Greece forces Germany to weigh austerity endgame

Greece's elections have confirmed its role as the worst pupil in the euro-area class. But with all respect to Paul Krugman and others, austerity isn't dead: It's now up to Germany to decide whether to ease up or hold firm and watch Greece leave the euro.

The May 6 vote showed clearly that Greeks aren't willing to accept further cuts. Almost 70 percent of voters backed political parties -- from anti-Europeans to neo-fascists -- that oppose sticking to the terms of the two bailouts since May 2010.

There's now a high likelihood the country will miss its next deadlines under the 130 billion euro ($169 billion) program it agreed to in February. That means the European Union and other exasperated international creditors may soon have to decide whether to pull the plug, leaving Greece to default and exit the euro. Economists at Citigroup Inc. say the odds of that happening in the next 18 months are now as high as 75 percent.

The mild reaction of currency and equity markets -- outside Greece -- after Sunday's election shouldn't fool anyone. Letting Greece go would be a reckless gamble with the future of the single currency, risking political turmoil and unknown consequences for the European project as a whole.

The center-right New Democracy party, which came in first in the election with just 19 percent of the vote, has already said it's unable to form a government. Others will now try, but even if a rickety coalition is assembled, it won't have a mandate to stick with the current austerity program.

That makes it hard to see how the parties can form a government able to meet the May 31 deadline for Greece to elaborate further deficit reductions worth 5.5 percent of gross domestic product for 2013-2014. That's on top of a reduction in the primary deficit (excluding interest payments) of 8.25 percent of GDP that Greece already made and that affected mainly pensioners and wage earners, rather than wealthy tax evaders.

No wonder Greek voters are mad. But if the government misses the deadline, then the so-called troika monitoring Greece's bailout (the International Monetary Fund, the European Commission and the European Central Bank) has indicated it would halt further payments. German Chancellor Angela Merkel said Monday that it was of "utmost importance" that the government in Athens continue its program. Greece is due to get about 30 billion euros, much of it for recapitalizing the country's banks, in the second quarter. A little less than 4 billion euros of bonds come up for redemption over the next month.

Greek officials say that if bailout funds are halted, they would run out of money to pay pensions and salaries within weeks. Given that the state power company recently had to be given emergency funding, the lights might literally go out.

There are two ways to respond. One is to give the Greeks more time. Even though they are repeat offenders, there are signs that they are finally on track with the fiscal side of the program. In March, bank deposits finally began to rise, for the first time since 2009. The alternative is to stick with the austerity plan's deadlines and impose more tough love.

Under that scenario, the flow of money would be allowed to stop, making Greeks understand the true cost of going it alone. Then, when they hold fresh elections, by candlelight if need be, the result might be different. If it isn't, Greece could be allowed to default and spin out of the euro, strengthening the remaining currency zone.

Although an anti-bailout party roared to second place with 17 percent of the vote, and the neo-fascist Golden Dawn received 7 percent, making it into parliament for the first time, opinion polls suggest more than two-thirds of Greeks still want to keep the euro. They just don't want the austerity plan that goes with it. They would now understand that they can't have it both ways.

The trouble with tough love is that it may not work -- politics isn't always rational. It also could have unintended consequences. True, Greece's debt has been transferred from private hands to the ECB and other sovereigns better able to absorb the losses. But a default could cause investors to wonder just how determined euro-area leaders would be to save Spain, Portugal and Ireland. That could trigger bank runs and capital flight in those countries, with ripple effects for France and even Germany. Those kinds of concerns might help explain why investors are suddenly snapping up insurance on German debt.

The ultimate decisions will have to be taken by Germany, the euro area's unwilling guarantor. So far it has preferred partial -- and ineffective -- responses to the crisis, rather than bolder -- but necessary -- steps that we have advocated before, such as common euro bonds or a firewall big enough to cover the potential risks. Unfortunately, Germany seems prepared to offer more partial solutions to Francois Hollande, France's president-elect, as he presses for a growth pact to accompany austerity.

Three years into the crisis, it is clear that markets need to be convinced that Greece, Italy, Spain and others will be able to pay their sovereign debts, now and in the future. Otherwise, these countries will pay usurious rates that exacerbate the meltdown.

Taken as a whole, Europe's finances are sound, and it can afford to pay: The euro area's consolidated budget deficit last year was 4.1 percent of GDP, less than half the U.S.'s 9.6 percent. Common euro bonds would fix the problem of shoring up struggling countries, but would require Germany to pay higher interest rates for credit.

There's little sign that the German government or the ECB want to change course. Finance Minister Wolfgang Schaeuble oozed contempt recently when he said that Germany might make some gestures on growth measures to allow Hollande to "save face."

Greece's chaotic election result will force a hard decision on the euro area soon. The best course would be for Germany to acknowledge that it will have to risk more by agreeing to some form of euro bond, boosting demand at home, tolerating a little more inflation, and giving Greece, Spain and others more time to meet their fiscal targets.

Any comparison to the 1930s is overblown, but the political scene in Europe is fragmenting. The rise of anti-European and, in some cases, xenophobic parties in France, Greece, Italy, the U.K. and elsewhere is disturbing. If Germany refuses to bend, then it will, fairly or not, be held responsible for whatever happens next.

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