November 24th, 2011
10:13 AM ET

Only political solutions to Europe's economic problems

Editor’s note: This is an edited version of an article from the ‘Oxford Analytica Daily Brief’. Oxford Analytica is a global analysis and advisory firm that draws on a worldwide network of experts to advise its clients on their strategy and performance.

The euro zone’s current problems are often described as economic, but the solutions will inevitably be political. Leading euro countries are preparing to impose a system of much tighter, centralized controls over member states’ public finances. The European Commission yesterday proposed measures that would involve greater union, but tend to erode national sovereignty.

The trend towards greater supervision and union will be widely interpreted as the price that Germany demands for underwriting bailouts. The European Union summit on December 9 is thus shaping up to be a battle over the future governance of the region.

The key actors include both governments and the institutions they have created, including the European Commission. Near the heart of negotiations lie questions about how robust and direct a role the European Central Bank (ECB) should play in preventing collapse and contagion. The German government and central bank are more likely to budge on EU treaty change than changing the ECB’s mandate. France is keen to stay close to Germany, but is under pressure from markets eyeing the future of France’s AAA credit rating.

If investors take fright while political negotiations continue, then crisis management - not strategic restructuring - will continue to dominate. Even without severe market movements, euro-area leaders face significant issues and decisions in 2012. Increased controls and cooperation across the 17 euro zone members will distinguish it further from the 27-member EU, prompting questions about future relations between those EU members in the monetary union and those outside it (either by choice - like the United Kingdom - or because they do not yet meet its criteria).

The October EU summit supposedly ‘solved’ a technical problem in the European Financial Stability Fund. The Fund has not attracted enough investor interest because of uncertainty over what kind of guarantees it can offer investors - and how sustainable guarantees would be over time if, for instance, France loses its AAA rating, on which the Fund’s own AAA rating depends.

The EU’s Lisbon treaty currently allows for member states to withdraw from the EU but not the euro area. Some leaders - including Germany’s Angela Merkel - are keen to close this loophole. Ministries across Europe are currently drawing up contingency plans for any radically changed currency union, including the legal and political implications.

The current crisis is seen as a sovereign debt one, but could quickly become an acute banking crisis. Many governments and local banks in the euro zone are finding it difficult and expensive to borrow in the markets. This raises the risk of a credit crunch. The negative consequences for the real economy can already be observed. The result is mounting pressure on the ECB. It will have to decide how to manage the problems of countries facing rising yields in their bond auctions, and how to react to financial institutions, including in the United States and Asia, selling-off European government debt or not rolling over short-term loans to European banks. New ECB head Mario Draghi is keen to mend fences with Berlin after two German members of the bank’s governing council resigned this year.

So far Europe has avoided a 'Lehman moment' - the bankruptcy of a government or bank capable of triggering massive shocks to the global system, prompting wider recession. Although many elements of such an event are now better known and largely provided for, such an event could still happen.

The consensus view is that economic contraction in much of the euro area in early 2012 will be shallow-to-moderate and could start to ease mid-year. However, the strongly divergent trends across member states’ economies will continue. Prospects for southern Europe remain very negative, and even Germany's economy will struggle to maintain its expansion. This does not bode well for the euro zone, given how crucial Germany is to the area’s external export potential, as its primary engine of growth. Weakness in Germany feeds into supply chains across the region.

Germany should be well placed when world trade cycles improve, but other states could remain in recession for longer. This could lead to greater opposition to the overall idea of monetary union. Popular demands to exit the euro and resist greater centralization in Europe will intensify, boosting support for right-wing parties.

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Topics: Debt Crisis • Europe • Politics

soundoff (8 Responses)
  1. j. von hettlingen

    "The European Commission yesterday proposed measures that would involve greater union, but tend to erode national sovereignty". Too little, too late! The Eurocrisis is an awakening for many Europeans that man shouldn't build a gigantic ship that takes all passengers on board. It would be wiser to build smaller ones, so that when one goes down, not all will get drowned.

    November 24, 2011 at 4:56 pm | Reply
  2. Onesmallvoice

    The very idea of the "Eurozone" is and never has been a good one. Never has Europe faced an economic crisis, except after WW1 of course, as is doing today. The one and only sensible solution to this is just to simply dissolve the Eurozone altogether. Unfortunately, the current useless, bureaucratic leaders of Europe don't have the sense it takes to do that!!!

    November 25, 2011 at 10:04 am | Reply

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