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The Shape of Europe to Come

Commentary, 1 November 2011
International Institutions, Europe
Last week saw European leaders agree to a mega-deal with the aim of abating the huge crisis engulfing the continent. Yet much of the details appear to be smoke and mirrors with Europe inevitably facing decades of misery and decline.

Last week saw European leaders agree to a mega-deal with the aim of abating the huge crisis engulfing the continent. Yet much of the details appear to be smoke and mirrors with Europe inevitably facing decades of misery and decline.

By Dr Jonathan Eyal, Senior Research Fellow and Director, International Security Studies, RUSI

 Euro Flag Flickr/rockcohen

1 November 2011 - Europe is breathing a sigh of relief. The Euro crisis which has plagued the continent for the last eighteen months has finally being brought under control by a mega-deal reached at the end of last week. A large chunk of the debt of Greece, the country which has started the crisis, is about to be written off. European banks are going to be recapitalised. And the borrowing requirement of other EU countries will be safeguarded through an ingenious scheme which protects lenders from default. Yet much of this is just smoke-and-mirrors. For the deal will not halt the crisis; it merely postpones rather than avoid a much bigger mess. The Euro as currently constituted cannot survive. And the Europe which will emerge from this mess will be a radically different continent. Everyone - including Britain, which is now just a spectator - is likely to be affected by this in very profound ways.

Background

It is now clear that the calamity which faces Europe can be traced back to the end of the Cold War two decades ago, a period when, paradoxically, Europe seemed to be at the height of its powers. It was then that the EU embarked on its most audacious project: the creation of the Euro as its single currency. Some experts warned that no monetary union can succeed unless national economies approach a similar level of development and spending priorities are decided centrally, rather than in each state. But the Europeans ignored such warnings because at that time they seemed to be the masters of destiny; no economic theory was allowed to stand in the way of their vision.

The result is today's unmitigated disaster. A currency designed for an industrial giant such as Germany which exports more than the US, was also adopted by Greece, whose exports are 20 times smaller. European governments were allowed to spend as much as they wished, borrowing at cheap interest rates which they would have never enjoyed had their retained their old national currencies.

Europe's problem is no longer one of just too much debt, but one of long-term economic competitiveness, destroyed by an over-valued currency. For example, since Italy adopted the Euro, its effective exchange rate - based on its labour costs - rose by 26 per cent. The only way this disparity can be addressed is by either devaluing the currency, or by depressing the salaries of workers, a method which economists call 'internal devaluation'.

The first option is not available, since the Euro is controlled by a bank beyond the influence of any government. And the second option is equally impossible, since workers will not tolerate a huge drop in their earning power. So, even if Germany - which now bankrolls Europe -  agrees to guarantee the debts of all other European governments, this will still not stop Europe's crisis.

Getting out of Europe's monetary union is not an option either. According to the most optimistic calculations, an exit from the Euro could cost Italy about 10 percent of its GDP, as government debts remain unpaid and banks go bankrupt; the country will need about 25 years of uninterrupted growth to merely recover from this loss. In short, the Europeans are damned if they stay in the Euro, and damned if they don't.

Why The Current Deal Won't Work

Despite all the optimistic claims, the current deal cannot resolve the problem, for the following reasons:

  • Even if banks agree to accept a 50 percent cut in the value of the Greek debt they hold, this will not affect Greece's insolvency. Und er the most optimistic scenarios, the country still have a debt equivalent to 120 per cent of its GDP by the end of this decade. The Greeks are condemned to many years of painful economic reforms, for no particular purpose. It beggars belief to assume that they are going to accept this, only to still remain Europe's most indebted nation;
  • The current bailout fund is simply not sufficient to cover the borrowing needs of other countries, which cannot raise funds on the open markets. Clever schemes offering to insure lenders for 20 percent of their potential loss on future bonds will also be insufficient to restore confidence;
  • The Germans are determined not to allow the European Central Bank to print money, which is the only way the crisis can be resolved;
  • The more money that is put into the bailout fund, the less stable the economies of other European countries become: France, for instance, may lose its top credit rating, triggering off another crisis;
  • Italy, which is too big to bail, is unlikely to reduce its own gigantic debt, partly because it has no consensus on this matter, but also because its political scene is divided;
  • It is unlikely that cash-rich countries such as China will offer enough cash to meet Europe's borrowing needs.

One way or another - and perhaps even before the end of this year, the crisis will return, and the EU will be faced with the need for a much more radical approach.

Economic Implications

The only way out of this deadlock is to reinvent Europe's monetary union, this time according to economic, rather than political principles. Countries will have to abandon all control over their financial policies; these will be decided on a Europe-wide basis. And they will have to continue repaying their huge debts. Some nations will make it, but others will not; this will be a battle in which only the fittest survive.

Either way, the continent is inevitably facing decades of misery. Since the end of World War II, Europe's economic model was broadly the same. Each government came to power promising to expand the provision of health care and welfare services. And each took it for granted that the economy would inevitably continue to grow. Capital was cheap, companies made fat profits and jobs were plentiful.

