When Democracy and Austerity Collide: A Guide to the European Sovereign Debt Crisis

For the past several weeks, large-scale and at times violent demonstrations and strikes have erupted in Greece and Spain, fueled by unemployed youth (which in Greece stand at 36 percent and in Spain at 44 percent), students, and public-sector workers. These outraged “Indignants” strongly oppose deep public spending cuts and believe that they are being made to pay a very dear price for the mistakes of government officials, bankers, and bondholders. The initial public acceptance of significant austerity measures as a requirement for national financial solvency in the early days of the European financial crisis has come to an end.

There are two ways to look at the European sovereign debt crisis and specifically the Greek debt crisis today: through a rational economic and monetary lens or through a highly political and emotive lens. But to understand the crisis, in full, you must view the situation through both, guaranteeing a distorted and confusing image about where this crisis is going and how profoundly it will change the future of Europe’s economy and politics.

Understanding Greece

The rational approach to understanding the Greek crisis is the assumption that a country cannot sustain a debt-to-GDP ratio of over 140 percent (soon to approach 150 percent) with weak or negative economic growth (-4.8 percent Q1 2010, -2.8 percent Q4 2010, 0.8 percent Q1 2011) by austerity measures (Greece has lowered its deficit by 2 percent of GDP) and privatization measures alone (the Greek government is hoping for €50 billion from asset sales). To emerge from this crisis as quickly as possible, nearly all economists agree that Greece must devalue its currency, return to economic growth, and begin to pay down its debt. However, as one of 17 members of the European Monetary Union (EMU), Greece is unable to devalue its currency, the euro, and the EMU has no provisions for a member to temporarily leave and return to its national currency, in this case, the Greek drachma. Greece is also unable to independently restructure its debt as this would be considered a default, which would severely impact the Greek economy, as well as the other vulnerable economies in the eurozone, namely Ireland, Portugal, and Spain. A downturn in these periphery economies could set off a European banking crisis, which, in turn, would likely cause a second global economic shock.

So, the only option that Greece and Europe have at the moment is to further reduce Greek public spending (the parliament must vote next week on €28 billion in additional spending cuts); sell as many state assets as possible, which is no easy feat as the Greek land registry system is incomplete, making it difficult to quickly sell assets whose ownership is in question; and for the “Troika”—the European Union (EU), the European Central Bank (ECB), and the International Monetary Fund (IMF)—to keep lending Greece money so that it can stay financially afloat. Unfortunately, this prescription does nothing to change Greece’s debt-to-GDP ratio, which is the very source of the problem. In other words, Greece is like a bucket with a big hole in the bottom of it, and the European bailout package is like water. You can keep filling the bucket up with water, but unless you patch the hole—or restructure the debt—the water keeps going right out the bottom. Some European governments are beginning to have doubts about the political sustainability of continuing to pour water into the Greek bucket. Unfortunately, no one is seriously addressing the question of how to patch the hole.

Why can’t Europe seem to solve this crisis? In terms of economic scale and scope, Greece’s economy is small, representing less that 2 percent of the GDP of the 27-member European Union. But this isn’t simply about Greece. It’s also about the other European nations that have exceedingly high debt-to-GDP ratios, such as Italy, Belgium, and the United Kingdom, and it’s about Europe’s currently less-than-healthy banking system. This is why it is vital that the European Union, and specifically the eurozone countries, create mechanisms, processes, and institutions that can adequately address systemic financial crises across Europe. If Europe cannot get Greece right, it has little hope of stopping financial contagion from spreading to other major European economies. It is the contagion effect that is behind the talk of the potential dissolution of the euro, even though that outcome would be cataclysmic to Europe’s economy and its future prospect of integration.

What to Keep in Focus

Although we are talking about a sovereign debt crisis, this is actually a political crisis and a significant test of the European integration project and the European Union itself. “The cornerstone of our engagement with the world,” as described by President Obama, the U.S.-Europe relationship has a great deal to lose—politically, economically, and militarily—if Europe fails this test and becomes a source of instability.

The first test comes at the end of this week with a meeting of the European Council, the heads of state and government of the 27 EU nations, at which European leaders will approve additional mechanisms to support failing European economies in the form of a beefed-up European Financial Stability Facility (EFSF) and a new post-2013 European Stabilization Mechanism (ESM). Plans for a new bailout agreement for Greece, which could potentially dwarf last year’s almost €110-billion package ($160 billion at current exchange rates), will follow in later meetings. Look for how the markets react to statements by President José Manuel Barroso of the European Commission, Chancellor Angela Merkel of Germany, and the chair of the Eurozone finance group, Prime Minister Jean-Claude Juncker of Luxembourg. Last week, Acting Managing Director John Lipsky of the IMF told these leaders, in essence, to stop speaking publicly about the crisis altogether, as their conflicting statements were causing even greater market uncertainty. Specifically, if Chancellor Merkel continues to insist that bondholders share—voluntarily or involuntarily—the “pain” of future Greek bailouts as a condition for future German support for Greece, this position could be a potential deal breaker both for Greece and for the euro, as credit rating agencies have indicated they would interpret such a situation as a Greek default on its debt.

The second test comes on June 28 when the Greek parliament must approve the additional austerity measures in order to receive the next tranche of bailout funds. The demonstrations and protests will continue, driving the political stakes even higher for this vote. If Prime Minister George Papandreou of Greece can keep his socialist party faithful in line, the vote should pass, but this outcome is not a given as additional spending cuts and privatization of state assets will cut deeply into entrenched party interests. It was this climate that led the prime minister recently to reshuffle his cabinet. Although the media will focus on austerity measures, the most important job for the Greek parliament will be to find mechanisms to implement recent legislation. For the past year, the parliament has passed many laws to please and appease its European funders, but many of these laws have not been implemented, which has been exacerbated by the fact that there are few capable administrators able to do so in the various departments and ministries. This challenge is particularly acute when it comes to Greek privatization.
The third test comes by way of the additional pressure that is being applied to the borrowing costs of Ireland, Portugal, Spain, and Italy, resulting from the continued uncertainty over the Greek crisis. Bond yield spreads have risen (to 15.9 percent in Greece, 10.6 percent in Ireland, 9.6 percent in Portugal, 5.3 percent in Spain, and 4.8 percent in Italy) as this Greek tragedy has played out. If Europe is not careful, it will find itself revisiting previously agreed bailout packages earlier than anticipated. In this scenario, Spain is the country to watch. The IMF recently warned that Spain needs to implement “far-reaching” austerity reforms if it is to step back from its current state of “considerable” risk, a clear sign of growing international concern.

Heather A. Conley is a senior fellow and director of the Europe Program at the Center for Strategic and International Studies in Washington, D.C.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

© 2011 by the Center for Strategic and International Studies. All rights reserved.

Heather A. Conley