Unhappy Union: How the euro crisis – and Europe – can be fixed

UNHAPPYUNION

JOHN PEET is Europe editor and a former Brussels correspondent of TheEconomist. Hewas previouslyWashington correspondent and business affairseditor.

ANTONLAGUARDIA isBrusselscorrespondentofTheEconomist andwrites theCharlemagne column. He was previously The Economist’s defencecorrespondent,afterworkingfor twodecadesasaforeigncorrespondent in theMiddleEast andAfrica.He is the author ofHolyLand,UnholyWar: IsraelisandPalestinians(Penguin,2006).

UNHAPPYUNIONHowtheeurocrisis–andEurope–canbefixed

JohnPeetandAntonLaGuardia

THEECONOMISTINASSOCIATIONWITHPROFILEBOOKSLTDANDPUBLICAFFAIRS

Copyright©TheEconomistNewspaperLtd,2014Textcopyright©JohnPeetandAntonLaGuardia,2014

Firstpublishedin2014byProfileBooksLtd.inGreatBritain.

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FirstEdition

Contents

ListoffiguresAcknowledgementsPreface

1 “Iftheeurofails,Europefails”2 FromtheoriginstoMaastricht3 Howitallworks4 Build-uptoacrisis5 Trichet’stest6 SuperMario7 Thechangingbalanceofpower8 In,out,shakeitallabout9 Democracyanditsdiscontents10 Howtheeurospoiltanyotherbusiness11 Europe’splaceintheworld12 Afterthestorm

Notes

Appendices1 Timeline2 Treaties,regulationsandpacts3 Furtherreading4 HowTheEconomistsawitatthetime

Index

Listoffigures

4.1 GDP,1999–20144.2 Ten-yearbondyields,1995–20105.1 Ten-yearbondyields,2010–20126.1 Spain:five-yearCDSpremiumsonsovereignandbankdebt,2007–126.2 Ten-yearbondyields,July2011–December20136.3 Interestonloanstonon-financialcorporationsupto€1m,2007–149.1 PositiveopinionsoftheEU,2003–1312.1 EurozoneandUSGDPatconstantprices,2007–1412.2 Publicdebt,1999–201412.3 Unemploymentrate,1999–201412.4 Current-accountbalance,2004–14

Acknowledgements

MANY POLITICIANS, OFFICIALS, diplomats, academics, think-tankers and fellowjournalistshavehelpedustoformour ideasandwrite thisbook,somewithoutrealisingit.Alargenumberofpeoplegavegenerouslyoftheirtimeandsharedtheir insights (and often their personal notes of events), but wish to remainanonymous.Wewouldliketothankthemall.

For the Charlemagne columnist covering the twists and turns of the crisisfromBrussels,thepresscorpshasbeenasourceofgoodcheerandcomradeship,and a forum for the exchange of information, through endless late-nightmeetingsofEuropeanleadersandfinanceministers.Thecolleaguesandguestsof the “Toucan” dinner club have producedmany enlightening and enjoyableevenings.

The job of interpreting events has been made much easier thanks to theexpertiseofscholarswhofollowtheoftenarcaneaffairsoftheEU.Theyincludestaff at the Brussels think-tank, Bruegel – among them GuntramWolff, JeanPisani-Ferry,AndréSapir,ZsoltDarvas andSilviaMerler–whohaveofferedinvaluable expertise over the years. Similarly, Daniel Gros at the Centre forEuropeanPolicyStudieshasbeenasourceofsharpperspective.OnquestionsofEuropeinthewiderworldmanyhavebeenhelpfulandincisive,amongthemJanTechauatCarnegieEurope,DanielKeohaneatFRIDE,SirMichaelLeighattheGermanMarshallFundoftheUnitedStates,aswellasthemanyexpertsoftheEuropean Council on Foreign Relations. Philippe Legrain, formerly at theEuropean Commission’s Bureau of European Policy Advisers, has beenrefreshingly trenchant and forthright in his views of where Europe has gonewrong.

We would like to thank Stephen Brough, Penny Williams and JonathanHarleyforincubatingthisbookandseeingitthroughtocompletionwithcharm

andpatience,despitemanyinterruptionsandchangestothemanuscript.AndreaBurgess and Roxana Willis at The Economist have been indefatigableresearchersinfindingdataandproducingcharts.

Weoweaspecialthankstoseveralpeoplewhotookthetimetoreaddraftsof ourmanuscript and commented on all or parts of it. They include CharlesGrantandSimonTilfordattheCentreforEuropeanReformandHeatherGrabbeat theOpenSocietyFoundations, aswell as our colleagues atTheEconomist,EdwardCarrandZannyMintonBeddoes.

No one can write a book without being a burden on their families.Accordingly,wededicatethisonetoourever-supportivespouses,SaraandJane.

Preface

EUROPEHASLONGPRIDED ITSELFonbeingamodel for the restof theworldofhow to reconcile old enemies after centuries of war, blend the power ofcapitalismwith social justice and balanceworkwith leisure.Littlematter thatEuropeans did not generate as much wealth as overworked Americans;Europeanstookmoretimeofftoenjoylife.AndlittlematterthatEuropecouldnotproject thesamemilitaryforceas theUnitedStates;Europesawitselfasa“normative power”, able to influence theworld through its ability to set rulesandstandards.SomeEurophilesevenimaginedthatEuropewould“runthe21stcentury”,asthetitleofoneoptimisticbookputit.1

The collapse of subprime mortgages in the United States, and the creditcrunchthatfollowed,onlyconfirmedsuchconvictions.Thesinglecurrency,theEuropeanUnion’smostambitiousproject,wasseenasashieldagainstfinancialturbulencecausedbyrunawayAmerican“ultra-liberalism”,astheFrenchlikedtodescribethefaithinfreemarkets.ButwhenthefinancialstormblewinfromacrosstheAtlantic,theeuroturnedouttobeaflimsyumbrellathatfloppedoverinthewindanddraggedawaymanyoftheweakereconomies.ItledtotheworsteconomicandpoliticalcrisisinEuropesincethesecondworldwar.

Starting inMay2010, firstGreece, then IrelandandPortugalwere rescuedandhadtoundergopainfulinternaldevaluation,thatis,byreducingwagesandpricesrelativetoothers.Theprocessprovedsomessyandbitterthat,evenwithhundredsofbillionsofeuroscommittedtobail-outs,thecurrencyseveraltimescame close to breaking up, potentially taking down the single market andperhaps the whole EU with it. The EU’s hope of becoming a global powerdissolvedasEuropebecametheworld’sbasketcase.Morethanonce,theUnitedStatesforciblypresseditstransatlanticalliesandeconomicpartnerstodomoretofixtheirflawedcurrencyunion.

At the time of writing, in March 2014, the euro zone has survived thefinancialcrisis–anachievementinitself,butwonattoohighaprice.Theeurozone bottomed out of its double-dip recession in 2013. But despite signs of“Europhoria”inmarketsthedangerisfarfromover.

AmongEurophilesandEuroscepticsalike,thereisagrowingbeliefthattheeuro has undermined, and may yet destroy, the European Union. Instead ofpromoting economic integration, euro-zone economies have diverged. Ratherthan sealing post-war reconciliation, the euro is creating resentment betweennorth and south. Far from settling the age-oldGermanquestion,Germanyhasemerged as all-powerful. The decline of France has accelerated, and theungovernabilityof Italyhasbeen reaffirmed.Tensionsbetweeneuro“ins”and“outs”haveincreased,particularlyinthecaseoftheUK,whichnowhoverseverclosertotheexit.

Thechronicdemocraticproblemhasbecomeacute:theEUisintrudingevermoredeeply intonationalpolicymaking,particularly in the euro zone,withoutbecoming anymore accountable to citizens. Perversely, the clearest sign of acommonpolitical identity, theEuropean“demos” that federalistshopedwouldemerge,istobefoundinanti-Europeanmovements.

FornowtheriotsandcloudsofteargasinGreeceandthemassprotestsbySpain’s indignadosmay have faded away.But almost everywhere, apart fromGermany, which has barely felt the crisis, indignant voters have thrown outincumbentgovernmentsandabandonedcentristparties in largenumbers.Anti-EUandanti-europartiesareontherise,ofbothleft-andright-wingvarieties,inboth core and periphery countries, and in both euro ins and euro outs. Thescariest are inGreece,whichhasboth radical leftists andneo-Nazi extremists,and has witnessed murderous violence among their followers. But the mostconsequentialmayyetbe thescrubbed-up,besuitedpopulists incountriessuchasFrance,theNetherlandsandtheUK,whichwerehardlytheworsthitbythedebtcrisis.TheyhavealreadychangedthetermsoftheEuropeandebateinthesecountries.OncethechampionofEUenlargement,theUKisincreasinglyturningagainst the cherished right of freemovement of workers, and against the EUitself.

Asthecountriesof theeuro-zoneperipheryseektoregaincompetitiveness,theirmost striking export has been young emigrants in search of jobs abroad.ThesearenolongerthemanualworkersofyesteryearwhofilledthefactoriesofGermany,theminesofBelgiumandthebuildingsitesoftheUK.Nowitistheyounggraduateswhoareon themove. InPortugal, thepost-colonial flowhas

reversed,ashopefulsheadouttoBrazil,AngolaandMozambiqueinsearchofabetter life. In Ireland, some churches have set up webcams so that émigréparishionerscanwatchservicesbackhome.ManyhavemovedtootherpartsofEurope,notablyGermany.

ThestoryofhowtheEuropeanprojectwasborn,howtheeuronearlydied,how it was saved and how the EU should confront the dangers ahead is thesubject of this book. The appendices provide a timeline, a glossary and thehistoryofthecrisisastoldthroughcoversofTheEconomist.Chapter1recountsthe darkest days, when the European Central Bank (ECB), the InternationalMonetaryFund(IMF)andothersmadesecretpreparationsfor thedepartureofGreece from the euro, and the possible collapse of the currency zone. Theconsequences,allagreed,wereincalculable.

Chapter 2 shows how the idea of European integrationwas born from thepoliticalnecessitiesoftheearly1950s,withEuropeemergingfromtheruinsofthesecondworldwarandthenhavingtoconfrontthechallengeofthecoldwar.The euro was launched as a result of the failure of repeated attempts to fixexchangeratesbetweenEuropeaneconomies,andthedesiretoanchoraunifiedGermanymorefirmlywithinEuropeafterthecollapseoftheBerlinWall.

The system that was created through successive treaties was a complexhybrid with elements of federalism and intergovernmentalism, a pantomimehorsethatwaspartUnitedStatesandpartUnitedNations.Chapter3explainsthefunctioningoftheEU,andtheflawedstructureoftheeuro,tohelpmakeclearhowEuropeansmanaged,andmismanaged,thecrisis.

Chapter4showshowthelaunchoftheeurowasatfirstmetwithscepticismbyoutsiders, thentreatedwithhubrisbyinsiders.Blinkeredbythefiscalrules,European institutionswere for themostpartunawareof the realdanger to themonetary union. It did not come only, or mainly, from the accumulation ofdeficitsanddebt,whichbecameeasierformanycountriestofinanceasinterestratesfell.Rather,thebiggermenacecamefromunderlyingexternalimbalances,with current-account deficits allowed to balloon in the belief that thesewouldalwaysbefinancedwithinacurrencyunion.

As the financial crisis turned into a debt crisis in early 2010, Europeanleaders and institutions muddled through from summit to summit, devisingresponsesthatwerealwaystoolittle,toolate,andraisedthecostforall.Therewere two broad phases, coinciding roughly with the tenures of Jean-ClaudeTrichetandMarioDraghiaspresidentsoftheECB,asnotedinChapters5and6.

First there was a period of banking crises, bail-outs, austerity and debtrestructuring– focusedmost acutely inGreece.This increasingly fraught timeculminated inangryconfrontationsat theG20summit inCannes inNovember2011, where the prime ministers of Greece and Italy were summoned for adressing-downby fellow leadersand subsequentlypushedoutofoffice. In thesecondphasetherewasagrowingrealisationoftheneedtocomeupwithamoresystemic response.Seeking tohalt the“doom-loop”, inwhichweakbanksandweak governments were dragging each other down, leaders embarked on theprocess of creating a banking union in June 2012. Soon thereafter, the ECBsteppedinasamorecrediblelenderoflastresortforgovernmentsafterDraghideclaredthebankwoulddo“whateverit takes”tostoptheeurofrombreakingup.

ThecrisishasprofoundlychangedrelationswithintheEU.IthasconfirmedGermanyasthepredominantpowerinEurope;ithasshiftedinstitutionalpowerwithinBrusselsfromtheEuropeanCommissiontonationalgovernments;andithascausedagrowingtensionbetweeneuroinsandouts.ThistransformationisdescribedinChapters7and8.

The crisis has also widened the democratic deficit in Europe, which thegrowingpoweroftheEuropeanParliamenthasbeenunabletofill,asexplainedinChapter9.Moreover,ithasdisruptedthecorebusinessoftheEUthatisoftenoutof theheadlines, fromthesinglemarket to tradenegotiations,assetout inChapter 10, as well as the EU’s hope of exerting greater influence on worldaffairs,asorrytalerecountedinChapter11.

The concluding Chapter 12 assesses the damage done by comparing theperformanceof theeurozonesince thebeginningof theglobal financialcrisiswith that of theUnited States. It tries to draw lessons from the upheaval andoffersrecommendationsforreform.Themainriskstotheeurozone,andtothewider European Union, are now predominantly economic and political. Therecovery is still weak, making it harder to bring down unacceptably highunemploymentandleavingtheeurozonevulnerabletoatriple-diprecession,ifnot outright deflation. In turn, economic stagnation will worsen the growingpolarisationofEuropeanpolitics.

TheactionsofEuropeanleadersmayhaveavertedcollapseintheshortterm,but they have not found a lasting solution. The ECB’s bond-buying policystabilised debtmarkets but is untested, andDraghi’s great bluffmay not holdforever. The development of “economic governance”, involving tougher fiscalrules and deeper intrusion by Brussels institutions into national economic

policies,isunlikelytobeacceptedindefinitely.Atsomepoint,perhapsafterthecrisis has faded, national governments will want to reassert their autonomy.Discipline should be imposed by markets, not by Brussels. This means thatgovernments should be allowed to go bust when they make a mess of theireconomicpolicies.Inshort, theno-bail-outruleneedstoberestored.Doingsorequires a euro zone stable enough to withstand the shock of a default. Theanswer, the conclusion argues, is a targeted dose of American-style fiscalfederalisminwhichsomeoftherisksareshared.Thisinvolvesseveralreforms,fromcompletingtheembryonicbankinguniontoissuingjointdebtandperhapssetting up a modest central budget that can help stabilise economies. For theforeseeable future, the EU’s crisis of legitimacy can be addressed only byenhancingtheroleofnationalparliaments.

None of this will be easy, but all of it will be necessary if the project ofEuropean integration isnot just to survivebut to thrivewith theconsentof itscitizens.

JohnPeetandAntonLaGuardiaMarch2014

1“Iftheeurofails,Europefails”

INTHESPRINGANDSUMMEROF2012therewasafadinofferingadviceonhowtobreakup theeuro.More than twoyearsafter thestartof theGreekdebtcrisis,the experiment of the singleEuropean currency seemed to be close to failure.Successive bail-outs, crushing austerity and innumerable emergency summitsthat produced at best a half-hearted response were stoking resentment amongcreditor and debtor countries alike. And since national leaders seemed eitherunwilling or unable to weld together a closer union, the pressure of the eurocrisis was remorselessly pushing the cracks apart. Better, thought some, toattemptanorderlydissolutionthantobeconfrontedwithachaoticbreak-up.

In May the former chief economist at Deutsche Bank, Thomas Mayer,proposedthe introductionofaparallelcurrencyforGreece,a“Geuro”, tohelpthecountrydevalue.1InJulyPolicyExchange,aBritishthink-tank,awardedthe£250,000WolfsonPrizeforthebestplantobreakuptheeurotoRogerBootleofCapital Economics,2 a private research firm in London. The followingmonthThe Economist published a fictitious memorandum to Angela Merkel, theGerman chancellor, setting out two options for a break-up: the exit ofGreecealone,and thedepartureofa largergroupof fivecountries thataddedCyprus,Spain,Portugal and Irelandaswell.A footnote reported that theever-cautiousMerkelhadturneddownbothpossibilities,deemingtheriskstobetoogreat,andordered the paper shredded. “No one need ever know that the Germangovernment had been willing to think the unthinkable. Unless, of course, thememoleaked.”3

The imaginary memo was closer to the truth than readers might havethought.ThatsummerMerkeldidindeedponder,andreject,theideaofthrowingtheGreeks out of the euro.German, European and IMF officials had by then

drawnupdetailedplanstomanageabreak-upoftheeuro–nottodissolvethecurrency completely but rather to try to preserve asmuch of it as possible ifGreece (oranothercountry)were to leave.Theplansnever leaked,whichwasjustaswell.Themereexistenceofacontingencyplanfor“Grexit”mighthaveprovokedaself-fulfillingpanicinmarkets.Fewhadconfidencethatanyplantooverseeanorderlybreak-upwouldwork.

Officialsthoughttheunthinkableonatleastthreeoccasions.ThefirstwasinNovember 2011,whenGreece announced a referendumon its second bail-outprogramme. Germany and France, outraged by Greece’s insubordination,demandedthatthereferendumquestionhadtobewhetherGreecewantedtostayintheeuroornot.Forthefirsttime,EuropeanleaderswereopenlyentertainingthenotionofGrexit. In theevent thevotewasabandonedafter thefall,withindays, of the primeminister,George Papandreou. The secondmoment of perilcamebetweenthetwoGreekelectionsinMayandJuneof2012,whentheriseofradicalpartiesoftheleftandtherightincreasedtheriskoftheGreeksvotingthemselves out of the euro before cooler heads prevailed in the second ballot.(Even after the conservative leader, Antonis Samaras, had put together agovernment that belatedly committed itself to the EU adjustment programme,Merkel debated well into August over whether to expel Greece.) The thirddanger pointwas the tough negotiation over the bail-out forCyprus inMarch2013.Thenewlyelectedpresident,NicosAnastasiades, threatenedto leavethecurrencyifabail-outmeantdestroyingtheisland’stwolargestbanksandwipingout their big expatriate (mostlyRussian) depositors.After two rounds of uglynegotiationsAnastasiadessuccumbedtohisrescuers.

Theeurozonewouldhavebeenill-preparedtocopewithGrexitinlate2011.Jean-ClaudeTrichet,whopresidedovertheECBuntiltheendofOctober2011,would not countenance detailed doomsday planning. And without the centralbank’s power to create money, a break-up might have been uncontrollable.Trichet’s successor, Mario Draghi, did set up a crisis-management team inJanuary2012.Withinayear theECBand the IMFhaddevelopedanhour-by-hour,day-by-dayplantotrytomanagethedepartureofaeuro-zonemember.Bythe time of the negotiations with Cyprus, admittedly a smaller country thanGreeceor theother rescuedeconomies, theprospectofCyprexitdidnotcauseanywherenearthesamedegreeoffearamongofficials,ormarkets.

Others also worked up contingency plans, not least in the EuropeanCommissionand theEuropeanCouncil, thoughhereco-ordinationwasweakerfor fear of disclosure. “Everything in Brussels leaks,” says one of those

involved. Officials recount how on one occasion Herman Van Rompuy,president of the European Council, raised the prospect of Grexit with JoséManuelBarroso,presidentoftheCommission.“Idon’twanttoknowthedetails.ButIhopeyouaretakingcareofit,”VanRompuysaid.Evenso,hisownsmallteamofeconomistsalsoquietlyworkeduppositionpapers.

Itallmadeforastrangedanceinthedarkness.WithintheCommission,staffattheeconomicsdirectoratehadbeenexpresslyorderednottodoanyworkonthe response to a possible break-up, even though a discreet group of seniorcommissionersandofficialsdid just that:plan forasplit in thecurrencyzone.Theyhadtwomainpurposes:first,tosetoutwhatwouldhavetobedone;andsecond, to make the case for why it should not be done. For others it was amatter ofmanaging aswell as possible. For all concerned a big dilemmawashowmuchtotelltheGreekauthoritiesaboutthepreparationsfortheircountry’spossiblereturntothedrachma.Theanswerwas:hardlyanythingatall.

Likethegoldstandard,onlyworseFixedexchange-ratesystemshavefallenapartthroughouthistory,fromthegoldstandardtovariousdollarpegs.Butgivingupafixedpegisverydifferentfromscrapping an entire currency. This has happened too, but usually only whenpolitical unions have broken apart: for instance, the break-up of the Austro-Hungarian empire, the collapse of the Soviet Union or the velvet divorcebetween theCzechRepublicandSlovakia.Andnoneof theseprecedentsquitecapturesthespecialcircumstancesoftheeuro.It isasinglecurrencywithoutasinglegovernment.Itismadeupofrichcountries,manyofwhichhavebuiltuplarge debts and large external imbalances, so the sums at stake areproportionately large. A map of the world sized according to each country’sgovernmentspendingshowsEuropeasahuge,puffed-upballofpublicmoney.4Moreover,theeurozoneisasubsetoftheEuropeanUnionanditssinglemarket,withinwhichgoods,services,capitalandpeoplemovemoreorlessfreely.Asaresult, the spillover effects on other European countries would be that muchgreater.

