Nothing to celebrate

Nothing to celebrate

Written by Charles Grant, 04 January 2012
From Foreign Policy

Think 2011 was a bad year for Europe? 2012 could be a whole lot worse - if EU leaders don't get serious and deal with these 6 problems.

Welcome to the new year. In Europe, it doesn't look particularly promising. Even in the most optimistic scenarios for the euro and the EU economy, 2012 will be a year of austerity, recession, rising unemployment, and falling living standards. And the worse the economic situation becomes, the more Europeans are likely to turn against the euro, the EU, immigration, free trade - and each other.

The eurozone crisis looks like it will last a long time. One reason is the ideological rift over economic philosophy that divides eurozone leaders. The predominant view in Germany and a few other countries is that severe curbs on public spending, combined with structural reforms designed to boost productivity, will in the long run engender growth and cure the eurozone's sickness. However, many leading economists in the Anglo-Saxon world, France, and Southern Europe think this German medicine is self-defeating. They argue that the root of the malaise is imbalances within the eurozone - not only the current account deficits of Southern Europe, but also Germany's current account surplus (almost 6 percent of GDP in 2011). The German method of tackling imbalances is to impose stringent austerity and wage cuts on the southern countries, which will then reduce imports and require less external financing. But the problem with that remedy is that it leads - at least in the short and medium terms - to shrinking output and therefore debt burdens that become unsustainable. That increases the probability of governments defaulting, thus threatening the solvency of banks across Europe.

Critics of the German medicine therefore argue that structural reforms in the European periphery should be combined with efforts to boost demand, particularly in the core countries. They point out that the markets have started to worry as much about the peripheral countries' capacity to grow as their ability to repay debts. The European Union's peripheral economies could be helped not only by aid and investment from abroad, but also by a rebalancing of the German economy so that it consumes, invests, and imports more (especially from its European partners).

Such arguments go down badly in many circles in Germany, especially when they come from Anglo-Saxons who, as the Germans rightly say, have mismanaged their own economies and are prone to be cavalier about inflation. Some Germans claim that too much generosity toward southerners will encourage moral hazard in the form of excessive spending. They believe that the eurozone crisis is rooted in governments' breach of EU rules on deficits. (In fact, of the five peripheral countries in trouble, only Greece seriously breached the 3 percent budget deficit limit in the years before the crisis unfolded; Portugal was slightly above 3 percent). So in 2011, the Germans pushed the European Union to adopt much stricter rules on government borrowing, through legislation, and in 2012 they are trying to enshrine similar rules in a new treaty.

Many EU governments think this German economic analysis is flawed and that the new treaty requested by Chancellor Angela Merkel is pointless. But they have gone along with the German plan for greater fiscal discipline in the hope that Berlin will feel reassured that strict rules will stop the southerners from overborrowing and that it will then do whatever is necessary to save the euro. In the short term, that would mean relaxing its opposition to the European Central Bank's buying the bonds of countries in difficulty or lending to bailout funds in order to restore confidence to financial markets. In the long term it would mean mutualizing the costs of sharing a currency through a scheme for collective borrowing such as the issuance of "Eurobonds." At the start of 2012, though, Germany's leaders are far from adopting such policies. Public opinion may constrain their ability to do so, but it is hard to see how the euro can endure without them compromising on some of their economic principles.

A second reason to suppose that the euro crisis will be long-lasting is the poor quality of leadership, not only in Germany but all across the EU. Where are the Churchills, Monnets, Adenauers, Giscards, Schmidts, and Delors of today? Throughout 2011, EU leaders gathered at one EU summit after another. On each occasion they unveiled a fresh "solution" to the eurozone crisis. Every time, the measures taken turned out to be too little, too late.

The financial markets have started to doubt the EU's ability to sort out the problems of its currency. So have governments all over the world. The United States, China, India, and Brazil have urged Europe's leaders to act more decisively.

All is not lost, yet. This is because a eurozone breakup would have a horrifying impact, destabilizing banks, threatening legal contracts, and cutting economic output. There would be a surge of capital controls, border checks, and knee-jerk protectionism. The single market and the EU might not survive in their current form. One can only imagine how, in such a climate, xenophobic populism would thrive. Therefore political leaders - even ones who are less than brilliant - have large incentives to try to hold the euro together.

