The Greek Crisis and Beyond

NEW YORK – As euro-zone leaders face growing uncertainty in financial markets about the public finances of Greece and other member countries, their statements, albeit somewhat vague, underscore a much larger story – one that will force firms and investors to question their assumptions about Europe’s economic, financial, and political environment.

Let’s first dispense with a powerful emerging myth. Greece’s troubles have encouraged some to wonder aloud if the euro zone can survive its growing internal imbalances. But such doubts ignore the political and cultural factors that buttress a deep European commitment to preserve the monetary union.

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The euro was created partly in order to bolster internal market efficiency and prevent currency volatility. But it is also the product of a deep-rooted European conviction that transnational institutions and economic interdependence have helped establish and sustain peace across the continent for the past six decades. In a world of weak multilateral institutions – including a G20 beset by substantial differences of opinion on basic questions – it is more important than ever that euro-zone governments bolster their collective clout in an uncertain, unprecedented, and competitive global environment.

For member states, the euro zone is simply too important to fail. That means that solutions to the many problems they now face will require adjustment to the way each of them taxes and spends. Yet, from one government to the next, the result will be massively uneven – a recurring problem during Europe’s multi-decade drive for internal currency stability. This divergence on fiscal policy has many causes, and no single shock will alter it.

Understanding the increased importance of fiscal policy is complicated by confusion over how various euro-zone governments actually make policy decisions – a process that relies on an ever-changing, complex mix of opaque institutional factors and domestic political dynamics that vary considerably from one country to another. In an era in which transparency and disclosure are the prevailing norm in most aspects of European governance, the politics of fiscal policy still look like conference diplomacy, circa 1815.

This is Europe’s new reality, not a momentary lapse in good order. Companies and investors exposed to risk in Europe must assume much more volatility in interest rates within the euro zone and increasingly uneven growth and inflation prospects. The convergence of sovereign debt yields implied and required by the establishment of the common currency need not return.

The absence of a stable framework will force investors to re-think asset-allocation decisions and risk pricing. As the bond market begins, finally, to price in greater relative risk in euro-zone sovereigns, the intellectual underpinnings of the idea of a global division between emerging-market and developed-market bonds will be fundamentally tested.

These shifts will be gradual, persistent, and less predictable than what investors had come to expect during the deceptive calm of the euro’s first decade, when the currency union’s establishment, together with EU enlargement and liberalization, appeared to create a stable and benign environment.

Finally, remarkable and lasting policy shifts will not be limited to countries in immediate financial trouble. German fiscal policy could soon look very different from the zero-deficit bias that prevailed under the grand coalition that governed from 2005 until 2009. During that period, the deficit-reduction camps within both the Social Democrats and the Christian Democrats made common cause to fend off pressures from other factions within their respective parties for a change in policy.

That structure is no more. Today, the right wants tax cuts and the left, now reconstituting itself, may push for higher spending. No one believes that Germany is at risk of default, but investors overlook this sort of policy shift at their own risk. After all, a significant change in policy direction within the euro zone’s biggest economy could have a much larger effect on the currency union than developments in Greece.

Given internal conflict over taxes and spending, maybe Germany, not Greece, will become the euro zone’s first country to see a government fall.