Dream of United Europe frays at the edges

The warnings have been flying for months, but now it’s crunch time. Is the game up for big Europe? Karen Kissane in London and Eric Johnston in Brussels report.

At a joint news conference last week, Germany’s Angela Merkel and France’s Nicolas Sarkozy let their guard drop. Asked whether they could rely on Silvio Berlusconi to get Italy’s economy in order, they exchanged a mocking glance, rolled their eyes heavenward and smirked.

No one’s laughing now.

Berlusconi, the playboy Prime Minister described by one commentator as a man no one would trust with their daughters, much less their economy, has been forced to exit the political stage, to the relief of the German Chancellor, the French President and most of Berlusconi’s MPs.

But he has left behind a shambles that has become the latest threat to the future of Europe. Italy might soon follow Greece into economic meltdown, a prospect that has sparked talk of a deep recession, an end to the euro and the collapse or shrinking of the European Union.

The crisis in Europe is also undermining the fragile global economic recovery, leaving the world “looking straight into the face of a great depression”, Simon Johnson, a former chief economist at the International Monetary Fund, warned this week.

Other commentators also threw the term about. “I think it is pretty clear that we are in a very precarious economic situation that is highly similar to the Great Depression,” David Edwards wrote in Forbes magazine.

The chief of the IMF, Christine Lagarde, joined the chorus of doom, warning on a visit to Asia that “there are dark clouds gathering in the global economy. Countries need to prepare for any storm that might reach their shores.”

The advice might have been easier for Asia to accept with grace if only Lagarde’s corner of the world had been able to set the example.

But political disasters piled one upon the other at breakneck speed this week, leaving dithering European leaders looking like the Road Runner who has raced off a cliff only to realise, too late, that there is no ground under his feet. Again.

By week’s end, after four days of agonised talks over power sharing, Greek politicians finally named a new prime minister, Lucas Papademos, a former vice-president of the European Central Bank. He will lead an emergency unity government backed by socialist and conservative MPs until early elections, possibly in February.

The decision provides hope to the rest of Europe that the Greek parliament will pass the austerity measures required to get its next batch of bailout funds, without which it will be bankrupt by Christmas.

The Greek economy is in free fall, having contracted 15 per cent under existing austerity measures, says Simon Tilford, the chief economist with the Centre for European Reform in London.

It is feared that if the government defaults on its debts, it will spark a banking crisis through the euro zone.

But only time will tell if Papademos, who negotiated Greece’s disastrous entry to the euro zone, can wrangle the nation’s notoriously fractious MPs into line. ”Even yesterday, the old guards, at least, of both parties were not very keen to co-operate,” George Tzogopoulos, a research fellow with the Hellenic Foundation for European and Foreign Affairs in Athens, told the Herald.

In any case, by the time the Greek announcement came, the glare of the market’s critical spotlight was on Italy. It owes a whopping ?1.9 trillion ($2.5 trillion) – 120 per cent of its gross domestic product.

While the Italian economy is much richer than Greece’s, with a lot more private wealth and profitable industries, investors panicked that the government might not be able to keep up its repayments. Interest rates on its sovereign bonds soared to more than 7 per cent – the rate that sent Ireland, Greece and Portugal reaching for their IMF begging bowls.

The emergency saw Berlusconi packed off and plans developed to install an EU ”technocrat” as the temporary leader. Mario Monti, an economist and a former commissioner of the EU, was being proposed to fill in as prime minister to lead – you guessed it – another ”government of national unity”, like Greece’s.

Front of house, the talk was of undying support for the vision of a united Europe and for the present members of the euro family. Merkel said Germany was ”definitely not pursuing plans” for a smaller euro zone (17 of the 27 countries in the EU use the euro).

Back of house, however, preparations have been barrelling along. The Chancellor of the Exchequer in Britain, George Osborne, has a team working on a plan to protect the pound if the euro collapses. On the Continent, Reuters revealed EU officials had been discussing for months whether some countries should leave – or be thrown out of – the EU.