Ultimately, Germany's leaders will have to decide whether they want to save the euro or let it fracture. At the end of 2011, one Élysée official told me: "We think that in the last resort the Germans will try to save the euro. But we worry that by the time they move, it may be too late."

Here, then - before it's too late - are the six major worries that European leaders will have to contend with in 2012:

1. The EU's global prestige is waning. This is particularly unfortunate at a time when the Arab world is in turmoil and democratization in eastern neighbors such as Ukraine is stalling. The eurozone crisis has consumed the time and energy of EU governments and also made continental leaders look incompetent. Notwithstanding military action in Libya, they have failed to make help for the emerging democracies in North Africa an urgent priority. A significant part of Europe's soft power, its attractiveness as a model, has eroded. That makes it harder for the EU to influence events in others parts of the world.

The financial constraints on EU capitals have forced them to cut contributions to EU military missions, leaving operations such as those in Bosnia and the Horn of Africa desperately short of troops and equipment. In Bosnia, there are now only about 1,200 EU peacekeepers, though the military commanders of that force say they need many more troops. EU commanders also say they need a dozen ships to combat pirates off the Horn of Africa, but they currently have less than half that number. Washington is starting to see Europe less as a partner than as a liability whose missteps might drag the U.S. economy back into recession. No longer do EU leaders speak confidently of projecting power or influence, alone or with the United States. Instead, if the economic crisis worsens, the EU might even have to contend with failing states and security crises within its own boundaries.

2. Europe is fragmenting into increasing numbers of subgroups. Within the eurozone there are the AAA-rated countries that set the terms of rescue packages and the deficit countries that cannot borrow easily and must therefore swallow those terms. In 2011, the antagonism between the Germans, along with their northern allies (such as Finland and the Netherlands), and the southerners grew severe. Then there are the "pre-ins" like Poland, Latvia, and Lithuania, that plan to join the euro one day and are ready to accept eurozone discipline, as well as the countries outside the euro that do not plan to join, like Denmark and Sweden.

And then there is Britain, which has no desire to join either the euro or any European club committed to fiscal discipline. Since the December 2011 summit in Brussels, the EU has been heading for a rift between those countries prepared to join an intergovernmental fiscal compact (nearly all of them) and Britain (and perhaps a few others) outside it. The more divided the EU becomes, the greater the risk that its policymaking will be incoherent or ineffective, especially if the trend toward intergovernmental decision-making weakens EU institutions. The existence of a fiscal compact, with its own procedures, alongside the EU would pose serious risks for the integrity of the single market.

"Variable geometry," meaning that not every country engages in every EU policy, is inevitable and already applies to the Schengen Agreement, the euro, and EU defense. But the EU should try to avoid a two-tier architecture in which a core grouping has its own institutions and procedures that apply not only to the management of the euro but also to a wide range of other policies. Such a setup would damage not only the single market but also the mutual trust that contributes to the EU's strength, cohesion, and effectiveness.

3. The European Commission (EC) is not what it was. The EC, the executive that initiates policy and polices the market, has been weakening vis-à-vis the member states for 20 years, but the financial and euro crises have accelerated its decline. Merkel and French President Nicolas Sarkozy - rather than the EC - have led Europe's response to these crises. The big countries provide the money for eurozone bailouts and will not let the EC tell them what to do. They have curbed its role in the new bailout mechanisms. If the new fiscal compact takes off, it will be a more intergovernmental body - with a lesser role for the EC - than the EU.

The weakness of the European Commission matters: It is committed to extending and policing the single market, as well as maintaining a strong competition policy. Indeed, those priorities have cost it support in Paris and Berlin. The EC has a better record than any single member state of considering the wider European interest, as it has done on issues like energy security and climate change. It is also the friend and protector of the small member states, which worry about the increasing dominance of France and, especially, Germany.

The EC certainly makes mistakes. Sometimes it is too concerned to protect its own prerogatives. Also, very few of the current commissioners are heavyweight politicians who speak with authority. But the weaker it becomes, the less it will be able to focus the EU's attention on long-term challenges, speak up for the smaller countries, or defend the single market.

