The Bomb

The European Union in 2017 has the appearance of a sickly old man with so many ailments that it is hard to know whether he’ll be carried off by pneumonia, blood poisoning or stroke. The continent lurches from crisis to crisis while Brussels struggles to find policy responses that go beyond “kick the can down the road”. Many of these wounds have been self-inflicted: the selective insistence on austerity has undermined economic growth, while the bailouts of Greece, Cyprus, Portugal, Spain, Ireland, Romania, Hungary and Latvia has amounted to just over half a trillion euros since 2008. This has raised popular anger at “profligacy” — especially in Northern Europe — while the often brutal conditions imposed by the “Troika” has raised the hackles of nationalist defenders of state sovereignty. The European Union can’t be blamed for the Syrian Civil War, unlike the debacle in Libya, but the refugee and immigrant policy has fanned the flames of xenophobic nationalism, playing into the hands of far right parties challenging the status quo. Euroscepticism is at an all-time high even as Brussels seeks more power from national parliaments to deal with the myriad financial, economic, social and military challenges that confront it.

All eyes are currently focused on the French general election in April as the next detonator[1]. A Marine Le Pen victory could send the Eurozone into an immediate death spiral; thanks to her promise to hold a referendum on the single currency, markets would likely sell off anything and everything denominated in euros. But even though a Le Pen victory remains unlikely, the year is young. September brings us German federal elections — with rapidly eroding support for Angela Merkel — as well as the possibility of a Catalan referendum on independence from Spain.

Markets have yet to price in these political blasting caps, but spreads are already beginning to widen between the safe harbors, German bunds and British gilts, and the peripheral markets in Southern Europe — including France. This is a response to rumors of the ECB tapering its supply of helicopter money, delivered through the mechanism of sovereign debt purchases with any kind of collateral on hand, including my daughter’s kindergarten Crayola project. This has artificially lowered the cost of debt for riskier markets, though it has also reduced the incentive to implement hard reforms in these countries: from over 7.2 euros to 1.6 euros for Spanish 10-year bonds and from 6.2 to 2.2 euros for Italian bonds. This has come at a price to the ECB balance sheet, but more importantly, it has engendered more and more resistance in Germany.

The result so far has been a modest increase in the spread of European bonds — nothing like the height of the 2012 crisis when the Euro looked to be finished, but a disturbing development nonetheless. And it is a harbinger of worse to come, for no one in Europe wants to discuss the bomb which is quietly ticking away: Greece needs to repay 7.4 billion euros to the ECB and Athens doesn’t have the money.

This deafening silence is deliberate: European politicians are desperate to avoid the Greek negotiations becoming a campaign issue in their home countries. But this seems unavoidable, as the Greeks are at the end of their tether and the international creditor institutions are squabbling amongst themselves over the conditions to release the next tranche of funds. Angela Merkel insists that the IMF will participate; the IMF insists that it will not participate unless there is negotiated relief to make the Greek debt sustainable; the Germans then say that debt relief is out of the question. Even within Germany, Merkel’s CDU and the Socialists are divided on the subject; the hawkish Finance Minister, Wolfgang Schäuble, has always pursued a hard line with the Greeks, to the point of contemplating a “temporary” Grexit. Martin Schultz, the Socialist frontrunner and clear challenger to Merkel’s continued leadership, calls Grexit “unthinkable” and insists that the IMF is not a sine qua non of a continued bailout program. But Schultz is not yet in charge, and Mrs. Merkel is undoubtedly counting on the IMF — led by former French Finance Minister Christine Lagarde — to roll over as it has every time in the past, even in contradiction to the institution’s governing rules[2].

This time may be different. Mrs. Lagarde is still the head of the IMF, but the United States now has Donald Trump as President. Mr. Trump has already made plain his opposition to the Greek bailouts on multiple occasions; has publicly embraced Brexit as the best thing since sliced bread; has accused Germany of manipulating the Euro to favor its exports; and has nominated as ambassador to the EU a man who compared the European Union to the Soviet Union, claiming both needed “taming.” Mr. Ted Malloch has recently speculated whether Greece would break out of the Euro and even if the single currency would survive the next 18 months. This indicates a certain degree of ambiguity on the part of the American President to the European Union; he is not winning hearts and minds in Brussels.

In fact, Mr. Trump views Europe in much the same light as he does China: an economic rival and a currency manipulator. His foreign policy continues to be dominated by an almost mercantilist view of international trade as a zero sum game: which is why he is “soft” on petro states like Russia and Saudi Arabia, but takes a hard line against countries that can actually compete with America, like China, Europe, Japan and South Korea.

Is Donald Trump really trying to sabotage the European Union and bring it down? The collapse of the Eurozone would allow a predatory Trump Administration to negotiate far better bilateral trade deals with the individual member states than it could possible get with the collective 27 member bloc. That is certainly the approach Mr. Trump is taking with the United Kingdom, with a trade agreement likely between the two allies before the UK’s two-year negotiating term with Europe expires. If this is the case, Mr. Trump has a wonderful opportunity to throw a wrench in the works this summer: the Administration need only demand a review of Greece’s debt repayment scenarios by the IMF and when the institution admits that the debt burden is unsustainable, the Administration could — with all legal justification — use its blocking share of votes[3] to prevent IMF participation in any new deal with Athens.

Would that scuttle any possible deal with Greece? No…the European Union could and would proceed without the International Monetary Fund. But IMF participation has always provided useful political cover for Europe’s politicians and it would be an especially heavy blow for Angela Merkel, who has stated that IMF participation is essential. She could try to make up for this blow by imposing even stricter terms on Greece, to appease the conservatives back home: but there is little more blood to be squeezed from that stone. Alexis Tsipras is already facing a backbenchers’ revolt for acquiescing to two more years of austerity. Any additional harsh demands would likely see his coalition fall apart; and without a Parliament to approve the package, Greece would default on its loan repayment. Then, adios muchachos. So Germany might need to settle for more lenient terms, which would probably kill Mrs. Merkel’s chances of reelection while at the same time boosting Alternativ Für Deutschland, the German counterpart to UKIP and the National Front.

In the end, Greece will again get the money, because no one really wants to pull on the string that would set the Euro to unravel across the continent. But there will be a political cost that will likely claim Mrs. Merkel, who has been a central pillar of keeping the Euro and the Union together. Her likely successor, Mr. Schulz, is an experienced politician and former President of the European Union[4], well-known and respected: but it is unclear that he will be able to guide Germany and Europe through the multitudinous pitfalls that await this year and next.

The bomb ticks on.

Sources and Notes

[1] The Dutch election is actually sooner, in March, but even a victory there by Geert Wilders, the ideological soulmate of Le Pen’s National Front, would not have the same impact. The French political system grants the President far greater powers than the Dutch Prime Minister has.

[2] The IMF has broken a number of them with Greece, but the fundamental one is that the IMF shouldn’t lend to nations with unsustainable debt burdens. During the first Greek bailout, the IMF doctored its models to show an unbelievable rate of GDP growth; but in subsequent bailouts, the Fund simply shrugged its shoulders after initially pushing back a bit against European pressure.

[3] The United States has 16.53% of voting shares and 85% of votes are required to approve a measure in the IMF Executive Board.

[4] He stepped down on 17 January 2017 in order to seek election as German Chancellor this year.