europe’s make or break moment

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Europe’s Make or Break MomentRobert Kahn & Charles KupchanPublished online: 04 Dec 2013.

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Despite the progress that European leaders have made in bringing financial stability to the eurozone, the European Union continues to face a severe eco-nomic and political crisis. This crisis has not only threatened the viability of the single currency, but also fostered political tensions that are weakening the foundations of the EU. These troubles emerged from financial mismanage-ment, unsustainable public debt and the lack of structural competitiveness in the southern tier. Economic missteps developed into political fragmentation, pitting wealthier member states in the north against weaker economies in the south. Economic dislocation has combined with political division to awaken widespread public scepticism about the merits of European integration.

European leaders have responded to this crisis by combining fiscal con-solidation with a credible road map for banking and fiscal union, a step meant to provide the euro with the collective oversight and enforcement mechanisms it needs – and should have had when it was first introduced. The problem is that the austerity being doled out to put Europe’s house in order is undermining the readiness of European publics to accept the deeper union that is needed to redress Europe’s economic woes. The debt crisis has soured European electorates on the project of European integration, rena-tionalising politics and calling into question whether member states will be prepared to countenance the more extensive integration that European leaders are currently striving to bring to fruition.

Europe’s Make or Break Moment

Robert Kahn and Charles Kupchan

Robert Kahn is Steven A. Tananbaum Senior Fellow for International Economics at the Council on Foreign Relations. Charles Kupchan is Professor of International Affairs at Georgetown University, Whitney Shepardson Senior Fellow at the Council on Foreign Relations and Senior Fellow at the Transatlantic Academy.

Survival | vol. 55 no. 6 | December 2013–January 2014 | pp. 29–48 DOI 10.1080/00396338.2013.862933

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30 | Robert Kahn and Charles Kupchan

This essay begins by examining the economic side of the eurozone crisis. Significant strides have been made by periphery countries in reforming their economies and reducing their fiscal deficits, and the liquidity actions of the European Central Bank (ECB) have provided important breathing space. However, the crisis has left a legacy of damaged bank balance sheets and excessive levels of government debt in many countries. We suggest that more rapid progress towards fiscal and banking union may be needed to establish the conditions for a return to growth that is essential for exiting the crisis. The essay then goes on to examine the political prerequisites of recovery. Our analysis provides cautious optimism that the EU is heading down a path that could bring the crisis to an end, and that EU member states are committed to remaining on this path. However, the EU is by no means out of the woods; rebuilding public confidence in the project of European integration will be an essential but elusive task in the months ahead. Now that the debate over bailouts and austerity has politicised the EU and spilled into British pubs, French cafés and Greek tavernas, elites have little choice but to engage publics and seek to convince them of the merits of deeper union.

From crisis to recovery: fostering growthIn the five years since the onset of the Great Recession, there have been notable achievements in resolving the eurozone crisis and accelerating progress towards economic, monetary and financial union. Impressive fiscal consolidation across the periphery has reduced imbalances and most countries have made significant strides towards restoring competitiveness. Sizeable rescue packages and extraordinary central-bank liquidity support have filled financing gaps and helped to stabilise markets.

But the record of structural reform has been less impressive. Despite some important successes, including fiscal reform in Italy and labour-mar-ket liberalisation in Spain, the structural agenda has lagged. This outcome should not be a surprise, as structural reforms cut at sensitive and estab-lished interests, and can be disruptive to economic activity in the near term. But, as a consequence, the reform process to date has been heavily tilted towards fiscal austerity.

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Europe’s Make or Break Moment | 31

In the financial sector as well, despite significant steps, progress has been insufficient to re-establish market confidence. Bank balance sheets remain weighed down by poor loans. Stress tests have been incomplete and have failed to provide a convincing case that banks will weather adverse sce-narios. Capital injections have addressed the obvious losses, but significant capital shortages remain. As a result, European financial markets have become fragmented and credit rationing is now a significant drag on growth, particularly for small- and medium-sized companies in the periphery.

