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.