Ithadtakenyearsforcountriestopreparefortheintroductionoftheeuro.Ifanyleft,theymighthavetoadapttotheredenominationofamember’scurrencyovernight, or at best over a weekend. Nobody could be sure about theconsequences should the supposedly irrevocable currency become revocable.Therewere twoprevailing beliefs.Onewas the amputation theory: severing a

gangrenouslimbsuchasGreecewouldsavetherestofthebody.Theotherwasthe domino theory: the fall of one country would lead to the collapse of oneeconomy after another. Grexit might thus be followed by Portexit, Spexit,ItalexitandevenFrexit.

Given such uncertainties, the objective for officials preparing contingencyplanswasclear:regardlessofwhichcountrylefttheeuro,therestmustbeheldtogetheralmostatanycost.Thoseinvolvedspeakonlyinguardedtermsaboutpreciselywhattheywouldhavedone.Wouldthedepartureof,say,GreecehaverequiredCyprus to leave aswell, given their close interconnection?TheECBwouldhavefloodedthefinancialsystemwithliquiditytotrytoensurethatcreditmarketsdidnotdryup,astheyhaddoneafterthecollapseofLehmanBrothers,andtoforestallrunsonbothbanksandsovereigns.Largequantitiesofbanknoteswould have been made available in the south to reassure anxious depositorsespecially if, as during the Cyprus crisis, banks were shut down and capitalcontrols imposed. The ECB would probably have engaged in unprecedentedbond-buyingtoholddowntheborrowingcostsofvulnerablecountries.Loanstocountries already under bail-out programmes would have been increased, andsomekindofprecautionaryloanextendedtoSpainandItaly.

The IMF would have helped Greece manage the reintroduction of thedrachma. This would probably have required a transition period (perhaps asshort as one month) involving a parallel currency, or IOUs akin to the“patacones” that circulated in Argentina after it left its dollar peg in 2000,thoughEUlawyers thought thesewouldbe illegal.TheECBwouldhavedealtwith the technicalitiesofadaptingEuropeanelectronicpayment systems to thedepartureofamember.TheCommissionwouldintroduceguidelinesforcapitalcontrols.

Greecemighthaveneededadditionalaidtomanagetheupheaval,notleasttobuyessentialgoods.Inwhatremainedof theeurozonetherewouldhavebeendifficult decisions to take over the allocation of losses arising within theEurosystemofcentralbanks.Nationalgovernmentswouldhave todecidewhoshould be compensated for losses in case of default and the inevitablebankruptciescausedbytheabruptmismatchbetweenassetsandliabilitiesasthevaluesofcurrenciesshifted.Theymightalsohaveincreaseddepositguarantees,although in some cases that might have done more harm than good if theadditional liability endangered public finances inweaker countries – as it haddoneinIrelandin2008.

Perhaps, thought some, there should be a Europe-wide deposit guarantee.

Indeed,manythoughttherewouldhavetobeadramaticpoliticalmovetowardsgreaterintegration.Nobodyquiteknewwhatformthismighttake,butitwouldhave had to signal an unshakeable commitment to stay together.Without theinfuriatingGreeks,greaterintegrationmightevenappearmorefeasible.Indeed,itwassuchaprospectthatconvincedsomeseniorEUofficialsthatitwouldbeagood idea to let the Greeks go after all: not because contagion could becontained,as theBundesbankwouldsometimesclaim,butpreciselybecause itcouldnot.Grexitwouldbesoawfulthatitwouldforcegovernmentstomakealeapintofederalism.

Safe,fornowAll these considerations, andmore,were onMerkel’smind in the summer of2012 when she decided instead to keep the Greeks in. Beyond the financialprice,Germanycouldnot risk thepoliticalblameforbreakingup thecurrencyand, potentially, the European project itself. As she had repeatedly declaredsincethefirstbail-outofGreecein2010,“iftheeurofails,Europefails”.

Twoother events changed thedynamicsof thecrisis.First, at a summit inJune,MerkelandotherleadersagreedtocentralisefinancialsupervisionaroundtheECBandthenhavetheoptionofrecapitalisingtroubledbanksdirectlyfromtheeurozone’srescuefunds.Themoveheldoutthepromise,forthefirsttime,of abankingunion inwhich the risksof the financial sectorwouldbe shared.The aim was to break the doom-loop between weak banks and weakgovernments that threatened to destroy both, especially in Spain. The second,evenmoreimportant,developmentthatsummerwasDraghi’sdeclaredreadinessto intervene in bondmarketswithout pre-set limits, on condition that troubledcountries sought a euro-zone bail-out and adjustment programme. He thussharplyraisedthecostofbettingagainsttheeuro–tothepointthat,atthetimeofwritinginMarch2014,Draghi’sgreatbluffhasyettobecalled.

Theeurohasbeensaved,atleastforawhile.Butevenaseconomicoutputbegins slowly to recover, the euro zone remains vulnerable and the widerEuropean project remains under acute strain. As The Economist’s imaginarymemo toMerkelnoted, thecontingencyplans for thedemiseof theeurowerenever shredded; they weremerely filed away. AsThe Economist’s imaginarymemo toMerkel noted (see cover story headlined “Tempted,Angela?” in theissueofAugust11th–17thinAppendix4),thecontingencyplansforthedemiseoftheeurowerenevershredded;theyweremerelyfiledaway.

2FromtheoriginstoMaastricht

THE EUROPEAN PROJECT was a consequence of the secondworld war and thecoldwar.How to tame theGerman problem that had led to twoworldwars?HowtoharnessitseconomicpowertorebuildEurope?Andhowtoreconstitutethe German army to help fend off the Soviet threat? The answer to theseconundrums was to fuse the German economy within a common Europeansystem,andtoembeditsarmedforceswithinatransatlanticmilitaryalliance.

Alreadyin1946,justayearafterthewarhadended,ChurchillcalledinhisZurichspeechforthecreationofa“kindofUnitedStatesofEurope”,tobebuiltonthebasisofapartnershipbetweenFranceandGermany:1

Atpresentthereisabreathing-space.Thecannonhaveceasedfiring.Thefightinghasstopped;butthedangershavenotstopped.IfwearetoformtheUnitedStatesofEuropeorwhatevernameorformitmaytake,wemustbeginnow.

Four years later, with a strong nudge from the United States, the Frenchforeignminister,RobertSchuman,producedaplantointegratethecoalandsteelindustries of France, Germany and anyone else who would want to join theproject. This led directly to the creation of the European Coal and SteelCommunity(ECSC)in1951.2

ThesolidarityinproductionthusestablishedwillmakeitplainthatanywarbetweenFranceandGermanybecomesnotmerelyunthinkable,butmateriallyimpossible.Thesettingupofthispowerfulproductiveunit,opentoallcountrieswillingtotakepartandboundultimatelytoprovideallthemembercountrieswiththebasicelementsofindustrialproductiononthesameterms,

willlayatruefoundationfortheireconomicunification.

ThiswasthegermoftheideaofEuropeaneconomicintegration.Todaytheanniversaryofthespeech(May9th)iscelebratedasaholidaybytheEuropeaninstitutions(knownasSchumanDay).TheECSCencompassednotonlyFranceand Germany, but also Italy and the three Benelux countries, Belgium, theNetherlandsandLuxembourg.JeanMonnet,aFrenchcivilservantandscionofacognac-tradingfamily,whowasinmanywaystheéminencegrisebehindtheentireEuropeanproject,actedasthefirstpresidentofitshighauthority.3

Schuman andMonnet followed the successful establishment of the ECSCwith an attempt to set up a pan-European army, the European DefenceCommunity.ButthiswasasteptoofarforFrance.TheplanwasblockedbyavoteintheFrenchNationalAssemblyinAugust1954.HenceforthNATOwouldprovidethenecessarysecurityumbrella,whileEuropeanintegrationwouldfocusoneconomicmatters.

TheMessinaconferenceof1955preparedthegroundforthesigningin1957oftheTreatyofRome,underwhichthesixEuropeancountriesthathadjoinedthe ECSC established a European Economic Community (EEC), whichproclaimed the objective of an “ever closer union”. The treaty established acustoms union and envisaged the progressive creation of a large unifiedeconomicareabasedonthe“fourfreedoms”ofmovement–ofpeople,services,goodsandcapital.TheEECisthedirectforerunneroftoday’sEuropeanUnion.

Despite Churchill’s ringing call in 1946, the UK, always a sceptic aboutEuropean political integration, had stood aside from the process. Indeed,ChurchillhimselfwasclearthattheUKwouldencouragebutnotjoinEuropeanintegration. The British Labour government refused to sign up to Schuman’splan, with the then home secretary (and grandfather to a later Europeancommissioner,PeterMandelson),HerbertMorrison,declaringbluntly that“it’snogood:theDurhamminerswon’twearit”.4AlaterTorygovernmentsentonlya juniorofficial toMessina,with clear instructionsnot to signup to anything.Yet by 1961, only four years after the Treaty of Rome, the Macmillangovernment lodged an application for membership, only to see it blocked byCharlesdeGaulle’svetoinJanuary1963.

Currencyroots

ThenotionofasinglecurrencywaspresentattheverycreationoftheEuropean

project.JacquesRueff,aFrencheconomist,wroteinthe1950sthat“Europewillbemadethroughthecurrency,oritwillnotbemade”.5Theideaofacommoncurrencyhasevenearlierroots.Variousexchange-rateregimesemergedin19th-centuryEurope,includingtheZollverein(customsunion)andthegoldstandard.The Latin Monetary Union, set up in 1866, embraced a particularly unlikelysounding group: France, Italy, Belgium, Switzerland, Spain, Greece, RomaniaandBulgaria (evenmore bizarrely,Venezuela later joined it).When it startedWalterBagehot,editorofTheEconomist,deliveredawarningthathasacuriousechotoday:6

Ifwedonothing,whatthen?Why,weshallbeleftoutinthecold…Beforelong,allEurope,saveEngland,willhaveonemoney,andEnglandbeleftstandingwithanothermoney.

Intheevent,theLatinMonetaryUnionfellapartwhenitwashitbythedisasterofthefirstworldwar.

The 1930swas another period of currency instability in Europe – and theworld.TheUKandtheScandinaviancountriesallchosetodotheunthinkablein1931by leaving thegold standard anddevaluing.A rival “goldblock” ledbyFranceandincludingItaly,theNetherlandsandSwitzerland,chosetostayonthegold standard until 1935–36. As Nicholas Crafts showed in a 2013 paper forChatham House, the early leavers did much better in terms of GDP andemploymentthanthestayers–andFrance,whichsufferedalotfromclingingsolongtogold,playedaroleequivalenttotoday’sGermanybyhoardingthestuffandalsoinsistingonrunninglargecurrent-accountsurpluses.7

AlthoughthedesireforcurrencystabilitycarriedthroughintotheearlyyearsoftheEuropeanproject,theglobalsystemoffixedexchangerateslinkedtothedollar (and thus to gold) set up after the 1944BrettonWoods conference thatestablishedtheInternationalMonetaryFund(IMF)andtheWorldBankseemedsufficient for most countries. But over time, and especially in France, theperception was growing that this system gave the Americans some sort ofexorbitant privilege.Thiswas one reasonwhy theEuropeanCommission firstformallyproposedasingleEuropeancurrencyin1962.Bytheendofthedecade,the revaluation of Germany’s Deutschmark against the French franc in 1969createdfreshtraumainbothcountries,whichturnedintorenewedworrieswhentheUnitedStatesformallyabandoneditslinktogoldtwoyearslater.

As the difficulty of livingwith a dominant but devaluing dollar increased,

Willy Brandt, then German chancellor, revived plans for a currency union inEurope. His plan was taken up in the 1971 Werner report, named after aLuxembourgish prime minister, which argued for the adoption of a singlecurrencyby 1980.The reportwas endorsed in 1972by allEuropean heads ofgovernment, including those from the three countries that planned to join theclub in 1973: Denmark, Ireland and the UK. Indeed, at a summit meeting ofheads of government in Paris in December 1972, all nine national leaders,includingtheUK’sEdwardHeath,signedupblithelynotonlytomonetaryunionbutalsotopoliticalunionby1980.Alast-minuteattemptbytheDanishprimeminister to ask his colleagues exactlywhatwasmeant by political unionwasignoredbytheFrenchpresident,GeorgesPompidou,whowasinthechair.8

ItwasthefinalcollapseofBrettonWoods,followedbytheArab-Israeliwarandoil shockand thenby theglobal recessionof1974–75, thatupsetmostoftheseambitiousplans.Yetby thenWestGermany, alwayson the look-out forgreatercurrencystability,hadalreadysetupasystemlinkingmostofEurope’scurrencies to theDeutschmark, swiftly dubbed the “snake in the tunnel”. Theideawastosetlimitstobilateralcurrencyfluctuations,enforcedbycentral-bankintervention. However, it turned out that the snake had only a fitful andunsatisfactorylife.TheUKsignedupinmid-1972,onlytobeforcedoutbythefinancialmarketssixweekslater.BothFranceandItalyjoinedandleftthesnaketwice.Devaluationswithinthesystemweredistressinglyfrequent.

By 1978 therewas still no sign of a general return to the BrettonWoodssystemoffixedexchangerates.SoEurope’spolitical leaderscameupwiththeidea of creating a grander version of the snake in the form of a EuropeanMonetary System (EMS). The EMSwas mainly the brainchild of the Frenchpresident, Valéry Giscard d’Estaing, and the German chancellor, HelmutSchmidt, although the president of the European Commission, Roy Jenkins,actedasmidwife.InMarch1979,theEMScameintobeing.Itsmainprovisionwasanexchange-ratemechanismthatlimitedEuropeancurrencyfluctuationsto2¼%eithersideofacentralrate(orto6%forthosewithwiderbands).Allninemembersof theEuropeanCommunity joined thesystem–except,as sooften,theUK (thismeant, incidentally, that theEMSbroke up one ofEurope’s fewexistingmonetaryunions,thatbetweentheUKandIreland).

Yetforall itsambitions, theEMSprovedonlya littlemorepermanentandsolid than the snake. Italy was at best a fitful and wobbly member. And theelection in 1981 ofFrançoisMitterrand asFrance’s first Socialist president oftheFifthRepublicledtorepeateddevaluationsofthefranc–untilthepresident,

under the guidance of his new financeminister, JacquesDelors, and hismostsenior treasury official, Jean-ClaudeTrichet, adopted a newpolicy of le francfort.WhenayearortwolaterDelorsarrivedinBrusselsasthenewpresidentoftheEuropeanCommission,hewasquickonceagaintodustdowntheoldplansforaEuropeansinglecurrency.

EnterDelors

The result was the Delors report, commissioned by European leaders in June1988, which advocated a three-stage move towards European economic andmonetary union (EMU). First, complete the single market, including the freemovementofcapital.Second,prepare for thecreationof theEuropeanCentralBank and ensure economic convergence.Third, fix exchange rates and launchtheeuro,firstasacurrencyofreckoningandthenasnotesandcoins.TheDelorsreport went on to form the basis of theMaastricht treaty, negotiated over 18monthsandfinallyagreedon,withmuchfanfare,intheeponymousDutchcityin December 1991. The treaty was formally signed only in February 1992.MaastrichtlaidthefoundationsforanewECBandasingleEuropeancurrency,tobebroughtineitherin1997or(atthelatest)1999.Italsopromisedtomakeprogress towards the parallel objective of political union; and it symbolicallyrenamedtheEuropeanCommunitytheEuropeanUnion.

Thenewtreatyreflectedaboveall thechangedpoliticalsituationinEuropeafterthefalloftheBerlinWallinNovember1989andthesubsequentcollapseof the Soviet empire.Mitterrand, in particular,wasminded to acceptGermanunificationafterthefallofthewallonlyifFrancecouldsecuresomecontroloftheDeutschmark,whichhe fearedwouldotherwise becomeEurope’s de factocurrency.Ineffect,hehadnowishtoreplacethedominanceofthedollarwiththedominanceof theDeutschmark.Hence theunderlyingFranco-GermandealatMaastricht.

TheFrenchhadlongfavouredanewsinglecurrency,overwhichtheyhoped(vainly, as it turned out) to exert greater influence, in large part to offset thegrowingmight of a newly powerful unitedGermany. In his turn, theGermanchancellor,HelmutKohl,acceptedtheideaofgivinguptheDeutschmark,whichmany German voters as well as the Bundesbank were against, as a price forunification and as a giant step towards building a political union in Europe.Other countries signed up to thiswithmore or less enthusiasm.As usual, theBritishconcernwasmainlytobeallowedtooptoutiftheywanted,anobjective

thatwas easily securedby JohnMajor, theprimeminister,who told thepressthattheresultwas“game,setandmatch”totheUK.9

Besides a general (especially German) desire for currency stability and awishtocontainthepowerofaunitedGermany,twootherforceswereimportantindrivingEuropealongtheroadtowardsMaastrichtandthedecisiontoadoptasingle currency. One was theoretical: the literature on shared currencies thatbegan with Robert Mundell’s 1961 article outlining a theory of “optimumcurrency areas”. Mundell, a Canadian economics professor, posited thatsubstantialwelfaregainsweretobehadifagroupofcountriessharedacurrency– because of more transparent prices, lower transaction costs, enhancedcompetition and greater economies of scale for businesses and investors. Butthese gains needed to beweighed against the possible costs from losing bothmonetaryandexchange-rateindependence.10

Such costs, according to optimal currency-area theory, risked beingespecially high if the countries concerned suffered from internal labour-orproduct-marketrigidities,hadverydifferenteconomicstructuresorwerelikelytobesubjecttoasymmetricshocks.Thetheorywentontolookathowgroupsofcountries that did not meet these conditions could be changed to make themmoresuitable.Theobviousremediesweremoreflexibility,notablyinlabourandproductmarkets;greater labourmobility, so thatworkerswho lost jobs inonecountry could move freely to countries with more job opportunities; and asubstantialcentralbudgetthatcouldtransferresourcestocountriesthatgotintotrouble.The1977MacDougall report had argued that, in the early stagesof aEuropean federal union, a central budget would have to be at least 5–7% ofEurope-wideGDP,excludingdefence(thatis,5–7timesthesizeoftheexistingEuropeanbudget),ifitwastobeeffective.11

Thesecondforcedrivingmonetaryunionwasamorepracticalone:themovetowards a full single market that was being pushed forward by the DelorsCommission, most notably by the British commissioner of the time, ArthurCockfield. The Single European Act, approved and ratified in 1986–87, hadpaved the way for much greater use of qualified-majority voting (that is, asystemofweightedmajority as opposed to unanimity) onmost directives andregulations. This was crucial to the adoption of the 1992 programme forcompleting the single market. With this step, what was about to become theEuropeanUnionatlastembraced,moreorlessinfull,thefourfreedomsthathadsupposedlyunderpinnedtheprojectfromitsverybeginnings:freemovementofgoods, services, labour and capital (the last remaining capital controls were

abolishedin1990).12The link between the singlemarket and the single currency is not always

clear,especiallytoEurosceptics,whotendtopreferthefirsttothesecond.Thereason it exists lies mostly in the fourth of the four freedoms: movement ofcapital. It is best summed up by the notion of the “impossible trinity” thatbecamepopularintheeconomicsliteratureinthe1980s:thecombinationoffreemovementofcapital,whollynationalmonetarypoliciesandindependentcontrolofexchangerateswasdeclaredtobeunworkableorevenimpossiblebecausethethreewerelikelytocontradicteachother.Thesolution, itwasheldbothintheliterature andbyEurope’spolitical leaders,wasnot to revert to constraintsoncapitalflows,stilllesstounpickthesinglemarket,butinsteadtopressforwardtoasinglecurrency.

YetMundell’sworkalsoshowedquiteclearlythat,outsidealimitedcentralgroup,Europewasalongwayfrombeinganoptimalcurrencyarea.Labourandproduct markets were inflexible and overregulated. Workers’ mobility waslimited,notjustforobviouslinguisticandculturalreasonsbetweencountriesbuteven within them. Asymmetric shocks, far from being rare, were worryinglycommon:Germanunificationwasitselfanexampleofone,aswasthecollapseof Finland’s trade with Russia in 1990 and the bursting of various propertybubbles in the 1980s.And countries’ economies variedwidely:Germanywasstronginmanufacturingbutweakinservices,whereastheUKwasthereverse,for example, while national housing andmortgagemarkets differed hugely intheirstructure,operation,importanceandsensitivitytointerest-ratechanges.TheMaastrichtnegotiatorswerewellawareofsuchproblems,althoughmanywereswift to point out that the United States had a single currency without reallybeing an optimal currency area either. But there were crucial differencesbetweentheAmericansystemandtheeurozone.