The most significant gap in Europe’s crisis response has been the failure to address the ‘doom cycle’ linking national governments to their financial systems. Throughout the periphery, insolvent banks have required rescues from governments, which in turn have damaged market confidence by causing sovereign-debt ratios to soar. This debt overhang then goes on to restrict invest-ment and close off market access, leaving lasting scars. Kenneth Rogoff and Carmen Reinhart have shown that financial and debt crises often require quite lengthy recovery periods. In their study, This Time is Different, output fell by an average of more than 9% during such crises, and it took countries an astound-ing 23 years before the damage to sovereign-debt levels was unwound.1

Moving ahead: overwhelming force versus incrementalismThroughout the current crisis, Europe has struggled over how fast to move towards full economic and financial union, and how much firepower to bring to bear to restore financial stability. One camp argues that to restore confidence and stabilise markets in times of crisis, policymakers must use overwhelming force – Colin Powell’s admonition in a very different context. The other camp believes that financial support and moves towards fuller monetary union need to be measured, incremental and heavily condi-tional on economic performance to ensure that periphery countries do not abandon discipline and fall back into bad habits.

The policy response of the United States during 2008–09 reflected the first line of thinking. The use of the Troubled Asset Relief Program, major Federal Reserve programmes for purchasing assets and providing liquid-ity to financial institutions, forced capital injections and aggressive stress testing all served to convince markets that the worst-case scenarios were

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off the table. In Europe, in contrast, Germany has led the charge in arguing that it would be irresponsible to move rapidly to fiscal and banking union without first correcting the practices that produced the crisis in the first place. This concern about moral hazard – that bailouts will discourage reform in the periphery – has prompted Germany to insist that support for countries in crisis, and steps towards monetary union that will mutualise these costs, can succeed only if accompanied by upfront policy reform.

Europe’s incrementalism gave way to a more aggressive approach last year after the ECB launched its own version of the Powell Doctrine. The ECB’s promise to purchase periphery bonds (through its outright mone-tary transactions programme), coupled with Mario Draghi’s pledge to do ‘whatever it takes’ to defend the euro, stabilised markets and put those who might want to speculate against the survival of the euro on the sidelines.2 Even during the subsequent Cyprus crisis and national elections that tem-porarily left Italy in political limbo, European markets held their ground and spreads remained near multi-year lows. For now, at least, Europe looks to have moved beyond the series of crises and emergency weekend meet-ings that have dominated the last several years.

At the same time, it would be a mistake to assume that current low spreads reflect confidence that the crisis is resolved. The patient has been moved out of critical care but is still chronically ill, and will remain so until growth returns and debt sustainability is re-established. The ECB has provided an important bridge until that time, but market pressures could return quickly if countries were seen to be abandoning their commitment to reform and financing gaps were to re-emerge.

The problem is that prospects for growth are grim. In its spring 2013 fore-cast, the IMF projected a decline in euro-area growth of 0.4% this year, and growth of 1% next year. Private forecasters are more pessimistic. Growth at this level is insufficient to make headway in reducing high levels of unem-ployment, which have reached 27% in Spain and over 12% in the euro area as a whole. Youth unemployment, which averages 24% in the eurozone and exceeds 40% in Spain and Italy, represents a critical threat to Europe’s future. The challenge, therefore, is to restore growth before markets again lose confidence in the reform process.

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Macroeconomic policy has limited scope to provide the needed boost to growth. Financial conditions remain tight, despite rate cuts by the ECB. Markets anticipate additional cuts, but with rates already close to the zero bound, the scope for conventional monetary policy is limited. Formal quan-titative easing, involving the purchase of government bonds proportionally across the eurozone, is permissible under current law and is one option. An alternative for jump-starting growth is more aggressive use of macro-prudential policies to dramatically increase the flow of credit to small- and medium-sized companies in the periphery and reverse the ongoing frag-mentation of European financial markets. There are costs and distortions to any directed credit scheme, making the ECB understandably wary about moving aggressively in this direction.

On fiscal policy, recent statements by European leaders calling for diminished austerity are constructive to the extent that they signal that governments will not need to adopt counterproductive cuts when targets

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Figure 1. European government expenditure and short-term interest rates during global recessions and recoveries

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are missed. But this incremental easing of austerity will not be sufficient to produce growth. As shown in Figure 1, fiscal policy in Europe (the paler line in the chart on the left) has been extremely tight in the years following the Great Recession, compared to past recoveries, even as interest rates have remained low (the paler line in the chart on the right). Countries in the north which have the fiscal space to stimulate regional demand have not been prepared to do so. Meanwhile, countries that need stimulus have a limited ability to finance it through additional borrowing, given already high debt levels and constrained market access. Italy, Spain and France are all debat-ing a modest easing of fiscal policy; the resultant financing gaps could be a test of the market’s current stability.