A senior EU source said ”intense consultations” had been taking place ”at all levels” and that a smaller euro zone was one possibility: ”We need to move very cautiously but the truth is that we need to establish exactly the list of those who don’t want to be part of the club and those who simply cannot be part.”

Greece might have become the cranky relative no one wants at the dinner table.

If Greece should walk away from the union and its mountain of debt – or be ejected, which would require political finesse as the European treaty contains no mechanism for it – it might lead to investor panic. Markets could freeze lending to the next most vulnerable states, like hyenas picking off wildebeests at the back of the herd, as one analyst remarked.

There is consensus that the failure of Italy would almost certainly set the dominoes falling across the zone because Italy is too big to bail out. ”Its economy is three times as big as the Irish, Greek and Portuguese economies put together,” Tilford says.

If Greece leaves, that will make departures by others much more likely and, if Italy left, ”France would be under huge pressure,” Tilford says. ”France assumes that if Greece and one or two other states left, that its status as a core part of the euro zone would be secure. But that’s far from clear. Its borrowing costs are already higher than Greece’s. If Italy goes, France will go, because it won’t be able to reassure investors.”

Raffaello Matarazzo, a research fellow at the Institute of International Affairs in Rome, sees a blacker scenario: ”I think there is no ‘next problem’ after Italy. I think if Italy collapses, the euro zone collapses.”

For ordinary people, ”collapse” would mean living inside a catastrophe. If Greece goes bankrupt, for example, it can expect a run on the banks, possibly with individual investors losing their savings; no more government payments of pensions and wages; and an explosion in poverty and unemployment.

”To avert a situation where significant numbers would have to look for food on rubbish heaps, you would need a massive, co-ordinated, external help program,” says Thomas Klau, a senior political analyst at the European Council on Foreign Relations in Paris.

Saul Eslake, an economist at the Grattan Institute in Australia, says Europe should have allowed Greece to default on some of its debt 18 months ago. ”Greece would have defaulted on less debt and there would be far fewer questions on the future of the euro. Instead, Europe has been kicking the can down the road every time this issue came up.”

But a full default by Greece would risk another Lehman Brothers-type financial shock, a senior financial official with the EU said. Greek debt was held mostly by Europe’s weakened banks. If Greece did not pay it back, this would drain their already low level of capital. ”If we let Greece go, it threatens to bring down the whole system,” he says.

Default by Italy, he says, would be like a nuclear bomb going off on financial markets.

There is so much concern about the immediate pain of money problems, there has been little debate about another potential casualty of the euro crisis: democracy.

European and Greek politicians were horrified when the former Greek prime minister George Papandreou last week proposed a referendum in which the Greek people would be asked whether to accept the terms of the euro bailout. Papandreou lost his position as a result, because the bailout is widely loathed in Greece and politicians thought the Greeks would refuse it – and they decided not to risk facing the will of the people.

Now it seems Italy is to have a ”technocratic” rather than a democratic government. It worries Sarah Ludford, a Liberal Democrat member of the European Parliament for the seat of London. ”When democracy is seen as too uncertain, that is food for thought,” she said. ”It’s almost like the 1930s. It’s a very sobering thought. If it’s necessary to have Mario Monti in charge of Italy for a while, it ought to be strictly limited.”

She says while politicians fear the economic costs of not fixing the problem, they should also be aware of the social costs of their decisions. ”We have seen a rise in extremism on the far right, and when people are fearful for their job or out of a job, they are more likely to find a scapegoat, which tends to be foreigners or migrants. So this is all politically worrying.”

Hans Marten, the chief executive of the European Policy Centre, also warns of social tensions simmering below the surface, including a problematic vein of nationalism.

He says when one adds to this the poor outlook for economic growth in many countries, and high unemployment – particularly among the young – Europe is facing conditions not far from the Europe of the 1930s.

But while the risk of apocalypse is real, there is an alternative future in which the euro zone and the EU survive by evolving. The principle underlying the sliding-doors alternative can be summed up in the old saying, whatever doesn’t kill you makes you stronger.

