Staring into the abyss - The Economist · Staring into the abyss The euro crisis might wake Europe...

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E U R O P E A N D I T S C U R R E N C YNovember 12th 2011

Staring into the abyss

Europe.indd 1 26/10/2011 16:58

WHEN BRITAIN ABANDONED the gold standard in 1931, it was not onlyforsaking a system for managing the currency but also acknowledgingthat it could no longer bear the mantle of empire. When America brokethe dollar’s peg with gold in 1971, it ushered in a decline that continueduntil Paul Volcker re-established con�dence in the currency in the early1980s. As Joseph Schumpeter, the great Austrian economist, once wrote:

�The monetary system of a peo-ple re�ects everything that thenation wants, does, su�ers, is.�

In the same way, the crisisthat has engulfed the EuropeanUnion (EU) is about much morethan the euro. As governmentbonds, share prices and banksswoon and global recessionknocks on the door, the �rst fear isof �nancial and economic col-lapse. But to understand what ishappening to the currency youalso need to look at what is hap-pening to Europe.

The euro will not be safe un-til Europe answers some funda-mental questions that it has runaway from for many years. Attheir root is how its nationsshould respond to a world that israpidly changing around them.What will it do as globalisationstrips the West of the monopolyover the technologies that havemade it rich, and an ageing Eu-rope starts to look increasinglylike the western peninsula of a re-surgent Asia?

Some Europeans would liketo put up carefully designed

fences around the EU’s still vast and wealthy market. Others, including agrowing number of populist politicians, want to turn their nations in-ward and shut out not just the world but also the elites’ project of Euro-pean integration. And a few�from among those same elites, mostly�ar-gue that the only means of paying for Europe’s distinctive way of life isnot to evade globalisation but to embrace it wholeheartedly.

This is not some abstract philosophical choice. It is a �erce strugglefor Europe’s future, being waged in Athens as George Papandreou losespower to a temporary government of national unity, in derelict factoriesin France and Belgium and in the wasted lives of millions of unemployedyoung Spaniards. This struggle will set the limits on Europe’s welfarestate. It will determine how the unbalanced partnership between Ger-many and France, and an increasingly detached Britain, will shape theEU. It will de�ne the high politics of Brussels and the low politics of Euro-pean populism. And it will decide the fate of the device that Schumpeterwould see as the embodiment of all this: the euro.

Staring into the abyss

The euro crisis might wake Europe up. But more likely, argues

Edward Carr, it will lead to compromise and decline

The Economist November 12th 2011 1

SPECIAL REPORTEUROPE AND IT S CURRENCY

1

A C K N O W L E D G M E N T S

C O N T E N T S

Many people helped with this special

report, some of them on condition of

anonymity. Particular thanks go to:

Steven Taylor, Valerio De Molli,

Daniela Schwarzer, Thomas Mayer,

Matthias Vollbracht, Markus Kerber,

Hans-Olaf Henkel, Ulrike Guérot,

Martin Roth, Pawel Swieboda, Pawel

Zak, Sweder van Wijnbergen, Bart

Rijs, Adriaan Schout, Bertholt

Leeftink, Eduardo Serra, Jose

Manuel Amor, Thomas Klau and

Willem Buiter.A list of sources is at

Economist.com/specialreports

An audio interview with

the author is at

Economist.com/audiovideo/specialreports

3 The causesA very short historyof the crisis

4 AusterityDestructive creation

4 The economicsIn theory

6 Anti-EU backlashBeyond the fringe

8 Europe’s big twoThe Nico and Angela show

11 Non-membersLook at it this way

12 After the crisisMaking do

2

2 The Economist November 12th 2011

o�cial reckons that, if the French president had at that momentasked for a vote, the heads of government would have suspend-ed the rules. The crisis today is at least as grave as it was then.

Since it is possible to avoid such a catastrophe, you mightthink that the worst will not happen. And indeed it is unlikely�but not impossible. Precisely because of the dire consequences,everyone is counting on the next person to see reason. The newGreek government might reckon that Europe would never letGreece collapse. At the same time the ECB and Germany mightrefuse to step in, because they do not want countries to evade re-form. Or perhaps austerity might eventually lead to populiststhat turn away from the euro�to hell with the consequences.

A euro-zone central banker confesses that he has latelybeen thinking about historical catastrophes such as the �rstworld war and wondering how the world blundered into them.�From the middle of a crisis�, he says ominously, �you can seehow easy it is to make mistakes.�

Economic and Monetary Union (EMU) was supposed tobanish the competitive devaluations that threatened the singlemarket in the early 1990s. It promised to bind a uni�ed Germanyinto the EU and pave the way for some sort of political union inEurope. Today that dream has not vanished altogether, but thesingle market is under threat once more. Europe’s nations are atloggerheads, Germany is in a state of outrage, and the link be-tween the euro and the nation state is more fraught than ever.EMU truly is, writes David Marsh, author of a history of the euro,�Europe’s Melancholy Union�.

�The 2008 crisis shows that the dominant economies werenot as dominant as they thought,� says Dominique Strauss-Kahn, the French former head of the IMF. �If Europe fails, it willsu�er from low growth, economic domination and culturaldomination.� Can Europe turn back from the abyss? Only if thecore countries will support the rest as they submit themselves toradical political, social and economic reform. Nobody should beunder any illusions about how di�cult that will be. 7

NORWAY

SWITZ.

SERBIA

MAC.

BOSNIACROATIA

ALBANIA

SWEDEN

DENMARK

UNITEDKINGDOM

BULGARIA

LITHUANIA

LATVIA

R O M A N I A

P O L A N D

CZECH REP.

HUNGARY

F I N L A N D

S P A I NPORTUGAL

F R A N C E AUSTRIA

ITALY

G R E E C E

MALTA

ESTONIA

CYPRUS

SLOVENIA

SLOVAKIA

G E R M A N Y

NETH.

LUX.BELG.

IRELAND

Euro-areagovernment

gross debtAs % of GDP

2011 forecast

0-25

Other EuropeanUnion members

25-50

50-75

75-100

100-125

Over 125

Source: EuropeanCommission

Interactive: Explore our guide tothe troubled economies of Europe atEconomist.com/euroguide2011

Just now the euro zone is caught in adismal downward spiral. Fears aboutwhether the governments in Greece, Por-tugal, Ireland, Spain and, most alarmingly,Italy will honour their �3 trillion ($4.2 tril-lion) or so of borrowing are wreckingEuropean banks, which own their debt.Struggling banks undermine con�denceand credit. Coming on top of �scal auster-ity, this is bringing on recession, deepen-ing fears that governments will be unableto pay back their debts, which furtherweakens the banks. And so the vice turns,down towards disaster.

The euro zone still has the capacityto stop this run on its banks and gov-ernments. As a block, it is less in-debted than America and its pub-lic-sector de�cit is lower. It hasthe money to fortify its banksagainst the default of Greece�and Portugal and Ireland, ifneed be. And it is minded bythe European Central Bank(ECB), which can in principle standbehind those vulnerable governments bybuying their debt in unlimited quantitieson the secondary market. But the EU hasrepeatedly failed to put forward a con-vincing euro rescue. Its latest and bravestattempt, at the end of last month, fell short of the mark�just likeall the others. That is because the Europeans are deeply at oddsover what the crisis is really about, and riven by disagreementover what each country must contribute towards solving it (seenext article). So long as the euro zone’s members cannot settlethese arguments, or at least agree that their di�erences matterless than �nding a solution, the collective action needed to de-fend the euro will remain impossible.

Many roads to disaster

While the world waits for Europe to make up its mind, ca-tastrophe is in the air. It could take many forms. A country mightstorm out of the euro�which the treaty forbids, but who couldstop a determined government? European banks might su�er afatal loss of con�dence. Italy or Spain might become unable toborrow on decent terms. Or a government trying to impose aus-terity might be replaced by one that rejects it. Any of these couldcause contagion and plunge the world economy into depression.

Some people speculate that Germany might lead a break-away core of euro-zone countries. But as the Teutonic eurosoared in value, banks and companies would lose huge sums ontheir assets abroad and its exporters would �nd themselves at adisadvantage. Besides, for Germany to out an EU treaty so braz-enly would damage all EU law, which argues strongly against it.

