While much of the world's attention was concentrated on France's presidential election last Sunday, the real action was in Greece. French President-elect François Hollande may be promising 75 percent income tax rates and a renegotiation of the European Union's fiscal treaty, but it was the result of the Greek elections that will determine the future of Europe.
The irony is that Greece should never have been allowed into the euro in the first place. It did not meet the entrance criteria, but Eurocrats in Brussels turned a blind eye because they viewed the creation of a European identity as more important than financial stability. When the process began to unravel, a panicked EU, along with the International Monetary Fund, responded by throwing money at the problem, in exchange for a promise of austerity.
The result of the Greek elections was a resounding rejection of the coalition government -- comprised of mainstream socialists and conservatives -- that engineered an EU/IMF bailout. The Conservative New Democracy (ND) party, the junior party in the coalition, received the most support of any party, but only 20 percent of the total votes cast. The coalition socialist party, PASOK, placed third, behind a coalition of other leftist parties calling itself Syriza. The Independent Greeks, a pro-Russian, anti-Turk conservative group led by a former ND legislator placed fourth, with the Communist KKE in fifth, the neo-fascist Golden Dawn sixth, and yet another leftist block seventh. No other parties achieved enough support to gain representation in parliament. Fully 66 percent of votes cast were for anti-bailout, anti-austerity parties.
Thanks to a bizarre quirk in the electoral system, ND gained 50 extra seats in parliament for coming in first. This measure, designed to aid the creation of coalition governments, could plausibly have resulted in a pro-bailout government forming despite the overwhelming rejection of the bailout parties. By Monday afternoon, however, ND leader Antonis Samaras had conceded defeat in his efforts to find a majority, which will allow the Syriza faction to attempt to form a coalition of the anti-bailout groups.
The upshot? Greeks have exchanged a democratic crisis for a financial crisis with far-reaching implications. If an anti-bailout government is formed -- a big if, as that would require the various anti-bailout groups to overcome their considerable ideological differences -- the subsequent rejection of the austerity policies demanded by the EU and IMF would almost certainly lead to a Greek sovereign default, Greece leaving the Eurozone, and the return of the Drachma.
If this happens, Greece will experience severe short- and medium-term financial pain, likely exacerbated by confiscatory leftist or autarkic policies -- or some combination thereof.
However, there is some good news. By leaving the euro, Greek living standards will eventually reach a market-clearing level, and, assuming that the Greeks have fully appreciated the problems caused by statist policies during this process, they may be well placed to welcome industry back to their country with low costs and barriers to entry. How urgent is market liberalization? A recent Financial Times column tells of one entrepreneur who was asked to provide a stool sample to the government before he was allowed to start an online business.
Add to reform Greece's unique national assets -- an amazing history and climate -- and tourism should also boom, raising Greek living standards once more.
Yet if the future for Greece in this scenario looks potentially fine in the long-term, the same cannot be said for the euro. It recently become obvious to everyone that the Eurozone's Target-2 system of payments between central banks tuned out market signals that otherwise would have warned that a crisis was coming. This system places the euro in very grave risk if a country were to default.
Financial journalist Martin Hutchinson described the system very well:
When a Greek makes a large euro payment to a German, his Greek bank makes a payment to the Greek central bank, which makes a payment to the Bundesbank, which pays the German bank, which pays the German. This is quite different to the U.S. system. There is no central bank of Alabama intermediating dollar payments between Alabama and New York, and there was equally no need for such intermediation in the [E]urozone -- it just gave the otherwise redundant national central banks something apparently useful to do.
This means that the effects of capital flight are doubled. Not only does the central bank of Greece have an existing imbalance with the Bundesbank, the German central bank, but when a Greek moves his money from Greece to Germany, the imbalance grows larger.
Now consider what would happen if Greece were on the verge of default. The fear of successive default by the other shaky economies -- Spain, Portugal, and Italy -- would lead to rapid capital flight from those countries to Germany. The Bundesbank is probably able to absorb the effects of Greek default and capital flight, but it simply could not absorb the capital flight from other countries. Germany may well be forced to leave the euro rather than subject itself to this risk. This could all happen extremely quickly.
Should Americans be worried? Yes, because the United States will be caught up in a crisis it could have helped prevent. The European Project that now stands on the precipice of self-inflicted destruction was enthusiastically supported by successive U.S. presidents, who all urged Europe down the path to union for the simple reason of diplomatic convenience. If the scenario I have outlined above comes to pass, we may see a banking crisis that could make 2008 look like a walk in the park.