What is needed is an accelerated move towards economic and financial union that would definitively draw a line under the crisis. Such a bold step would provide a powerful boost to market confidence and go a long way towards addressing the fragmentation of financial markets. We discuss below the political ramifications involved. But the next section first pro-poses some economic principles that should guide the debate.

New rules, old debtIt is an unfortunate reality that over the last 30 years we have had a great deal of practice in resolving international debt crises. Although the cir-cumstances differ, there are common themes that run through the official response to the developing-country debt crisis of the 1980s, the East Asian financial crisis of the 1990s and the Great Recession.

The first theme is that, in each case, policymakers attempted to put in place a new financial architecture that corrected the market failures that had caused the crisis, and created incentives for better behaviour from debtors in the future. Most of the European debate has focused on these new rules. Fiscal rules have been tightened, financial sectors reformed under the auspices of the Financial Stability Board, crisis-response capabili-ties strengthened through new facilities – the European Financial Stability Facility (EFSF), the European Financial Stabilisation Mechanism and the European Stability Mechanism (ESM) – and a range of structural reforms implemented. But the core issue under discussion – and the one that may

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well make or break the eurozone – is how best to achieve deeper economic integration through banking union and a more unified fiscal policy.

The euro area is unique in its combination of a common monetary policy and decentralised, but coordinated, fiscal and structural policies. With the onset of the crisis, however, it became clear that the benefits of the euro, com-bined with Maastricht rules, were insufficient to produce harmonised and consistent fiscal policies. Greater fiscal union would be needed to allow fiscal resources to be pooled in the event of shocks, notably financial-sector shocks. A better financial architecture was also needed to ensure that the combined fiscal policy stayed on track and was sustainable politically and economically.

Although there is broad agreement within the eurozone on these long-term objectives, creditor countries have insisted that the mechanisms through which fiscal union would be achieved – for instance, issuing eurobonds backed jointly by all members and allowing fiscal decisions about taxes and spending to be made by a common euro-area institution – can only come at the end of the reform process, if at all. Thus, attention has turned towards banking union as the most important immediate step towards reinforcing the eurozone and breaking the feedback loop between banks and their sovereigns.

In some respects, a great deal of progress has been made on the road to banking union. The road map that has been approved highlights three essential steps: a common supervisory mechanism led by the ECB; a common cross-border resolution mechanism; and a system for allocating losses. Important progress has been made on the supervisory piece of the puzzle, with agreement on a plan for ECB oversight of major banks begin-ning in late 2014. Resolution is proving harder, although leaders appear committed to agreement on this piece by the end of the year. The divisions are most stark, not surprisingly, on the question of how banking losses will be allocated, with sharp differences on issues such as the rules for allocating losses to a bank’s private creditors and shareholders, the role of the ESM in supporting banks and whether there is a need for a funded, pan-European deposit-insurance system. It has not been lost on policymakers that deci-sions on these issues could go a long way towards mutualising losses across countries, a form of fiscal union through the back door.

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As the sense of crisis has receded, the pressure for ambitious solutions has dissipated. For example, current proposals for banking union envisage that a portion of the ESM could be used to support banks, but only in limited amounts and subject to strict conditionality. Past losses would not be eligi-ble for support. Without a prompt return to growth, it is not hard to imagine rising non-performing loans and losses quickly outstripping the capacity of the ESM to act. A more ambitious policy framework for protecting govern-ments from this death spiral remains central to a durable improvement in market conditions.

The second theme is that the debt overhang must be addressed. New rules to maintain financial stability are not enough by themselves. Another lesson from past debt crises is that such events leave a legacy of debt overhang. There is no single number for debt above which a country is definitively insolvent. That threshold will vary across countries based on a range of eco-nomic, political and social factors. But resolving the debt overhang in the periphery will require acknowledging that it will be nearly impossible for these countries to grow their way out of existing debt levels without debt relief, and that as long as uncertainty remains over how that is done, invest-ment and growth will be compromised. There would appear to be growing acceptance of the need for debt relief, but an inability, at least for now, to discuss it. There is some hope that in the wake of the German elections there will now be greater scope for a forthright discussion of this issue.

In the European context, rescue packages and restructurings (as in the cases of Greece and Cyprus) have imposed losses on private creditors and shifted much of the remaining debt overhang to official creditors. For example, it is now the case that over 90% of Greece’s government debt is owed to official creditors. Consequently, reducing Greek debt to sustainable levels, and more generally resolving the debt overhang in the periphery, primarily requires decisions on the allocation of losses to official creditors.