Greece is more likely to buckle under austerity and quitafter a succession of governments like the new one. But it wouldbe a desperate act. Banks would collapse and capital ee, andmany of Greece’s companies, unable to pay their euro-denomi-nated bills, would go bankrupt. Already shut out of debt mar-kets, Greece would probably lose all �nancial aid from the EU.

Amid recession and the contagion of a debt default, bankcollapse or Greek departure from the euro, Europe’s single mar-ket would be in danger. At an EU summit in 2008, when the �-nancial crisis was raging, Nicolas Sarkozy chastised the commis-sion for being too zealous in upholding competition. A senior

EUROPE AND IT S CURRENCY

SPECIAL REPORT



IN GERMAN EYES this crisis is all about pro�igacy. Greeceset the tone when it lied about its circumstances and lived

beyond its means (see map and charts opposite and below). There is no disputing Greek dissipation, nor the fact that the

euro zone’s troubled members, which also include Portugal, Ire-land, Spain and Italy, must now pay a heavy price. But those oth-er troubled countries were not exactly pro�igate. Before the crisisthe governments of both Ireland and Spain ran budget surplus-es. Both meticulously kept within the limits for de�cits and debtsset down by the stability and growth pact�unlike Germany,which �outed the rules for four years from 2003 (and avoidedpunishment). Nor did Italy lurch into extravagance.

Debt in these countries has become a burden not becauseof government pro�igacy but because each enjoyed a decade oflow interest rates and was then hit by the �nancial crisis. Easycredit fuelled debt in households and the �nancial sector. TheEuropean Central Bank oversaw a binge of cross-border lending.In the crisis unemployment and hardship have deepened, in-creasing the bill for welfare. Some countries, such as Ireland andSpain, have needed to �nd money to prop up their banks. Thesenew expenses fell on the state just when tax receipts collapsed�catastrophically in countries that had seen a property boom.

At the same time interest rates surged. Before the crisis in-vestors assumed no euro-zone government would default on itsdebt. However, as Peter Boone and Simon Johnson of the Peter-son Institute in Washington, DC, explain, Germany then sig-nalled that defaults could happen and that investors would haveto bear a share of the losses�a reasonable demand, but a hardone to introduce in the middle of a crisis. Some investors askedto be rewarded for the extra risk and others, unwilling to startpaying for credit research, just walked away. This set o� a spiralof falling bond prices, weakening banks and slowing growth.

Even where troubled euro-zone countries had not beenpro�igate, they have been running unsustainable current-ac-

count de�cits. Low interest rates fuelled domestic spending andspurred in�ation in wages and goods, which in turn made theirexports more expensive and left imports relatively cheaper. Butit was also because Germany was recycling the surpluses pro-duced by its export machine, �nancing their consumption.

Germany’s economy is remarkable in many ways, but itwas as unbalanced as the euro zone’s peripheral economies. Intheir determination to save, Germans seemed to forget that inthe long run the point of exports is to pay for imports. They mustnow regret having invested their savings abroad in Americansubprime mortgages and Greek government debt.

Your debt, your fault

To end the crisis, the euro zone members agreed last monthto write down half of the Greek debt owned by the private sec-tor, recapitalise Europe’s banks and boost the fund created as a �-rewall to protect solvent euro-zone governments. It is an ambi-tious plan, but Greece may need even more help and the �rewalldoes not look strong enough to withstand a bout of contagion.

And even when the crisis has abated, restoring Europe tohealth will take many years. That is because the troubled coun-tries need to control their government de�cits and to re-establishsound current accounts by improving their competitiveness.Germans feel that the responsibility for this lengthy adjustmentlies exclusively with borrowers, which must urgently restorebudget discipline. Signi�cantly, the German word for debt,Schulden, is the plural of Schuld, meaning guilt or fault.

However, this strategy risks being self-defeating. By push-ing for immediate austerity the euro zone is deepening recessionin the troubled economies, which will only make their debtharder to service. Germany’s approach su�ers from a fallacy ofcomposition. It is not possible for everyone to save their way toprosperity. As Keynes argued after the Depression, someone,somewhere must be consuming. In Europe that should be coun-tries such as Germany and the Netherlands that were runningvast current-account surpluses during the boom. But the credi-tors are loth to accept that they are part of the problem.

Creditor governments, most of all Germany, face a dilem-ma. They need to save troubled governments in order to preventcontagion. On the other hand they also want to keep up marketpressure for reforms and to establish the principle that govern-ments are on their own�so that German taxpayers will not belanded with the bill every time some EU country goes on aspending spree. So far Germany is trying to have it both ways,and succeeding only in getting everyone deeper into the mire. 7

The causes

A very short historyof the crisis

To understand the politics of the euro, it is necessary

to look at its causes

Sources: Bloomberg; European Commission; IMF; Thomson Reuters

GermanyIreland Spain France GreeceItaly Portugal

1Who are the champions?

Ten-year government-bond yields%

Nominal unit labour costs2000=100

Budget balance% of GDP

40

30

20

10

0

10

+

–

2000 02 06 0804 10 1290

100

110

120

130

140

2000 0402 06 08 10 1995 2000 05 10 110

5

10

15

20

25

30



SPECIAL REPORT

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TIPOS INFAMES IS a �ne bookshop in central Madrid, runby three young friends and stocked with the sort of books

you were always meaning to read, until work and children got inthe way. Well aware that the intellect needs gentle encourage-ment, the owners lure you in with strong co�ee and generousglasses of Spanish wine. Running a bookshop is di�cult, says�Curro� Llorca; these days he doesn’t get so much reading doneeither. But business is passable.

Curro and his friends needed three years to set up shop.They had to obtain a full house of separate permits, one to sellbooks, a second to sell co�ee and a third to sell wine. The townhall said not to worry and advised Curro to open his doors whilehe was still waiting for the paperwork. But the budding entrepre-neurs wondered what they would do if the police turned up.

Tormented by unemployment, Spain needs new �rms likeTipos Infames. Yet in the World Bank’s ranking of how easy it isto start a business the country comes only 133rd, after Kenya.

Next to quelling the crisis, the single most important taskfacing Europe’s economies is to grow, because only then willthey eventually be able to pay o� their debts. In order to do that,they need to improve their competitiveness. And the best routeto improved competitiveness is to streamline the public sectorand overhaul the markets for labour and services.

Yet Europe has failed for many years to accomplish justsuch structural reforms. Looking at Curro, the economic logic forchange is unanswerable. But the politics is grim. Across Europe,business is held back by bureaucracy. Powerful interest groupsare protected at the expense of everyone else.

The crisis only strengthens the case for reform (see box). Butit also means that reform must take place against the backgroundof austerity, as societies struggle to determine who will shoulder

the burden of debt. The darkening cloudsof civil disobedience and anarchy con-fronting Greece’s new government showwhere this struggle can lead. Europe’s fu-ture depends not just on governmentsputting forward the right policies but onthe capacity of democracies to bringabout peaceful change.

How to gain in Spain

How might reform work? Again,consider Spain. Reform there shouldstand a good chance. The country hasdone well out of EU membership. After itjoined in 1986, incomes caught up withthe rest of the union. Its large exportershave remained an island of e�ciency, ascompetitive as any in Europe. Spain re-cently signalled its commitment to theeuro zone by writing a cap on future def-icits into the constitution.

Moreover, the Spanish may beabout to vote for change. An election laterthis month is likely to bring in a new con-servative government under Mariano Ra-joy of the People’s Party (PP). If the opin-ion polls are to be believed, he stands towin a sweeping victory and to be able togovern with an absolute majority. Giventhat the PP also controls many of Spain’sregions, Mr Rajoy will have an unprece-

Austerity

Destructive creation

The economic case for reform is overwhelming, but

the politics will be hard

Athenian democracy on four legs

OVER THE PAST decade Europe’s troubledeconomies have lost competitivenessagainst Germany, as the charts on theprevious page show. Within a �xed curren-cy they cannot devalue. Instead they needa combination of lower real wages, lowerinput prices and higher productivity.Higher in�ation in Germany would makethat easier. Structural reforms are hard,otherwise governments would have un-dertaken them long ago. But if countriescontinue to avoid hard choices, the ad-justment will eventually be forced on themthrough recession and unemployment.