Perhaps ironically, it was the UK’s David Cameron, prime minister of acountrythatwillprobablyneverjointhesinglecurrency,whobestsummedupthesedefects,speaking12yearsafter theeurowaslaunchedataDavosWorldEconomicForum.Ashethenputit:13

Thereareanumberoffeaturescommontoallsuccessfulcurrencyunions:acentralbankthatcancomprehensivelystandbehindthecurrencyandfinancialsystem;thedeepestpossibleeconomicintegrationwiththeflexibilitytodealwitheconomicshocks;andasystemoffiscaltransfersandcollectivedebtissuancethatcandealwiththetensionsandimbalancesbetween

differentcountriesandregionswithintheunion.Currentlyit’snotthattheeurozonedoesn’thaveallofthese;it’sthatitdoesn’treallyhaveanyofthese.

Instead of creating such structures, the creators of the euro limitedthemselvestodevisingasetof“convergencecriteria”thatnationalgovernmentswouldberequired tomeet inorder toqualifyformembershipof theEuropeansinglecurrency.Yet,asmanyarguedevenat thetime, theyquite irresponsiblychose ones that had little to dowith transforming Europe into something thatmighthavemorecloselyresembledanoptimalcurrencyarea.

The right debate at Maastricht would have been about how best to pushforward structural reforms to labour and product markets, how to improvecountries’ competitiveness and current-account positions, how to create abackstopsystemoftransfersorinsuranceandhowtomakesurethattheputativeEuropeanCentralBank could act properly as a lender of last resort. Plenty ofcommentators, includingmany from theUnitedStatesand theUK,madesuchobservations.One examplewas an article inThe Economist inOctober 1998,whichconcluded:14

Thecurrentset-uplooksunsatisfactory.TheECBshouldberecognisedaslenderoflastresort.Itcouldalsobegivencentralresponsibilityforfinancial-sectorsupervision.

In the event, the five criteria chosen for the Maastricht treaty were: lowinflation and low long-term interest rates; two years’ membership of theexchange-ratemechanismoftheEMS;and,mostcontroversiallyofall,ceilingsonpublicdebtof60%ofGDPandonbudgetdeficitsof3%ofGDP.Whywerethese last two tests chosen? The leaders of more prudent countries (that is,Germanyand theNetherlands)argued that, if the singlecurrencywere topassmusterwithscepticalfinancialmarketsandpublicopinion,limitswouldhavetobe setonpotentiallyprofligatepublicborrowers (bywhich theychieflymeantItalyandtheMediterraneancountries).

Butthetruthwasalotmorepolitical.Germanvoterswerestillhostiletotheidea of giving up the Deutschmark. One reason was a widespread fear thatGermany might end up having to bail out Europe’s most indebted countries,especiallythemostindebtedofall:Italy.Thusthedebtanddeficitcriteriaweredevisednotsomuchontheireconomicmerits,butratherintheexpectationthat

theywouldkeepItaly(andpresumablyalsoSpain,PortugalandGreece)outofthesinglecurrency,asthesecountrieswereexpectedtofinditallbutimpossibleto pass the two fiscal tests. The hope, in short, was that EMU would beginsmoothly but with a small core group, essentially theDeutschmark zone plus(almostcertainly)France.

Ready,steady,goTwobigeventsoverturnedthistidyplan.Thefirst,whichcoincidedominouslywiththenegotiationandsignatureoftheMaastrichttreaty,wasyetanotherboutof financial-market jitters. Throughout the trauma of German unification, theEMSanditsexchange-ratemechanismhadcontinuedtooperate.Indeed,theUKchosetojoininmid-1990,afteralongandpoliticallycontroversialexperimentby the then chancellor of the exchequer, Nigel Lawson, to “shadow” theDeutschmark without informing his prime minister, Margaret Thatcher. Thestrainofkeepingupwitha strongDeutschmark soonbegan to tell, and itwasconsiderably increased inNovember 1990 by the ousting of Thatcher, largelyovertheissueoftheUK’sattitudetoplansforthenewEuropeantreatythatlaterbecameMaastricht.

ButitwastheaftermathofGermanunificationinthatsamemonththatreallygot themarketsgoing.ThisasymmetricshockmayhavecostWestGermanyalot of treasure and required massive new investment, but its effect in themarketplace was to increase demand for the German currency. That sent theDeutschmarksoaring,hittingGermancompetitivenessata timewhenmuchofEuropewasonthevergeofrecessionoractuallyinit.Themarketsbecameevenmorejitterywhen,inaJune1992referendum,theDanesnarrowlysaidnototherecentlysignedMaastrichttreaty.InearlySeptemberFrenchvoterssaidyes,butbythethinnestpossiblemajority.BythenthestrainsontheUK,ItalyandFranceitself of supporting their exchange rates tokeepupwith theDeutschmarkhadgrownintolerable.Inadramaticweekinmid-September,firstItalyandthentheUKwere forcedoutof theEMS’sexchange-ratemechanism.And theGermanBundesbankhadtointerveneheavilytokeepFrancein(atrickitrepeatedinlate1993, when the permissible bands in the exchange-rate mechanism werewidenedto15%).

Those involved inwhat the British later came to call “BlackWednesday”drewverydifferentconclusionsfromit.Francebecameconvincedthatasinglecurrency, over which it still hoped to exert some political control, was moreessentialthanever,forwithoutittheBundesbankwouldremainparamount.The

UKconcludedthatacurrencystraitjacketwasabadideaandthatitcouldneverrelyonGermansupport,soBlackWednesdaycametobeseenasanotherreasontostayoutofasinglecurrency,ifoneevercameintobeing(itisworthrecallingthatayoungCameronwasapoliticaladvisertothechancelloroftheexchequer,Norman Lamont, at the time of Black Wednesday). Italy, Spain and otherMediterraneancountriesdrewadifferentlessonstill:theydecidedthat,whileasingle currency might well impose pain on them, it would be better to dowhatevertheycouldtohoponboardfromthebeginningratherthanriskfallingfurtherbehind.

Hence also the second big development in the 1990s: the response of theMediterranean countries,most ofwhich theGermans stillwanted to keepout.The test case was Italy. In the early 1990s its budget deficit and, even moreobviously,itspublicdebtwerewayabovetheMaastrichttargets.Yettherewasboundtobesomeflexibilityinthesystem,notleastbecauseBelgium,whichastheseatoftheEuropeaninstitutionsandpartoftheBeneluxtriowasseenbyallas an essential foundermember of EMU, also had a public debt in excess of100%ofGDP.In1996RomanoProdi,whohadbecomeItalianprimeministerjust over a year earlier, spoke to his Spanish counterpart, José Maria Aznar,aboutthepossibilityofjointlystandingasidefromthethirdstageofEMUwhenitcame.ButAznarrepliedthathe,atleast,wasdeterminedtojoinfromthestart.ThatdroveProdinotonlytorejointheEMSbutalsotoredoublehisefforts tocut Italy’s budget deficit to below3%ofGDP.Given theBelgian position, itwasalwaysgoing tobehard toexcludeItalyon thegroundsof itspublicdebtalone.This became truer stillwhenFrance and to some extentGermany itselfhad tomassage theirbudgetnumbers togetbelow the3%ceiling in1997and1998.

As the likelihood that Italy would be a founder member of the singlecurrencybecameevermoreobvious,theGermanfinanceminister,TheoWaigel,started to press harder for a formalisation and tightening of the rules limitingbudget deficits and debts after EMU had started, as well as before. TheMaastrichttreatyhadlaiddownanexcessivedeficitsprocedure,butWaigelfeltthatitwastooflexible.Instead,hedemandedanew“stabilitypact”thatwouldautomatically impose swingeing fines on any country that ran a budget deficitabove3%ofGDP.Mostother countries, ledbyFrance,naturally resisted anyautomaticsanctions.

EventuallyWaigelwas forced togiveground: the fineswouldbe imposedonly with the approval of a “qualified majority” of member governments

(excluding the miscreant). When in France a new Socialist government wasformedafterthepartywontheparliamentaryelectionofJune1997,heevenhadto concede a change of name to turn it into a “stability and growth pact”.Ironicallyenough,hisownboss,HelmutKohl,losthisjobjustoverayearlatertohisSocialDemocraticchallenger.Thismeantthatthetwooriginalchampionsoftheeuro–KohlandMitterrand–hadbothleftofficebythetimeitactuallybegan (and the two countries also had nominally centre-left governments in1999).Their successors asGerman andFrench leaders,GerhardSchröder andJacquesChirac,feltlesscommittedeithertotheeuroingeneralortothestabilityandgrowthpactinparticular.Indeed,theyweretobecomethefirsttobreachitsterms,inlate2003.

By late 1997, then, it was clear that all EU countries except Denmark,Sweden and the UK, all of which had opted out in one way or another, andGreece,whichwasmilesfrommeetinganyof thecriteria,wouldjoin theeurowhen it began life in 1999. Physical notes and coins followed only in 2002,partlybecauseofthetimesaidtobeneededtoprintandminttheminsufficientquantities.InthemeantimeGreecequietlyslippedintojointhesinglecurrencyat the start of 2001, at a time when few people were looking. Perhapsworryingly, thisechoed thestoryofGreece’sentry into theEEC in1981.TheCommission had given a negative opinion onGreece’s application, but itwasoverruled by national governments largely on the basis that, as France’sclassicallymindedpresident,ValéryGiscardd’Estaing,putit,“onedoesnotsayno to Plato”.15 It also helped that Greece’s prime minister in 2001, CostasSimitis,wasbothGermanophileandGerman-speaking.AfterGreecejoined,thefunreallybegan.

3Howitallworks

THEEUROPEANPROJECT (and thus theeuro) suffersboth froma lackofclarityover its precise nature and end-point and from the dull complexity of itsinstitutionalstructure.Likeapantomimehorse,ithaslonghadadualcharacter,reflectinganinitialcompromisebetweenthosecountrieswantingaUnitedStatesof Europe and those preferring a club of nation-states. Thus it has federalistelementssuchastheEuropeanCommission,a(nowdirectlyelected)EuropeanParliament, a EuropeanCourt of Justice and a EuropeanCentral Bank. But italsohasstronginter-governmentalbodies:theCouncilofMinisters,representingnational governments, and the European Council of heads of state andgovernment.Animportantforcethroughouttheeurocrisishasbeenthetensionbetweenthosepreferringfederalanswers(oftencalledthe“community”method)and those favouring inter-governmental solutions (sometimes referred toas the“union”method).1

AttheheartofboththeEUandtheeurostandstheEuropeanCommission,towhicheachofthecurrently28nationalgovernmentsappointsonecommissionerfor a five-year term (the next Commission takes office at the end of 2014).Commissioners, based in Brussels, are legally required to be whollyindependent, although in practice they usually do what they can to advancenationalinterests.The“college”of28commissionerssitsabovea20,000-strongbureaucracy that functions as the European Union’s executive branch. TheCommission is the guardian of the treaties, has the near-exclusive right oflegislative initiative, administers competition and state-aid law and conductscertain third-partynegotiations, for instanceon trade,onbehalfof theEUasawhole.

The Council of Ministers is the senior legislative body. It consists of

ministersfromnationalgovernments,meetingindifferentformations(financeorEcoFin, agriculture and fisheries, environment, and so on). Inmany areas theCouncil takesdecisionsbyqualifiedmajority,asystemofweightedvotes that,under the 2009 Lisbon treaty, is due to change in late 2014 into a newarrangementofa“doublemajority”thattakesgreateraccountofpopulationsize.Council meetings are prepared by officials in the Committee of PermanentRepresentativesinBrussels(COREPER);EcoFinmeetingsareoftenpreparedbythe official-levelEconomic andFinancialCommittee; and there is also a euroworking group. The Council presidency rotates every six months from onecountrytoanother,thoughthissystemhasbeenmodified,underLisbon,bythearrival of a permanent president of the European Council and a highrepresentative for foreign policy, who chairs Council meetings of foreignministersaswellasbeingavice-presidentoftheCommission.

TheEuropeanCouncilis,ineffect,themostseniorformationoftheCouncilofMinisters. Itdidnotexistat thestartof theEuropeanproject,butover timethe practice of calling occasional summit meetings of heads of state andgovernment to give general direction and to resolve the most contentiousdisputesbecamehabitual.UnderLisbon, theEuropeanCouncil has a full-timepresident, currently Belgium’s Herman Van Rompuy, who serves for amaximumoffiveyears(histermexpiresattheendof2014).VanRompuyhasset thepatternofholdingEuropeanCouncilmeetingsevery twomonthsor so.These summits haveoften receivedmuchpublicity, especially during the eurocrisis when they have often drifted into weekends and the early hours of themorning.Over time, theEuropeanCouncil hasbecome the strategic engineofthe European Union, largely displacing the Commission, a switch that hasbecomeevenclearerasaresultoftheeurocrisis.

The Commission makes most of its legislative proposals jointly to theCouncilandtheEuropeanParliament,thesecondlegislativebodyintheEU.TheParliament,whichhasbeendirectlyelectedsince1979,nowhas751members.AtFrenchinsistence,itisformallybasedinStrasbourgformostofitsmonthlyplenarysessions,althoughitscommitteesandmostof itsmembers(MEPs)aregenerallybased inBrussels.Electionsareheldeveryfiveyears: the2014onesare scheduled to take place between May 22nd and May 25th. Successivetreaties have given the Parliament ever-greater powers, and it is nowmore orless co-equal with the Council of Ministers in legislation. The EuropeanParliamentmustapprovetheannualbudgetaswellasthemultiannualfinancialframework. It can reject the budget (it did so inDecember 1979). Unlike the

Council,itcanalsosacktheCommission(itusedthispowertoforcetheSanterCommission’s resignation in 1999). And, again under Lisbon, the Parliamentnow has the power to “elect” the Commission president, after he or she isnominatedbytheEuropeanCouncil,aprovisionthatcreatesanobviousriskofahugeinstitutionalbust-up.

Themost important remaining institution is theEuropeanCourt of Justice,based inLuxembourg,whichacts as theEuropeanUnion’s supremecourt andadjudicates on disputes both among the institutions and between countries inareasofEUcompetence(soithasnoroleinthecriminallaw,forexample).Thecourthasonejudgepercountry,thoughthereisalsoaCourtofFirstInstancetoreduceitsworkload.Casesareusuallydecidedbysimplemajority.TheCourtofJustice(nottobeconfusedwiththeStrasbourg-basedEuropeanCourtofHumanRights, part of the Council of Europe) has advanced European integration inseveraljudgments,notablythe1963VanGendenLooscase,whichestablishedthe principle of the supremacy of European over national law, and the 1979CassisdeDijonjudgment,whichlaiddownthatgoodssoldinonecountrymustbeabletobesoldinall.OtherEUbodiesincludetheCourtofAuditorsandtheEuropean Investment Bank, both based in Luxembourg, the Economic andSocialCommitteeandtheCommitteeofRegions,bothbasedinBrussels–andaplethoraofsmalleragenciesscatteredrightacrossEurope.2

These institutions operate collectively by the “community method”. Thisdescribes the classical path of EU legislation: a proposal is made by theCommission;itisadoptedbyco-decisionbetweentheCouncilandtheEuropeanParliament,oftenfollowedby“trilogue”betweenthetwoandtheCommissiontoreconcile their positions; it is then implemented by national authorities and issubjecttothejurisdictionoftheCourtofJustice.Butatmanytimesinthepast,and againduring the euro crisis, national governments, especially thoseof theUK and France, have jibbed against the community method. President deGaulle’s Fouchet plan would have set up inter-governmental institutionsalongside the Brussels machinery. The Maastricht treaty introduced two new“pillars” for foreign and security policy and for justice and home affairs, inwhich the roles of the Commission and the Parliament were limited andlegislationwasnotgenerallyjusticiableattheCourtofJustice,unlikemostotherEUactivities.

Inpracticemostsucheffortstoworkoutsidethe“communitymethod”haveprovedunsatisfactory.TheFouchetplandidnotget anywhere.TheMaastrichtpillarshave,undertheLisbontreaty,beensubsumedbackwithinthefirstpillar.

Yetmanynationalgovernments,includingnowGermany,stilllikethesimplicityof working inter-governmentally. During the euro crisis, Angela Merkel hasoften praised the “union method”, which downgrades the roles of theCommission,theParliamentandtheCourtofJustice.

EntertheECB

SeveralinstitutionsforthesinglecurrencywereboltedontothesystemaftertheMaastricht treatywas ratified. Foremost among these is the European CentralBank, which started work in June 1998 (it had a forerunner, the EuropeanMonetary Institute, set up in 1994). The ECB,which at German insistence isbased inFrankfurt,homeof theBundesbank,sitsat theapexofwhat iscalledthe European System of Central Banks, to which all national central banksbelong(eventhosefromEUcountriesstilloutsidetheeuro).TheECBhasasix-strongexecutiveboard,headedbyapresidentandavice-president,allofwhomserve single eight-year terms. Its governing council consists of this boardplusthegovernorsofthenationalcentralbanksofcountriesintheeuro.Itnormallytakes decisions by simplemajority.The initial systemof one vote per councilmemberistobesuperseded,mostprobablyduring2015,byanarrangementthatwillgivetheexecutiveboardsixvotes,addfourvotesthatrotateamongthefivebiggesteuromembersandgivetherest,nomatterhowmanythereare,11votesin total (this change creates at least the theoretical possibility that theBundesbank’spresidentmightnotalwayshaveavoteonthecouncil).

The ECBwasmodelled on theGermanBundesbank but is inmanywaysevenmorepowerfulandindependent.Itsgoal,fixedbytheMaastrichttreaty,isprice stability (close to but below 2%), whereas the Federal Reserve, itsAmerican counterpart, is also required to pay attention to employment. Itsoperational independence in delivering the goal of price stability, which itdefinesitself,isalsoguaranteedbythesametreaty.Unlikeothercentralbanks,ithas no single government or finance ministry to interact with and report to,though its president testifies before theEuropeanParliament and attendsmostmeetingsoftheEuropeanCouncilandoftenEcoFinandtheEurogroupaswell.InlinewiththeBundesbankmodel,whenEMUarrivedtheECBwasnotgivenoverall responsibility for bank supervision, which stayed at national level, anarrangement that has since been deemed unsatisfactory, with the planned“bankingunion”givingsupervisionofmostlargeEuropeanbankstotheECB.Italsohadnoobligationtoactasthesystem’slenderoflastresort,ahugepotential

problemonceittookovertheoperationofmonetarypolicyfromnationalcentralbanks.

OnebigdifferencebetweentheECBandmostothercentralbanksisthatitismuch smaller (it has a staff of less than 1,000) and also, because of thecontinuing role of the national central banks, a lot more decentralised. Thatmakes the role of the president, the ECB’s public face, especially important.Given this, itwas foolish anddangerouswhen theEuropeanCouncil chose towelcomethenewbankwithanall-daywrangleinMay1998overwhoshouldbeitspresident.ThejobhadlongbeenintendedtogotoWimDuisenberg,aformerDutchcentralbankerwhohad run theEuropeanMonetary Institute.Butat thelast minute the French president, Jacques Chirac, put forward Jean-ClaudeTrichetforthejob.Theoutcomewasabotchedandundignifiedcompromiseinwhich the termwas informallysplitbetween the twomen.Duisenbergsteppeddown in2003, leavingTrichet to serveacompleteeight-year term,untilhe inturnwasreplacedbyanItalian,MarioDraghi,in2011.

ThelackofanystrongpoliticalauthoritytoactasacounterparttotheECBwasobvious from the start.TheCommissionhas scarcelymore accountabilitythan the bank. The European Parliament is elected, but it has no executiveauthority.TheEuropeanCouncilandEcoFinincludenon-membersoftheeuro.From an early stage the French pushed for the creation of some form of“economic government”, but the Germans resisted the concept in order tosafeguard the ECB’s independence. Instead, in 1998 European governmentscameupwiththeideaofa“Eurogroup”offinanceministers.Financeministersfrom non-euro countries fiercely resisted the Eurogroup’s establishment. TheUK’sGordonBrown,thenchancelloroftheexchequer,triedhardtojoinasanobserver at the group’s first meeting at the Château de Senningen inLuxembourginJune1997,onlytobetoldbyhisFrenchcounterpart,DominiqueStrauss-Kahn,thattheeurowaslikeamarriageandthat,inamarriage,onedidnotinvitestrangersintothebedroom(apreceptthatStrauss-Kahnhasfollowedonlyerraticallyinhisownlife).

Inanyevent theEurogroupsoonbecameaccepted,anditevenacquireditsown permanent chairman: first, Jean-Claude Juncker, Luxembourg’s primeminister and finance minister, and then, from the end of 2012, JeroenDijsselbloem, the Dutch finance minister. By this time it had also becomeaccepted,onceagainoverobjectionsfromcountriesoutsidetheeuro,supportedby Germany, that European heads of government shouldmeet periodically ineuro-zone summits, usually just after full European Councils. In either

formation,theEurogrouphasnostatutorybasisandnolegislativepowers.Butithasbecomeanessentialpartofthesinglecurrency’sarchitecture.

