Europe's Downward Economic and Political Spiral

The clearest of fault lines are now appearing in Europe's single currency project that has to cast doubt upon the long-run survivability of the Euro in its present form. For not only does the European fiscal austerity pact appear to be driving the European periphery into an ever more serious downward economic spiral, poor economics across Europe is undermining the European political center's authority to pursue coherent policies.

Increased political change in the European periphery is also now starting to exacerbate Europe's economic downturn by making it difficult to govern, and by heightening market uncertainty about the periphery's political ability to stay the course. Sadly, there appears to be nothing on the European horizon that offers hope that this economic and political downward spiral is soon to be arrested.

From the very beginning of the European debt crisis in early 2010, the European policy response has consistently been guided by the principle of conditioning bailout support to the implementation of rigorous fiscal austerity. This has been the case in all of the IMF-EU bailout programs for Greece, Ireland, and Portugal, as well as in the EU's most recent financial support program for the Spanish banking system.

Fiscal austerity has also been made the requirement for any eventual movement to a European fiscal union and for additional ECB support. To that end, at the December 2011 European Summit, a "fiscal pact" was adopted that committed all Euro member countries to balance their budgets over the next few years. The attainment of that objective was to involve multi-year budget tightening of as much as 2 to 3 percentage points of GDP a year for countries like Spain, Italy, and Portugal, notwithstanding the fact that these three countries are all experiencing serious economic recessions and meaningful domestic credit crunches.

The underlying reason for tying bailout packages to budget austerity has been to assure the electorates in countries like Germany and the Netherlands that the European core countries would not be called upon to finance a bottomless pit in the periphery. However, a basic flaw with this approach has been that major fiscal austerity is being imposed on countries that are already in recession and that are stuck in a Euro straitjacket, which precludes these countries from using exchange rate policy to boost their external sectors as an offset to the very negative effect of fiscal tightening.

More than two years into the crisis, it is clear that Europe's fiscal austerity strategy is not working. The clearest example is in Greece where the Greek economy has already contracted by 16 percent from its 2009 peak, and where the Standard and Poor's rating agency expects that economy to contract by a further 10-11 percent in 2012-2013. However, deepening economic recessions are also very much in evidence in Italy and Spain, Europe's third and fourth largest economies. According to the IMF, both of these countries' economies are now expected to contract by between 1 ½ to 2 percent in both 2012 and 2013.

Deepening recessions in the European periphery are fueling a veritable political backlash against austerity, which is being manifested in a dramatic erosion of the political authority of the traditional political parties. Once again, Greece provides the clearest example of this tendency. Whereas in 2010 PASOK and the New Democratic parties commanded 75 percent of the overall Greek vote, these two parties together barely received 35 percent of the Greek vote by May 2012. By contrast, there has been a dramatic rise in the fortunes of parties on the extreme left and right of Greece's political spectrum.

While Greece provides the clearest example of the adverse political winds that are now blowing in Europe, it is far from an isolated case. Over the past two years, some nine sitting Euro governments have fallen as bailout fatigue has set in across the continent. And more troubling yet, there has been a clear increase in public support for populist parties in countries like Finland, France, Italy, and the Netherlands; those populist parties all waging campaigns against the Euro.

Given Europe's proposed unchanged economic policy mix for the periphery for the foreseeable future of severe fiscal austerity within a Euro straitjacket, one has to expect a continuation of the periphery's downward economic and political spiral. This has to raise questions about the periphery's longer-run political ability to remain within the Euro. It also has to raise questions as to whether the time is not long overdue for Europe's core countries to start devising a Plan B that might allow for the orderly reduction of the number of countries that are to remain within the Euro as the means to secure the Euro's very survival.