At the same time these economiesmust work o� their debts. For the publicsector, that can be through a combinationof tax increases, spending cuts or growth.But it is hard, not least because Westernsocieties have started ageing, whichmeans that fewer people are in work payingtax and more in retirement claiming bene-

�ts. The IMF reckons that for the rich world’sgovernments to take public debt back to60% of GDP by 2030 they would need toimprove their budget balances by a huge 8%of GDP by 2020. If governments fail to gettheir borrowing under control, then theadjustment will, again, be forced on theeconomy�this time by the bond markets.

Experience suggests that some poli-cies are better than others. If you want toincrease competitiveness, productivitygrowth is less disruptive than wage cuts,and wage cuts are better than unemploy-ment. If you want the government to shiftits �scal balance, you should cut spendingby roughly four times as much as you raisetaxes. Growth is better than either tax risesor spending cuts�but, experience alsosuggests, growth after credit busts isscanty. The best recipe for growth is to raiseproductivity through structural reforms�but nobody said that was easy.

In theory

Above anything else, Europe’s troubled economies need growth



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dented mandate to remake Spain. �People know the PP is goingto be severe,� says José Ignacio Torreblanca of the EuropeanCouncil on Foreign Relations.

But what a task he faces. A prime target will be Spain’s noto-riously dysfunctional labour market. This provides a group ofageing, virtually unsackable �insiders� with gold-plated con-tracts, whereas the rest have to make do with highly insecuretemporary contracts. Among other things, insiders bene�t fromwage-escalation clauses, so that in 2009real pay rose by 3.2% even though theeconomy shrank by 3.7%. And Spain givesyoung people a terrible deal: in a down-turn they are the �rst to be sacked. Notonly are roughly half of under-30s out ofwork, but those who do have jobs aremainly on temporary contracts that leavethem without a career structure and give�rms no incentive to train them.

Mr Rajoy is elusive about his plans.The outgoing government has underta-ken some labour-market reform, but mostpeople expect the PP to go much furtherand doubt that the weakened Spanish un-ions will be able to put up much of a �ght.But that is the easy bit. To transform theSpanish economy, Mr Rajoy also needs totake on two far more elusive foes.

First is the country’s dense jungle ofregulation and bureaucracy. This datesback to Franco, who from the 1950s sought to give Spaniardsmore freedom by trying to establish the rule of law even as he de-nied them democracy. The profusion of administrative lawcreated a dense and unaccountable bureaucracy. Ignácio San-chez-Cuenca, director of the Juan March Institute in Madrid, en-countered so many obstacles to hiring academics from outsidethe EU for the institute that it took up a quarter of his time. So hehired a �rm of lawyers to do the job and now spends 5-10% of hisbudget that way.

What makes Spain’s bureaucracy especially poisonous is

Mr Rajoy’s second foe: the country’s �ercely independent re-gions. Each tends to interpret regulations in its own way, so overtime the Spanish market has fragmented. Juan José Güemes, a PP

politician and a professor at the IE Business School in Madrid, ex-plains how the star-rating system for hotels di�ers slightly acrossSpain, which limits competition among national and interna-tional chains and reduces economies of scale. Last year the Cata-lan government decreed that hotels must serve pa amb tomà-

quet, bread with tomato, a local speciality, if they are to count as�luxury�. Miguel Cardoso, an economist at BBVA, a Spanishbank, estimates that, thanks to a lack of competition, half of thein�ation in Spain over and above the average for the euro zone inthe past 15-20 years came from �rms increasing their margins.

Mr Güemes’s colleague at IE, Fernando Fernández, addsthat each of the regions sponsors its own development policyand its own businesses, often �nanced by local savings banks.This is ine�cient, but the regions are popular because theyspend taxes collected by the central government. Moreover, re-gional autonomy is an antidote to the centralising, anti-unionbias of Franco’s Spain. Even if the centre can control the regions’spending�a big if��we have a free market at the national leveland are protectionist at the regional level,� says Mr Fernández.

Each reforming government in Europe faces di�erent obsta-cles, but Spain is typical of them all in the sense that radical struc-tural reform entails rewriting the social contract. Just now thegenerous wages of many of those in Spain’s protected jobs aresupporting entire households of unemployed spouses andgrown-up children. Scrapping thousands of bureaucratic ruleswill not just make the economy more e�cient but also recast therelations between government and citizen. However unambigu-ous the economics of reform, the politics is almost always hard.

Too hard for some. Rome alone is said to have half as manylawyers as the whole of France. The legal system there moves soslowly, Italians joke, that they put you in jail when you are ac-

cused and release you when they �ndyou guilty. Yet faced with the liberalisa-tion of their profession in a recent budget,Italy’s lawyers somehow managed tohang on to their perks�was it because somany politicians are lawyers?

Instead of imposing reforms, thefag-end of a government under Silvio Ber-lusconi has relied excessively on tax rises.After he was shamed by euro-zone lead-ers during recent summits Mr Berlusconiat last came up with a more ambitiousprogramme�but even then he was ob-

liged to accept the supervision of the IMF. The mix of hopeless-ness and humiliation has left his government close to collapse.

Others have shown more courage. Ireland’s governmenthas cut wages and slashed bene�ts and services. Unit labourcosts have fallen by 8% and the economy grew by 1.6% in the sec-ond quarter. The cuts have been even harsher in Estonia, wherethe economy shrank by 15% in 2009. Growth has soared sincethen and unemployment tumbled. Still, both economies face ahard slog. Because they are counting on foreign demand as asource of growth, they are vulnerable to a global recession.

Spain needs new companies like Tipos Infames. Yet thecountry comes only 133rd in the World Bank’s ranking ofhow easy it is to start a business



SPECIAL REPORT

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EUROPE HAS A dissonant new voice. Anti-Muslim, anti-elite, anti-globalisation and increasingly anti-Brussels, pop-

ulists now count for something in the Nordic countries, amongthe Dutch and Flemish, in France, Italy and Austria, and in partsof eastern Europe. They come in many varieties, but all claim torepresent what Pierre Poujade, France’s original post-war popu-list, called �the ripped-o�, lied-to little people�.

These movements are sometimes described as neo-fascist.Some of them indeed are, and all of them embrace odious andintolerant views of one sort or another. But to dismiss them asfascist, and thereby safely rule them out of European politicallife, o�ers the liberal mainstream false comfort. Over the pastfew years populists have found ways to set themselves apartfrom a neo-Nazi ideology. Many support gay and women’s rights

(all the better, they think, to bash the Muslims), and many are fer-vently pro-Israel. They are here to stay.

Europe’s populists are not likely to form governments; theylack the votes and are completely unequipped for o�ce. How-ever, mainstream politicians do not know how to see them o�.So their obsessions and their resentments have seeped into thedebate, even among those who would never vote for them.

This matters just now for three reasons. First, because theeuro and its independent central bank are elite projects par excel-

lence. The high priests of Europe’s political class handed downthe edict that Europe needed its own currency. They forced theireconomies to converge during the 1990s and masterminded theextravagantly complex job of issuing new notes and coins. Nowthat the technocrats have been shown up as bunglers, the anti-technocrats stand to gain. Second, populists are nationalists andprotectionists and reject both the idea of paying to save Europe’stroubled periphery and the sort of structural reforms that Eu-rope needs for growth. And third, populists feed the widespreadmistrust of Brussels and all its works, which will constrain theoptions available to �x the euro.

To understand how populism has taken root, look at whathas happened in the Netherlands, once the very model of a toler-ant, pro-integration member of the EU. In his study of the mur-der of Theo van Gogh, a �lm director, by a radical Dutch Muslimin 2004, Ian Buruma borrows the term regenten to describe themodern Dutch elite. Like the self-con�dent 17th-century rulingclass of merchants smugly gazing from the portraits of FransHals, the 21st-century regenten looked out for themselves and ne-glected the things that bothered ordinary people.

In the Netherlands the beef was with the immigration thatcreated �dish cities� of Turkish and Moroccan households tunedto satellite television from abroad. The regenten were all in fa-vour of multiculturalism and in no hurry to press immigrants toassimilate. In the early 2000s a �amboyant gay university lectur-er called Pim Fortuyn made a political career out of condemningwhat he saw as Muslim intolerance and regenten neglect.