One model comes from the Paris Club of official creditors, which restruc-tures the debt of developing countries on an ongoing basis. Countries that can no longer service their debt come to the Paris Club for relief. Their framework includes three principles: a firm cut-off date, after which new debt of the country is not rescheduled; clear rules for when and how much

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debt relief will be granted and the subsequent priority of creditors; and conditionality, in the form of an IMF programme. Although there are other models for providing relief, these principles should help guide the euro-zone as it continues to address debt overhang in the periphery.

The third theme is that scalability is important. It is always hard at the start of a crisis to estimate the resources needed to resolve it. When over-whelming force is being applied, a central premise of the effort is that any reasonable scenario can be dealt with. If the policies fall short of what markets think is needed, questions will naturally arise as to whether there are any arrows left in the quiver, and it is likely to be hard for policymakers to come up with easy fixes that restore confidence.

Incrementalism, in contrast, has the advantage of anticipating the need for course correction. If current arrangements prove inadequate, policymakers can come together and expand the facility, relax the rules or oth-erwise do what is needed to move forward. For obvious reasons, policymakers often cannot say that the current arrangements will be changed, and moral-hazard con-cerns can be a motive for wanting to make any change difficult. But to the extent that it is politically, legally and administratively viable to build flex-ibility into plans, it makes sense to do so.

Incrementalism – with all its strengths and weaknesses – has been on display in Europe. Early rescue programmes for Greece, Portugal and Ireland underestimated the depth of the recessions that would follow and the financing that would be needed. The EFSF and ESM funding was small relative to mainstream estimates of the need; stress tests were unconvinc-ing. Conditionality was often so onerous politically that many countries delayed asking for support, exacerbating market pressures. Needed restruc-turings were postponed. Critics have charged that this reflects the inability of Europe to make the tough choices necessary to resolve the crisis. Yet, in several instances, Europe has responded by expanding facilities or easing terms, scaling up the rescue effort to match the increased need.

A more charitable explanation of the past two years is that the EU moves slowly and deliberately by necessity, given the need for consensus among 17

The EU moves slowly and

deliberately by necessity

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eurozone members (or 28 members when EU-wide decisions are needed). Furthermore, designing institutions and rules for a new Europe will inevita-bly take time. Markets work on a faster timeline, however, and the resultant tension all but promises that market pressures will return. Europe’s ability to scale up its support in a timely fashion may be critical to whether the European project succeeds.

Avoiding a low-growth futureA revival of growth is the centrepiece of any successful strategy for preserv-ing the eurozone. But what level of growth can Europe realistically aim for? Even before the crisis, European growth was weak, having lagged behind other industrialised countries since the 1980s. Figure 2 shows that, for the 15 original members of the EU, growth and productivity have been on a trend of long-term decline relative to the US. The performance of the 12 (now 13, with the recent addition of Croatia) emerging economies that joined the EU from 2004 has been better, but the growth in these countries’ income is less than is suggested by economic models of convergence.

Europe’s weak productivity performance reflects well-known structural weaknesses: rigid labour and product markets; inadequate investment in human capital and research; and disincentives to put resources into inno-vative ventures instead of traditional industries. In some countries in the

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Figure 2. EU15 and EU12 GDP relative to the US, 1980–2017 (US = 100)

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periphery, such as Spain, growth was also unsustainably fuelled by a rela-tively unproductive construction boom. Rising deficits were papered over for many years by easy money and optimism about convergence, but the failure to address the structural agenda hit home with the crisis.

Compounding these trends are adverse demographics. As in many industrialised countries, Europe’s population is getting older, and the number of retirees is growing. An IMF study estimates that the region’s old-age dependency ratio (the number of people 65 and over, relative to those between the ages of 15 and 64) is projected to double to 54% by 2050, meaning that the EU will have one elderly person for every two workers.3 The resultant sharp increases in pensions and health-care costs will further stress an already unsustainable social safety net.

To these longer-term trends, the current recession added an additional drag. All recessions lead to a cyclical loss in output, the recovery from which allows activity to return to trend. However, the depth and duration of this recession, with its lack of investment and lost labour-market skills, risks turning a cyclical downturn into a structural growth decline. Thus, one element of a long-term growth strategy is giving urgent attention to establishing the basis for recovery, so that today’s headwinds do not leave a lasting legacy of lower growth.

