Alarm over Europeís financial predicament is surging again. The immediate cause is the European Unionís fiscal pact. Germany insisted on this plan to cut public borrowing sharply and immediately, and euro-area governments hoped it would restore stability. Itís doing the opposite.
The pact is proving so unpopular that itís undermining governments, and not just in the peripheral countries most obviously at risk. The stresses caused by the EUís strategy influenced presidential elections on Sunday in France and forced a crucial partner in German Chancellor Angela Merkelís austerity drive, Dutch Prime Minister Mark Rutte, to offer his cabinetís resignation on Monday.
While socialist Francois Hollandeís campaign against French President Nicolas Sarkozyís ďexcessive austerityĒ has received considerable attention, Europeís big surprise came when the Dutch coalition government resigned, days after the far-right anti-EU Freedom Party refused to go along with the center-right Liberalsí plans for budget cuts to comply with the new fiscal pact. Voters in the Netherlands donít appear to be deserting the Liberals, but the collapse of the coalition and the need for new elections complicates parliamentary ratification of the budget deal, due by the end of the year.
Thereíll be some crowing about this. The Netherlands has been Germanyís leading ally in the EU, calling for stringent budgets and criticizing the fiscal self-indulgence of Greece and other sinners.
The Dutch government was as keen as Germanyís to ram the pact down the throats of the so-called Club Med countries. Now it has choked on its own efforts to comply, making Rutte the latest of about a half-dozen European leaders to be unseated by the financial crisis.
This new political turbulence is spilling over into financial markets, threatening a vicious circle of worsening economic stress and political risk. The Netherlandsí sovereign debt position is strong -- it enjoys an AAA rating, despite concerns over high levels of household debt. On Monday, investors demanded higher yields from Dutch government bonds, but Spain remains the country to watch. Its debt position is anything but strong. Yields on its 10-year bonds rose above 6 percent on Monday, stirring fears of insolvency. Spain is the euro areaís fourth largest economy, and might settle the EUís fate. If it goes the way of Greece, the EUís financial defenses would probably be overwhelmed, and the wider global recovery would again be in peril.
That doesnít need to happen, but the fiscal pact makes it more, rather than less, likely. Even if the deal on budgets were politically feasible, it would be financially unsound. In countries without recourse to monetary easing or currency devaluation, the strategy demands too much austerity too soon.
Itís one thing to apply pressure on governments for needed policy reforms -- evidently the guiding principle of German policy. Itís another to bring the ceiling down on the entire euro project. Thatís the gamble Germany is now taking.
Spainís new government has made brave budget cuts -- though not brave enough to fully comply with the pactís demands -- and under the most difficult circumstances is carrying out long- overdue labor-market reforms. Yet according to the International Monetary Fund, Spain faces continuing recession followed by a dismally slow recovery, even if all goes well. Its unemployment rate is more than 23 percent; one in two young people is without work. Remarkably, the commitment of Spanish voters to the European Union seems not to have dimmed. But there must be a limit to Spainís tolerance of such acute economic pain. The EU should stop testing it.
Pooling of Risk
Without compromising on long-term fiscal control, the Spanish government needs to ease the short-term fiscal pressure, and the EU should help it do so. The way to do this, as we have argued before, is through formal pooling of fiscal risk. The European Central Bank must explicitly promise to be a lender of last resort to euro-area sovereign borrowers, or the EU must introduce some form of euro bond or other collective borrowing arrangement. This would reduce Spainís borrowing costs to a level consistent with solvency, and would allow some needed short-term fiscal moderation.
Such a plan, of course, would be the very fiscal union Germany has opposed. Merkel should consider that her choice might come down to this: fiscal union, with the costs it implies for German taxpayers; or isolation for Germany in Europe, economic collapse in some countries, renewed contraction in others, and political turmoil spreading across the union. In either case, Germany pays -- but in the second case, it pays much more.
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