Another component is the “excessivedeficit procedure”.Thisbegan in theMaastrichttreatyandwasreformulatedintothestabilityandgrowthpact,whichwas approved in 1997. However, from the very beginning the rules againstexcessive deficits andpublic-debt levelswere interpreted flexibly, not least sothat Belgium and Italy could join the single currency. The stability pact’sprovisions for sanctions were watered down in negotiation from beingautomatic, as the Germans originally wanted, to requiring qualified-majorityapproval by the Council. Even so, the pact attracted much criticism fromeconomists, who felt that, given euro-zone countries’ loss of an independentmonetary and exchange-rate policy, more not less fiscal flexibility might beneeded. It was also thought that imposing central rules might undermine theforce of the treaty’s “no-bail-out” provisions, because it would imply a highdegreeofcentralintrusion.Better,manyargued,torelyonthebondmarketstoimposedisciplineonanycountrythatborrowedsomuchthatitlookedtobeatriskofdefaulting.3

The pact’s credibility was further dented in 2002 when Romano Prodi,presidentoftheCommission,calledit“stupid”.Portugalwasthefirstcountrytogetintodifficulties,anditwasdulyrequiredtoamenditsbudgettocomplywiththepact.Butitwasneverlikelytoconstrainbiggercountriesand,inlate2003,itspotencywasalmostentirelydestroyedwhenFranceand,ironically,Germanyitself persuaded the Council to override a Commission recommendation thatbothcountries shouldcut theirbudgetdeficits,whichhaddriftedabove3%ofGDP.4

Theguttingofthestabilitypactmadeitlessofasurprise,whenthefinancialcrisishit in2008, that thedeficits anddebt levelsofmosteuro-zonecountrieswentabovetheMaastrichtceilings.Naturally,thecrisisalsopromptedcallsforarevival of the excessive deficits procedure, but with new teeth. Its newincarnation, adopted in late 2011, includes the “two-pack” and “six-pack” andsetsout a “European semester”.Euro-zonecountriesnowhave to submit theirdraft budgets to theCommission in advance, and theCommission can requestchangesbeforenationalparliamentsevenhaveachancetoconsiderthem.Anewexcessiveimbalancesprocedurehasalsobeenadded,enablingtheCommissiontomonitor andmake recommendations for countries that, amongother things,run large current-account imbalances (defined, with a nod to chronicallyunderconsuming Germany, as 4% of GDP for deficits but 6% of GDP for

surpluses).Intermsofsanctions,thenewprocedureslooksimilartotheoldexceptthat

now a Commission recommendation will be automatically adopted unless aqualified majority in the Council votes against it. Such a negative qualified-majorityprocedure is alsoenshrined in the“fiscal compact” treaty,whichwasapprovedandratified in2012asan inter-governmental treatyusing the“unionmethod”,partlybecauseseveralgovernmentsincludingFrance’sandGermany’slikeditthatway,partlybecausetheUKandtheCzechRepublicrefusedtosignit (the Czechs now plan to do so) and partly because it allowed the treaty’sdrafterstoprovidethatitwouldcomeintoforceevenifsomecountriesfailedtoratify it. The fiscal compact requires all signatories to insert debt brakes intotheirnationalconstitutionalarrangements.Italsoformalises,withtheEuroPlusPact,theexistenceofeurosummits,alongsideEuropeanCouncils.

The euro crisis has added a set of further, ad hoc pieces to the singlecurrency’s institutional architecture, many of them also set up on the unionmethod.FirstcamethetemporaryEuropeanFinancialStabilityFacility(EFSF),aninter-governmentalvehiclesetupinarushaftertherescueofGreeceinMay2010.AlongsidethisthereisasmallerEuropeanFinancialStabilityMechanism,whichusestheEUbudgetascollateral.Bothfundsarebeingsubsumedintothepermanenttreaty-basedEuropeanStabilityMechanism(ESM).TheESMwassetupasanorganisationunderpublic international lawwithaboardofgovernors(that is, financeministers) andamanagingdirector,KlausRegling,previouslytheCommission’s economicsdirector-general.Althoughan inter-governmentalbody,theESMhasoperationallinkstotheCommissionandisalsosubjecttothejurisdictionoftheEuropeanCourtofJustice.

Treaties,treatiesOnereasonitisoftenhardforoutsiderstounderstandhoweithertheEUortheeuroworks is that, for thepast25yearsor so, theentireEuropeanprojecthasbeengoingthroughaveritableorgyoftreaty-making.AftertheSingleEuropeanActof1986andtheMaastrichttreaty,signedinFebruary1992,therewasbutashort pause before theAmsterdam treaty of 1997 and then theNice treaty of2001. Each time, it seemed, the driving force for successive treaties was awidespread feeling of dissatisfaction at what had been done on the previousoccasionandatwhathadfailedtobeagreedorhadbeenleftout.TheexpansionoftheEuropeanUniontotakeinAustria,FinlandandSwedenin1995and,inafar bigger challenge, eight central and eastern European countries from the

formerSovietblockplusCyprusandMaltain2004wasanotherconsideration.Evenas theeuroemerged from infancy inDecember2001, justbefore the

date for the issue of euro notes and coins, EU leaders, meeting in Laeken inBelgium,decidedtohaveonemoregoattheirgoverningtreaties.Thistimetheyset up a convention on the future of Europe, chaired by a former Frenchpresident,ValéryGiscardd’Estaing,whichswiftlydecided,amidmuchexcitedchatterdrawinganalogieswithPhiladelphiain1787,todrawupacompletenewconstitution for the EU. The text of this constitutional treaty was broadlyendorsedbyan inter-governmentalconferenceand thenadoptedataEuropeanCouncilmeetingin2004.Butafterthatthetroublebegan,becausenofewerthanten countries announced plans to put the draft constitution to nationalreferendumsbeforeratification.5

Severaltreatyreferendumshadbeenheldbefore,andinsomecasestreatieshadbeen rejectedonly to beput to thevote again (this happened inDenmarkoverMaastricht and Ireland over Nice). But never had so many referendumsbeenpromisedatonce.Intheevent,itshouldnothavecomeasahugesurprisewhentwoofthefirstfoursaidno:inFranceonMay29th2005andthenintheNetherlandsonJune3rd2005,inbothcasesbylargemajorities.Theexpedientofmakinga fewmodificationsandaskingsingle smallcountries tovoteagainwas clearly not going to work with such large founder members. So theconstitutionwasabandoned.

The immediate impactof thissetbackon theeuromayhaveseemedslight.But it fosteredabroadersenseofcrisis in theEUasawhole.Onereasonwasthatitmadeeverybodyleeryoffurtherattemptsattreatychange,afeelingthathaspersistedintotheeurocrisis.ThegloomwasintensifiedbythecoincidenceofyetanotherrowovertheEU’sbudget.Althoughthebudgetissmall,atlittlemore than 1%ofEU-wideGDP, its excessive spending on agriculture and itsskewed net benefits have caused repeated arguments at least since MargaretThatchercametopowerintheUKin1979andpromptlydemanded“mymoneyback”. Her determined handbagging of fellow European leaders eventuallyproducedaseriesofadhocrebates,followedbyapermanentabatementofthenet British budget contribution, which was agreed at a European Council inFontainebleauin1984.6

Despitethisdeal,subsequentnegotiationsontheEU’smultiannualfinancialframeworkhaveprovedalmostequallycontentious,andtheonein2005wasnoexception.TheUK,whichwantedasmallerbudget,lessspendingonagricultureandtopreserveitsrebateuntouched,wasonceagaininthedoghouse,butseveral

other countries favoured budgetary cuts while the newmembers from centralandeasternEuropewantedfarmorespending.Acompromisewasreachedonlyattheendoftheyear,whentheBritishprimeminister,TonyBlair,gaveuppartof the rebate to ensure that the UK would bear a fair share of the costs ofenlargement to the east. But the sour atmosphere helped to cloudmuch otherbusiness, including that of the euro. Juncker, as president of the Council,declaredthattheEUwas“indeepcrisis”.

ThegloomalsospiltoverintotheotherbigissuefacingEuropeanleadersatthe start of2006:what todoabout the failed constitutional treaty.On this thekeypersonwasthenewGermanchancellor,AngelaMerkel,whotookofficeinlate 2005 at the head of a “grand coalition” between herChristianDemocratsandtheSocialDemocrats.Shewasdeterminedtoreviveasmuchasshecouldfromtheconstitution,notleastbecausethenewvotingsystemthatitproposedatlong last recognised thatGermany’spopulation is larger than thatofotherEUcountries.Afterherfellowcentre-rightleader,NicolasSarkozy,becameFrenchpresidentinmid-2007,thetwopressedaheadwithwhatlaterbecametheLisbontreaty,which incorporatedmost ofwhat had been in the constitution but in adisguisedandlesscomprehensiblefashion.

Criticscomplainedthatrevivingthetreatyinthiswaywasabackdoorroutearound the negative votes in France and theNetherlands. They objected evenmore vociferously when almost all EU leaders, including the French and theDutch, said they would not try to ratify Lisbon by referendums but useparliamentary votes instead. The exception was Ireland, which wasconstitutionally required tohold a referendum.Yet again, Irishvoters saidno,this time in June2008.But justoverayear later, after the financial crisishadstruck,theywerepersuadedtochangetheirmindsinafreshvote,soLisbonwasfinally approved in late 2009. The new permanent president of the EuropeanCouncil,HermanVanRompuyofBelgium,andthenewhighrepresentativeforforeignandsecuritypolicy,BaronessCatherineAshtonoftheUK,werechosenatasummitshortlyafterwards,afteryetanotherwrangle.ButbythenthefocusofattentionwasstartingtoshifttothecrisisinGreece–andparticularlytothefiscalproblemsofanewlyelectedGreekSocialistgovernment.

4Build-uptoacrisis

IFTHEREISANORIGINALSINinthecreationoftheeuro,itis,formanyinBerlinandBrussels,thebreachofthestabilityandgrowthpactin2003.GermanyandFrancecolludedtoblockanyofficialrebukeorsanctionsforlettingtheirbudgetdeficitsriseabovetheMaastrichtceilingof3%ofGDP.AfterabattlewiththeEuropean Commission that ended up at the European Court of Justice, theynegotiated a looser version of the pact in 2005 that, to critics, rendered ittoothless.Fromthenon,sothestorygoes,allsemblanceoffiscaldisciplinewasabandoned. Today’sGermanministers castigate their predecessors for leadingtheeurozone into sin rather thanvirtue.Yet thisaccountoffersatbestonlyapartialexplanationofwhatwentwrong.

Itistruethatcountriesthattightenedtheirbeltstoqualifyformembershipofthe single currency relaxed their reforming effort after it started life in 1999.Manyfeltthatitwasenoughtohaveprovedwrongthedoom-mongersintheUKandtheUnitedStateswhohadpredictedeitherthattheeurowouldneverarriveorthatitwouldquicklybreakup(atonepointin1999,whenitfellinvalue,itwas christened a “toilet currency”by traders inLondon;others referred to theeuroasthe“zero”).Moreover,asEuropethenenteredamildrecessionin2001–02 there were others, beyond France and Germany, that were in excessivedeficit. In purely economic terms, though, the original stability pact was toorigid, pushing countries into procyclical austerity whenever they foundthemselvesinadownturn.Thereformedversionmadegreaterallowancesfortheimpact of the economic cycle, and tried to strip out one-offmeasures throughwhichcountriessoughttogamethenumbers.

Most euro-zone countries remained within the limits and, in subsequentyears,thenumberofsinnersgraduallydeclined.Therealfailingofthepactwasthatanobsessionwithbudgets,especiallytheannualdeficits,blindedministers

andofficialstomoreseriousunderlyingproblemsintheeurozone.“Thewholesystemwaslookingat theeconomythroughthekeyholeoffiscalpolicy,”saysoneCommissionveteran.By2007thefiscalsituationhadseeminglyneverbeenbetter.Allmembersoftheeurozonewereoutoftheexcessivedeficitprocedure(EDP) bymid-2008, and so formally deemed to have their public finances inorder though thecredit crunchwas intensifying.TheCommissionboasted thatreform of the pact had promoted discipline and national “ownership”. EvenGreecewasreleasedfromtheEDPin2007,despitepersistentdoubtsaboutthereliability of its figures. But, rather as with the enforcement of the pact,governmentswouldnothearoftheCommissionbeinggiventhepowertoaudittheirnationalfigures.

Itissignificantthat,ontheeveofthecrisis,threeofthefivecountriesthatwouldlaterhavetobebailedout–Ireland,SpainandCyprus–werevirtuousbythe standards of the stability and growth pact. They were running budgetsurplusesandhadastockofdebtwellbelowtheMaastrichtceilingof60%ofGDP. Their problem was not a matter of poor enforcement, or of fabricatedstatistics, but of a misguided belief that controlling fiscal policy was all thatreallymattered.Thecrisisrevealedthemuchgreaterimportanceofseveralotherfactors:economicimbalances,particularlyinthecurrentaccountofthebalanceof payments; private debt; and the role of the financial sector in financingexternaldeficits.

Unbalanced

Thefocusonfiscalruleshadbeenjustifiedbytwobeliefs.Thefirstwasthat,ina single currency with a common exchange rate and monetary policy, fiscalsinnerswerelesslikelytobepunishedbymarketsthatmightotherwisespeculateagainstacountry indangerof running intoproblemsofhigh inflationordebt.Profligacy in one country could thus drive up borrowing costs for all. Thesecond,conversely,wasthataeuro-zonecountrythatgotintotroublewouldnotbeabletodevalueorloosenmonetarypolicy,andwouldnotenjoythesortsofautomatictransfersthatoperateinfederalcountries,sothemaintooltoabsorbashockwouldbegreaterborrowingbythegovernment:hencetheneedforsoundpublicfinances.

In countries with their own currencies, markets and policymakers closelywatch the current account for signs of an economy getting out of line. Thecurrent-accountbalanceisameasureofthebalanceoftrade,foreignincomeand

transfers. A deficit can be a problem if, say, it highlights a country’s loss ofcompetitivenessandexportshare;oritcanbebenign,ifitreflectsgreaterreturnsoncapital flowing intoacountryundergoingaperiodof fastcatch-upgrowth.Current-accountdeficitsmustbydefinitionbefinancedbycapital inflows.Yettherewasawidespreadbelief,echoedonoccasionby theCommissionand theECB,that,inasingle-currencyzonewithanintegratedfinancialmarket,current-account imbalances did not matter any more than they did within federalcountriesliketheUnitedStates.

Intheearly2000s,yearsthatbecameknownasthe“greatmoderation”,whenmoney was cheap, euro-zone countries were able to build up large externalimbalances(15%ofGDPinGreece).Hadtheystillhadnationalcurrencies,thiswould surely have provoked a response from markets. Instead, everybodybenefitedfromlowinterestrates.Thuswasbornthegreatparadoxofeconomicandmonetaryunion. Inorder forcountries tosurvivewithin it, theyneeded tomake deeper structural reforms to improve their competitiveness; and yet thepressure to push through those reforms was reduced by the benign mood offinancialmarkets.ManyhadhopedthecreationoftheeurowouldforceossifiedcountrieslikeItalytochangetheirways.Losingtheabilitytodevaluemeantthatcompetitiveness could be recovered only by “internal devaluation” (that is,bringing down wages and prices relative to others), boosting productivity, orboth. This meant liberalising labour and product markets, and promotingcompetition. But for countries used to high inflation and high interest ratesbeforethelaunchoftheeuro,anylossofcompetitivenesscouldbemaskedforalongtimebycheapermoney.

Byabout2005itwasapparentthatnationaleconomies,farfromconvergingas they had been expected to do,were pulling apart. The differenceswere nogreater than the dispersion in growth rates in American states, but they wereworryinglypersistent.Someweregrowingfastwithhighinflation,amongthemIreland, Greece and Spain. All were enjoying a boom fuelled by low interestrates. At the other end of the spectrum, mighty Germany was growinganaemically, butwith very low inflation.To some extent theECB’s one-size-fits-allinterestrateexacerbatedthispolarisation:interestratesweretoolowforoverheatingcountries,buttoohighforGermany(thesituationisreversedtoday).The two oddities were Italy and Portugal, which seemed to be suffering theworstofbothworldswith,simultaneously,slowgrowthandhigher-than-averageinflation(seeFigure4.1).

FIG4.1FromharestotortoisesGDP,1999–2014,1999=100

*ForecastSource:Eurostat

There were, indeed, marked differences among both the hares and thetortoises.Amongthefast-growingcountries,Greecehadagovernmentthatwasspendingrecklesslyandfiddlingstatistics,whereasSpainandIrelandhadpublicfinancesseeminglyingoodorder,butprivatesectorsthatwererunninguphighdebtasaside-effectofhousingbooms.Toofewquestionedwhetherbuoyanttaxrevenuesmightnotjustbeawindfallfromapropertybubble.Whenitburst,theywould collapse and spending would shoot up to pay for unemployedconstruction workers. Ireland’s net exports were booming even as it wasoverheating, but Spain’s were shrinking. Over two decades, Ireland had gonefrom being the poorest EU country to being one of the richest. Butwhile theCeltic Tiger put on real muscle in the early years, boosting productivity byturningitselfintoanexportbaseformultinationals,lateritjustgorgeditselfoncheapcredit.

Among the laggards,Germany’s sicklinessmasked a process of protractedreform,especiallyGerhardSchröder’sAgenda2010labour-marketandwelfarechanges, pushed through after 2003. Germany was still digesting the cost ofabsorbing the former East Germany, and had entered the euro with anovervaluedcurrency.Butinacountryaccustomedtolivingwithahardcurrencyandlowinflation,andrelativelyconsensualindustrialrelations,Germanbossesandworkerssetoffonthelongslogofwagerestrainttoregaincompetitiveness.

Internal demand was so weak that almost all Germany’s growth came fromincreasingexports.But inItalyandPortugalslowgrowthwasanunmistakablesignalofreformparalysis.Bothwere losingexportshare.Higher inflationwaspushingupwages,whileproductivitywas stagnant. Italyhadhigherdebt thanPortugal,butPortugalwasrunninghigherbudgetdeficits.

One cause of the problem was that southern European countries were hitharderthannorthernonesbyChina’sentryintotheWorldTradeOrganisationattheendof2001.China’sexportsoftextiles,clothingandfootweargrewsharply;those of Italy and Portugal declinedmarkedly.Another issuewas that foreigndirect investment had shifted from the Mediterranean countries to the newcountriesfromcentralandeasternEuropewhich joined theEUin2004.Therecheapskilledlabourwasplentiful.Germanymadefulluseoftheopportunitybyshiftingfactoryproductioneastward.ButFrance,amongothers,resisted.Ratherit regarded low-cost, low-tax eastern Europe resentfully as a source ofcompetitionand“socialdumping”.AccordingtotheWorldBank,whichin2012producedadetailedreportonEurope’seconomicmodel,1anotherdrawback insouthernEuropewasthatmanyofitssmallfamily-runbusinesseswereunsuitedtocompetinginabigEuropeanmarket.

Thestrikingnorth-southdivide thathasemerged inEuropemayhaveevenmore profound historical and sociological roots. Many cite Max Weber’sProtestant work ethic. Others speak of Catholics’ greater readiness to absolvesins.Whengiving lectures,VítorConstâncio,vice-presidentof theECBandaformereconomicsprofessorfromPortugal,wouldsometimesholdupacolour-codedmapofEuropeandaskaudienceswhatthedarkercoloursinthenorthandlightershadesinthesouthmightrepresent.TheusualreplywasGDPperhead.In fact, they denoted literacy rates in the 19th century, with bible-readingnorthernProtestantsmoreliterate thanthepriest-dominatedsouthernCatholics.Plainlydebtanddeficitsarenottheonlyoreventhebestmeasureofeconomichealth. The trend in unit labour costs (flat in Germany but rising fast in theperiphery) and current-account balances (surpluses inGermany and deficits intheperiphery)iscrucial.

Someof the euro zone’s problemsmight have been alleviated by reforms,both national and European, to make wages and prices more responsive. Butalongwithreformfatigueinmembercountries,therewasalsointegrationfatigueacross the EU.Deepening the singlemarketmight have provided a source ofgrowth and competitive impulse. Much of the EU’s productivity lag, incomparisonwiththeUnitedStates, isduetounderperformingservices.Butthe

EU’s services directive, designed to break down some of the barriers, waswatered down after the defeat of the constitutional treaty in referendums inFranceandtheNetherlandsin2005.OnereasonwasthepanicinFranceoverthesupposed threat of the “Polish plumber”. Soon afterwardsRobertoMaroni, anItalianministerfromtheNorthernLeague,causedastirbyexcoriatingtheeuroforItaly’spoorperformanceandcallingforareturntothelira.

