Ten days ago, the political landscape in Europe changed profoundly.
Greece voted in the main to elect parties from the far right and far left who are opposed to austerity, and France elected a socialist President who again is strongly opposed to austerity.
The political limits of austerity have been reached in Greece and France, and the consensus behind it in Germany is fraying. The defeat for the conservatives in the state election in North Rhine-Westphalia shows anti-austerity sentiment is growing in Germany as well.
The importance of this issue is highlighted by the conduct of the new French President. The first thing Francois Hollande will do as President is fly directly from his inauguration to meet with the German Chancellor, Angela Merkel, in Berlin later today. The meeting will almost certainly be inconclusive. It is a get-to-know-you affair, without advisers in attendance, and the distance between the French and German leaders upon how to respond to the problems in the Eurozone is massive.
The state of play
What does all this mean for Europe and for us?
For Europe, last week most share markets are down by about 5%, and the euro itself dropped to a three-month low. The markets are spooked that this may be the beginning of the end for the euro. Paradoxically, however, these changes may represent the euro’s only hope of long-term survival.
The policies the EU imposed on Greece (and Spain and Portugal) forced painful reductions in salaries, benefits, and pensions on their people. A floating exchange rate allows uncompetitive economies to regain their competitiveness through devaluation. A fixed exchange rate, such as the euro, allows no such relatively painless adjustment process.
The only way to make a nation’s exports more competitive when its exchange rate is fixed is to cut input costs (reduce actual wages). And this is what has been happening to many individuals in Greece, Spain and Portugal. Their cost of living has remained constant while their salaries have been slashed by one-third or at times, even one-half - that is for those who are lucky enough to have a job. Every second Greek under the age of 24 cannot obtain employment.
Change was necessary in Greece. Ever since joining the Eurozone a decade ago, Greeks stopped acting like adults and began behaving like three-year-olds in a chocolate factory. Greek public sector salaries grew far more rapidly than those of their private-sector counterparts. The public sector became bloated with unnecessary employees, and public sector benefits (such as early retirement on generous pensions) became ridiculously and unsustainably generous. To make matters worse, tax collection by government was so profoundly ineffectual as to be a national scandal. In short, the entire nation behaved as if everyone could feed off the public teat without the milk ever running out.
So structural adjustment was required of the Greek economy – public sector pay rates and conditions had to be made reasonable and sustainable and income and other taxes have to start being collected properly. However, austerity imposed across the board is no way to grow an economy. If pay rates in the public and private sector, employment, and government spending are all cut severely, the only possible result is an economy in recession and a sharp fall in government tax revenues.
Germany and France were hoping that if they bankrolled the southern economies for long enough, these economies may emerge as lean and efficient and able to stand on their own feet. However, seeking to achieve these ends in this way has imposed extreme social suffering on the southern nations. And the leaner economies that could eventually emerge won’t have invested strongly in the education and health of their people, so they will be leaner but less resilient and productive.
On the weekend, French and Greek voters rejected this future resoundingly. Austerity could only ever work in the long-term, and its short-term consequences have proven politically intolerable.
Certainly the risk of Greece having to exit the European Union has risen substantially. Many experts are putting the risk of this at 40% to 50% by year’s end.
Greece is a tiny economy, relatively insignificant unless you are Greek. Yet if it abandons the euro all eyes will switch to Spain, an economy larger than ours, and one where currency turmoil puts real fear into the hearts of bankers. For the truth is, no one can predict what the fallout will be if the euro falters and becomes a currency for Northern Europe only.
What about Australia?
And here lies the principal potential fallout for Australia. Should the euro collapse, the world’s financial markets will freeze, many for up to a year. Think late 2008, only worse. Fortunately, our banks have considerably reduced their reliance on capital markets abroad for wholesale funding. So while this will be disruptive, the disruption should be less than last time. Likewise, our banks do not typically hold substantial amounts of European sovereign debt, so again the consequences should not be severe.
The euro has already fallen in value and will probably continue to do so. A cheaper euro means a relatively more expensive and less competitive Aussie dollar – bad news for our exporters that compete with European ones, such as wine, agricultural exports, education and tourism. We will become a more expensive destination for European university students and European tourists.
So the short-term consequences for us of the unravelling of the Eurozone won’t be pretty; there will be severe, sustained turmoil in global financial markets. However, while Australia will suffer some fallout from all this, the sky won’t fall in - and one would still rather be here than just about anywhere else in the world.
The optimistic take on this week in Europe is that there is now a small but real chance that the euro might survive. Austerity - as it was being imposed by northern Europe on the south - was never going to work. It was never going to generate the tax revenues to enable southern nations to service their debts – even with the 50% debt haircut that Greece’s creditors agreed to accept earlier this year. Austerity of the degree imposed shrinks economies severely and is a self-defeating policy.
However, with France and Greece rejecting austerity, other possibilities open up. Greece must continue with reforming its public sector, slashing jobs, pay rates and benefits. However, this must be accompanied by new efficient government spending on national priorities.
Prospects for growth?
Throwing much of one’s workforce out of work and then expecting the private sector to somehow magically employ them in the midst of a government-induced deep recession is fanciful. It is simply not going to happen. So government must identify the areas of national weakness - be they in infrastructure, education or wherever - and address them.
This is a very challenging task, requiring high levels of competence in governance. So, it is unlikely to be achieved. However, a profound pro-growth restructuring of their economies remains the only medium-term hope for prosperity for Greece, Spain and Portugal, and their only chance of remaining in the Eurozone.
The prospects of this are slim, but better than the prospects a week ago of unremitting austerity leading to economic growth.