Europe's model has been fraying for years. An ageing population has already made the generous provision of pensions unsustainable. The cradle-to-grave welfare system excused the Europeans from hard work: when France faced a high unemployment problem, it simply shortened the working week, on the assumption that employers would be forced to hire more people.

The nanny state also protected people from the consequences of their own actions: children from broken families were left  to the state to look after, while few Europeans saved any money, because no financial cushion for a rainy day was needed. And, as Europe became less competitive, its share of global trade shrank. A century ago, Britain alone was responsible for over half of global commerce; today, all of Europe accounts for a quarter.

Yet, although European governments knew that they had to address these problems, they hoped that the process of adjustment would be gradual, and that economic recessions will remain short. When the global financial crisis struck in 2008, Prime Minister Gordon Brown, famously proclaimed that it would last a mere six months. But even when this proved to be untrue, politicians still believed that recovery was just around the corner. Mr David Cameron, for instance, came to power last year vowing to cut his country's debt mountain, but only spoke about 'sharing the proceeds of growth', rather than the shrinking economic cake.

Europe's current crisis means that the hard choices can no longer be postponed. As debts are being repaid and governments struggle to balance their books, welfare and pension entitlements will be slashed. Banks will get more protection than people. And Europeans will be forced to save rather than spend, leading to a prolonged period of zero growth, similar to that which afflicts Japan.

But the continent is ill-prepared for what lies in store. Politicians, all of whom were born during an age of plenty, have yet to explain what needs to be done. And the European Union, which until now was associated with ever-rising prosperity, will soon become a hated institution, the organisation which imposes permanent austerity with no democratic accountability. Unsurprisingly, therefore, Europeans are now lashing out at others - immigrants, 'devious bankers' or 'unfair traders' such as China - rather than admitting that the failure is theirs alone.

Still, the coming European Depression will be different from the global, Great Depression of the 1930s. For, while last century's crisis resulted in a great expansion of the role of the state, the current European crisis can only be solved by actually shrinking the powers of governments. The only common thread between these two huge economic disasters is that, as always, it will be the average citizen who will pay the immediate price.

Political Implications

The Euro will not simply collapse, to be replaced by national currencies. Instead, some countries, mainly on the continent's south, will be forced out of the system, but Germany, Austria, the Netherlands and Finland - all with their finances in good order and still competitive - will continue to operate the currency. The main imponderable is whether France will be in this select group. And the guess is that the French will do everything to stick to the Germans, even if this means economic pain for decades, if only because, without its alliance with Germany, France will face its biggest strategic defeat since World War II. So, there is a good chance that Europe will have a 'hard core' and a softer periphery

That will present Britain with fundamental choices. British Euro-sceptics - mostly within the Conservative Party - are delighted by the crisis: they claim, with some justification, that it vindicates their position. But they may be rejoicing too soon. For, once the Euro zone splits, Britain will have to decide whether it wishes to remain inside Europe's core, or whether it will join the periphery. It is a choice every bit as difficult as that faced by Harold Macmillan and Harold Wilson during the 1950s and 1960s. And it may tear the current coalition government apart.

The decision by some European countries to ask for cash from China also carries grave strategic implications. If the Chinese were to comply and offer credit, they will exact a heavy price: Beijing will demand that Europe grants China its coveted 'market economy' status, thereby allowing more Chinese goods to enter European markets tariff-free. The Chinese will also demand a lifting of the arms ban which the EU still applies to Beijing. And China will also expect the Europeans to offer support in Beijing's tussles with the United States, over trade and currency issues. A Europe which kowtows to China is one which will soon have big disputes with the US. And, as European budgets shrink, the continent's defence expenditure will shrink as well, raising further problems for NATO. Finally, Europe's obsession with its own financial crisis means that the continent's international footprint will virtually disappear: gone are the days when Europe could preach good governance and democracy to others, or undertake any serious military of foreign policy initiatives.

Meanwhile, the almost permanent state of ferment and economic crisis at home will result in the rise of populist parties, which will either concentrate their ire on immigrants, Muslims, or the hated 'bankers'. Fascism is unlikely to engulf the continent, but populism of various hues will, and it can paralyse Europe just as much.

Conclusion

Nothing could have prepared Europe's politicians for what has turned out to be their continent's worst crisis in more than half a century.  All their historic assumptions and financial models are melting down; Europeans appear condemned to decades of austerity and economic decline, regardless of what they do from now on. And ironically, the Euro project, designed to produce a closer-knit European federation, will be remembered by history as the one step too far, the one event which shattered Europe's peace.

The views expressed here are the author's own and do not necessarily reflect those of RUSI.

Author

Jonathan Eyal
Associate Director, Strategic Research Partnerships

Dr Eyal is the Associate Director, Strategic Research Partnerships, and International Director, at the Royal United Services Institute... read more

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