Slow growth, economic divergence and political tension led someeconomiststostartaskingasearlyas2006whethertheeuromightbreakapart.DanielGrosoftheCentreforEuropeanPolicyStudies,athink-tankinBrussels,thought that sluggishGermanyand roaringSpainwould soon swapplaces (healsoworriedaboutItaly).2SimonTilfordoftheCentreforEuropeanReforminLondonpaintedascenarioinwhichmarketsmightloseconfidenceinItaly,withits slow growth and reluctance to reform, pushing up its borrowing costs anddebt,inturnpromptingdemandsthatItalyleavetheeuro.3

BankingontheeuroThelaunchoftheeurogreatlyincreasedfinancialintegration.Oftenbanksgrewlargeincomparisontotheirhomecountries’GDP,andincomparisontobanksintheUnitedStates,inpartbecauseEuropeanfirmsreliedmoreheavilyonbankloans than on the corporate-bond market. But it was a lopsided sort ofintegration.Cross-border lending to banks and sovereigns grew fast, but retaillending remained Balkanised in national markets. Cross-border ownership ofbanks grew only slowly.Mergers and acquisitions tended to happen within acountry’sborders,asignofstrongeconomicnationalisminthebankingsector.

Cross-borderownershipwasmostapparentintheEU’snewmembersfromcentralandeasternEurope.Amongmembersof“old”Europeitremainedforthemostparttiny.Butbylate2007,partlyasaresultoftheCommission’seffortstochip away at internal barriers, there was enough cross-border expansion topromptatleastoneeconomist,NicolasVéron,topublishapaperfortheBruegelthink-tankinBrusselstitled:IsEuropeReadyforaMajorBankingCrisis?4Henotedthatbankshadbecometoolargeanddiversifiedfornationalsupervisors,even if they met in the then Committee of European Banking Supervisors(CEBS),tooverseeproperly.Hesaid:

Theprudentialframeworkforpan-Europeanbankshasbecomeamazeofnationalauthorities(51aremembersofCEBSalone),EU-levelcommittees

(nofewerthannine)andbilateralarrangements(some80recentlymentionedbyEuropeanCommissionerCharlieMcCreevy).

Inanearlyhintatthefuture“bankingunion”thatwouldemergefiveyearslater,Véronarguedthat the largestcross-borderbanks(includingBritishones,givenLondon’slargefinancialcentre)shouldbesupervisedbyanEU-levelbody,witha single set of rules to deal with failing banks and a harmonised deposit-insurancesystem.

Financialintegration,itwaswidelyhoped,wouldstimulateamoreefficientallocation of capital across the EU.And in the euro zone, itwas supposed toprovide a means of absorbing country-specific shocks given the lack ofadjustmenttools.Butwhencrisisstruck,financialintegrationprovidedanopenchannel for financial contagion to spread.The fact that bankswere large, andthattheirbondholdingswerestronglybiasedinfavouroftheirownsovereign’sdebt,helpedcreateadeadlyfeedbackloopbetweenweaksovereignsandweakbanks.Andbecausemostofthebanks’cross-borderassetswereintheformoflending, rather thanequity, the international flows thathad financedeuro-zoneimbalancescouldmoreeasilybecutoffwhencreditbecamescarce.

Resoundingcomplacency

Most or all of these problems were reasonably well understood and, indeed,predictedbeforethelaunchoftheeuro.IntheCommission’sbookontheeuro,EMU@10,5publishedin2008justaheadofthetenthanniversaryofthestartofthe monetary union, there is mention of worries about imbalances, thedivergence of economies and the dangers lurking in the banking system. Butnowhereinits320turgidpagesdiditissueaclearwarning,ofthesortthatsomeindependenteconomistswerevoicing,abouttherisksofaself-fulfillingmarketpanic,orofadestructivedoom-loopbetweenbanksandsovereigns,oroflargecontingent liabilities in banks endingupon thebooksof alreadyoverindebtedsovereigns. The clearest message was one of self-congratulation over the“resoundingsuccess”oftheeuro.Ithadboostedeconomicstability,cross-bordertrade, financial integration and investment, declared the authors. Traumaticexchange-rate crises were a thing of the past, and fiscal stability had beenenhanced. Indeed, theeurohadbecome“apoleofstability forEuropeand theworldeconomy”.Theeurohavingsurvivedadecade,andregaineditsstrengthagainst the dollar, itwas perhaps natural forEuropean officials to boast of its

achievementsanddismiss thedoomsayers,particularly thosefromtheEnglish-speakingworld.

A much deeper mystery is the complacency of financial markets. Theyutterly failed to distinguish between the dodgy credit ofGreece and the rock-soliddependabilityofGermany.Theyieldongovernmentbonds(whichmovesinversely toprice) fell inperipheral countries in theearlyyearsof theeuro sothatitbecamealmostidenticalacrosstheeurozone.Italysometimeshadtopaysix percentage points more than Germany in interest to borrowmoney in the1990s. By 2007, this “spread” had fallen to a fraction of a percentage point(about 20 basis points). Gettingmarkets to impose discipline on governmentshadbeenonereasonforenshriningtheno-bail-outruleandforbiddingtheECBfrommonetisinggovernmentdebt.

Perhaps investors were simply chasing anything that offered a marginallybetteryield.Marketsoftenovershootinbothdirections,afterall.Somewerestillconvinced the euro would lead to convergence among European economies.Othersassumedthatdefaultwithintheeurozonewasunthinkable:whateverthetreaties said, solidarity amongmemberswouldprevail, onewayor another. Inhis 1989 report on setting up a single currency, Jacques Delors himself hadarguedthat,farfrompenalisingimbalances,financialmarketsmightforawhilefinancethembecauseoftheattractionofalargepoolofeuro-denominateddebt:6

Ratherthanleadingtogradualadaptationofborrowingcosts,marketviewsaboutthecreditworthinessofofficialborrowerstendtochangeabruptlyandresultintheclosureofaccesstomarketfinancing.

AsFigure4.2shows,bondyieldsofcountriesintheeurozonebetween1990and 2010 thus came to look like a length of rope frayed at both ends.BeforeEMU yields were spread far apart, reflecting themarket’s perception of eachcountry’s riskof inflation,devaluationanddefault.They thennarrowedas thelaunchofEMUapproachedbeforebecomingcloselyentwinedthroughthefirstdecade of the euro. Then, with the onset of the euro crisis in late 2008, theyspread out once more as markets suddenly started to worry about the risk ofdefault.GreeceandIrelandweretobethefirststrandstocomeloose.

FIG4.2UnbondedTen-yearbondyields,1995–2010,%

Source:Eurostat

5Trichet’stest

OFTHESENIORFIGURESINTHEEUROZONE,itwasJean-ClaudeTrichet,presidentoftheEuropeanCentralBank,whogavetheclearestwarningsofthedangerofgrowingdeficits.Hewasahawkaboutrespectingthestabilityandgrowthpact.Moreover, from 2005, he would turn up every month at ministerial meetingswithchartssettingouthisconcernsabouteconomicimbalances.Afavouriteoneshowedthedivergenceinunitlabourcostsacrosstheeurozone.Anothertrackedthe giddy rise of public-sector wages. His main concern was that the loss ofcompetitivenesswouldharmgrowth.Buthealsoknewtheeurozonewasnotafederal country; there was no central budget to help countries that got intotrouble.Thecountriesoftheeurozone,hewouldsay,werelikeLaCigaleetlaFourmi,JeandelaFontaine’sfableabouttheimprovidentcicadaandthehard-working ant. Those in the periphery sang in the warm sunshine, while theindustriousGermanshelddowntheirwagesandputmoneyasideforarainyday.Butwhenwintercame,Trichetcouldscarcelystandaside.Centralbankswieldthepowerof financial alchemy, able toproduce an endlessquantityofmoneyoutofthinair.OftenonlytheECBhadthemeanstoprovidethevastamountsofliquidityneededtostoparunonsoundbanks,oronsolventsovereigns.

The ECB’s treaty-prescribed independence gives it a peculiarly remote,Olympian status. In public, the dialogue between governments and the centralbankisdetachedandreverential.GovernmentsarefrowneduponiftheydemandactionfromtheECBtoovehementlyinpublic.Behindthescenes,theECBhasbeen an intensely political actor, from designing and monitoring bailoutprogrammestoengaginginhand-to-handcombatwithleadersoverreforms.TheGallicrowsbetweenTrichetandtheFrenchpresident,NicolasSarkozy,becamelegendary.OftheECB’scomponentbanks,Germany’sBundesbankisthemostimportantandpureinitsconvictionthatitisnotthejobofcentralbankerstoget

politiciansoutoffiscaltrouble.Itspresident,JensWeidmann,believestheECBshouldactlikeOdysseusbeforethesirens:lashitselftothemastwithstrictrulesandtellthesailorstostufftheirearswithwaxtoshutoutthepoliticians’calls.Thisisthebackdroptothecrisisasitdevelopedfrom2007.

ChacunsamerdeAsglobalcreditdriedupafterthecollapseofsubprimemortgagesintheUnitedStates,theECBwasthefirsttoopenthecashtaponAugust9th2007,makinganextra€95billionavailable tobanks, soon followedby thecentralbanksof theUnitedStates,Canada,JapanandAustralia.Thetriggerwas theannouncementthatBNPParibas,aFrenchbank,wassuspendingwithdrawals fromtwofundsheavilyexposedtosubprimecredit.Itsaidashortageofliquiditymadetheassetsimpossibletovalue.AnydoubtsthatEuropewouldfeeltheforceofthefinancialcrisiswerequicklydispelled.AfewdaysearlierIKB,aGermanbankthathadplayed recklesslywithasset-backed investments,hadbeenbailedout; amonthlatertherewasarunonNorthernRock,aBritishlenderthatwouldeventuallybenationalised.Trichet’squickandfirmresponsepromptedtheFinancialTimestopickhiminDecember2007asits“PersonoftheYear”.

It was the bankruptcy of Lehman Brothers on September 15th 2008 thatreallycausedglobalpanic.ThedecisionbyIrelandafortnightlatertoextendanunlimitedguaranteetoallbankingdebtprovokedbothangeratarashmovethatwassuckingdepositsfromtherestofEuropeandascramblebyothercountriesto issue their own guarantees. Sarkozy, whose country held the rotatingpresidencyof theEU,sought tocontrol the free-for-allbycallinga summitofleadersofthefourbiggestEuropeaneconomiesonOctober4th.Hepushedforthe creation of a common European bank-rescue fund, worth perhaps €300billion,butwasslappeddownbyAngelaMerkel,theGermanchancellor.“Elleadit, chacunsamerde” (“she saideverybodyshoulddealwithhisownshit”)washowSarkozyscathinglyrecountedtheconversationtohisaides.AtanothersummitinPariseightdayslater,thistimeofalleuro-zoneleadersplustheUK’sprime minister, Gordon Brown, Merkel changed her tune. Her mindconcentratedbythecollapsebetweenthetwosummitsofHypoRealEstate,shenowacceptedtheneedforamassiveEuropeanresponse.Itwouldbeworth€1.9trillioninloanguaranteesandcapitalinjectionstopropupthebanks.Themovewasco-ordinatedandsubjecttoEUstate-aidrules,buteachcountrywouldstillhavetocleanupitsownbankingmess.ThehyperactiveSarkozythenflewofftoCamp David (taking along the president of the European Commission, José

ManuelBarroso)topersuadePresidentGeorgeBushtocallaglobalsummitonthefinancialcrisis(itwouldbecometheG20summit).

Under the Irish single-market commissioner, Charlie McCreevy, theCommission had hitherto favoured light-touch regulation of finance. But inOctoberBarrosoenlistedaformerIMFbossandFrenchcentral-bankgovernor,Jacques de Larosière, to produce a report on how to tighten control over thefinancial sector. It was delivered within three months. After much resistancefromtheUK,thereportwouldleadtothecreationin2011offournewEuropeanfinancial supervisory bodies: three new regulators for banks, insurance andmarkets,andtheEuropeanSystemicRiskBoardtomonitorthreatstotheoverallfinancialsystem.Thetaskwouldbepursuedwithzealafter2010byMcCreevy’sFrenchsuccessor,MichelBarnier,whovowed thatnoaspectof financewouldescaperegulation.

Soon after Lehman’s demise, staff at the IMF’s European departmentpredictedthat“it’sgoingtorainprogrammes”.Thefirstcameintheformofaclassic balance-of-payments crisis that hit the newer, fast-growing eastern EUmembersthatwereoutsidetheeuro.Asforeignmoneyfledandcurrenciescameunder pressure,Hungary and then Latvia applied for IMF bailouts inOctoberand December 2008, respectively. Romania followed in March 2009. Thesebailoutswere co-financedby theEU, theWorldBank andothers.The easternturmoilfedtheillusionthattheeurohadbroughtprotectionfromtheworstofthecrisis. Trichet called the single currency “a shield” against global turbulence.Slovakia was more than glad to be able to slip into the single currency onJanuary1st2009.Tothefuryofsome,theeurozoneresistedpressuretosoftenitsadmissioncriteriasothatotherscouldfollow.

But the combined impact of bank rescues, fiscal stimulus and the start ofrecession aggravated the public finances of several countries.Might the crisisspreadtotheeurozoneafterall?IrelandandCypruswerelikelycandidatesforassistance because of their outsized banking sectors. Spain looked fragilebecauseofitspropertybust.OthersthoughtthatAustriawasvulnerablebecauseof its banks’ exposure to central and easternEurope.However, the first euro-zonedebtcrisiswouldbegininacountrywhosebankswerereasonablysound,but whose public spending had run out of control and whose statistics weredodgy:Greece.

Greektragedy

Oddly,perhaps,thefirstblowtoGreekdebtwasnotfinancialbutpolitical.Thedeathofa15-year-oldschoolboy,shotbythepoliceinDecember2008,setoffafortnight of riots across the country. Even for people used to a degree ofritualised street clashes, the scale of the unrest was unprecedented since therestorationofdemocracyin1974.Theviolenceseemedtoreflectadeepmalaiseoverhighyouthunemployment,adynasticpoliticalsystembasedonpatronage,a kleptocratic and ineffective public administration, educational reforms – andthe public bailout of banks. Other European leaders worried that therebelliousnessmightspread(Sarkozycancelledaplannedschoolreform,fearing“regicidal”mobs).

The teeteringGreekprimeminister,KostasKaramanlis, sackedhis financeminister, George Alogoskoufis, a month later and then loosened the publicpurse-stringsaheadofanelection.Greekbondyieldshadbeendriftingupwardfrom the start of the credit crunch in 2007.Butwith the riots the spread overGerman bonds blew out, rising from about 160 to 300 basis points in lateJanuary 2009, after Standard & Poor’s had downgraded Greece’s debt. TheEuropean Commission placed Greece (and five others) under surveillance forbreachingthe3%deficitlimit.ItsaidGreeceandIrelandshouldstepupdeficit-cutting.

Senior French and German officials held secret meetings about how torespondshouldGreeceloseaccesstobondmarkets.Buttheproblemseemedtoresolve itself, helped by reassurances from theGerman financeminister, PeerSteinbrück, that weaker euro-zonemembers would be helped if they got intotrouble. The comments were echoed by the Commission and the ECB. For awhile the unspoken assumption that countries of the euro zone would standbehindeachotherincaseoftroubleappearedtohavebeenreaffirmed.Spreadsnarrowed again. Then the Greek Socialist opposition party, Pasok, won alandslide victory in the election on October 4th 2009. Its leader, GeorgePapandreou, son and grandson of previous Greek prime ministers, hadcampaignedonapolicyoffiscalstimulus.Hehadpromisedabove-inflationpayrises,investmentingreenenergyandotherspendingto“kicktheeconomybackinto action again”. Output was at a standstill because of a drop in summertourismandshippingrevenueshadfallenbecauseofshrinkingglobaltrade.ButPapandreoubreezilydeclaredthat“themoneyexists”.

It didn’t. On October 16th, less than a fortnight after coming to power,Papandreouannouncedthatthepreviousgovernmenthadleftanenormousholeinthebudget.Hisfinanceminister,GeorgePapaconstantinou,saidthedeficitfor

2010wouldbeabove10%ofGDP,afigurepromptlyrevisedupto12.7%.Yetsurprisingly,fellowEuropeanleadersatfirstpaidlittleattentiontothisopeningactoftheGreektragedy.Policydebatefocusedonfinancialregulation,howtoendstimulusprogrammesamidsignsofatentativerecoveryandtheconclusionofthelongsagaoftheLisbontreaty.AnEUsummitinNovemberdidnotevendiscussGreece,butratherwhoshouldfillthetwobigjobscreatedbythetreaty:theeventualchoiceswereHermanVanRompuyasEuropeanCouncilpresidentand Catherine Ashton as foreign-policy chief.Meanwhile, as ratings agenciesdowngraded Greece, finance ministers chastised the country. At a summit inDecember Papandreou delivered an unusually candid admission of Greekcorruption before fellow leaders. Yet many still hoped that Greece wouldsomehowgetitselfoutoftroublebytighteningitsbelt.

Solvaydoesn’tsolveitVanRompuy’sinauguralactwastocallaninformalsummitattheBibliothèqueSolvayinBrusselsonFebruary11th2010toholdageneraldebateontheEU’sgrowth-promotionstrategy.ButasGreekbondyieldsspikedoverthe7%markin late January,he realised somethingwouldhave tobedone,or at least said.VanRompuyhad little ideahowmuchhispresidencywouldbedominatedbytheGreekcrisis.Buthismild,self-deprecatingmanner–andhisexperienceasBelgium’sbudgetminister inbringingdownhiscountry’sdebt–madehimanidealbackroomdealmaker.Hedelayedthestartofthesummitformorethantwohours, closetinghimselfwithPapandreou, the leadersofFrance,Germany, theEuropean Commission and the ECB. The previous year French and GermanofficialshadspokenprivatelyofextendingbilaterallinesofcreditshouldGreeceget into trouble, but the German coalition had since changed and the publicmoodwas hostile to any idea of lendingmoney.Germans had been promisedtheywould never have to pay for other countries. Perversely, perhaps, it waseasiertohelpnon-euroEUcountriesinfinancialtroublethantolendmoneytothelikesofGreece.

From the outset the discussion reflected national prejudices and personaltraitsthatwouldshapethesubsequentresponse.TheimperiousSarkozywantedEuropeanleaderstoreactquicklyandforcefully;thecautiousMerkelwasinnorush to respond.The former thought the crisiswould go away if governmentsjust put up enoughmoney to see off the speculators; the latterwas convincedthat the crisis would be assuaged if Greece just took serious action to cut itsdeficitand reform itseconomy. Inacountry thathadnot runabudget surplus

since 1974, French voters did not share the same resentment asGerman onesoverGreekprofligacy.SarkozyalsorejectedtheinvolvementoftheIMFasanaffront toEurope.Trichetconcurred,perhapsalsobecausehe thought theIMFwouldtrytoimposeconditionsontheECB.Bothmenmayhavebeenconsciousthat the IMF was run by Dominique Strauss-Kahn, a potential Socialistchallenger to Sarkozy. Yet after sharing these initial qualms, Germany cameroundtoinsistingonIMFinvolvementtoensurerigour.

VanRompuypaperedover thesedifferenceswithastatement thatdeclaredsupport for Greece “to do whatever is necessary” to curb its deficit, andannounced that the Commission would “monitor” the implementation of thepromiseddeficit-cutting,“drawingon theexpertiseof the IMF”.Hesaideuro-zone members “will take determined and co-ordinated action, if needed, tosafeguard financial stability in theeuroareaasawhole”.But togetMerkel toswallowthe implicitcommitment toabailout,headdeda finalsentence:“TheGreekgovernmenthasnotrequestedanyfinancialsupport.”

IrrationalultimaratioByMarch everybody knew the request would come. The “troika” that wouldnegotiatethebailout–consistingoftheIMF,theEuropeanCommissionandtheECB–wasbornandmadeaninitialsecretvisittoGreeceinearlyMarch.Amidugly German headlines telling Greeks to “sell your islands” and a magazinecover depictingVenus deMilo givingEurope themiddle finger, a summit onMarch 25th prepared what Greece called a “loaded gun”. Member countriesdeclaredthattheystoodreadytopoolbilateralloansintoafundthat,alongwiththeIMF,wasreadytobailoutGreece.Germanyattachedseveralconditions:adecision had to be taken unanimously and include “strong conditionality” toreform, and loans would be extended at “non-concessional” interest rates,reflectingtheriskoflendingtoGreece.Aboveall,themechanismcouldbeusedonly on the basis of ultima ratio, as a last resort to prevent Greece fromdefaultingonitsdebt.ThisGermandoctrine,bornoftactical,domesticandlegalconsiderations, would come repeatedly to hamper the euro zone’s ability toresponddecisively.