4. Britain is moving to the margins of Europe. In Britain's nearly 40 years of EU membership, its influence has never been lower. Britain's negative attitude to European integration, a sometimes Europhobic domestic political debate, and a failure to cultivate allies in the EU have left it unpopular and isolated. Even countries that agree with the British on substantive issues such as free trade, deregulation, or Atlanticism are embarrassed to be seen as siding with them. The diplomatic disaster of the December 2011 summit, which left Britain in a minority of one, was symptomatic of Britain's waning influence.

Many factors are eroding the British people's support for the EU: immigration, which is blamed on the EU; the eurozone crisis, which has shown EU leaders to be incompetent; a stream of regulations affecting the financial center of the City of London, some of which seem to be driven by French and German interests; and of course the tabloid press, which does what it can to stir up Europhobia.

The Conservative Party, like public opinion, is becoming ever more Euroskeptic. Many Conservatives want to renegotiate the terms of EU membership - a polite way of saying "withdraw." It is now quite plausible to imagine that Britain will leave the EU within 10 years. Prime Minister David Cameron and the current generation of Conservative leaders do not want to take Britain out of the EU, but the next generation of leaders, when they eventually take over, could easily follow the wishes of the party's membership and call a referendum on withdrawal from the EU.

5. France, for the first time in the history of the EU, is clearly No. 2. For most of the EU's history, the Franco-German couple has provided joint leadership. The financial and eurozone crises, however, have accentuated France's relative economic weakness vis-à-vis Germany - notably its less well-capitalized banks, higher budget deficits, and poorer export performance, all of which leads to higher borrowing costs.

Outwardly, Merkel and Sarkozy still get together and make decisions that the rest of the eurozone then follows. But on most of the key issues concerning the euro - should there be a new treaty, are Eurobonds needed, should the European Financial Stability Facility be allowed to borrow from the European Central Bank - Germany's views prevail. Sarkozy's strategy appears to be to hug Germany close in the hope of being able to influence the details of policy and maintain the appearance of parity.

The December 2011 EU summit was a rare example of a partial French victory. Merkel would have preferred all 27 countries to agree to a new treaty, while Sarkozy was sympathetic to the idea of a new intergovernmental body for eurozone countries alone. Britain's rejection of a new EU treaty enabled Sarkozy to establish such a body, but he had to go along with the German idea that it should include most of the countries not in the euro.

The leaders of France's Socialist opposition have attacked Sarkozy for being so willing to follow the Germans. François Hollande, the Socialist candidate for the presidency, has claimed that he would "renegotiate" the fiscal pact to make it less focused on austerity. That pact, however, will be concluded before this May's second round of the French presidential election, and if Hollande wins he will have to accept what Sarkozy has signed up to. The perception that France is no longer leading Europe might strengthen French Euroskepticism. The National Front's Marine Le Pen is a big critic of the EU and the euro and is profiting from their difficulties. A surge of support for the National Front leader in the presidential election could push mainstream politicians away from the idea of further European integration.

6. Germany is the unquestioned leader for the first time in the history of the EU. But whether it knows how to lead is a different matter entirely. Many Germans are uncomfortable with this role. Germany's politicians are learning very slowly, perhaps too slowly, about the responsibilities that come with leadership. Too many of them define their national interest in a relatively narrow way. Too few of them explain to the public that the euro is good for the German economy: If the currency broke up, a new deutsche mark would soar in value and damage the competiveness of German exporters. They could also point out that the euro was the price Germany paid for an easy reunification and that it has become the symbol of Germany's postwar European identity.

Increasingly, Germany's neighbors are calling on it to assume its responsibilities. As the Polish foreign minister said in Berlin this past November: "We ask Berlin to admit that it is the biggest beneficiary of current arrangements and that it therefore has the biggest obligation to make them sustainable.… I fear German power less than I am beginning to fear its inactivity."

At the beginning of 2012, a healthy eurozone requires two things. First, it requires governments in the peripheral countries committed to structural reforms that will lay the basis for future growth. Since the end of last year, the Greeks, Irish, Italians, Portuguese, and Spaniards have all had such governments (though these governments' longevity is far from assured). Second, a healthy eurozone requires a Germany that is taking the necessary steps to ensure the euro's survival. But 20 years after the Maastricht summit that gave birth to the euro, Germany's partners are still waiting for the European giant to step up to the plate.

 

Charles Grant is the founder and director of the London-based Centre for European Reform. He was previously a journalist for the Economist, covering financial markets, the European Union, and defense.