By Desmond Lachman, Resident Fellow at the American Enterprise Institute
There is nothing that concentrates a politician's mind as does an impending election. Angela Merkel, Germany's powerful and currently popular chancellor, would appear to be no exception to that rule. For in anticipation of scheduled German presidential elections in the fall of 2013, Mrs. Merkel has now substantially softened her stance toward the European debt crisis. And she has done so in order to secure peace on the European crisis front, which she recognizes as being crucial to her re-election prospects.
It is not clear, however, whether Mrs. Merkel fully appreciates that keeping the European debt crisis under control does not simply depend upon her desire, no matter how powerful a politician she might be. Rather it crucially depends on political developments in the individual countries in the European periphery that could very well be beyond her control. It is also not clear whether Mrs. Merkel appreciates how radically the politics in the European periphery can deteriorate between now and the German elections particularly were its economic environment to continue to deteriorate. After all, those elections are around one year away and one year in the middle of a debt crisis tends to be an eternity.
Euro Preservation Remains the Goal
The clearest of signs that Mrs. Merkel wants to hold the euro together at any cost, at least through the forthcoming German elections, is her whole-hearted support of Mario Draghi, the president of the European Central Bank (ECB). Mrs. Merkel is supporting Mr. Draghi's new policy initiative to do "whatever it takes" to save the euro by buying unlimited quantities of Italian and Spanish government bonds, subject to those countries having IMF-style economic adjustment programs. And she is doing so despite vociferous opposition from Jens Weidmann, her hand-picked president of the German Bundesbank, who strongly believes that the ECB is in the process of leading Europe down an inflationary path.
Yet another sign that Mrs. Merkel is desperate to keep the euro crisis under control in the run-up to the German elections is the marked softening of her attitude toward Greece.
Earlier in the year, she took the hard-line position that the Greeks needed to fully live up to its commitments under the IMF-EU bailout program and it was up to the Greeks whether or not they wished to remain in the euro. In that vein, she ruled out any notion of Greece being given more time to meet its budget deficit targets and she dismissed out of hand any idea of Germany being asked to participate in a third bailout package for that country. More recently, however, Mrs. Merkel has vigorously backpedaled on both of those issues and has gone so far as to visit Athens to underline her change of heart towards keeping Greece in the euro.
An Ineffective Strategy
What is all too likely to prove to be the fundamental flaw in Mrs. Merkel's strategy of keeping the euro afloat is that the lifeline that she is having the ECB and IMF throw to the European periphery comes with unpalatable strings attached. Those strings are attached to assure a sceptical German electorate that the periphery will correct its wayward ways and that Germany will not be throwing money down a bottomless pit.
When the ECB commits itself to buying large amounts of Italian and Spanish sovereign governments bonds it only does so provided that those countries sign up to multi-year IMF-style economic adjustment programs. Similarly when the IMF and ECB now again pull Greece back from the brink they do so on the strict condition that the Greek government secures parliamentary approval for public spending cuts for 2013-2014 amounting to as much as 6 percentage points of GDP in the depths of a very severe economic recession.
Austerity vs. the Euro
If Mrs. Merkel should have learnt anything over the past year, it is that fiscal austerity does not work in a euro straitjacket. Since that straitjacket precludes countries in the periphery from devaluing their currencies to promote their external sectors as an offset to the negative effects on output and employment of fiscal tightening. This is particularly the case at a time of economic recession, at a time when the European periphery is experiencing a credit crunch, and at a time when countries like Ireland and Spain are in the full throes of housing busts.
It should have comes as no surprise to Mrs. Merkel that fiscal austerity under these circumstances would throw the European periphery into the sort of deflationary spiral that is now all too evident in Greece, Italy, Portugal, and Spain. It should also have come as no surprise to her that deteriorating economic conditions in the periphery would spawn social and political instability as manifested by anti-austerity general strikes, acute regional tensions particularly in Spain, and the rise of anti-establishment political parties on both the extreme left and extreme right of the political spectrum.
Electorally Mrs. Merkel likely has little real option but to continue her strategy of bailing out the European periphery subject to the periphery agreeing to IMF-style economic adjustment programs. However, for that strategy to work, the European periphery will have to accept the austerity that goes along with Mrs. Merkel's support. Whether or not the European periphery will continue to have the political willingness to persevere with austerity through the German elections remains to be seen. Growing social and political unrest on the streets of Athens, Lisbon, and Madrid, suggest that Mrs. Merkel might have a long year ahead.
American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.