Germanybelieved,withgood reason, thatcountrieswouldcut theirbudgetdeficitsandreformtheireconomiesonlyunderextremepressurefrommarkets.Moreover,Merkelcouldhope towinoverheroutragedvoters to the ideaofabailoutonly if shecoulddemonstrate that itwasneeded tosave theeuro.Andgiven that opponents would inevitably petition the constitutional court in

Karlsruhe, she could justify the breach of the no-bail-out rule in Europeantreaties only on the grounds of a genuine emergency, on the well-knownprinciple of Not kennt kein Gebot: “Necessity knows no law”. Lawyers inBrusselsalsonotedthattheno-bail-outrulewashardlycategorical.TheLisbontreatysaysonlythatcountriesthatshall“notbeliablefororassume”thedebtofothers;itsaysnothingoflendingmoney.1Thattheeurozonewouldlaterinvokeanotherarticledealingwithassistancefornaturaldisasterssaysmuchaboutthelegaldiscomfort.2

Theloadedgundidnotfrightenthemarkets.TheEurogroupthencockedtheweapononApril11th,sayingthatitstoodreadytolendGreece€30billioninthefirstyearofaprogramme, towhichtheIMFwouldaddanother€15billion.Apremiumof300basispointswouldbeadded to theborrowingcosts– a steepprice,butnotassteepas the7%yieldthatmarketsweredemandingforGreekten-yearbonds.Thisstillprovidednodeterrent.InlateAprilStandard&Poor’sdowngradedGreekdebttojunkstatus,andalsocutitsratingsforPortugueseandSpanish bonds. On May 2nd, responding to a formal request for help fromPapandreou,whosaidhiscountrywas“asinkingship”,theEurogroupagreedtotheinevitablebailout.Ithadgrownto€110billionoverthreeyears–thelargesteverprovided toasinglecountry–as itbecameobvious thatprivate investorswouldnotrolloverexistingdebt.

Even so, the deal was filled with contradictions. Greece was supposedlybeing rescued,but itwas subjected to anunworkableprogrammeandpunitiverates of interest (Merkel boasted that Germany would make a profit on theloans). IMF staff thought there should be less up-front austerity and morestructuralreforms,buttheEuropeanswerestillfocusedonfiscalrules.Thedebt-sustainabilityassessmentreliedonoptimisticassumptions.OneIMFofficialwasblunter: “We lied.” Indeed, it would emerge later that many members of theIMF’s board had deep misgivings about the programme.3 Brazil’s executivedirector,PauloNogueiraBatista,wasprescientwhenhearguedthattherisksoftheprogrammewereimmense.RatherthanabailoutofGreeceitcouldbecomeabailoutofinvestorsandbanksastheydumpedtheirbondsontoofficiallenders.The whole thing could prove “ill conceived and ultimately unsustainable”.Critics argued that Greece’s huge debt should instead have been restructuredimmediately. That said, even themost hawkish IMF staffmembers thought itwastoodangeroustodothisinthemiddleofamarketpanic.Butthelingeringdisputewould,lateron,hardentheIMF’sattitudetoGreeceandfuturerescues.

Even the triplingof theGreekbailout failed to quell themarkets.And the

crippling adjustment demandedofGreece–deficit reductionof 11percentagepointsoverthreeyearsintheteethofarecession,nearlyhalfofitfront-loadedinthe first year – provoked riots outside theGreek parliament, and the death ofthree peoplewhen anarchists set fire to a bank.AsGreek bonds rose beyond12%,contagionpushedIrishyieldsclose to6%andPortugueseonesupabove7%. Stockmarkets around the world slumped as investors fretted about thefinancialandpoliticalstabilityofablockthatmadeuparoundaquarterofglobaloutput.

Savetheeuro

After months of indecision and half measures, the euro was now in mortaldanger.ThemoodofforebodinggrewdarkerstillonMay6th2010,thedayofastrange“flash-crash”onWallStreet,inwhichtheDowJonesIndustrialAveragecollapsed by about 1,000 points before recovering within minutes, perhapsbecauseofatechnicalglitch.TheECB’sgoverningcouncil,inLisbonthatdayfor its monthly meeting, faced a momentous decision: should it start buyingsovereign bonds to stop the panic? The Federal Reserve and the Bank ofEngland had been doing so under their policy of quantitative easing to bringdownlong-termborrowingcosts.ButtheECBhadnotgonesofar,waryoftheprohibition against anything resembling “monetary financing”, that is, printingmoneytofinancepublicdebt.Aftertheofficialmeeting,Trichettoldjournaliststhat the subject of bond-buying had not been discussed. Later on over aninformaldinner,however,thecouncilhadreachedatentativeagreementtostartselectivelybuying thebondsofvulnerablecountries.4Thenextday,as leadersgathered in Brussels for a euro-zone-only summit, ostensibly to endorse thebailoutofGreece,manyparticipantsseemedunawarethattheywouldbecalledupontodosomethingmuchbigger:setupasafetynetforthewholeeurozone.

Trichetdeliveredasternlecture.Hetoldleaderstheeurowasindanger,andthattheyweretoblameforthemessthroughrecklesspolicies.Itwasnowtheirresponsibility to fix it. Trichet would not disclose his readiness to buy bondsuntiltheleadershadtakendecisiveaction;theECBwouldnotriskactingalone,or being seen to do so under political pressure. The summit could not reachagreement, so financeministerswere told to takeup the task twodays later, aSunday, before markets reopened in Asia. The Commission then tabled aproposal,basedonitsaidprogrammeforcentralandeasternEurope,tocreatea€60billionwarchestfortheeurozone.Themoneywouldberaisedbyissuing

bondsonthemarketguaranteedbytheEUbudget.TheBritishprimeminister,GordonBrown,whohadjustlostageneralelectiononMay6th,hadtobeaskedforhisapproval.Membercountries,includingthenon-euroUK,wouldbeliableforpossiblelosses.

Yet too little money could be raised this way. And ministers would notextendloanguaranteestotheCommissiontoexpandthefund.Instead,aspecial-purpose company, incorporated in Luxembourg and backed by governmentguarantees, would be created to ensure national governments retained fullcontrol over themoney.The final deal could not be concluded until nightfall,after polling stations closed in the German state of North-Rhine Westphalia(Merkel’sChristianDemocratslost).Consensuswasthenquicklyreachedontheamount: €440 billion. Thus were born the Commission’s European FinancialStabilisation Mechanism (EFSM) and the larger inter-governmental EuropeanFinancialStabilityFacility(EFSF).TheIMFwouldmatcheverytwoeurosputupbytheeurozonewithoneofitsown,anunusualentryintorich-worldaffairs.The totalmadeavailable todefend theeurozoneamounted to€750billion,orroughlyaround$1trillion.

Trichetnowhad thepoliticalcoverheneeded.TheECBannounced that itwould buy bonds under the SecuritiesMarket Programme (SMP), not to helpcrippled countries but on the grounds that dysfunctional markets were“hampering themonetary policy transmissionmechanism”. At the same time,theECBopenedthetapforliquiditytothebanks,whiletheFederalReserveandother central banks helped out by reopening dollar swap lines, in essence ameansfor theFederalReserve toextenddollar liquidity in theglobal financialsystem via other countries’ central banks (which would continue to bear thecreditrisk).Theenormoussumsmobilisedthatweekendweresupposedtobeadeterrent, aweaponnever tobeused.But, just aswith the “bigbazooka” thatHankPaulson,thentheAmericantreasurysecretary,hadtalkedaboutin2008,itwouldnotbelongbeforeithadtobedeployed.

The ECB’s U-turn on bond-buying, following an earlier U-turn on takingGreek bonds as collateral for banks, raised questions about its independence.Tellingly,MerkelgavethebankthenodtobuybondseventhoughAxelWeber,theBundesbankpresident,whobrieflyflirtedwiththeidea,opposedthemove.Itiseasierforpoliticianstohavethecentralbankputupthemoneythanaskforitfrom taxpayers.Moreover, governments could notmake up theirminds aboutmarkets.Theydenouncedspeculatorsforplottingtodestroytheeuro,yetsetoutto borrow hundreds of billions from the same financiers to save the single

currency. They blamed ratings agencies for ignoring the dangers of dodgyfinancial engineering, then excoriated them for exaggerating the threat ofsovereigndefault.But the events inMayestablishedoneprinciple: facedwithcatastrophe, governments would act. The ECB would act too, though only ifgovernmentsmovedfirst.Yetdelayraisedthepriceofresolvingthecrisis,andalsofeddoubtsaboutwhethertheeurocouldsurvive.

MerkozyinDeauville

TheEuropeansummits inJuneandSeptember2010weremoreor less routineaffairs, although spreads started creeping up again in the summer after themarketeuphoriainMay.Governmentsturnedtoreformingtheinstitutionalset-upoftheeuro.PartofthepriceMerkeldemandedforbailingoutGreecewasastrengthening of the stability and growth pact, and closer co-ordination ofeconomicpoliciestoimprovethecompetitivenessoftheweakercountries.Thisbecame part of her mantra: greater control in exchange for greater solidarity.Sarkozy was not keen on such notions. But he liked the idea of creating asmaller,moreexclusivecoreclubthatwouldkeepoutpeskyliberalfreetradersfromtheUKandothernorthEuropeancountries.InMarchSarkozyhadstartedpushinganoldFrenchconceptofaneconomic“government”fortheeurozone,latersoftenedinofficialcommuniquésas“governance”.Tohismind,economiesshouldberunbyleaderswithlotsofdiscretion,notbyrule-boundbureaucrats.OneundeclaredaimwastorestraincompetitionbyharmonisingtaxesandsocialspendingtoFrenchlevels.

Reconciling these positions was made harder by two problems. First, theFranco-Germanrelationship,thetraditionalengineofEuropeanintegration,wasworkingpoorly.Second,bothSarkozyandMerkelweredeeplysuspiciousoftheEuropeanCommission.So inMarch2010EUleadersappointedVanRompuy,notBarroso,theCommissionpresident,todrawupaplantotoughenfiscalrules.But the Commission then pre-empted Van Rompuy’s report by publishing itsownpackageofsixlegislativeproposalsoneconomicgovernance(laterknownas the “six-pack”). Beyond deficits, the six-pack put greater emphasis onreducingthestockofdebt(toItaly’sdismay).Andbeyondthefiscaltargets,EUsurveillance would look at a broader range of economic indicators to detectunderlyingimbalances.Lastly, it invertedvotingrulessothatsanctionsagainstmiscreantsnolongerrequiredaqualifiedmajorityofcountries;instead,penaltiesrecommended by the Commission would be approved unless blocked by a

qualifiedmajority.Germanyalsopushedtwomoreradicalideas.Onewastosuspendthevoting

rights of profligate countries. Such provisions existed for countries breachingfundamentalvaluesofdemocracyandhumanrights; thesameshouldapplyforbreachesoftheeurozone’sfiscalrules,thoughtMerkel.Herotherdemandwasamechanismforthe“orderlyinsolvency”ofgovernments.Thisideawasnotnew.After Argentina’s default on its foreign debt in 2001, the IMF proposed astatutory “sovereign debt restructuring mechanism”, an insolvency regime forgovernmentsakintotheUSChapter11bankruptcyforcompanies.Theaimwastomakedefaultlessmessyandpainful,andensurethatbailoutsdonotservejustafewluckycreditors.Buttheproposalranintoinsurmountableopposition,notleast from the United States, which did not want to cede power to asupranationalauthoritytoco-ordinatetheprocess.ThecrisisinGreecebroughtthe ideaback to thefore. In theeurozone,at least, the ideaofasupranationalbodywaswell-establishedthoughattimesacceptedonlygrudgingly.

AllthiswaspartofGermany’sdeterminedefforttominimisetheriskthatitwould be called upon again to bail out another country or, indeed, to bail outGreece a second time. Tougher fiscal rules, monitoring and sanctions wouldreduce thechancesof countriesgetting into trouble.And if anotherdebt crisisdid take place, and the country needed a bailout, the taxpayer should not bemadetocarry thewholeburden.Moreover, the threatof lossesshouldsharpenthevigilanceofbondmarkets.

Othercountriesforthemostpartacceptedtheneedtostrengthenthestabilityandgrowthpact.Butgovernments,andabovealltheECB,wereresistanttoanynotionoffacilitatingdebtrestructuring.Onereasonwasareluctancetobearthestigma:defaultingondebtwassomethingthathappenedinpoorercountries,notthe industrialised world. Another was a concern that, in a world in whichcountries could more easily restructure debt, the borrowing costs for allsovereignsmightberaised.Athirdwasthefearofrekindlingmarketturbulence.Insteadof ensuring thatmarkets enforceddisciplineongovernments in future,debtrestructuringmightpromptanotherpanicthatwouldpushgovernmentsintoimmediatebankruptcy.Afterall,GreecewasnottheonlyEuropeancountrywithalargeburdenofdebt.

SomeofthechangesthatGermanydemandedwouldrequireachangeofthetreaties, whichmany countries were reluctant to embark on after the politicalagony they suffered over the constitutional and Lisbon treaties. But Merkelfavoured treaty change anyway, despite the promise that Lisbonwould be the

lastrevisioninageneration.SheworriedthatthelegalbasisoftheEFSFmightnotstanduptochallengeintheKarlsruhecourt.Evenifitdid,thefundwasdueto expire in 2013 and would surely have to be replaced by something morepermanent.

On October 18th Van Rompuy called a last meeting of his taskforce offinance ministers in Luxembourg. Christine Lagarde, then the French financeminister,predictablysoughttoamendthe“automaticity”ofthesanctions.Butallwere astounded to hear the then German deputy finance minister, JörgAsmussen,declarehewas incomplete agreementwithher.WhatwereFranceand Germany up to? The answer came later in the evening from the Frenchseaside resort of Deauville, where Sarkozy was hostingMerkel for a Franco-German summit (as well as a three-way summit with Russia). France andGermanynowsupportedanewtreatytomakepossiblethecreationofa“robustandpermanent”crisis-resolutionsystem.Germanygotapromisethat, infuturebailouts, there should be an “adequate participation by the private sector”; inotherwords,privatebondholderswouldhave tobearpartof thepain in futurecrises.Franceobtainedasofteningofthe“automatic”sanctions.

InBrusselstheaccordwasseenastheworstofpoliticaldeals.Manyworriedabout theweakeningof thecommitment tofiscaldisciplineandfearedthat thethreat of future debt restructuring, known as private-sector involvement (PSI),mightcausealarminmarketsthatseemedtobecalmingdown.EvenSarkozy’ssenioradviserswarnedhimagainstit.TheyworriedthattheimplicitassumptionofsolidaritywithintheeurozonewasbeingexplicitlyrejectedthroughPSI,withunforeseeableconsequences.Butheoverruledthem.

Deauville thus marks the start of the “Merkozy” era. Merkel became thedominantfigureinEuropewhileSarkozydecidedthattheonlywaytomanagethecrisis,andtokeepmarketsoffFrance’sback,wastohugherclose.Deauvillealsomarked a second,more dangerous phase of the story. Investors started towalkawayfromvulnerablesovereignsand,withindays, torunafteraspateofbadnews.AstatisticalrevisionraisedGreece’s2009deficitabove15%ofGDP,and its overall debt by about 12 percentage points to 127% of GDP; Greeceadmitted it was having problems collecting taxes; and PIMCO, one of thebiggest fixed-income managers, predicted that Greece was likely to defaultwithinthreeyears.

The mood at the next EU summit on October 28th was grim. Leaders ofsmallercountrieswereannoyedbytheFranco-Germandiktatandthepressuretoreopenthetreaties.AndTrichet,whohaddemandedthattheVanRompuyreport

formally note his reservations over weakened sanctions, warned leaders overdinner that the threat of debt restructuring would spook markets. “You don’trealise the gravity of the situation,” began Trichet. But he was cut off bySarkozy:“Perhapsyouspeaktobankers.We,weareanswerabletoourcitizens.”Merkeljoinedin:taxpayerscouldnotbeaskedtofootthewholebill,notwhentheyhadjustpaidtosavethebanks.AndMerkelgotmostofwhatshewanted,withsurprisingease.Thesummitagreed torevise the treatyalthough, tomakesure it was a “limited” change that could be passed with a smaller risk ofreferendums,Merkelhadtoabandonthedemandtosuspendvotingrights,whichSarkozyhadconcededatDeauville.

The euro zone thus abruptly moved from the idea of bailing out debtorcountries tobailing inbondholders.Theprinciplewassoundbut theexecutioncontradictory,notleastbecause,asexplainedinitiallybytheGermans,PSIwaslikelytoapplytoallfuturebailouts.InMaygovernmentshaddeclinedtoimposehaircutsonGreekbonds for fearofdestabilisingmarkets, thuspretending thatGreece’s insolvencywasmerely amatter of a shortageof liquidity.Now theyseemed tobe threatening all future investors in euro-zonebondswithpossiblelosses;inotherwords,evencountrieswithliquidityproblemsmightbetreatedasinsolvent.ForTrichetthiswasabetrayaloftheECB’spoliticallyriskydecisiontostartbuyinggovernmentbondstoholddownborrowingcosts.Bythetimeofthe G20 summit in Seoul on November 12th, yields on Portuguese and Irishbondswerewellover theirpreviouspeaks inMay.Europeanfinanceministerssaid the issue had been misunderstood: existing bonds were safe; only newbonds issued from 2013 might be subject to haircuts. But the damage ofDeauvillewasdone.

NoluckfortheIrish(orPortuguese)Alarmnow focusedon Ireland.Havingalreadypouredbillions into thebanks,the government announced in September 2010 its “final estimate” for banklosses.Anglo IrishBank, themost cavalier of the lot,would cost €30 billion.AddedtoIreland’salreadylargebudgetgap,theone-offcostofthebankingbustpushedIreland’sbudgetdeficitin2010to32%ofGDP.Fearsforthesolvencyofthestatepushedupbondyields.Deauvillemadeabadsituationimpossible.Inmid-November Ireland started negotiating the terms for a bailout, despiteproteststhatithadenoughcashtosurviveformonthstocome.ButtheECBhadhad enough of propping up Irish banks.By the end ofNovember Ireland hadagreed to a €67.5 billion assistance package from the euro zone and the IMF,

withbilateralloansfromtheUKandSweden.The liquidity provided by the ECB had proved to be amixed blessing. It

allowedIrelandtoavoidasuddenstopinfunding,ashadpreviouslyhappenedinIceland (which was not in the EU). But the ECB also prevented the Irishgovernment from protecting taxpayers by imposing losses on senior bankcreditors, again as had happened in Iceland (it also wiped out foreigndepositors).Evenso,thebankingbustwasnottheonlyoreventhemaincauseof Ireland’s economic troubles; the recession caused by the bursting of thepropertybubble createdabudgetdeficit of12%ofGDP in2010.But thebadbanks,andDeauville,tippedIrelandintoseekingabailout.Italsoledtoanearlyelection and the fall of the Fianna Fail-led government of Brian Cowen inFebruary2011.

InPortugal,meanwhile,itwastheresignationoftheSocialistgovernmentofJosé Sócrates, which had failed to win parliamentary support for a fourthausteritybudget inMarch2011 thatpushed thecountry into thearmsofeuro-zone rescuers. Portugal applied for a bailout in April and finalised thenegotiation for a €78billion packageonMay4th. Its debtwas not as high asGreece’s,nordid ithaveanout-of-controlbankingsector likeIreland.Instead,itswoesweremore likeItaly’s:yearsofchronically lowgrowth.Andwhereasthe euro zone had been reluctant to help Greece, it was now keen for bothIreland and Portugal to apply for assistance to try to stop contagion fromspreadingtobiggercountrieslikeSpainorItaly.

TheprogrammesforIrelandandPortugalweredevisedwithmoreplausiblefigures thantheoneforGreece.Thetwocountriesbenefitedfromhavingfullyfunctionalgovernmentsand,especiallyinthecaseofIreland,hadexportsectorsthat could benefit from the process of “internal devaluation”. In contrastwithGreece,moreover,bothhadoppositionpartiesthatforthemostpartagreedwiththebailoutprogrammes.TheelectionofFineGael’sEndaKennyinIrelandandofPedroPassosCoelhooftheSocialDemocraticPartyinPortugal(bothfiscalconservatives, despite the misleading name of the latter’s party) caused littledisruption to the troika’s programme for fiscal consolidation and structuralreforms.

Comprehensivefailure

The new bailouts in the winter of 2010–11 pushed European leaders to seekwhat they called a “comprehensive solution”. There was, inevitably, much

disagreementaboutwhatthiswouldentail.Somethoughtthepriorityshouldbemore “solidarity” to help countries cope with high bond yields. In December2010Jean-ClaudeJuncker,Luxembourg’sveteranprimeministerandpresidentof the Eurogroup, co-authored a call with Italy’s finance minister, GiulioTremonti, for the euro zone to start issuing common Eurobonds, guaranteedjointlybyall euro-zonecountries.Thiswould“sendaclearmessage toglobalmarkets and European citizens of our political commitment to economic andmonetaryunion,andtheirreversibilityoftheeuro”.5ButGermanywouldhavenoneof it.Tobeginwith, jointbondswere illegalunder the treaties,Germanyargued.Moreover,guaranteeing thedebtofotherswouldmeantakingonlargeand potentially unlimited liabilities, and would provide an incentive forprofligacy.Instead,Germanywantedmorecontrolanddiscipline.