Raising the EU’s long-term growth potential requires a more ambitious embracing of the structural agenda. The needed reforms will vary across countries – no one plan fits all. In the periphery, regaining competitiveness is essential to restoring growth. In the core, efforts to promote labour-force participation and more open service markets sit high on the agenda. In all countries, improvements in labour markets (including through greater access to labour markets and streamlining of employment benefits and pro-tection) are needed to strengthen employment prospects, including through lowering the cost of hiring and firing workers. Improving regulation and reforming taxes, strengthening incentives for innovation and education, and continuing financial-sector reforms are also needed. These types of reforms have featured prominently in IMF-backed programmes for periphery coun-tries such as Greece, Portugal and Ireland. Yet, in most cases, structural reforms have lagged. Furthermore, these reforms are also urgently needed

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in countries that do not have IMF support, raising questions about who will drive and discipline the reform process in these states.

Simulations by the IMF suggest that an ambitious structural reform along these lines could lift output by 4.5% over the next five years, and raise trend growth after that by as much as 0.5–0.75%.4 Many of these reforms reduce growth in the very near term, as in some cases industries are closed, workers laid off and resources reallocated to higher-productivity activities. Some reforms, such as market-opening measures, can spur growth from the begin-ning and should be prioritised in the reform effort. Although the agenda is ambitious, there is a track record of success in jump-starting growth through structural reform, including in the Netherlands (in the 1980s), Sweden (in the 1990s) and Germany (with the Agenda 2010 and Hartz reforms).

In sum, a revival of growth is essential to addressing many of Europe’s economic challenges, including preventing unemployment from becoming a long-term problem; returning to fiscal sustainability; breaking the bank–sovereign debt cycle; and maintaining public support for economic reform and deeper integration.

Austerity, democracy and the travails of unionThe restoration of growth and the realisation of fiscal and banking union will require rebuilding public support for deeper integration and the further diminution of national sovereignty. The agenda on the table will give the eurozone a quasi-federal character on monetary, fiscal and financial issues. Although the issue remains unsettled, this reform of EU institutions would likely require treaty change, which in turn would require popular consent in the form of parliamentary ratification and, in a few cases, public referendums.

Although EU leaders have decided that more integration is the antidote to the ongoing crisis, EU publics are unconvinced. Indeed, with the sole exception of the Germans, European electorates are growing increasingly sceptical of the merits of economic integration and of ceding more power to Brussels. According to a recent poll by the Pew Research Center:

Positive views of the European Union are at or near their low point in

most EU nations, even among the young, the hope for the EU’s future. The

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favorability of the EU has fallen from a median of 60% in 2012 to 45% in

2013. And only in Germany does at least half the public back giving more

power to Brussels to deal with the current economic crisis.5

A perilous gap is opening between the project of European unity and the European ‘street’.

The good news for the EU is that this loss of public confidence in European integration has yet to produce a national government that is intent on leaving the eurozone or backing away from the Union – with the exception of Britain. Despite successive years of austerity, the mainstream parties in power across the Union have remained pro-EU. Indeed, Europe’s dominant centre-right and centre-left parties have moved towards the ideo-logical centre in recent years, closing ranks behind the need to guide the EU back to financial and political health.

But there is also bad news for the EU: Europe’s mainstream parties are rapidly losing market share. The move of the centre-right and centre-left to the pro-EU centre has ceded considerable ground to populist, anti-EU parties hailing from both ends of the political spectrum. It has not happened yet, but electoral trends suggest that one or more of these anti-EU parties could soon find themselves in power.

In the Greek elections last year, the share of votes won by the two main parties plunged to just above 30%, down from more than 75% in the 2009 elections. The primary beneficiaries were parties that opposed the austerity package that was Greece’s ticket to staying in the eurozone. A pro-EU coali-tion of centrist parties eventually took power, but public attitudes towards the EU have since eroded even further. Polls taken in the spring indicated that Syriza, a left-wing party that opposes the country’s bailout terms, had become the nation’s most popular party.

