Eurozone faces the domino principle

It happens like this: the election result in Greece means pro-austerity parties lack the parliamentary support and the moral authority to govern. Demands from Athens for tough bailout conditions to be softened are turned down by the International Monetary Fund, the European Central Bank and the European Commission.

Political impasse in Greece leads to a second general election being called for next month.

The German chancellor, Angela Merkel, makes it clear the next tranche of cash to keep Greek banks and the state solvent will not be given unless the plan is adhered to in full.

The strains on the single currency become intolerable; Greece leaves the euro and defaults, starting the process by which monetary union unravels.

In May 2010, when in Britain David Cameron and Nick Clegg were negotiating the terms of their coalition agreement and Greece received its first package of financial support, the idea that Europe was about to be gripped by a crisis which would put monetary union in peril was ridiculed. This week, as the euro fell on the foreign exchanges, the Greek stockmarket plunged and investors piled into the safe haven of German bonds, it no longer seems quite so far-fetched.

The jittery mood in the markets reflects the fear that the turmoil of the past five years - the subprime crisis, the near-death experience of the banks, the deepest slump since the Great Depression, the sovereign debt crisis - is about to reach a climax over the coming months with a battle for the euro's very survival.


For two years, Europe has been force-fed a diet of unrelenting austerity. Spending cuts have been imposed, pensions have been made less generous, and taxes have gone up. The policy has been an economic disaster. Growth has collapsed, unemployment has soared and - not surprisingly - budget deficits have been much bigger than forecast.

Election results from France and Greece show that it has also been a political disaster: voters have decisively rejected Euro-sadism and made it clear they want their politicians to chart a different course. Democracy has trumped austerity.

In the fantasy world of Brussels policymakers, the eurozone would fast-track to full fiscal union, but there is no realistic chance of this happening any time soon. Nor does there seem much prospect of ameliorating austerity with a growth strategy that would give the more vulnerable countries a fighting chance of meeting unrealistic deficit reduction targets.

Francois Hollande may be talking about ''a new start'' but his slogan finds no echo in Berlin, where the German government was insisting that the weekend elections change nothing. To be sure, Merkel emphasised the need for growth in her message of congratulation to the new French president but while the rhetoric may change, German policy promises to be unflinching.

Greece, Merkel says, must grind its way through its structural adjustment program; France must adhere to the fiscal compact thrashed out last year; there will be no Eurobonds to transfer resources from rich to poor parts of the zone, and no extension of the European Central Bank's remit so that it can emulate the quantitative easing programs of the Federal Reserve and the Bank of England.

The deep problems of monetary union are encapsulated in this tension. The eurozone is a currency union, not a federal state, which means it lacks a single finance minister calling the shots and a centralised budget like that in the US or Britain. Germany is by far the biggest and most powerful nation in the eurozone, and, while committed to keeping the single currency alive, takes a conservative approach to monetary and fiscal policy.

Forecasting what is likely to happen in financial markets is a mug's game, but it's a fair bet that the next few weeks will not be pretty. Fears that the election of Hollande as the new French president will lead to a rift between anti-austerity Paris and pro-austerity Berlin is one concern. Yet Hollande's deficit reduction plan is not significantly different from that proposed by Nicolas Sarkozy. It is early days, but there was no knee-jerk sell off in French bonds, reflecting the feeling that Merkel and Hollande will settle their differences to keep the Berlin-Paris axis strong.

A bigger immediate threat is that a Greek exit from the euro - rated as a 50 to 75 per cent probability by Citigroup - will have a domino effect on Portugal, Spain and Italy.

Jason Conibear, director of the foreign exchange firm Cambridge Mercantile, said the euro was as attractive to investors as a toxic derivative during the subprime crisis: ''There's every chance the euro will go into freefall in the weeks ahead against all the major currencies. Investors are waking up to the fact that the once-ridiculous notion the euro could collapse is increasingly the most likely outcome.''

On past form, the response of Europe's policymakers will be to muddle through. But that is no longer a realistic option.

Europe is heading deeper into a double-dip recession. As Tristan Cooper, at Fidelity Worldwide Investments, noted: ''The irresistible force of German austerity has clashed with the immovable object of Greek popular resistance.'' Unless the terms of Greece's bailout are made less onerous, it is heading for the euro exit door. The warning signs for the commission are there: sow the wind and you will reap the whirlwind.

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