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Europe's New Message: My Way or the Drachma Highway



The drama surrounding Prime Minister George Papandreou's proposal to hold a referendum on Greece's acceptance of its bailout package, followed by his change of mind, has had the positive outcome he apparently intended. Though messy, his tactics have broadened the political support for the International Monetary Fund (IMF) reform program in Greece. That much became clear when the main Greek opposition party, New Democracy, declared its broad political support for the IMF program. It looks likely that Papandreou's days as prime minister are numbered, and that he will likely step down to make room for a short-term caretaker government, perhaps led by a technocrat, such as former European Central Bank (ECB) vice president Lukas Papademos. But it matters less now who is Greek prime minister, as the two main parties are both committed to pursuing the IMF program path. As a result, the eventual disbursement of the next IMF tranche looks quite certain, eliminating any risk of an imminent Greek default. Even new elections in Greece should not be a particular concern, with both the mainstream parties now committed to reform.

The dramatic events of early November have in some ways been the political equivalent of the initial rejection of the Troubled Asset Relief Program (TARP) in the US Congress in October 2008. Like Congress, which changed its mind after the markets revolted, Greece has achieved close to the degree of domestic political stability seen in Portugal and Ireland in 2011, the other two euro area IMF program countries, where austerity and reform enjoy the political support of all the main parties. This is unambiguously good news for the euro area.

Moreover, this pattern is likely to repeat itself in the upcoming Spanish elections later this month, where the main center-right opposition party, Partido Popular, which supports economic reforms, is likely to take over from Spain's current Socialist Worker's Party (PSOE), which has also backed economic reforms since May 2010. This leaves only Italy among the euro area peripheral countries without a clearly articulated bipartisan and broad-based political base of support for implementing far-reaching structural economic reforms and austerity programs.

Consequently, Italy is now the most direct "political contagion" target from recent events in Greece. Prime Minister Silvio Berlusconi's tenure will surely have been shortened by the likely demise of Papandreou. Like Papandreou, he will probably be pushed out by a rebellion within his own coalition and replaced by a temporary technocratic caretaker government. The fact that Italy committed itself at the G-20 in Cannes to "invite the IMF to carry out a public verification of its policy implementation on a quarterly basis" must surely further shorten Berlusconi's political life. It looks highly unlikely that he can survive this international loss of credibility when he returns to Rome.

Months of political drama in the euro area look likely to produce a broad-based political consensus across the euro area periphery about the future direction of the euro area. Not populism, no sudden defaults, but instead the euro area will move broadly in the direction of fiscal consolidation and IMF-inspired and ECB-demanded structural economic reforms.

Without getting into a philosophical discussion about the relative merits of direct democracy (e.g., Swiss style referenda based decision making) vs. representative democracy (e.g., the idea that voters elect parliamentarians to represent their political interests), it should be noted that direct referenda on highly complex issues like the IMF program are not suitable for a direct plebiscite. Highly complex issues tend to get overshadowed and hijacked by easier to grasp political messages. There is nothing inherently ideal about referenda. It would consequently be a mistake to believe that Papandreou's stillborn referendum idea will be replicated.

Financial market participants, pundits, and commentators should preferably stop data mining for the single issue euro area opinion poll results that fit their preconceived normative judgments. In practical political terms, it matters very little that a majority of Germans might poll that they want the Deutsche Mark back, or that majorities of the population in the large euro area nations poll that the euro has a negative impact on their economies.1 Single issues rarely indicate how voters will behave at the next parliamentary election. Decades of European electoral history shows that Europeans vote inconsistently in single-issue referenda and national parliamentary elections. Electorates might reject individual referenda propositions supported by 80 percent of national parliaments, and then turn around and re-elect virtually the same set of parliamentarians at the next elections. What matters is how Europeans vote on election day. So far during this crisis, they have endorsed stability-oriented and pro-reform governments.

The big news of recent days, however, is not actually from Greece. Instead it has come from Cannes, although not from the G-20 itself. It was at the G-20 that Chancellor Angela Merkel of Germany and the host, President Nicolas Sarkozy of France, made important statements following their meeting with  Papandreou. They made it clear that were Greece to reject last week's euro area agreement, not a single cent would be paid to Greece by either Europe or the IMF. Second, they made it clear that Greece faced a decision, not on whether to adopt the IMF program, but on whether to remain in the euro area. These strong statements had the desired effect on the Greek politicians, who quickly gave up on the idea of a referendum. But the significance of the Merkel and Sarkozy statements goes far beyond even that development.

This crisis initially made it clear that the "no bailout clause" in the euro area was not credible, but that countries would receive support if they ran into trouble. Now it is equally clear that euro area bailouts are not unlimited and without the toughest of conditions. If recipient countries reject the IMF reform plans, Plan B is to eject them from the euro area. The coercive political force of this threat cannot be overestimated. The economic costs for any member leaving the euro area are catastrophic. The euro area now has been equipped with a political and institutional nuclear weapon to use against recalcitrant members and seemingly has the will to use it.

The fact that this warning was so clearly articulated at crunch time in the euro area means that this Plan B expulsion threat will not disappear. A taboo was broken that cannot be undone. Whether or not the legal options in the EU Treaty are there, we now know that if a euro area member repeatedly threatens the systemic stability of the euro area, there is political will in the euro area to force that nation out.

This message will be read carefully by recipients and opponents of euro area bailouts. The institutional coercive power of the euro area has increased dramatically—more than any future Treaty change might achieve.

1. See for instance Financial Times "Europe's voters threaten crisis backlash," November 2, 2011, for a classical example of an alarmist but utterly irrelevant euro area opinion poll.

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