In the first round of France’s presidential contest last year, roughly 30% of the electorate voted for either Marine Le Pen, whose far-right party calls for France’s withdrawal from the eurozone, or the leftist Jean-Luc Mélenchon, who frequently attacks the EU’s economic liberalism and its infringements on French sovereignty. In a parliamentary by-election in June 2013, Le Pen’s National Front bested the governing Socialist Party. A local election in

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October was won by a National Front candidate. Opinion polls from spring 2013 reveal that 77% of the French public believes that economic integration has done more harm than good to their country, and 58% have an unfavour-able impression of the EU as an institution.6

In the Italian elections last February, the Five Star Movement, led by populist comedian Beppe Grillo, received more votes than any other party, garnering over 25% of the total. Meanwhile, the Civic Choice platform of Mario Monti, the technocratic prime minister who had led Italy back to financial stability, received only 10% of the vote. This result, which initially paralysed Italy’s political establishment, produced a grand coalition of the centre-left and centre-right – a government of uncertain effectiveness and durability. As of spring 2013, only 11% of Italians believed that European integration strengthened their nation’s economy.7

In Austria’s September election, the two main parties had their worst showing since the Second World War, losing considerable ground to a number of smaller parties. Even in Germany, a party in favour of jettisoning weak peripheral economies from the eurozone – Alternative for Germany – is making inroads. Although it fell just shy of the 5% of the vote needed to enter parliament in elections in September, its mere existence is an impor-tant indicator of the stiffening political headwinds facing the EU.

Despite this clear strengthening of anti-EU political forces, euroscep-tics have yet to take power in Greece, France, Italy, Germany or most other member states. As previously mentioned, however, Britain is the one exception. There, Prime Minister David Cameron is navigating an anti-EU revolt within his own party, one stoked in part by the rising elec-toral strength of the UK Independence Party, which calls for Britain to quit the EU. Cameron himself favours Britain’s continued membership in the Union, but only if the country is able to negotiate a more attenuated relationship. His plan is to consolidate and formalise a ‘two-speed’ EU in which members outside the eurozone would contribute less to the Union budget and form their own caucus. He also wants to return a significant measure of political power from Brussels to London, and, assuming he is re-elected, put Britain’s more distant relationship with the EU to a popular referendum.

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Although Cameron’s moves are meant to provide the British with the breathing room they need to stay put in the EU, his course of action could well precipitate the UK’s exit. Of Europe’s 28 members, 11 are outside the eurozone. Most of Britain’s companions in this outer circle, however, plan to eventually join the eurozone, which would leave Britain as the odd one out – absent from what will become the EU’s main decision-making venue. The British would be unlikely to remain in a union in which their voice would be so marginalised. So, too, could a popular referendum produce a vote in favour of exit, effectively tying the government’s hands.

Britain would likely pay a heavy economic price if it exited the EU. Companies that have located production in the UK to gain access to the single market could relocate. London’s role as the euro’s main financial centre could be compromised. European bankers and traders who are not British citizens would no longer enjoy an automatic right to work in Britain. In the aftermath of the country’s departure from the Union, these dislocat-ing consequences of an exit could make for strained political and economic relations between the EU and the UK.

Britain’s exit from the EU is a realistic, perhaps even a likely, possibility. That outcome would deal a serious blow to European solidarity; weaken the EU as an economic bloc; deny the EU the valuable role that London con-tinues to play in guiding economic integration and the enlargement of the Union; and shake the foundations of the transatlantic alliance. Britain has long served as a bridge between the US and Europe. But with the UK’s own defence budget on the chopping block, London cannot remain an important partner on matters of security if it becomes a minor player within the EU. Britain would consign itself to a no-man’s land if it abandoned its attach-ment to the EU, weakening the Union as a security actor as well as Europe’s tether to the US. The EU would surely survive Britain’s exit. But the UK, the EU and the transatlantic community would all face a significant setback.

Getting past the point of no returnThat a union roughly six decades old is facing such tribulations is not his-torically anomalous. Unions cohere slowly and incrementally. The US, for example, enjoyed over seven decades of prosperity and relative political

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stability before falling prey to a civil war that took over half a million lives. It was not until after the Civil War that the US had a single currency and, arguably, not until the twentieth century that the nation had a strong federal character and a robust national identity that trumped loyalty to the separate states. Processes of economic and political union in Germany, Switzerland and elsewhere followed a similarly tortuous route.

That the historical record suggests the EU’s current troubles are par for the course is by no means cause for complacency. Europe’s project of inte-gration is not past the point of no return; were the euro to fail, the EU could well fail with it. Europe has thus arrived at a make or break moment. On

the one hand, it could emerge from the current crisis a stronger and more coherent union, armed with the finan-cial and fiscal institutions needed to guide the eurozone back to health. Deeper integration could also spill over into the realm of foreign and defence policy, ultimately giving the EU the ability to project its voice more effec-tively on the global stage. On the other hand, the EU could unravel. It is entirely plausible that the project of

European integration has already passed its high-water mark, and that it will pull apart in the years ahead.