What did this have to do with Europe? At �rst, nothing atall. But after Fortuyn, too, was murdered in 2002 (by an animal-rights activist, not a Muslim), another Dutch politician, Geert

Anti-EU backlash

Beyond the fringe

The rise of populists is a threat both to the euro and to

the EU as a whole

A touch of xenophobia

The nightmare is Greece. Government there has never beenabout the rational design and administration of policy, but aboutdishing out patronage. When George Papaconstantinou, thecountry’s �nance minister at the time, was asked why tax re-ceipts collapsed in 2009, the year his government came to o�ce,he explained that �the �rst thing the government does in an elec-tion year is pull the tax collectors o� the streets.�

Even so, the government of George Papandreou (in whichMr Papaconstantinou served) undertook reform with a savagerythat would once have been unthinkable. He had a gun to hishead, because the troika of the EU, the IMF and the ECB releaseaid each quarter only if the Greek government meets its targets.

Yet, beset by protests, a shrinking economy, the dishonourof being bossed around by foreigners and the prospect of a de-cade of further austerity, Mr Papandreou could not carry thecountry with him. His reluctantly resigned, following a botchedproposal to hold a referendum on the euro zone’s plans forGreece. The installation of a new government of national unitysmacks of Argentina, where a succession of short-lived adminis-trations fought to avoid default�before eventually succumbing.

Mr Papandreou’s ejection contains a warning. At root, thesolvency of a country is determined by the government’s capaci-ty to raise revenues and cut spending. Politicians run up againstthe popular will long before they run out of things to tax.

The crisis has also brought down governments in Ireland,Portugal and Slovakia. Spain, and others, are likely to follow.Where will voters turn when they have had their �ll of austerityand reform? The lesson of the 1930s and of emerging-market cri-ses down the years is that people can take only so much auster-ity. If the burden gets too heavy, the political system collapses.

This fear lies behind the warnings of Milton Friedman andMartin Feldstein, two American economists, who said that theeuro is inherently unstable. Until recently euro zone leaderssco�ed at such talk. But in the past couple of weeks they havesuddenly begun to contemplate Greece’s departure from the sin-gle currency. And contemplation is one step short of action.Their change of heart is not just because of mayhem in Athens,but also because of the di�cult politics of the euro at home. 7



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Wilders, took up his cause and increasingly exploited popular re-sentment against the regenten project of European integration.

As the EU has grown from six to 27 countries, the Dutch,who were among the founder-members, have felt their in�u-ence drain away. They have gone from being bene�ciaries ofEuropean funds to net contributors. They feel they have had totake in migrant workers from eastern Europe who threaten theirjobs. Sometimes the EU has imposed unpopular decisions, aswhen it ruled that the distinctive, often religion-based Dutchhousing associations were discriminatory, or that Turks were ex-empt from a mandatory exam for immigrants because Turkey isan o�cial candidate for EU entry.

The extent of anti-European sentiment became clear backin 2005, when the Dutch voted in a referendum to reject a pro-posed new constitution for the EU by a crushing 62% to 38%. Itwas the �rst time the Dutch elite had condescended to ask ordin-ary people about Europe and, says André Krouwel, a political sci-entist at Amsterdam Free University, even people who had noth-ing against Europe found something in the constitution todislike.

With Mr Wilders’s Freedom Party on one side and the anti-globalisation Socialist Party on the other, the pro-European, pro-globalisation middle is being squeezed out of Dutch politics. Thecentre parties used to win 80-90% of the vote. In the most recentelection they got only 54%. Meanwhile, the tweets of Mr Wilders,whose party has just 16% of the seats in the Dutch parliament,manage to grab 40% of the media coverage of politics, reckonsMr Krouwel. �He has destroyed Dutchconsensus democracy,� he adds.

A similar story is emerging across Eu-rope, though the details di�er. The TrueFinns are more Eurosceptic than anti-Mus-lim; the Danish People’s Party and theSweden Democrats are obsessed by im-migration; Italy’s Northern League is con-sumed by contempt for Naples and thefeckless South, as well as immigrants andthe EU; Belgium’s Vlaams Belang standsfor Flemish independence; France’s Na-tional Front is being dragged away fromits fascist, anti-Semitic past by Marine LePen; Hungary’s Jobbik has not even be-gun to change out of its jackboots.

But the punchline is the same.Heather Grabbe of the Open Society In-stitute in Brussels calls it �the politics ofresentment against elites�. This sentimentmakes o�ce a dangerous place for popu-lists. After Jörg Haider’s Freedom Partywon 27% of the vote in an Austrian elec-tion in 1999 it joined a coalition govern-ment, but in the 2004 elections to the European Parliament it gotonly 6.3%. Out of power, the Austrian populists (now split intotwo parties) saw their overall strength recover to almost 30% ofthe vote within just four years.

These days populists prefer to stand half-in and half-out ofgovernment, where they can claim credit for policies on, say, im-migration even as they disown the di�cult decisions that minis-ters often have to take. That was the strategy of Pia Kjaersgaard’sPeople’s Party, which put its stamp on immigration policy inDenmark until the election of the Danish left in the summer.These parties talk tactics with each other, says Sarah de Lange ofthe University of Amsterdam. And so the Danes have been cop-ied by Mr Wilders, pictured above, who supports a Dutch minor-ity government but is not part of it.

The Dutch �nance minister, Jan Kees de Jager, says that thisleaves the Dutch approach to Europe unscathed. The govern-ment can pass legislation on the EU by calling on the support ofthe opposition centrist parties, depriving Mr Wilders of in�u-ence. That line is supported by surveys showing that the level ofDutch backing for �Europe� in the vaguest, most generalisedsense has not dramatically fallen over recent years.

But this argument is not wholly convincing. Dutch atti-tudes to sovereignty have hardened. Politicians come back fromBrussels to The Hague complaining that they could not get thedeal they wanted. The idea of spending Dutch money to rescuethe Greek economy was unpopular. If �xing the euro requiredanother referendum, the government would struggle to win.

Don’t look for gratitude

Moreover, that Dutch vote against the European constitu-tion was part of a Europe-wide popular backlash against the EU.The constitution was supposed to renovate the EU’s creaking leg-islative machinery as well as bringing Brussels closer to the peo-ple. But the people either did not understand it or were not inter-ested. Having been rejected in France as well as the Netherlands,the constitution was reworked as the Lisbon treaty and was at�rst rejected again, this time by a referendum in Ireland. Thetreaty-cum-constitution limped into law in 2009, eight di�cultyears after work on it had begun. The instrument intended to for-tify the EU with popular legitimacy won just three out of six ref-erendums. Ten governments had backed away from promises of

popular votes.The message is clear. However un-

pleasant some of the populists’ views are,they are on to something with the EU. Or-dinary Europeans see Brussels as remoteand elitist (see chart 2, next page). As ithappens, the European project was likethat from the very beginning�and for thebest possible reasons.

Look back to the founding of theEuropean Economic Community, theEU’s forerunner, in 1957. What from thevantage point of 2011 might seem like anundemocratic �x was actually inspiredstatecraft. After the second world warmany Europeans feared that the ghastly

cycle of economic depression, instability and war was going tobegin all over again. They were caught between the horror ofGerman revanchism and the nightmare of a communist take-over. Europe was the antidote to the madness that had almostdestroyed Western civilisation in two world wars, and it was tobe administered by the regenten of the day. The architects of theEEC did not seek to harness popular enthusiasm, because it wassuch enthusiasm that had led to Fascism and Bolshevism.

No wonder that EU business has always been more aboutthe horse-trading of the committee room than about the rhetoricof the debating chamber. David Marquand, a former British MP

and a commentator on Europe, writes: �At the heart of the Euro-pean project lay an unacknowledged but pervasive ambivalenceabout politics. In transcending the nation state, the founding fa-

With Mr Wilders’s Freedom Party on one side and theSocialist Party on the other, the pro-European middle isbeing squeezed out of Dutch politics



SPECIAL REPORT

2

1

thers were also seeking to transcend�or rather to escape from�the messy, vulgar, clamorous irrationality of political life.�

Inspired by the quest for peace, Europe’s designers expect-ed their creation to be justi�ed by what the Brussels o�cials stillcall �output legitimacy��that Europeans would accept the EU

because it worked. But that is not what has happened. Today’sEuropeans take peace for granted. They are more inclined tomeasure the EU by the prosperity it has brought. However, itdoes not get the full credit for that either because national politi-cians, instead of explaining how much the EU has contributed toEuropeans’ wealth, take the credit for themselves. And many ofthem like to blame Brussels for everything that is bad.

