The European (Dis)Union
By Stephen Smith
The European Union had an informal meeting on May 23, 2012, but European policy is basically on hold until the result of the June 17th Greek election is known. This is because of two main reasons, aside from the fact that deep divergences of opinion remain among Euro Zone policymakers. First, an important part of the European strategy is to influence the outcome of the Greek election, while respecting Greek sovereignty, in order to maximize the odds that Greece stays in the European Union. The best way to do that is for the EU leaders to make clear that they will not cave in to the Greek political parties' demands to renegotiate the terms of the bailout or that they consider the election to be a referendum on the permanence of Greece staying in the EU. European policymakers' focus will remain squarely on that message for the next few weeks, although work on strengthening the EU will take place behind the scenes. Second, and perhaps even more important, both deposit insurance and a direct recapitalization of banks through the European Stability Mechanism would require a transfer of resources from the European core to the periphery. These actions would be politically very difficult. Historically, politically difficult decisions were made only as a last resort, when it was clear that a failure to make them would have put the very existence of the currency union at risk.
The June 17th Greek elections are rapidly approaching. While late last week polls indicated that Syriza, the largest anti-bailout party was ahead, over the weekend other polls were released that suggest the traditional parties, New Democracy and Pasok, should get more seats than earlier this month and thus be able to form a government that would implement the terms of the bailout agreed to with the European Union and International Monetary Fund. Overall, judging from comments by the public reported in the Greek media, it seems that the idea of casting the new elections as a referendum on Greece’s permanence in the Euro is beginning to succeed. This should give an advantage to traditional parties, but still the election is likely to be a close one. As a consequence, we expect to continue to see polls pointing to an alternating lead between Syriza and New Democracy.
The prospects for, and the eventual outcome of the election will probably set the tone for the markets in coming weeks. We see the formation of a government that supports the terms of the bailout as bullish for the markets in the short term because it would reduce substantially the risk of an imminent Greek exit. A win by Syriza, instead, would accelerate the whole exit debate and the associated European policy response. Markets would probably be very unstable in the next few months because of the unknown of a member country either pulling out of the European Union or being asked to leave. The exit process would likely go as follows: Syriza refuses to implement the terms of the bailout; Europe withholds the next bailout tranche in July; Syriza defaults on some debt payments; the European Central Bank declares Greek banks insolvent and cuts them off its emergency lending program; the European Central Bank cuts the Bank of Greece off the payment system, preventing any fresh Euros from reaching Greece; at that point, Greece would have to introduce a parallel currency which then would morph into an altogether new currency.
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