European leaders are well aware of the stakes, which is precisely why they are so determined to save the euro and make the leap towards fiscal and banking union. They are also seeking to give the EU greater democratic legitimacy and accountability by, for example, strengthening the hand of the European Parliament in selecting the president of the commission. Choosing the president of the Council through popular elections is another option under consideration. The key question is whether these and other steps will succeed in re-legitimating the European project in the eyes of European publics.

Facing an uphill political battle, EU leaders have fully committed to rebuilding public confidence in Europe. One component of the determined push is the deployment of a robust public-relations campaign. After a period of timidity in which EU leaders were ceding the political narrative to euro-sceptics and following rather than shaping public opinion, many of them

Were the euro to fail, the EU could well fail with it

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have reversed course and launched purposeful efforts to convince voters of the continuing merits of the EU. Angela Merkel, Enrico Letta and José Manuel Barroso – these and other officials have been giving the hard sell to voters.

The second, and perhaps more important, component of the push is to deliver to EU electorates improved economic conditions. An initial pre-scription of stark austerity has of late been giving way to recognition that countries will need more time to adjust. Leaders have also prioritised steps to bring down youth unemployment, with Germany helping countries in the southern tier develop training programmes similar to those that have benefitted its own manufacturing workforce. Meanwhile, the French gov-ernment has taken steps to liberalise the nation’s labour regulations to provide the private sector with the incentives to hire younger workers. As previously mentioned, moving more quickly towards fiscal and banking union, and alleviating the debt overhang in the periphery, would also help to promote growth.

One key question is how long it will take for these steps to produce con-crete improvements in economic conditions, and thereby start to reverse the continuing slide in public support for the EU. Will public attitudes firm up quickly enough to provide elites sufficient backing for the deeper union they envisage? Will forthcoming elections in member states continue to produce governments dominated by centrist parties that are pro-EU, or will popu-list parties continue their ascent? These concerns apply not only to national elections. Elections for the European Parliament that will take place next May could well yield a sizable bloc of eurosceptic MEPs.

A second, more existential, question is whether souring attitudes towards the EU may prove somewhat immune to economic recovery. It is worth keeping in mind that French and Dutch voters rejected the EU’s constitu-tional treaty in 2005. The renationalisation of European politics began well before the current financial crisis. As in the US, Europe’s middle class is being buffeted by technological change and globalisation, which are increasing unemployment, depressing wages, fuelling inequality and testing the limits of the European welfare state. The EU is not to blame for these dislocations, but often becomes the scapegoat. Meanwhile, immigration is taking a toll

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on enthusiasm for open borders and labour markets, prompting a turning inward among European electorates. Ending the financial crisis within the eurozone will do little to alleviate these concerns.

It is also conceivable that lagging support for the European project is a function of generational change, not just a sharp economic downturn. For Europeans who came of age during the Second World War or the Cold War, the EU is a sacred escape route from a bloody past. Not so for younger Europeans, who have no geopolitical past from which they seek to escape. A recent poll revealed that French citizens over 55 are almost twice as likely to see the EU as a guarantee of peace as those under 36. And with youth unemployment skyrocketing in many member states, the younger genera-tion hardly sees the EU as a pathway to prosperity.

Despite these indications that public disaffection with the EU may have deep and lasting roots, it is a reasonably safe bet that Europe, although it is unquestionably passing through a grave economic and political crisis, will eventually recover its forward momentum. After all, the project of European integration has from the beginning moved in fits and starts, often emerg-ing stronger from periods of setback. After a slow start, European leaders have finally ramped up credible efforts to stabilise the eurozone, return the Union to the path of growth and rebuild popular support for integration. The EU is by no means back on course. But at least there is a flickering light at the end of the tunnel.

Broader stakesMuch rides on the success of the eurozone’s efforts to restore financial sta-bility and growth. According to a recent IMF analysis, an intensification of the euro-area crisis would drag down the global economy, producing ‘nearly equivalent losses in the UK and Eastern Europe, and more moderate but still significant losses’ beyond the EU.8 Strong policy responses outside the EU – such as lowering interest rates (where possible) and allowing fiscal deficits to widen to absorb the decline in demand – reduces, but does not eliminate, prospective losses. A few countries, such as the US and Japan, would benefit from safe-haven effects, while countries that can depreci-ate their exchange rates can limit the damage to their exports. However,

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countries that have currencies linked to the euro, or that confront domestic constraints preventing policy easing, would feel the full brunt of a eurozone shock. Low-income countries would not be immune, due to their reliance on commodity trade and their more limited scope for buffering policies.