The EU has not helped its own cause. Terms like �the com-munity method�, �Coreper� or �co-decision� seem almost de-signed to scare people o�. Its processes are comically obscure.Paul Magnette, a Belgian politician, reckons that there are 22 dif-ferent legislative procedures and 30 legal instruments for deci-sion-making in the EU�and that is only counting what is knownas the ��rst pillar� of EU competencies (don’t ask).

All this has led critics to complain about the EU’s �demo-cratic de�cit�. But that line of attack is o�-beam. The commission(which is unelected, but must be approved wholesale by the par-liament) can only propose legislation and help to enforce it. Newlaws need the backing of ministers from national governmentsand the elected European Parliament. Compared with nationalcapitals, Brussels is admirably free with information and brief-ings once you penetrate the jargon and the procedure.

What the EU lacks is not democracy but popular engage-ment. It always has and it always will. There is a small industrychurning out suggestions for how to remedy this. How about di-rectly electing the commission’s president? Or sending nationalMPs to sit part-time in the European Parliament? Or staging Eu-rope-wide referendums, so that a single country cannot hold theother 26 to ransom? None of them would change the fact that theEU is remote, impenetrable and elitist. However hard it tries, theEU will not be loved by European citizens�even those who arebroadly pro-European. In the words of Anand Menon, a Britishacademic, it is �structurally condemned to inspire apathy�.

�Public opinion is a new actor in the EU,� says CharlesGrant, director of the Centre for European Reform. �It limits whattechnocrats can do.� Beset by populist anti-elitism on one sideand impenetrable technocracy on the other, the fate of the eurotherefore lies squarely in the hands of national governments.And none more so than the duo that have long made the runningin Europe, France and Germany. 7

2

Source: Eurobarometer, spring 2011 *Average

0 20 40 60 80 100Denmark

GermanyBelgium

SwedenNetherlandsFrance

Finland

PolandSpain

Euro area*Ireland

AustriaPortugalItaly

Romania

BritainGreeceCzech Republic

Europinions“My voice counts in the EU”, % of respondents who:

AGREEDISAGREE DON’T KNOW

WHEN DE GAULLE’S foreign minister asked him which of-�cials France should dispatch to Brussels to sta� the new

European Commission, the general replied: �Send the most stu-pid.� Although these days France installs some of its best peoplein Brussels to watch what the EU gets up to, that condescendingattitude has never entirely disappeared. If it had a choice, Francewould keep the commission �rmly in its place and run the showwith Germany as a sort of European G2, but enlargement of theEU to 27 countries got in the way. The euro crisis presents Francewith the best chance in decades to drag the EU back on track.

At the same time, though, the crisis has established a newGerman dominance in Europe. As the continent’s biggest econ-omy, Germany has set the terms of the various euro-zone res-cues. Having largely absorbed east Germany since uni�cation in1990, it is looking for markets in the emerging economies. And,bit by bit, it is carving out a more assertive and independent role.

When Nicolas Sarkozy, France’s president, meets AngelaMerkel, Germany’s chancellor, the atmosphere can be chilly. MsMerkel has said she thinks she is �the most boring person Mr Sar-kozy has ever met�. But what matters more is the unresolvedcombination of France’s designs and Germany’s power. Theirdi�cult partnership weaves yet another strand into the dramaof the euro, adding to the uncertain future of the EU itself.

The blues in Berlin

During the euro crisis Ms Merkel has often seemed torn, re-fusing such things as a concessionary interest rate for Greece,only to change her mind later. That partly re�ects her tempera-ment: cautious, tactical and naturally inclined towards the mid-dle path between standing �rm and coming to the rescue. But, tobe fair to Ms Merkel, it is also because Germany itself is torn.

On the one hand, Germans know that their fate is stillbound up with European integration, as it has been for the past60 years. The country’s pro-European �nance minister, Wolf-gang Schäuble, says that although Germans might be sceptical ofthe euro, they are not Eurosceptics. Opposition parties have criti-cised Ms Merkel for being too reluctant to save the euro zone.They have put forward bold plans, such as Eurobonds issuedjointly by the entire euro zone, combined with a leap in �scal in-tegration. The opposition has been rewarded with a strong per-formance in regional elections. By contrast, Ms Merkel’s partyhas su�ered at the polls and her coalition partner, the more Eu-rosceptic Free Democratic Party, is on its knees.

Moreover, the German economy is intricately tied into theEuropean economies around it: they are a source of parts andsupplies for German industry, a place where German banks andinsurers have invested their savings, and a market for Germangoods. A collapse of the euro or a chaotic default by a Europeangovernment or bank that spread through the EU economywould be a terrible outcome for Germany.

On the other hand Germans also feel indignant. They thinkthat at the time of monetary union they were conned with thefalse promise that the euro and the European Central Bankwould be worthy of the mighty D-mark and its guardian, the

Europe’s big two

The Nico and Angelashow

Is Europe run by France and Germany, or by Germany

alone?



2

1

Bundesbank. These were potent symbols of German nation-hood. As Helmut Kohl, chancellor at the time, told the thenFrench president, François Mitterrand: �The D-mark is our �ag. Itis the foundation of our post-war reconstruction. It is the essen-tial part of our national pride; we don’t have much else.�

The euro is no D-mark. Day after day German televisionand newspapers portray Europe as a threat to German prosper-ity. The �no bail-out� clause, designed to ensure that govern-ments will not be held liable for other countries’ debts, has beentrampled underfoot. As the crisis has grown, the share of Ger-mans who think the euro will be a long-term success has fallenfrom 78% in 2008 to 55% earlier this year. Ordinary Germans areasking if they should ship their savings to Switzerland.

And, in German eyes, the ECB is no Bundesbank. When thebank proposed to buy bonds of troubled governments in theopen market, two Bundesbank vigilantes objected, arguing thatthe policy took the ECB across the threshold from monetary to�scal policy. Having lost the argument, they resigned. At the endof last month the Bundestag passed a non-binding resolutionagainst the ECB’s �nancing the euro-zone rescue fund or continu-ing to buy bonds once the rescue fund can do so instead. Jörg Ro-choll, dean of the ESMT business school in Berlin, talks of a�common feeling of betrayal� over the ECB.

When Germans look at Europe’s periphery they see econo-mies that partied when they should have been sobering up.After uni�cation Germany put itself through economic boot

camp. The unions agreed to lower pay rises. The government cutbene�ts, raised charges and made it harder for workers to claimdisability allowances. Between 1994 and 2009 the country’s unitlabour costs fell by about 20% against the rest of the EU. But theadjustment was a hard slog. Jobs went abroad, where labourwas cheaper, and unemployment rose to a peak of 12.1% in 2005.That same year the Social Democrat-led government of GerhardSchröder paid the price at the polls, bringing Ms Merkel to power.

Yet, thanks to these e�orts, Germans have enjoyed world-class economic performance over the past decade (see chart 3).No wonder, then, that they resent seeing the fruits of their ownself-denial being used to pay for everyone else’s self-indulgence.In any case, Germans have never quite got over the anxiety thatthey developed in those years of austerity. Whereas the rest ofEurope looks at Germany and sees an economic powerhouse,many younger Germans doubt that they will live as well as theirparents do, and fret that the social safety net will not be therewhen they need it.

There was a time when Germany bore its �nancial contri-butions to the EU with stoicism. Uwe Kitzinger, a British academ-ic and former o�cial in Brussels, called them �a form of delayedwar reparations�. But now the country is making its anger felt.

�As the pivotal state in monetary union,� writes DavidMarsh, �Germany is becoming more self-centred but less sure-footed, more hectoring but more vulnerable.� Mr Schröder putdown a marker back in 2000. At a summit in Nice he demanded

that in ministerial votes on EU legislationGermany’s large population should havea bigger say than other countries. Lastyear the Bruegel think-tank in Brusselspublished an essay entitled �Why Ger-many Fell out of Love with Europe�. AndJean-Claude Juncker, the prime ministerof Luxembourg and head of the Euro-group, in which the euro-zone’s �nanceministers meet, complained that the�Germans are losing sight of the Euro-pean common good.�

Moreover, the world is changing.German trade has been shifting awayfrom the euro zone. In 1999 German ex-ports to Portugal, Ireland, Spain andGreece totalled �30 billion, a multiple ofthose to China, just �6 billion. By last yearexports to China, worth �53 billion, ex-ceeded those to the four peripheral econ-omies. Goldman Sachs, a bank, reckonsthat China is poised to match France asGermany’s biggest trading partner.

