Two-and-a-half years ago I wrote a short piece titled "The End of the World as We Know It" which began like this:
Consider the following scenario. After a victory by the left-wing Syriza party, Greece’s new government announces that it wants to renegotiate the terms of its agreement with the International Monetary Fund and the European Union. German Chancellor Angela Merkel sticks to her guns and says that Greece must abide by the existing conditions.
Fearing that a financial collapse is imminent, Greek depositors rush for the exit. This time, the European Central Bank refuses to come to the rescue and Greek banks are starved of cash. The Greek government institutes capital controls and is ultimately forced to issue drachmas in order to supply domestic liquidity.
With Greece out of the eurozone, all eyes turn to Spain. Germany and others are at first adamant that they will do whatever it takes to prevent a similar bank run there. The Spanish government announces additional fiscal cuts and structural reforms. Bolstered by funds from the European Stability Mechanism, Spain remains financially afloat for several months.
But the Spanish economy continues to deteriorate and unemployment heads towards 30%. Violent protests against Prime Minister Mariano Rajoy’s austerity measures lead him to call for a referendum. His government fails to get the necessary support from voters and resigns, throwing the country into full-blown political chaos. Merkel cuts off further support for Spain, saying that hard-working German taxpayers have already done enough. A Spanish bank run, financial crash, and euro exit follow in short order.
As Greece goes to the polls on January 25th, we have come closer than ever to the second sentence of this dystopia becoming reality. The problem is not what Syriza demands: debt relief in the South, combined with demand expansion in the North, is necessary if the euro zone is to recover. The problem is the chain of events that could be unleashed if Germany and others mismanage the consequences of a Syriza victory.
In particular, Angela Merkel may well believe that the rest of the euro zone is now sufficiently insulated from the consequences of a Greex exit from the euro. And she may be right. But she may be wrong too. A Grexit would set a precedent, and markets may sense Spain's future in the euro is no longer assured. Much will depend on the way the game will be played by all sides and on market psychology. Which means there is huge uncertainty about the outcome.
In view of the short-run problems, it seems foolhardy to contemplate the distant future. But I was asked to do just that for a volume on the future of European democracy, which led to this piece. I still believe that the political trilemma provides the right framework for thinking about these issues. So my discussion revolves around the implications of the trilemma for Europe.
The euro was something that had never been tried before: monetary union among democracies that retained political sovereignty. It is instructive to consider the narratives under which such a leap of faith could have made sense at the outset:
One theory, perhaps held most strongly by conservative economists, rejected the Keynesian perspective and re‐enshrined the “self‐equilibrating market” at the center stage of policy. In this worldview, the apparent malfunctions of markets – the boom and bust cycles in finance and macroeconomics, inequality, and low growth – were the product of too much government intervention to begin with. Do away with moral hazard in financial markets, institutionalized labor markets, counter‐cyclical fiscal policy, high taxes, and the welfare state, and all these problems would disappear.
This free market nirvana had little use for economic governance at any level – national or European. The single market and currency would force governments into their proper role – which is to do very little. The creation of transnational political institutions were a distraction at best, and harmful at worst.
A second theory was that Europe would eventually develop the quasi‐federal political institutions that would transnationalize its democracies. Yes, the single market and currency had created a significant imbalance between the reach of markets and the reach of political institutions. But this was a temporary phenomenon. In time, the institutional gaps would be filled in, and Europe would develop its own Europe‐wide political space. Not only banking and finance, but fiscal and social policy as well would become EU‐wide.
This image envisaged a significant amount of convergence in the social models that exist around the EU. Differences in tax regimes, labor‐market arrangements, and social insurance schemes would have to be narrowed. Otherwise, it would be difficult to fit them under a common political umbrella and finance them out of a largely common fiscal pot. The British, with their own sense of uniqueness, understood this well, which is why they always pushed for a narrow economic union and resisted anything that smacked of political union as well.
As I note in the piece, neither of the two theories could be articulated too openly. Doing so would have raised a torrent of criticism and objections. The minimalist economic model had little attraction beyond a narrow group of economists. And the federalist model would run up against widely divergent views even among the pro‐European elites about the political future of the union.
That these opposing, but at least internally coherent visions could not even be widely discussed in polite company should have told us something: neither in fact offered a practical solution to the euro zone’s institutional imbalance. Nevertheless, the absence of public discussion and debate meant that they would not be explicitly repudiated. So both justifications could linger on in the background, providing their adherents some comfort about the sustainability of the union’s arrangements.
Alas, the euro zone’s problems ‐‐ deflation, unemployment, and economic stagnation on the economic side, and voter dissatisfaction and the rise of extremist parties on the political -- no longer allow such equivocation.