Conversely, the restoration of financial stability and economic growth in the eurozone would have positive implications well beyond Europe. The EU is the world’s largest market; its return to economic health would help fuel global growth – especially important should China’s economy continue to slow. The transatlantic community would reap particular benefits. The American and European economies are already closely intertwined – some $1 trillion in goods and services cross the Atlantic on an annual basis – and could become more so should ongoing negotiations succeed in establish-ing a US–EU free-trade area. According to the European Commission, the proposed trade pact could add 0.5% to the EU economy and 0.4% to the US economy by 2027. At least 400,000 jobs would be created. In light of the fiscal and structural constraints facing EU member states, an economic pact with the US is an attractive option available for stimulating growth and employ-ment. The pact would in turn ensure that growth within the EU spills across the Atlantic.

A transatlantic free-trade area would bring geopolitical as well as economic gains. The two sides of the Atlantic need to refurbish liberal democracy and free-market capitalism at a time when the spread of Western values seems to be stalling. The Arab Spring has done more to fuel political Islam than liberal democracy. State capitalism is alive and well in Russia and China. Under these circumstances, the US and Europe need to show renewed solidarity in defence of a liberal international order.

Finally, an EU that enjoys economic growth and political stability is needed to help anchor an international system that is entering a period of historic change. For the first time since the Second World War, the output of the advanced industrialised democracies represents less than 50% of global GDP. The aggregate GDP of China is expected to surpass that of the US within roughly 15 years. A major change in the global pecking order is afoot.

An EU that is lurching from one financial crisis to the next will be unable to play its part in managing this period of historic change. For now, the EU

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remains preoccupied with its own affairs. Moreover, its individual member states are too small to shoulder global responsibilities on their own. If Europe continues down its current path it, as Richard Haass warns, ‘faces a future that is more likely to resemble Japan’s than China’s’. ‘Europe’s posi-tion as a major power in the twenty-first-century world’, Haass laments, ‘looks to be all but over.’9 Only if the EU recovers from its ongoing economic and political crisis will it have a chance of speaking with a more collective voice and projecting its power and will beyond its own neighbourhood. As the US focuses on economic renewal at home and scales back its footprint abroad, Washington desperately needs a more capable partner in Europe. The starting point for consolidating that more capable partner is financial stability, economic growth and the re-legitimation of the project of European integration.

Notes

1 Carmen M. Reinhart and Kenneth Rogoff, This Time is Different (Princeton, NJ: Princeton University Press, 2009), pp. 223–47. Another conclusion from their research, that there was a cliff for growth when government debt exceeded 90% of GDP, has been shown to be in error. But their central thesis, that resolving the overhang of debt is a critical (and challenging) task following a crisis, has stood up and is supported by other research.

2 James Wilson, Robin Wigglesworth and Brian Groom, ‘ECB “Ready to Do Whatever it Takes”’, Financial Times, 26 July 2012, http://www.ft.com/cms/s/0/6ce6b2c2-d713-11e1-8e7d-00144feabdc0.html#axzz2gUPnHK1q.

3 Giuseppe Carone and Declan Costello, ‘Can Europe Afford to Grow Old?’, Finance and Development, vol. 43, no.

3, September 2006, http://www.imf.org/external/pubs/ft/fandd/2006/09/carone.htm.

4 Bergljot Barkbu et al., ‘Fostering Growth in Europe Now’, IMF, 18 June 2012, http://www.imf.org/external/pubs/ft/sdn/2012/sdn1207.pdf.

5 Pew Research Center, ‘The New Sick Man of Europe: The European Union’, 13 May 2013, p. 1, http://www.pewglobal.org/2013/05/13/the-new-sick-man-of-europe-the-euro-pean-union/.

6 Ibid., pp. 2–3.7 Ibid., p. 23.8 IMF, ‘2012 Spillover Report’, 9 July

2012, p. 6, http://www.imf.org/exter-nal/np/pp/eng/2012/070912.pdf.

9 Richard N. Haass, Foreign Policy Begins at Home: The Case for Putting America’s House in Order (New York: Basic Books, 2013), p. 42.

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europe’s make or break moment

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