And Germany, too, is changing. Itscontroversial decision not to join France

*Average †Government, household and corporate debt, excluding financial sector

3The best and the rest

Sources: IMF; OECD; McKinsey

GDP per personAverage annual growth rate, 2001-10, %

Overall debt†

End 2010, % of GDPUnemployment rateHarmonised definition, September 2011 or latest month, %

0 0.4 0.8 1.2

Germany

Britain

Euro area*

United States

France

4 6 8 10 115 7 9

Germany

Euro area*

Britain

United States

France

0 50 100 150 200 250 300

Britain

France

United States

Germany

Keep up now, Nicolas



SPECIAL REPORT

2 and Britain in the NATO campaignagainst Libya’s Muammar Qadda� repre-sented what Constanze Stelzenmüller, ofthe German Marshall Fund, calls �a loos-ening of the ties�. NATO, she says, is nolonger bound by the �unifying energy ofthe Russian threat�.

Re�ecting on Germany’s strife overthe euro and its refusal to �ght in Libya,Hans Kundnani, editorial director of theEuropean Council on Foreign Relations,recently argued in the Washington Quar-

terly that �Germany’s economy is too bigfor any of its neighbours, such as France,to challenge�but not big enough for Ger-many to exercise hegemony.� This, he con-cluded, is an economic statement of the�German question� that tormented Eu-rope for 75 years after German uni�cationin 1871.

The most likely answer to that ques-tion today is compromise. Germany is not about to walk awayfrom Europe, nor to let the euro fail. But Germany’s price will be arescue in which it will be explicitly seeking to put its own inter-ests above all others. What does that mean for France?

The pressure in Paris

Thanks above all to De Gaulle, France has been fabulouslysuccessful in Europe. Having been defeated and occupied byGermany, France was humiliated and neglected by America andBritain. In 1954 Eisenhower called the French �a helpless, hope-less mass of protoplasm�. But armed with the general’s brilliantcombination of cunning and self-belief, France made itself indis-pensable to the construction of Europe. It then used that status totame the German threat, to project French power in the worldand to get the EU to pay for its own expensive farm subsidies.

But that policy has run its course. A senior French politiciansays that today’s Franco-German coalition �is fragile and publicopinion is hostile�. In French eyes today’s EU su�ers from three�aws. First, the commission and the ECB have too much scope toact independently of governments. Second, the British-backedpolicy of enlargement has gradually changed the character ofthe union, making it harder for French views to prevail and over-emphasising open markets. And third, taking Mr Kundnani’sGerman question, France needs to renew its deal with Germany.

The euro crisis o�ers a tantalising chance to do so. Becausethe euro will need more and better governance, France has an

4

Source: European Commission

Running out of ropeFrench government, % of GDP

0

10

20

30

40

50

60

70

80

90

38

40

42

44

46

48

50

52

54

1980 85 90 95 2000 05 10

Debt Spending

opportunity to sideline the commission by creating new institu-tions controlled by governments. If decisions can be taken by the17 members of the euro zone, rather than the 27 of the EU, thenthe restored Franco-German duo might take charge.

France has already made progress. Throughout the euro cri-sis Mr Sarkozy has appeared alongside Ms Merkel at Franco-Ger-man summits to set policy for the entire euro zone. His rewardwas that the euro zone will have two summits a year and its ownsecretariat. Germany has seemed willing to fall in with theFrench preference for an intergovernmental �Europe des patries�.

Yet even if the other 25 countries in the EU are ready to goalong with this, France faces a huge obstacle. To be an equalpartner, it has to be a plausible match for German power. �Ideas

can come from France only if it is economically strong,� says An-dré Sapir, of the Bruegel think-tank. France’s military force helps,but the economy lets it down. Moody’s and Standard & Poor’shave both warned that they might cut their rating of French gov-ernment debt, alarming the government in Paris.

The economy’s problems run deep. French industrial ex-ports have fallen from 55% of Germany’s in 2000 to around 40%now. Fewer than a third of France’s industrial companies spendmoney on R&D, compared with almost half in Germany. And al-though France’s government �nances are fairly healthy com-pared with those of many other rich countries, the marketsdoubt the country’s long-run capacity to pay its way.

Demography is on France’s side: its population is growing,whereas Germany has one of the EU’s lowest fertility rates. Yetthe trajectory of government borrowing raises concerns, giventhat in 1980 France’s debt was only 20% of GDP (see chart 4). Thepublic sector’s share of the economy is already greater than Swe-den’s, which limits the scope for tax increases. Mr Sarkozy’s gov-ernment reformed pensions last year, the �rst increase in work-ing time in France since the second world war. However, thechange put the minimum retirement age back by only two years,to 62, and it met with huge resistance. The Socialists are promis-ing to reverse it if they win the presidential election next year.

Jean Pisani-Ferry, a director at the Bruegel think-tank,points out that the French are ambivalent. Although they arecreditors, the media have covered the Greek crisis very di�erent-ly from the German ones, emphasising the su�ering of ordinarypeople. �The French see a magni�ed version of their own fail-ings,� he says.

Germany still needs France to get things done in Europe. IfParis and Berlin can agree on a policy then most of the othercountries will rally round. But in the recent summit talks over aeuro rescue, France gave way to German demands�notably thatthe ECB should not lend to the rescue fund. The risk for France isof becoming a foil for Germany rather than a genuine partner.

In the 1990s France quali�ed for monetary union by cling-ing doggedly on to the strong franc, even as others devalued.Some of those who run France readily acknowledge that theyneed a similar act of will today. �Politicians have not told theFrench people the truth,� says Bruno Le Maire, the French agri-culture minister. �We said there was no need to change. It’s false�France has to accept the world as it is�We have to give Ger-many the idea that we can succeed with the market, not with aprotected Europe.� 7

Germany still needs France to get things done in Europe.If Paris and Berlin can agree on a policy then most of theother countries will rally round



1

EVERY COUNTRY SEES �Europe� as a projection of its ownhopes and fears. For Germany it is redemption; for France a

means to amplify French power; for Italians it is not Rome; forBelgians it is not Brussels; for the Baltic states it is a long way fromMoscow; for Romania and Bulgaria it is order; for Spain it is thesolution; and for much of central Europe it is home.

The rest of the world has a stake in what happens in Eu-rope, too. The overwhelming feeling is frustration that Europeanleaders seem so incapable. Andrew Balls, of PIMCO, the world’slargest bond investor, says that the di�erence between emerging-market crises and G10 crises has always been that you expectG10 governments to remain in control. After a series of half-res-cues of the euro, he wonders whether this rule still applies.

It is a sure bet that at crucial moments America will be onhand to browbeat Europeans into taking action. The Federal Re-serve will stand by to back the European Central Bank. Neitherwants to see the world economy dragged into recession by Euro-pean blunders. But America has enough troubles of its own.

The idea that China might become a dragon ex machina,spending hundreds of billions of dollars on the bonds of trou-bled European governments, is fantasy. China will o�er encour-agement. It may invest in the euro zone’s new special-purposevehicles to buy the debt of troubled euro-zone governments�with the right political concessions, it may even be generous. Butthe amounts of hard Chinese cash will be limited, if only be-cause the euro zone’s creditor nations were unwilling to putmore of their own money into the pot.

The ins and outs of being in

Within the EU, the crisis is a test of the European dreams ofcountries that are not part of the euro zone. Many of them are re-lieved to have escaped the turmoil. But they are now in a spot. Ifone day they surrender their own currencies, as in theory theypledged when they joined the EU, the revamped governance ofthe euro will a�ect them deeply.

Take Poland, by far the biggest economy among the formercommunist countries and still outside the euro zone. It has had agood crisis, being the only EU country to avoid a recession, atleast so far. That is mostly because of domestic demand, but alsopartly thanks to its ability to devalue the zloty.