Under this scenario, the euro zone sorts out who is to be in and who is to be out, and tightens the membership rules so everyone inside the magic circle shares some responsibility for budgets, taxes and debt (fiscal integration). European leaders have discovered with a thud that critical economists were right all along: it is impossible to have a single currency unless the parties share these other policies.

Oversight of national budgets was boosted from last April, giving the European Commission unprecedented access to budget forecasts and spending plans. The measures include significant financial penalties for countries that stray from budget discipline.

Many commentators believe Germany will have to drop its opposition to bailouts by the European Central Bank, which is probably the only body in a position to prop up Italy.

And further integration is seen as crucial to preventing another crisis like this one. ”A European finance minister must be appointed and a common budget must be the main target of a new European ministry of finance,” Tzogopoulos says.

But he – like most of the others interviewed for this story – believes Greece will probably stay in the euro. Greeks are mad at their politicians, and at the bailout terms, but like being in the euro, he says.

Matarazzo says political support for the zone is likely to increase next year, with Greece, France and Italy facing elections that are likely to be won by oppositions that want a closer Europe ”and the possible launch of European bonds”.

Sarkozy has predicted a ”two-speed Europe”, with euro zone states moving closer together and the other EU members making up a looser confederation. He has said: ”There are 27 of us. Clearly, down the line, we will have to include the Balkans. There will be 32, 33, 34 of us. No one thinks that federalism, total integration, will be possible with 33, 34, or 35 states.”

This could further marginalise Britain, whose Prime Minister, David Cameron, has been frustrated by his inability to influence euro decision making during the crisis.

Cameron is torn. He wants Britain to be central to European debate but euro-sceptics in his party want more distance from the European arena. They have been strengthened by the crisis, renewing their calls for Britain to wrest back some of the political powers and policies it has ceded to Brussels.

Critics say the euro zone grew too fast and failed to take voters with it. There is a low turnout for European elections, which is interpreted as a sign that the grand project has failed to enchant the populace.

Another problem is the EU’s cumbersome structure makes its processes for responding to the crisis slow and complex, giving the short-term tactical advantage to nimble markets. But another name for that cumbersome structure is democracy.

”We are a union of 27 member states with governments and parliaments of democratic systems,” says a senior EU official.

”The EU is not the United States of Europe; we do not have a federal government. The European Central Bank does not have a federal reserve bank, so we have to go back to national parliaments [for decisions to be ratified].

”That is the nature of the EU and others should not be complaining about that.”

Whatever the outcome, there will be a lot of suffering along the way. Greece has no easy options; the austerity measures and complete default will both mean economic hardship.

Others in the union will suffer, too, says Florian Baumann, of the Centre for Applied Policy Research in Munich. ”The other countries like Germany and France which are not so seriously affected, they will have to suffer because of the money they gave away for the bailout [of Greece]. And another problem that will affect all the countries of Europe is the recession.”

He believes political leaders were right to block the Greek referendum. A deep crisis is no time to go to the people for a vote, he says. ”It’s not a wise idea to involve people in urgent and very complex decisions in the [European] project. And no one ever wants pension cuts or to lose income. I think what Europe will have to do in the future, though, is let its people decide about the general development and politics of the EU.”

As the crisis lurches on, it is important to remember the EU’s achievements, says Australia’s ambassador to the EU, Brendan Nelson.

”Look at Australia. We are a federation with six states and two territories. How long have we been talking about a common education curriculum in Australia? We started in 1961 and we are just now on the cusp of this. Imagine 27 countries – 17 in the euro zone – who are trying to manage the problems associated with the monetary union without a fiscal union.

”We are very frustrated about the pace and scope of the member states in dealing with the crisis. But if you step back and say, ‘Well, in 18 months they have reached the point where 27 countries – not six states – can now check each other’s budgets and budget forecasts and they’ve put an emergency fund together’. There’s a lot that’s been done.”

Nelson, a former leader of the Liberal Party, likens the European response to the crisis to ”making sausages”.

”It’s best not to watch. It’s just good to see the final product. And when we get to see that – I don’t know.”

First published in the Sydney Morning Herald.