ until its deficit is back to 3% is small. Or to be more generous, it remains to be proven that Greek voters will permit the Greek government to do what it has promised to do.

That Greece and the other high spenders return to the budget vicinity of the Maastricht treaty is necessary lest the euro devolve to into a club where the savers of Northern Europe subsidize the spenders of the south. That reality would not last long at the polls nor would the EMU

But is it a good idea for the future of the monetary union for Germany and France, and it will be seen primarily as German instigation and enforcement, to demand the type of financial austerity and economic pain from the population of Greece now and perhaps Spain, Portugal, Ireland and others in the future that could very easily turn the voters of these countries against the EMU and the euro?

“The responsibility for the European currency lies in the hands of the EMU. We do not want to delegate it to the IMF”, said Mr. Schaueble. Perhaps the EMU needs to consider whether enforcing its own rules is really in its own best interest?