And yet mainstream opinion in Warsaw is in no doubt thatthe nation’s destiny is tied to the euro, and particularly to Ger-many. That is partly an economic calculation. Germany is a vitalexport market for Poland. Its components and parts help makeGerman industry competitive. Ryszard Petru of demosEUROPA,a think-tank, argues that being part of the euro would help en-sure that foreign direct investment (FDI) keeps coming. It hasbeen very important in modernising the Polish economy, but re-mains relatively low.

The Polish establishment also thinks that the euro makespolitical sense. Although the country started as �ercely Atlanti-cist after communist rule came to an end, it is now somewhatdisenchanted with the United States. When Barack Obama can-celled the Bush administration’s missile-defence shield (whichwould have protected Poland) in 2009, he chose a fraught date:

September 17th, the anniversary of the Soviet invasion of Polandin 1939. Poles felt slighted, even though the system’s replacementturned out to be bigger and better. They also think they were notproperly rewarded for their support of America in Iraq.

As the idea has gained ground that the euro zone mightform an EU inner circle, so Europe itself has come to seem moreimportant to Poland. �It is not just tactical,� says AleksanderSmolar of the Stefan Batory Foundation, a think-tank. �For 1,000years we have been trying to get into the real Europe, Charle-magne’s Europe. Many times we have failed.�

Politicians are quick to say that Poland �has no problemswith tighter discipline and budget control�. They point out thatthe Polish constitution already says government debt should notexceed 60% of GDP�one of the criteria of the EU’s much-abusedstability and growth pact. Polish o�cials still have fresh memo-ries of their country’s EU accession, when they were bossedaround and told to shape up. After that, a dose of euro-zone dis-cipline might not seem too irksome.

What does worry Poles, though, is any hint that their coun-try might lose in�uence. The normally equable Donald Tusk, Po-land’s prime minister, �ew into a rage in February when hiscountry and the other nine euro �outs� looked as though theymight be excluded from the �competitiveness pact�, a Germanscheme to help integrate the 17 economies in the Eurogroup. MrTusk won a reprieve, with a promise that the outs could join in aspecial �euro plus� group. But this may not add up to much: thereal decisions may still be taken by the 17 euro members. In theend, if Poland wants to be con�dent of making its voice heard, itwill probably have to take the plunge and apply to join them.

They see things di�erently in Britain, and to a lesser extent

Non-members

Look at it this way

The euro crisis is a threat to non-members too

Tusk gets into shape



SPECIAL REPORT

2

1

Denmark, both of which have formal exemptions from joiningthe euro�though Denmark’s currency is pegged to it. The domi-nant emotion among Eurosceptic Britons is not sympathy fortheir main trading partners but fury that Britain is being draggeddown by what they see as continental Europe’s failure.

Blighty and bluster

Under the Conservative Party, the senior partner in the rul-ing coalition with the pro-European Liberal Democrats, Britain isfast drifting o� into the Atlantic Ocean. Many Conservativeswould like to use a new treaty on the euro, agreed on among all27 EU members, as a chance to put some British business onto thetable. One group of Tory MPs has suggested repatriating powersover criminal law, social policy, �nancial regulation, farming and�sheries. These are not fringe voices: fully 81 Tory MPs de�edtheir party to vote against the government in a recent bill callingfor a referendum. In a continent full of visions of Europe, none ismore jaundiced than Britain’s. But even allowing for that, theConservatives’ scheming looks ba�ingly complacent.

The crisis could profoundly a�ect British interests. The eurozone represents over 40% of Britain’s trade. London is the EU’sbiggest �nancial centre. And senior o�cials in Brussels think theEurogroup could well become a place where important businessis done, to the disadvantage of outsiders. �I see a real danger ofEurope splitting,� says one. Resented all over the continent as abad European citizen, Britain should not expect any sympathy ifthe agenda turns against it. When you ask euro-zone politiciansabout British interests, they say: �If Britain is worried, there’s aneasy solution. It should come into the euro.�

Tory MPs think they hold all the cards, because they calcu-late that the euro zone needs British backing to reform the EU’streaties. In fact Britain’s hand is weak. Rather than give in to Brit-ish demands to repatriate powers, the 17 euro-zone countriescould just sidestep London and sign a treaty outside the EU.

The Tory desire to strip down relations with Europe, as ifBritain might become a giant Norway or Switzerland outside theclub, makes no sense either. Britain is too big to be left alone bythe rest of the EU. At risk is the single market. Not only is it themost important EU institution for Britain, but without Britain’sliberal voice it may well veer towards protectionism. 7

Tory MPsthink theyhold all thecards, asthey reckonthat theeuro zoneneeds theirbacking toreform EUtreaties. Infact,Britain’shand isweak

IN THE HEART of the EU’s administrative district in Brus-sels, a little way inside the council building where EU min-

isters hammer out legislation, stands a big bronze bust of JustusLipsius. A 16th-century humanist who sought to reconcile Chris-tianity and Stoicism, Lipsius betokens learning and integrity.

On closer inspection, though, the bust turns out to be madeof painted plaster. If you rap it with your knuckle you hear thethwack of gypsum rather than the ring of cold metal. Low downon the great scholar’s mantle is a small white patch where thepaint has chipped away. Far from adding dignity to the businessof the council, the mock-bronze inadvertently honours the Brus-sels tradition of making do. It is this spirit of grubby compromise,not lofty idealism, that will determine the future of the euro.

That is because, as Joseph Schumpeter argued, a monetarysystem cannot be separated from the society that underlies it.Saving the euro is about much more than the optimal design of acurrency area. Even as the euro zone �ghts to steady its banksand its sovereign borrowers, it must grapple with the profoundchoices that this special report has set out.

Four choices

The most important of these is Europe’s attitude to global-isation. The more the euro zone embraces growth-enhancing re-form, the lower the chance that its members will, after years ofgrinding austerity, succumb to the political fatigue that couldlead to the euro’s collapse. However, the economic imperativefor austerity and restructuring is already putting the govern-ments of the euro zone’s troubled periphery under severe strain.

A second choice is about what it means to be �European�.Among the euro zone’s creditors, populist parties are increasing-ly rallying against the EU. Battered by austerity, the citizens ofdebtor countries could easily go the same way. Elites all acrossEurope have lost their authority. The European Commission andthe parliament tend to be resented by national governments. Allthis limits the scope for �xing the euro by transferring sovereign-ty to Brussels.

A third is about the leadership of Germany and France. Thecrisis has given the leading role in Europe to Germany. It must de-cide what price it is willing to pay for leadership and how to useits new power. Will it come round to the idea that the EuropeanCentral Bank (ECB) must put its balance-sheet behind the eurozone’s governments? Meanwhile, France, greedy to redesign Eu-rope according to its own tastes, must decide whether it is pre-pared to take the di�cult steps needed to keep up with Germany.

The fourth is about Europe’s divisions. Eastern Europe isanxiously watching the confusion and disarray to its west. Itmust choose whether its destiny should eventually be inside theeuro. Britain, too, must work out what it wants from the EU. Inthe past it has yanked the continent towards open markets andeconomic liberalism. Today Britain is striding away from Europein a very British �t of absent-mindedness.

These questions are complicating the rescue of the euro. Inthe crystalline world of political and economic theory the im-mediate task is to stop the run on Europe’s banks and sovereign

After the crisis

Making do

Instead of going all out for the serious reforms it

needs, Europe is likely to settle for the minimum

borrowers. This requires a controlled de-fault of insolvent governments�which,so far, means Greece�and the protectionof solvent governments by a pledge tobuy as many of their bonds as it takes toward o� market panic. At the same timeEurope’s banks must be protected withfresh capital. The euro zone showed at lastmonth’s summit that it is coming aroundto this design�though the package theycame up with was still too puny. But thetwo other components of any completeeuro rescue are still embryonic.

One is reform of the euro’s gover-nance. The euro zone needs a fund thatcan help member states cope withshocks. More ambitiously, the credit rat-ing of the entire area might be used to is-sue Eurobonds, which would be less vul-nerable to speculation. The euro zonemust ensure that delinquent borrowersdo not exploit these facilities to run upbills for everyone else to pay. And, toblock the vicious circle in which failingbanks amplify the weakness of sovereignborrowers, it must establish a Europeanmechanism for insulating banks from their sovereigns.

In theory all this is possible. In practice, however, it wouldinvolve a large transfer of sovereignty to give the central euro-zone authorities the scope to raise money, regulate banks andprevent errant �scal policy. Few countries are ready for that. Theprospect of a United States of Europe is about as real as thebronze of Justus Lipsius’s bust.

