Spain, Debt and Sovereignty

George Friedman

Eurozone countries on June 9 agreed to lend Spain up to 100 billion euros ($125 billion) to stabilize the Spanish banking system. Because the bailout dealt with Spain's financial sector directly rather than involving the country's sovereign debt, Madrid did not face the kind of demands for more onerous austerity measures in exchange for the loan that have led to political instability in countries such as Greece.

There are two important aspects to this. First, yet another European financial problem has emerged requiring concerted action. Second, unlike previous incidents, this bailout was not accompanied by much melodrama, infighting or politically destabilizing threats. The Europeans have not solved the underlying problems that have led to these periodic crises, but they have now calibrated their management of the situation to minimize drama and thereby limit political fallout. The Spanish request for help without conditions, and the willingness of the Europeans to provide it, moves the European process to a new level. In a sense, it is a capitulation to the crisis.

This is a shift in the position of Europe's creditor nations, particularly Germany. Berlin has realized that it has no choice but to fund this and other bailouts. As an export-dependent country, Germany needs the eurozone to be able to buy German products. Moreover, Berlin cannot allow internal political pressures to destabilize the European Union as a whole. For all the German bravado about expelling countries, the preservation and even expansion of the existing system remains a fundamental German interest. The cycle of threats, capitulation by creditors, political unrest and then German accommodation had to be broken. It was not only failing to solve the crisis but also contributing to the eurozone's instability. In Spain, the Germans shifted their approach, resolving the temporary problem without a fight over more austerity.

The problem with the solution is that it does nothing to deal with the larger dilemma of European sovereignty and debt. Germany is taking responsibility for solving Spain's banking problem without having any control over the Spanish banking system. If this becomes the norm in Europe, then Germany has moved from the untenable threat of expelling countries to the untenable promise of underwriting them. Europe, in other words, has accommodated itself to the perpetual crises without solving them.

In our view, the root of the problem is the struggle to align the world's second-largest exporter with a bloc of nations that ought to be enjoying positive trade balances but are instead experiencing trade deficits. Germany, however, views the root of the problem as undisciplined entitlement and social program spending that leads to irresponsible borrowing practices. Thus the Europhiles, led by Germany, don't look for solutions by redefining the European trading system, but rather by disciplining countries, particularly within the eurozone, on their spending and borrowing practices.

According to a report in German magazine Der Spiegel, European Central Bank President Mario Draghi, Eurogroup President Jean-Claude Juncker, European Council President Herman Van Rompuy and European Commission President Jose Manuel Barroso are drafting a plan to stabilize the system. Under the purported plan, all eurozone members would be required to balance their budgets. Borrowing would be permitted only if approved by a Europe-wide finance minister, a position that would have to be created and supported by a select group of eurozone finance ministers. If approved, money could be borrowed by issuing eurobonds.

The report appears to be well grounded, with European leaders confirming that the four individuals are working on a plan (though they did not confirm the plan's details). The approach outlined in the report would attempt to resolve Europe's problems by increasing the Continent's political integration -- a concept that has been discussed extensively, particularly by the Germans and Europhiles. Given the circumstances, this would seem to be a reasonable position. If all of Europe is going to be responsible for sovereign debt issued by member countries, then the stakeholders who have the most invested in the European project must have control over borrowing. The moral hazard of de facto guarantees on borrowing without such controls is enormous.

There are two problems inherent in this approach. The first, as we have said, is the assumption that Europe's core problem is irresponsible borrowing and that if borrowing were controlled, the European problem would be solved. Irresponsible borrowing is certainly part of the problem, but the deeper issue is trade.

The European Union is built around Germany and therefore the sort of economic dynamism that Germany enjoyed in the 1950s and 1960s, when the country benefited from access to the U.S. market while retaining some protection for its own emerging industries. Eurozone countries' inability to cover debt payments stems in part from their inability to compete with Germany. Under normal circumstances, the economies of developing countries grow through exports driven by lower wage rates, but the shared currency prevents developing European countries from taking advantage of low wages. Borrowing may be too high, but Germany's dependence on exports makes it impossible for Berlin to allow a Greece or a Spain the time and space to develop critical economic sectors in the way that the United States allowed Germany to develop after World War II.