Its prioritywas the finalisation of the treaty change to create a permanentbailout fund, to be known as the European StabilityMechanism (ESM). Thiswasfollowedbymovestoencouragemorestructuralreforms.Overtwosummitsin March 2011 leaders agreed to a voluntary pact to promote labour-marketflexibilityandotheraction.ItwasfirstknownastheCompetitivenessPact,thenthe Pact for the Euro and, in its final form, the Euro Plus Pact. Once a year,countrieswouldmakereformcommitmentsthatwouldbescrutinisedbypeers.Some countries, like Belgium, disliked the challenge to their wage-indexationsystems; others, like Ireland, worried about the pressure to raise their lowcorporate taxes. But perhaps the strongest reaction came from non-eurocountriesthatdislikedthecommitment,pushedbyFrance,toholdspecialeuro-zone summits at least once a year. The Euro Plus Pact turned out to beineffectual,andwassoonforgotten.Manyaspectsofeconomicpolicyremainedthe competence of national governments, so the commitments would not bebinding.AbitofpeerpressurefromEuropecouldnotovercometheresistanceathomethatsuchreformswouldinevitablyprovoke.

Thequestionof solidarity couldnot be avoided for long.By spring itwasapparentthattheEFSFwasunderpowered,notjustbecauseitwasstartingtouseup its resources for Ireland andPortugal, but because its real lending capacitywasonlyabout€250billion,nottheadvertised€440billion.ItsabilitytoborrowonAAA termswas limited by the fact that only six countries had that creditrating.Therewasalsogrowingpressure to turn theEFSF into amore flexiblecrisis-management tool, not just a fund of last resort. The “comprehensivepackage”announcedonMarch24thallowedboth the temporaryEFSFand thenewESMtobuybondsontheprimarymarket(butnot thesecondarymarket).

The ESM would not be operational until 2013. But the final agreement toenhance theEFSF,by increasing loanguaranteesso that itcouldborrow to itsfullheadlinelevel,wouldhavetowaituntilJune,afteranelectioninFinland.

OnApril7th,thedaythatPortugalappliedforitsbailout,theECBdecidedperverselytoraiseits interestrate.Thechangewassmall–just0.25%–butitwas awrong-headed signalnonetheless.Recovery in the euro zonewasweak,with the notable exceptionofGermany.Headline inflationwas slightly higherthantheECB’stargetof“belowbutcloseto2%”becauseofhigheroilprices,butcoreinflationwasaround1%.Therealargumentwaspolitical.TheECB’sbond-buying policy had prompted the resignation in February ofAxelWeber,presidentoftheBundesbankandthemostobvioussuccessortoTrichet.Itmusthaveseemedagoodmomentforanyhopefulstoestablishtheirinflation-bustingcredentials.

Defaultoptions

By March 2011 the Greek problem was returning to the fore. Early onPapandreouhadearnedpraiseforsomebravebelt-tightening,butworriesgrewthat structural reforms were falling behind and privatisation had made noprogressatall.Matterswerenothelpedbysuccessivestatisticalrevisions,whichrevealedGreece’sfiscalholetobedeeperthanexpected.Andtherecessionwasalso worse than expected. Behind closed doors at a summit on March 11th,Papandreou spoke about the grim options facing his country: leave the euro,imposehaircutsonbondholdersorchangethemarket’sperceptions.

A softening of the bailout terms was an attempt to keep the third optionalive: interestwouldbereducedbyapointandloanmaturitiesextendedto7.5years (againstapromise tostepupprivatisation). Irelandwasdenied thesametermsbecauseKennyresistedpressurefromGermanyandespeciallyFrance toraise its low rate of corporate tax, even though attracting investment andboostingexportsofferedthebesthopeofrepayingitsdebt.

Despite the concession to Greece, the focus would quickly shift to debtrestructuring.TalkatDeauvilleaboutPSIwaspushingGreekbondsintoaself-fulfillingspiral.Greekyieldsrosefrommid-AprilamidgrowingtalkofhaircutsandevenofGreeceleavingtheeuro.Plainly,Greecewouldnotbeabletostartborrowingfrommarketsin2012,asitsbailoutprogrammeprojected.Andunlessthefinancinggapwasfilled,theIMFwouldhavetosuspendpaymentsbecauseofitsrulethatprogrammesbefullyfinancedforayearinthefuture.Thechoice

camedowntograntingGreeceasecondbailout,belatedlyrestructuringitsdebtmountain, or some combination of the two. Germany and some IMF stafffavouredimposingatleastsomelossesonprivatebondholders.Buttheyranintotwo separate problems. The first was the arrest on charges of sexual assault(eventuallydropped)ofStrauss-Kahn,theIMF’schief.Hisdeputy,JohnLipsky,opposeddebt restructuring; IMFhawkswouldhave tobide their timeuntil thearrivalofLagardeinJuly.Thesecondandgreaterobstaclewasthe implacableresistanceoftheECBtoanyofthevariousdegreesoffailuretorepaydebtfullyandon time.Noselectivedefault,nocredit event,nodefault, insistedTrichet;nothingshouldcastdoubtonthe“sovereignsignature”.

Greek politics also becamemore fraught. In JunePapandreou replaced hisfinanceminister,George Papaconstantinou,withEvangelosVenizelos, a partyheavyweight. The new man made a poor impression at his first EurogroupmeetingwhenheinsinuatedthattheeurozonecouldnotaffordtoletGreecegobust.

NoPSImplehaircut

The summit in July 2011 turned into two separate negotiations, one amongleaders and a parallel one with bankers, represented by the Institute ofInternational Finance, for a “voluntary” contribution. After more than sevenhoursof talks,euro-zone leadersagreed togiveGreeceasecondbailoutworth€109billion.“Voluntary”PSIwouldbringinanextra€37billion,resultinginanestimated cut of 21% in the debt burden (calculated in terms of net presentvalue). The repayment terms on loanswere greatly softened. The interest ratewas brought down by another 150 basis points, to around 3.5%, and thematuritiesextendedfrom7.5tobetween15and30years,withaten-yeargraceperiod.Crucially,thesametermswereextendedtoIrelandandPortugal,withapromisethattheeurozonewouldcontinuetofundcountriesuntiltheyregainedaccesstomarkets,aslongastheycompliedwithreformconditions.Thedecisionproved to be a godsend for Ireland,whosebondyields progressivelydropped,againstthetrendinsouthernEurope.

LeadersmoreorlessburiedDeauvillewhentheydeclaredthatPSIhadbeenan “an exceptional and unique” solution forGreece; all other countrieswould“honour fully their own individual sovereign signature”.This hadbeenoneofthree conditions set by Trichet in return for relenting on a limited debtrestructuring.TheotherswerethattheECB’sholdingsofGreekdebtwouldbe

spared the haircut, and that theESMwould relieve theECBof the burden ofbuying bonds on the secondary market. Indeed, the ESM was made moreflexibleinotherwaystoo.Itwasalsoallowedtolendmoneytogovernmentstorecapitalisebanksandextendprecautionaryloans.

The deal would prompt ratings agencies to declare a temporary “selectivedefault” (theEFSFwouldhave tooffer theECBalternative collateral), but itsvoluntary nature ensured it would not count as a “credit event” that triggeredpaymentsofcredit-defaultswaps,aformofinsuranceagainstsovereigndefaults.However, the deal proved to be theworst of bothworlds: the haircutwas toosmalltoturnaroundGreece’spublicfinances,butbigenoughtospreadfearthatotherbondswereatrisk.

Markets hadother reasons toworry.Theoriginal banking crisis hadneverbeensatisfactorilyresolved;ithadonlybeenmaskedbytheGreekturmoiland,to a great extent,worsened by the sovereign-debt crisis. The second round ofbank stress tests in July turned out to be another half-baked job. Plainly,sovereignbondscouldno longerbe treatedas risk-free.Butonly thebonds inbanks’ tradingbookswereaccountedforatmarketvalue; those in thebankingbooks were counted at face value because they would supposedly be held tomaturity.Analystsderidedtheeffort(only9outof90bankstestedwerefoundtorequireadditionalcapital),butforseniorofficials,particularlyinFrance,thetests already went too far in questioning the value of sovereign bonds. EvenmorealarmingwasasharpwarningbyLagarde, inherfirstspeechas thenewIMFchief,deliveredattheannualcentralbankers’retreatinJacksonHoleattheendofAugust,whenshecalledformandatoryrecapitalisationofbanks:

Banksneedurgentrecapitalisation.Theymustbestrongenoughtowithstandtherisksofsovereignsandweakgrowth.Thisiskeytocuttingthechainsofcontagion.Ifitisnotaddressed,wecouldeasilyseethefurtherspreadofeconomicweaknesstocorecountries,orevenadebilitatingliquiditycrisis.

Nightletters

Inmanyways, theeurocrisiswasalwaysabout Italy.Acollapseof the third-largest economy in the euro zone, and its second-largest debtor in absoluteterms,wouldsurelysinktheeuro.Spainmatterednotonlybecauseitwaslargerthan theotherbailed-out states,but alsobecause itwas the the last link in thechain of contagion before Italy. The size of the euro zone’s firewall was

inadequate because it could not protect Italy. Eurobonds were unacceptablebecausetheywouldmeanGermanyhavingtoguaranteeItaly’sgargantuandebt.Andthefearofmoralhazardwasacute, inpartbecausenobodytrustedItalianpoliticians to reform. Italy at least had the foresight not to engage in fiscalstimulus, and its primary budget (that is, before interest payments) was insurplus.Moreover,itsbanksseemedinreasonableshape,anddomesticsavingswerehigh.Evenso,bythestartofAugustitsborrowingcostshadspikedabovethe6%mark(matchedbySpain’syields).EverybodyknewItalywastoobigtosave.OnlytheECBcouldhelpitstayafloat.

On August 5th 2011 Italy’s prime minister, Silvio Berlusconi, received asternlettersignedjointlybyTrichetandDraghi.Iturgedhimtotake“immediateandbold”measurestospeedupItaly’sdeficit-cuttingandbalancethebudgetby2013,ayearearlierthanplanned.Italsosetoutalistof“significantmeasurestoenhance potential growth”, including the liberalisation of professional servicesand more labour-market flexibility. In the longer term there had to be aconstitutional reform to enshrine fiscal rules, an overhaul of the publicadministrationandtheabolitionofcostlylayersofgovernment.Asimilarletterwas sent to Spain’s primeminister, José Luis Rodríguez Zapatero, though itscontentsdidnotleakfortwoyears.

AdayearliertheECBhadreviveditsbond-buyingprogramme,initiallyonlyfor Portugal and Ireland. The implied message was clear: if Italy and Spainwantedhelptheyhadtoreformfast,asiftheywereunderatroikaprogramme.As the bank started buying up unprecedented amounts of Spanish and Italianbonds,JürgenStark,theGermanchiefeconomistontheECB’sexecutiveboard,announced his resignation “for personal reasons”: that is, his disapproval ofbond-buying. Predictably enough, Berlusconi soon started watering down hisproposedausteritybudget,anddidvirtuallynothingbywayofstructuralreformsto accelerate Italy’s sclerotic growth. His government was crumbling and hisrelationshipwithhisfinanceminister,GiulioTremonti,hadallbutbrokendown.On September 20th Standard & Poor’s downgraded Italy, expressing doubtaboutitsabilitytoreform.TheECBdowngradeditsilently,bysharplyslowingdown bond purchases. Amidmounting scandals over allegations of fraud andwhoremongering,tradeunionsandbossesalikecalledforBerlusconitoresign.

TheMerkozyduovowedtodealwiththecrisisdecisivelyintwosummitsinOctober(orratherfoursummits,giventhateachwassplitintoanEUsummitof27 followed by a euro-zonemeeting of 17).At the first gathering onOctober23rd,Berlusconiwasgivenanultimatumtopresentcrediblereformsatthenext

meeting three days later. Asked at a press conference whether they werereassuredbyhisresponse,MerkelandSarkozyhesitatedabittoolong,lookedateach other and, as the room erupted in laughter, smiled and smirked.Involuntary,perhaps,butitwasahumiliationforBerlusconiandagestureofnoconfidenceinItaly.

On October 26th the euro zone announced yet another “comprehensivesolution”. Italy promised to reform labourmarkets and pensions, cut red tape,abolishminimumchargesforprofessionalservicesandmore.Itwouldbesubjectto special monitoring by the Commission. And after another round ofnegotiations between leaders and banks, which barely seemed to involve thehaplessPapandreou,Greekbondswouldbesubject toa50%cut in facevalue(resulting in a 76% cut in terms of net present value). The aimwas to bringGreece’s debt down to 120% of GDP by 2020, a threshold chosen to matchItaly’sdebt,which,bydefinition,hadtobesolvent.

Tocontaintheimpact,theeurozoneneededbiggerfirewalls.Germanyhadbeen unwilling to increase its guarantees to the EFSF and many others wereunabletodoso,giventherisktotheircreditrating.FrancefavouredgivingtheEFSF a banking licence, so that it could borrow from the ECB. But Trichetblockedtheideaatabad-temperedimpromptumeetingonOctober19thonthefringesofhisofficialfarewellcelebrationatFrankfurt’soldoperahouse.Sothesummit set out two options. The EFSF could offer “credit enhancements” toinsureinvestorsagainstpartofthelossonsovereignbonds;oritcouldcreateaspecial-purpose vehicle inwhich other countrieswilling to help Europe couldinvest.Leadersalsoagreedtobolsterricketybanksbyforcingthemtofindabout€106 billion of extra capital by the end of June 2012 to meet a higher 9%threshold of “highest quality capital”, after marking sovereign debt to marketprices.

ThedealwassealedwithanotherlayerofthefavouriteFranco-Germanmix:Sarkozy secured a commitment to hold twice-yearly euro-zone-only summitswith the option, in future, of having a separate president; Merkel obtainedsupport for yet another revision of the treaty aimed vaguely at “strengtheningeconomic convergence within the euro area, improving fiscal discipline anddeepeningeconomicunion”.Yetwithindaysthemarketswerestruckbyanotherbombshell:theGreekprimeministerannouncedonOctober31stthathewouldholdareferendumtoapprovethetermsofthenewrescueprogramme.Marketstumbled.TheECBworriedthatbankrunswouldstartinGreece.Aftertwoyearsof crushing austerity, nobody could be expected to vote formore of it.Greek

bondyieldsshotup,pullingeveryoneelsealong(seeFigure5.1).Italianbondsagainpushedpastthe6%mark.Theeurozonewasclosetobreaking.

FIG5.1FromcrisistocrisisTen-yearbondyields,2010–2012,%

Source:ThomsonReuters

CanedinCannes

Thesystemofpeer-pressure,shyatfirstandthenevermoreinsistentasthecrisisworsened, reached its logical and brutal climax at theG20 summit hosted bySarkozy in Cannes on November 3rd–4th 2011. Papandreou was summonedbeforeSarkozy,Merkel and leaders ofEuropean institutionson the eveof thesummit.Hewas toldhehadshownhimself“disloyal”after fellow leadershadworkedhard to lift a largechunkofdebtoffGreece’s shoulders.UntilGreeceapprovedthenewprogramme,neithertheeurozonenortheIMFwoulddisburseacent(pasunsou),saidSarkozy.AndifPapandreouinsistedonthereferendum,the question should not be about the terms of the bailout but about Greece’smembershipoftheeuro.IfthecostofsavingtheeurowastoletGreecego,sobeit. Perhaps Greece could come back in after ten years, the French presidentsuggested.

AtajointpressconferencebySarkozyandMerkeltheultimatumwasmadepublic:“DoesGreecewanttoremainintheeurozone,ornot?”askedSarkozy.For the first time in thecrisis, theprospectof theeurobreakingupwasbeing

openlydiscussedby itsmost important leaders.Papandreouvacillated.He leftCannessayingthequestionwouldindeedbeaboutGreece’sfutureintheeuro,but once in Athens he declared it would be about the bailout terms after all.Venizelos,who had been a brooding presence at the encounter inCannes andwasurgedbysomeofthoseatthemeetingtohelpstopthereferendum,madehismove:hedeclaredhisoppositiontotheballotandledarevolt thatprecipitatedPapandreou’sdownfallaweeklater.

On themorning of November 3rd, it was Berlusconi’s turn to be roasted.Sarkozy andWolfgangSchäuble, theGerman financeminister standing in forMerkel,demandedthatItalyshouldapplyforaprecautionarylineofcreditfromthe IMF. Lagarde bluntly told the Italian primeminister that nobody believedhim.WithZapaterointheroom,theFrenchpresidentnotedwithdisappointmentthat a Spanish-style political solution – an early election in which the primeministerwouldnotstandagain–wasnotonofferinItaly.Therewasatouchofpersonal animosity: Sarkozy blamed Berlusconi personally for Italiannewspapers’attackson theFrenchfirst lady, theItalian-bornmodelandsingerCarlaBruni.

For his part, Berlusconi seemed detached from the severity of hispredicament and unprepared for the assault; “he was completely depressed,”recountedonewitness.Italyhadalwayslivedwithhighdebt,Berlusconitoldhispeers; it could survive for a long timewith higher interest rates and domesticsaverscouldbecountedontobuybonds.HewouldrefusetotaketheIMF’slineof credit – doing sowould be tantamount to admitting that Italy had becomeanotherGreece,saidhisofficials–buthewouldagreetointensemonitoringbythe Fund and the Commission. If Berlusconi was deflated inside the room,outsidehetriedtobrazenhiswayoutofisolation.“Thereisnocrisis,”hetoldjournalists.“Therestaurantsarefullandyoucannotfindaseatontheflights.”

The Italian primeminister still enjoyed a degree of understanding from atleastsomeintheroom,includingtheplacidVanRompuyandthemoreirascibleBarroso.Boththoughtaprecautionarylineofcreditworthsome€80billionwasfar too small to help Italy’s finances, and would only raise doubts about itssolvency. That night Berlusconi also got unexpected support from BarackObama,whonormallyhad little timeforBerlusconibuton thisoccasionsidedwiththedoves.TheAmericanpresidentallbuttookcontrolofasidemeetingofEuropeanleadersattheG20summit.HeurgedtheEuropeanstoactdecisively,and concentrated his efforts on trying to convince Germany to enhance theEuropeanfirewall.IftheECBpersistedinrefusingtointerveneinanunlimited

manner (for example, by issuing the EFSF a banking licence), how aboutcontributing the Europeans’ unused allocations of “special drawing rights”?SDRsarecreatedbytheIMFasareserveasset,asortofvirtualgold,andtheirsupply was greatly boosted in 2009 to give countries extra liquidity in thefinancial crisis. Now the tables were turned on Merkel. The idea was firmlyblockedbytheBundesbank,whichheldGermany’sallocationandregardedtheiruse as tantamount to printing money. The German chancellor said she mightrelent if Italy accepted an IMFprecautionaryprogramme, but the ideadidnotfly. Merkel came under such concerted pressure, some of those in the roomreported, that she was in tears, saying: “I was the hero, and now I am thevillain.”

GoodbyeGeorgeandSilvio.AndDavidtoo?Within days of the Cannes summit, the pressure from Europe, markets andinternal dissent had forced both George Papandreou and Silvio Berlusconi toresign,onNovember8thandNovember12th respectively. In theirplacecametwo technocratic prime ministers. Lucas Papademos, governor of the Greekcentralbankandaformervice-presidentoftheECB,wasappointedinAthens.MarioMonti, a former European commissioner, was installed in Rome. Bothwerechosen,withaprivatenodfromBrussels,fortheircloselinkstoEuropeanpolicymakers. Theirmain taskwas to restore the credibility of their countriesbeforetheirEuropeanpeersandthefacelessmarkets.Indeed, thearrivalof thetechnocratsmay have saved their countries from imminent economic disaster.Butthoughtheywerecalledupontocleanupthemesscreatedbythepoliticians,and endorsed in parliamentary votes, the manner of their appointment left aprofound worry about democracy in Europe: as well as dictating economicpolicies,Europewasnow,directlyorindirectly,dictatingthechoiceofpoliticalleaders.

PapademosandMonticouldnot,ontheirown,dealwithamarketcrisisthatwascorroding theentireeurozone.Given the failureof theCannessummit tobolsterthefirewall,thelastlineofdefencewasnowtheECB.AlleyesturnedtothenewmaninFrankfurt,MarioDraghi.AppearingforthefirsttimebeforetheEuropeanParliamentonDecember1st,hespokeopaquelyabouttheadvisabilityof a “fiscal compact”, some kind of additional commitment to budgetarydiscipline.The effects of previous reforms andof the arrival of technocrats inItaly andGreecewere not yet being felt, he explained.A compact enshriningnew balanced-budget rules in a more formal framework would send an

additionalsignalofcredibility.HethusalliedhimselftoGermany’scauseforyetanothertreatychange.