For a start, Germany and France will not allow the Euro-pean Commission to gain much extra power. In recent years Ger-many has become suspicious of the institution. Neither Ms Mer-kel nor Mr Sarkozy is fond of José Manuel Barroso, its president.The money for the euro-zone rescue pot, the European FinancialStability Facility, has come from the member states, mostly fromFrance and Germany. They are not about to hand control overhundreds of billions of euros to the commission.

One alternative might be to �x everything among govern-ments, in the Eurogroup, as France would wish. But smallercountries have seen, in the treatment of Greece and Italy, howFrance and Germany get to call the tune: �intergovernmental-ism� leaves them vulnerable. And Germany’s federal constitu-tional court in Karlsruhe ruled after the 2007 Lisbon treaty, theEU’s most recent piece of constitutional re-engineering, that the

German government could never again transfer sovereigntyaway from the German parliament to Brussels without also en-suring that German citizens have more say at the European level.Deals among a roomful of governments do not meet that test.

What about the German idea to give more power to theEuropean Parliament? Many national governments would ob-ject. How would Nicolas Sarkozy, emperor of the Fifth Republic,feel if the European Parliament had more sway over him than hisown tame Assemblée Nationale?

In short, there is no consensus in the euro zone for an ambi-

tious transfer of sovereignty to Brussels. Instead, in the spirit ofshoddy compromise, it will do as little as it can. As the summit inOctober hinted, the emphasis will be on binding countries bythe norms of prudent economic management�a superchargedversion of the set of rules the commission presented a year ago,including warnings about imbalances and �scal sustainability.

Perhaps such rules could be enshrined at national level.Just as euro-zone members are required to have an independentcentral bank, they could be obliged to set up independent o�ces

of statistics and budget sustainability andto enact constitutional guarantees ofgood behaviour. That would provideeuro-zone reassurance without euro-zonesovereignty. Perhaps, too, banks could beregulated at the EU level and be prevent-ed from ever becoming as dependent ontheir sovereigns as they are today.

All this will need to be backed up bystrong discipline�and that will lead to yetmore trouble. France would prefer thestick to be wielded at the discretion ofgovernments. Germany, however, wantsbinding rules and strong punishments.Germany is likely to carry the day, butonly if it can �nd a way to force through anew treaty.

That will be harder than it sounds. Afull treaty requires a convention, an inter-

governmental conference and then rati�cation by national par-liaments and a referendum in Ireland and quite possibly in othercountries, too. Old Brussels hands think that all this would takethree to four years. Moreover, the mood in Ireland just now is sobad that you could not get the ten commandments approved in areferendum.

Scarred by the di�culties of trying to write and ratify a con-stitution for the EU, the euro-zone countries may therefore try todress up a treaty as merely a �technical� adjustment. They maytry to sign a treaty among themselves, outside the EU. That



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The sun sets

Few countries are ready for a large transfer ofsovereignty. The prospect of a United States of Europe isabout as real as the bronze of Justus Lipsius’s bust

would stop Britain from causing trouble, and negotiationsamong 17 countries may be speedier than among 27. However,existing EU law requires the new agreement to mesh with all oth-er EU treaties, which may be awkward.

From an economic point of view such minimal new rulesfor governing the euro would be second-best. Despite what is of-ten said, no economic law dictates that a common currency musthave a common �scal policy. But �scal co-ordination does makelife a lot easier.

The price of a cobbled-together rescue is that some day theeuro zone will probably have to endure yet another existentialcrisis. It is all very well to talk of discipline and oversight rightnow, when disaster is still an imminent possibility; but warinessis bound to fade with time. Bubbles in�ate precisely becausepeople fail to recognise that they are living with dangerous im-balances. One French o�cial remembers being told by commis-sion economists during the boom to copy Ireland and Spain.Now the same people are telling him to copy Germany.

Postwar postscript

The third component of a textbook euro rescue would re-balance Europe’s dangerously lopsided economies. In the trou-bled countries of the euro zone this requires a programme ofthoroughgoing structural reforms, along with a plan to reducegovernment budget de�cits over the medium term. The eurozone’s creditor states would match this with a �scal stimulus de-signed to boost demand in their economies. That would helpdrag the ailing members out of recession.

Again, reality will fall far short of this ideal. The citizens ofuncompetitive economies are already exhausted by austerity,and Germany and the other creditor nations are reluctant to runde�cits. The danger is that people will refuse to accept the unem-ployment and austerity being imposed on them. If so, that willhugely raise the economic damage wreaked by crisis, as yet moreoutput is lost and more jobs are destroyed.

This is the greatest single threat to the survival of the euro.Governments will topple and the pro-grammes underpinning international aidwill fall apart. An angry, populist Greecemight well storm out of Europe as a harm-ful act of protest. At that moment the riskof contagion would be at its greatest.Would the single market survive? Wouldthe ECB and Germany, staring into theabyss, at last commit themselves to ring-fencing solvent governments?

Sometimes the worst really doeshappen. However, even if Greece goes, ageneral fragmentation of the euro zone re-mains unlikely. Collapse would not bene-�t any of its members. Even if joining wasa mistake, quitting would be a bigger one.Moreover, all the arguments over rescuefunds and bank bail-outs are in the endabout who will pay, not whether the sys-tem is worth saving.

The brinkmanship could go on for months and there mightbe more half-rescues like the one in October. But were a bank ora solvent economy suddenly to fall prey to a market panic, thengovernments and the ECB would surely step in. It would makeno sense for the ECB to put its own reputation for orthodoxy be-fore the ravages of de�ation. And if the euro zone ceased to exist,the ECB would have nothing to be orthodox about.

Remember, though, that even this action would only buytime for Europe’s troubled economies to resume the relentless

slog of regaining competitive-ness and working o� theirdebts. Sometimes you read thatsuch an enforced workout is ahopeless cause. Ageing, com-fortable Europeans have nostomach for hard work or invig-orating globalisation. Many gov-ernments will want to protecttheir companies, not subjectthem to competition. The temp-tation to use the euro zone to de-fend una�ordable privilegeswill be strong. The political cul-ture in a country like France haslong seen globalisation as athreat to be managed. That viewmay be hard to shift.

Yet this argument is too fa-talistic. Europe has a choice, justas America had a choice afterthe miserable decade of the1970s, when it decided to beatin�ation and re-establish thedollar. Europe has much to o�er:creativity and imagination,skills in design and manufactur-ing, expertise in science and en-gineering. And it has somethingto prove to an interconnectedworld. Confronted by global �-nance and business, no political system seems able to copealone. If collaboration cannot be made to work among the statesof Europe, bound by history and culture, can it work anywhere?

This newspaper’s fervent hope would be that Europeansembrace globalisation by at last getting serious about reformingtheir rigid economies and their welfare states. Indeed, the pre-sent crisis has presented them with a unique chance to breakapart the political interests that have held them back.

Crises have a way of speeding up history. In his magisterialaccount of Europe after 1945, Tony Judt writes: �Postwar in Eu-rope lasted a very long time, but it is �nally coming to a close.�The near-failure of the euro has made Judt’s world seem more re-mote than ever. The post-Nazi taboo on populist parties is fallingaway. Without the Soviet Union’s occupying armies, Germany isonce again the power that leads Europe but is unable to domi-nate it. The bloodless politics of Brussels, once a bulwark against

extremism, has now become an obstacle. The welfare state, builton postwar prosperity, has become too expensive for these strait-ened times.

It is often said that in the face of the euro crisis the EU musteither integrate or disintegrate. Either is possible. More likely,though, it will muddle through, integrating as little as it can getaway with, disintegrating as Britain becomes ever more de-tached, and reforming just enough to get by. When the fuss isover, the chances are that Europe will breathe a sigh of relief andcontinue rather faster down the path of genteel decline. 7

The Economist November 12th 2011


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The failure of the euro would not bene�t any of itsmembers. Even if joining was a mistake, quitting wouldbe a bigger one

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Issue Date: 12-11-2011 Zone: UKPB Desk: SR Output on: 07-11-2011----14:26 Page: SR14 Revision: 0

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Staring into the abyss - The Economist · Staring into the abyss The euro crisis might wake Europe...

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