The second problem is the more serious one. The ability to manage a national budget, including the right to borrow, is a central element of national sovereignty. If the right to borrow is transferred from national governments to unelected functionaries appointed by a multinational entity, a profound transformation of democracy in Europe will take place. The European Union has seen transfers of sovereign rights from national governments and their electorates before, but none as profound as this one. Elected governments will not be able to stimulate their economies without approval of this as-yet-unnamed board, nor will they be able to undertake long-term capital expenditures based on the issuance of bonds. This board thus will have enormous power within individual countries.

This prospective solution involves more than simply an attempt to solve banking and debt problems. It reflects a fundamental principle of European political philosophy: the belief that disinterested officials are likely to render better decisions than interested politicians. This idea derives from deep in European intellectual history. Georg Hegel, a German philosopher, made the argument that the end of history was its full rationalization, represented by the rational and disinterested civil servant. Jean-Jacques Rousseau distinguished between the general will and the popular will. He argued that the latter did not represent the interests of the people but that the general will, the source of which was not altogether clear, did.

There is a strand of thought in Europe that regards the disinterested professional as both safer and likely to make better decisions than the popular will and its politicians. This is not an altogether anti-democratic view, but it is a view that says that politics must be moderated by disinterested experts. This idea heavily influenced the structure that was created to manage the European Union and is clearly behind the idea of a European budget board.

The question of the budget is central to a democracy and a highly politicized process. It is one of the places in which the public and its representatives can debate the direction in which the nation should go. The argument has been made that the public and its politicians cannot be trusted with absolute power in this area and that power should be limited to unelected people. In a sense, it is the same argument that has been made for central banks, with even greater power.

The problem, of course, is that the decisions made by this board will be highly political. First, the board must be appointed. The selection of the chief eurozone finance minister and the finance ministers represented on the board will be determined in some process that likely will not take the views of average European citizens into account. Second, the board will make decisions that will determine how the citizens of individual nations live. The board derives from a political process and shapes national life. It is apolitical only in the sense that its members don't stand for election by the populations they oversee and thus are not answerable to them.

There was a similar agreement before the current crisis called the Stability and Growth Pact, which said that the national deficit of a European nation could not exceed a certain percentage. If the deficit did, the nation would pay massive fines. The French (and even the Germans) consistently exceeded these limits but did not pay fines. They were too powerful to be sanctioned, so the system broke down.

Today, we see a concept that goes far beyond the Stability and Growth Pact. The idea is that nations will have no deficits without the permission of an appointed board and that any debt they do take on will be issued through an EU mechanism. That mechanism will eliminate the option of cheating. It may be possible to issue unauthorized bonds, but without a European guarantee, the market would charge a country like Greece prohibitively high interest rates.

But the core problem is the decision about who will and will not be allowed to borrow. Ideally, this decision would be completely transparent and predictable. In practice, the differences and needs of different countries will be so vast that the board will have to make some decisions. Given that the board will be composed of the finance ministers of some eurozone countries -- and that they will have to go home after a decision -- the question of who will be denied permission will be perceived as highly political and, in some cases, as extremely unfair. In some cases, both will be true.

The ultimate issue has nothing to do with economics, save for the trade issue. It is a question of the extent to which European publics are prepared to cede significant elements of national sovereignty in exchange for secured lines of credit, subject to the authority of people they never elected. For EU supporters, the notion that political leaders must be selected by the people they govern is not an absolute. Rational governance by disinterested leaders is an alternative and, at times, a preferred alternative. This is not entirely alien to the European tradition. In practice, however, it could create an explosive situation. The board will determine its willingness to grant deficits based on its own values. It may not permit deficits to fund hospitals for the poor. It may allow borrowing to fund bank bailouts. Or the reverse.

In any event, by taking power from the electorate, it risks a crisis of legitimacy.

The system has evolved to a point where, to some Europeans, this crisis of legitimacy may be preferable to the current cycle of endless crises. It may work for a time. But the first time a nation's government is thwarted from borrowing to fund a project while another nation is allowed to borrow for its project, a new crisis will emerge. Who in the end will determine which deficit is permitted and which is denied? It will not always be the representatives of the country denied. And that will create a crisis.

During the U.S. Civil War, the future of the Union was challenged by the secession of the South. The decisions were made on the battlefields where men were willing to die either for the Union or to break away from it. Who will die for the European Union? And what will hold it together when its decisions are unpopular? The concept of extended integration can work, but not without the passion that moves a Greek or a German to protect his and his country's interest. Without that, the glue that holds nations together is missing in the European Union. The greater the integration, the more this will reveal itself.

George Friedman, Stratfor, June 12, 2012