Theideaofarevisionhorrifiedjustabouteverybody–eventhoseoutsidetheeurozone.ForDavidCameron, theBritishprimeminister, the ideaofa treatyrevisionwasboundtostirhisincreasinglyrestivebackbencherstodemandthathe use the opportunity to win something for the UK. Cameron’s diplomaticcampaignwasill-prepared,particularlyinhismisreadingofMerkel.Hisofficialsdidnot spell out theUK’sdemands– essentially theprotectionof theCityofLondon from new EU financial regulation – until the eve of the Decembersummit.TheBritishhadbeenlulledbyEUlegalexpertsintobelievingthattheeuro zone could not get around aUKveto.Butwhen the crunch came in thesmallhoursofDecember9th,Cameron’sattempttovetothenewfiscalcompacttreaty backfired. First, the EU’s lawyers said the compact could, after all, beadopted as a separate agreement outside the EU’s treaty. Second,most of theeuro“outs”signedup to it, leaving theUKisolated.BackhomeCameronwasbrieflyhailed as a conqueringhero, even thoughhehadvetoednothing at all.Sarkozyboastedprivatelythat“wegavetheBritishaslapintheface”.

Desperatetimes

Thebrutalityof thepoliticsat theendof2011reflected thedesperationof themoment.Afternearlytwoyearsoferrorsandmissedopportunities,theeurowasclose tobreakingpoint. Itwasapparent that theGreekbailoutprogrammehadbeen badlymisjudged. The euro zone leaders tended to pin the blame on theimpossibleGreeks.IfonlytheyweremorelikethestoicalBaltsandjustgotonwithcontrollingtheirdeficit,saidadvocatesofhardfront-loadedausterity,theywouldhavegotovertheirpainmorequickly.Latviahadsufferedlargelossesofoutput,pegged its currency to theeuro, sufferedabankingbust andhad tobebailedoutbytheIMFandEuropeanCommission.YetLatviarejectedtheIMF’sadvice to devalue the currency, and chose instead the agony of internaldevaluation.Itsubsequentlyemergedasoneofthefastest-growingcountriesintheEU.Intheviewofitsleaders,thekeyingredientwaspoliticalwill.Estoniaunderwent a similar experience. And as it joined the euro in 2011, EstoniaintenselyresentedhavingtocontributetothebailoutofthefarricherGreeks.

Internal devaluation is difficult at the best of times. The IMF’s deputymanaging director, Nemat Shafik, once memorably compared the process ofrecoveringcompetitivenesstopaintingahouse:

Ifyouhaveanexchangerate,youcanmoveyourbrushbackandforth.Ifyoudon’thaveanexchangerate,youhavetomovethewholehouse.

Successful adjustment requires flexible labour markets and an open economythatcanexportitswaybacktogrowth,aswellasapopulationwillingtoputupwiththepain.Greecehadnoneofthese:itwasaclosed,rigideconomyanditspoliticswaspolarisedbyahistoryofoccupation,civilwarandmilitaryrule.Assuch,Greecewasthemostrecalcitrantoftheeuro-zonecountriestoberescued.Greek leaders, even as they slashed the budget, did not understand howextensivestructuralreformsneededtobe,andmadenoprogressonprivatisation.IMFexpertsreturningfrommissionstoGreecewereincreasinglyalarmedbythedysfunctionalpublicadministrationtheyfound.AndtheGreekgovernmentwasnothelpedbytheopportunisticoppositionthat ithadtocontendwithfromtheNewDemocracyparty,whichhad,afterall,runupthedeficitinitslaststintingovernment.

Evenso,itwasplaintoallthatGreecewasbeingpushedintoarecessionthatwas far deeper than anyone had predicted. The situation was aggravated bysuccessive statistical revisions that kept pushing back the country’s startingpoint,andthecrushinglossofinvestorconfidencecausedbythegrowingtalkofGreeceleavingtheeuro.

To many, the Deauville bargain is the grievous error that turned anadmittedlyriskyGreekprogrammeintoacatastrophe.Inreality,Deauvillewasonlypartofawiderconfusion thatgrippedtheEuropeansfromthestart.TheywereinamuddleaboutwhetherGreecewassolventorbust,andthusvacillatedoverhowtodealwithitsaccumulateddebt.Theyfirstchoseacompletebailout;then at Deauville suddenly flirted with the idea of across-the-board bail-in ofcreditors; and then backed away from the ideamore or less entirely.By July,whentheygotaroundtocuttingGreece’sdebt,thehaircutwastoomodestandcame too late. Months were wasted seeking a “voluntary” contribution fromprivate creditors thatwouldnot trigger credit-default swaps (CDS); in the endCDS contracts were paid out anyway. The same uncertainty affected theirjudgmentaboutthepaceoffiscalconsolidation.TomakethenumbersfitwithinthemoneymadeavailablebytheeurozoneandtheIMF,Greecewasforcedintoexcessivelyharshdeficit-cutting(andatfirsthadtopayhighratesofinterest).IncontrastwithLatvia,whichcutitsbudgetasitsmaintradingpartnerswerestillstimulating their economies,Greecewas trying toconsolidate itsbudgetwhileotherswere reducingdeficits aswell.Crucially, theBaltic states also had low

debtstobeginwith;evenaftertheworstofitsrecession,Latvia’sdebtstoodatabout45%ofGDP,lessthanhalfofGreece’satthestartofitstroubles.

AsoberassessmentinMay2010shouldhavejudgedthatGreece’sdebtwasunsustainable, and that itwouldhavebeenbetter to cut thedebt sooner ratherthan delay the inevitable. This would have resulted in a more realisticprogramme,focusedlessonausterityandmoreonstructuralreform,andbetterable to absorb the inevitable political and economic bumps. At the time,however,itmighthavebeendifficulttoconvinceGermanythatitsbankshadtotakelossesonGreekdebtevenasGermantaxpayerswerebeingcalledupontolendenormoussumstoGreece.Thatsaid,evenalargedebtwrite-offwouldnothavesparedGreeceapainfuladjustmenttocloseabudgetdeficitgapof15%ofGDPandacurrent-accountdeficitofsimilarmagnitude.

Fudged assessments, unsustainable debt, inadequate financing, Greece’smanypoliticalfailuresanduncertaintyabouttheeuroallfedtheconstantfearofachaoticdefault.TheGreekdeathspiral,andtheincoherenceoftheeurozone’sleaders, threatened to take down thewhole currency. Contagion threatened tobring down Italy, the scariest debtor of all. Even with the will to act moredecisively,governmentswouldhavestruggledtofindthemoneytostabilisetheeurozoneonceItalystartedtowobble.Bytheendof2011,onlythecentralbankhadtheresourcestostabilisethesystem.Whatwouldittakeforittostandastheeurozone’slenderoflastresort?

6SuperMario

A SPIKED PRUSSIANMILITARY HELMET, aPickelhaube, decoratesMarioDraghi’sofficeon the35th floorof theEurotower inFrankfurt, theheadquartersof theECB. It was a gift from the editors of Bild, a German tabloid newspaper,intended as both a compliment to his reputation as “themostGerman” of thecandidates to run the centralbank (after the resignationofAxelWeber) andawarning to the former Italian central banker not to let downhis guard againstinflation.AshetookchargeoftheECBatatimeofgreatperilfortheeurozonehe had to act boldly, though he knew he could ill-afford to allow austerenortherners toaccusehimof turning theECB, theheir to theuncompromisingBundesbank,intoaEuropeanversionoftheBancad’Italia.

Replacing Jean-Claude Trichet in November 2011, Draghi brought a newstyle. His meetings were shorter, he delegated much more responsibility tocolleaguesand,havingspenttimeatGoldmanSachs,hewasmoreintunewithmarkets than his predecessor, as well as rather less stuffy. His first act inNovember (andalso inDecember)was to reversehispredecessor’smisjudgedraterisesearlierintheyear,catchingmostanalystsbysurprise.Itwasahintthat,instead of being compelled to respond to events, he would try to change themarket’s expectations. The fiscal compact he had asked for also gave himpoliticalcover foraboldermove: theprovisionofvastamountsofemergencyliquidity for Europe’s banking system, called Long Term RefinancingOperations(LTRO).Banksandsovereignswerefacingalargerefinancinghumpin2012,andbankswererunningshortofcollateral.Draghiactedtopreventanyfunding“accidents”thatmightbethesparkforanothercrisis.

ThefirstwaveofcashwasannouncedjustbeforetheDecember9thsummitthat endorsed the fiscal compact. The second wave was released in February2012. In all, the ECB provided €1 trillion-worth of three-year loans at a 1%

interest rate, and also eased collateral requirements.Nicolas Sarkozy gleefullylet everybody know that the banks, especially in southern Europe, would usemuchof themoney tobuyhigh-yieldingsovereignbonds; inotherwords, thiswasbond-buyingthroughthebackdoorof thebanks.Yet the“Sarkozytrade”,as it came tobeknown,didnot saveFrance from losing itsAAArating fromStandard&Poor’s(S&P)inJanuary.Eightothereurozonecountrieswerealsodowngraded. By leaving Germany as its only AAA-rated eurozone sovereignwith a “stable”outlook,S&Pdestroyed the symbolicparitybetweenGermanyandFrance.Europe’sdividinglineshiftedfromtheAlpsandthePyreneestotheRhine.Moreover,bychastisingsomany,S&Pmadeclearthattheproblemwasnotjustindividualcountries,buttheeurozoneasawhole.TheOctobersummitdealhadbeeninadequateanddidnotprovideenoughsupportfortroubledstates.Itsaid:1

TheoutcomesfromtheEUsummitonDec.9,2011,andsubsequentstatementsfrompolicymakers,leadustobelievethattheagreementreachedhasnotproducedabreakthroughofsufficientsizeandscopetofullyaddresstheeurozone’sfinancialproblems…Wealsobelievethattheagreementispredicatedononlyapartialrecognitionofthesourceofthecrisis:thatthecurrentfinancialturmoilstemsprimarilyfromfiscalprofligacyattheperipheryoftheeurozone.Inourview,however,thefinancialproblemsfacingtheeurozoneareasmuchaconsequenceofrisingexternalimbalancesanddivergencesincompetitivenessbetweentheeurozone’scoreandtheso-called“periphery”.Assuch,webelievethatareformprocessbasedonapillaroffiscalausterityalonerisksbecomingself-defeating,asdomesticdemandfallsinlinewithconsumers’risingconcernsaboutjobsecurityanddisposableincomes,erodingnationaltaxrevenues.

Over the following weeks Draghi’s cash would ease the spasm. The eurozonebreathedmoreeasily.Bondyields for ItalyandSpaindroppedmarkedly,byabout250and90basispointsrespectivelybetweenJanuaryandMarch.Thelong-drawn-out second Greek bailout, with its large haircut on privately heldgovernmentbonds,wasconcludedinFebruaryandmarketsseemedunconcernedbythetriggeringofcredit-defaultswapsthathadoncebeensofeared.

Draghiquietly retiredTrichet’sofficialbond-buyingoperation inFebruary.YetnosoonerhadhetoldBildinMarch2012that“theworstisover”thanthecrisis entered another,more perilous phase.TheLTROdrugwaswearing off,

andtheeurozonehadenteredadouble-diprecessionattheendof2011,causedinpartbythepreviousyear’sturmoil.Markets’concernshiftedfromthedeficittoshrinkingoutput,thatis,fromthenumeratortothedenominatorintheratioofborrowingtoGDP.

ThepaininSpain

Throughthecrisisthespreadofacountry’sbondyieldsoverGermanoneshasbeenthetemperaturechartoftheeurozone’ssickness.Thespreadinbondyieldsbetween Italy and Spain tells its own story of comparative illness. Before thecreditcrunch, Italianbondswouldyield10–20basispointsmore thanSpanishones. In January 2010 the lines flipped, in part because conservative Italianbanks seemed in better shape thanSpanishones, crippled as theywereby thepropertycrash.InAugust2011,though,ItalywasagaintheriskierbetasSilvioBerlusconi’s government began to collapse. In March 2012, the order wasinvertedoncemore(seeFigure6.2).

Thereweretwomainreasonsforthelatestswitch.First,Italy’sMarioMontibecame the darling of Europe, feted in Germany and the United States alike.Monti,someofficialssaid,wasItaly’srealfirewall.InSpain,meanwhile,doubtsspread about the credibility of the new conservative government of MarianoRajoy, even though it had been resoundingly elected inNovember 2011 on apromise of tough deficit-cutting and structural reforms. Second, Spain’seconomyanditsbanksweretakingaturnfortheworse.

InlateFebruarySpainannounceditwouldmissits2011deficit targetbyasurprisinglywidemargin, 8.5% ofGDP instead of 6%.OnMarch 2ndRajoyunilaterallychangedthe2012targetto5.8%,insteadoftheEU-mandated4.4%.ThathemadetheannouncementonthemarginsofanEUsummitatwhich25leaders signed the fiscal compact recommitting governments to budgetdiscipline, informing nobody of his move, caused much irritation; a feelingheightenedbythefactthathewithheldpublicationofhis2012budgetuntilafteraregionalelectioninAndalusiatobeheldattheendofthemonth(hispartylostanyway).

Spain’swoescausedadeeperrethinkamongEuropeanpolicymakers.Spaingavestrongcausetoquestionthediagnosisoftheeuro’sproblems.Thiswasnotacaseofprofligacy,as inGreece,or reckless“Anglo-Saxon”capitalism,as inIreland. Spain had run a budget surplus before the crisis and had boasted of

havingoneofthebestfinancialregulatorysystems.Moreover,Spain’spersistentbudget deficit raised questions about the favoured prescription of hard, front-loaded austerity. In April the IMF published the first of a series of studiessuggesting that fiscalmultipliers,whichmeasure how badly growthwould beaffectedbybudgetausterity,werelargerthanexpectedincircumstances,suchasthoseoftheeurozone,inwhichinterestrateswereclosetozero,creditwastightand neighbouring countries were all cutting their deficits. The Fund urgedeurozonecountriestoslowthepaceoffiscalconsolidation.

Above all, the alarming state of Spain’s banks highlighted a facet of thecrisis thathadbeensemi-neglected: thebankingcrisisof2009,maskedby thepanic over sovereign debt, had not been resolved. In fact the two wereinterconnected.InGreecethebankruptsovereignwasbringingdownthebanks.In Ireland, and increasingly now Spain, bust banks were endangering thesovereign.Theoutflowof capital thatSpainhad suffered from the summerof2011abruptlyacceleratedpaceinMarch2012.

Spain’sfinancialregulatorhadprovedunableorunwillingtocleanupbankswreckedbybadpropertyloans.Acrosstheeurozone,andbeyond,bankingwasoneofthelastbastionsofprotectionwithintheEU.Regulatorstreatedbanksasnational champions. They were reluctant to reveal losses, either for lack ofmoney to recapitalise banks, or for fear that they would be taken over byforeigners.Often governmentswanted to avoid rescued banks being forced todivest themselves of assets under state-aid rules designed to preserve faircompetition. By mid-2012, say EU officials, national regulators hadoverestimatedbankassetsinalmostallcasestheCommissionhadinvestigated,probably in an attempt tomask the scale of public assistance.Repeated stresstestsconductedbytheEuropeanBankingAuthorityhadbeendiscredited:inJuly2011 it gave a clean bill of health toDexia, a French-Belgian group thatwasbailed out in October 2011, and to Spain’s Bankia, part-nationalised in May2012.TheLTROmoneyhadprovidedbriefrelief,butbyencouragingbankstobuymorebondshadworsenedthedeadlyfeedbackloop.

FIG6.1ThedeadlyembraceSpain:five-yearCDSpremiumsonsovereignandbankdebt,2007–12

Sources:ThomsonReuters;SilviaMerlerandJeanPisani-Ferry,BruegelIn sum, Spain provided strong evidence that the problemwas not just the

behaviourof individualcountries,or theenforcementoffiscalrules. Instead, itwas property bubbles, imbalances and the unstable structure of the euro zone.Indeed,theeurozonefounditselfinthegripofthreeseparatecrises–banking,sovereign debt and growth – with each connected to the other throughdestabilisingfeedbackloops.Figure6.1showshowpremiumsforcredit-defaultswaps for Spanish sovereign bonds and Spanish banks closely followed eachother.Weakbanksendangered sovereigns thatwerecalledupon to save them,and weak sovereigns endangered banks holding bonds at risk of default.Recessionworsenedthedebtratio,butausteritytoreduceborrowingsuppressedgrowth, or caused even worse recession. Federal governments attenuate suchdoom-loopsbyproviding fiscal transfers (for example, throughunemploymentbenefits)anddealingwithshockstothefinancialsystem.Buttheeurozonehadnobudgetorcentralauthority.

One response was gradually to ease austerity. Already the second GreekprogrammeinFebruaryhadrelaxedthepaceoffiscalconsolidationandsoftenedrepaymenttermsonbailoutloans.InlateMay,despitetheirritationwithRajoy’santics,theCommissiongaveSpainanextrayeartomeetitsdeficittargetof3%ofGDPby2014, insteadof2013. In June itwasgiven apartial bailoutwhenfinanceministersagreedinprincipletolenditupto€100billiontohelpcleanupand recapitalise its banks. Unlike Greece, Spain was given only “light”conditions,andthesumincludedageneroussafetymargintoaddressunforeseenneeds. But the deal had little impact on borrowing costs. And now Spain’stroubleswereonceagainpushingupItaly’sbondyields.

EuropeàI’HollandaiseThe election on May 6th 2012 of a Socialist president in France, FrançoisHollande,whohadcampaignedonananti-austerityplatform,wasgreetedwithmixedfeelings:hopethattheMerkozydiktatwouldend,butalsoworrythattheuntestedMerkhollandemightleadtoparalysisorworse.Therewasnotmuchofahoneymoon.Onthesameday,Greekvoterscrushedbothmaincentristparties,the centre-right New Democracy and especially the Socialist Pasok. The oldgiantsbarelymustered30%ofthevotebetweenthem.Itwas,inasense,asiftheabortivereferendumthatcostGeorgePapandreouhisjobhadbeenheldafterall.Buthavingexpressedtheirrevulsionwith thepoliticalelite,Greekvoterswereless clear about what should replace it. Votes were scattered among anti-austerityfactionsrangingfromtheStalinistlefttotheneo-Naziright.Asecondballot was called in June to break the stalemate, amid hopes that the Greekswouldbehaverather like theFrench:votingwith theirhearts in the first roundbutwiththeirheadsinthesecond.

Hollande soon cast himself as the champion of the south. His promise torenegotiatethefiscalcompactwasfobbedoffwitha“growthcompact”thatwaslittle more than a repackaging of several modest and pre-existing Europeanspending initiatives.He also revived the idea ofEurobonds. Itwas unfair thatSpainhadtoborrowat6%whileGermanycoulddosoalmostfreeof interest,said Hollande at an informal EU summit to welcome him onMay 23rd. ButAngelaMerkelwouldnothearofdebtmutualisation.ThateveningHermanVanRompuyappointedhimselftowriteareportwithavagueremittofindwaysofdeepeningeurozone integration. Itwould looknotonlyatEurobondsbut also,crucially,at“moreintegratedbankingsupervisionandresolution,andacommondeposit-insurancescheme”.

Theideaofa“bankingunion”,asanalternativetothe“fiscalunion”pushedbyFrance,wasthustakingshapeasaresponsetotheSpanishcrisis.Economistshad long argued that, in an integrated financial market, centralised Europeanauthoritiesshouldberesponsibleforsupervisingbanksandforwindingthemupwhen they failed. InFebruary2011apaperbyBruegel, aBrussels think-tank,declared that “nothing less than supranational banking supervision andresolution bodies can handle the kind of financial interdependence that nowexists in Europe”. Such ideas had been considered for Jacques de Larosière’sreportonfinancialregulationinFebruary2009,butweredeemedtooambitious.The new European supervisory authorities – three new regulators for banks,insuranceandmarkets,andtheEuropeanSystemicRiskBoardtomonitorthreats

to theoverall financial system– thatemerged from the reportwere littlemorethanlooseco-ordinatingbodies.

Aseparatebutrelatedideawasthedirectrecapitalisationoftroubledbanksby the EFSF or the future ESM, to avoid the burden falling on vulnerablesovereigns.TheconcepthadbeenpushedbytheIMFinJuly2011.FrancehadalsowantedtodrawontheEFSFtorecapitaliseDexiainOctober2011buthadbeenturneddown.InApril2012theIMFreturnedtothecharge,thistimewithamore detailed longer-term proposal for a single European supervisor with asingle resolution authority and fund, and a Europe-wide deposit-guaranteescheme.BytheendofMaythechorusofsupportersfor“bankingunion”grewlouder, as the ECB and the Commission joined in. Under the deliberatelyunderstatedtitleof“integratedfinancialframework”,bankingunionwasoneofthe four pillars of Van Rompuy’s June 26th report on the future of the euro,alongside fiscal union (including tighter budget controls and a timetable forEurobonds),economicunion(co-ordinationoflabour-marketandotherpolicies)andpoliticalunion(togivedemocraticlegitimacyandaccountabilitytotheotherthreepillars).2

The breakthrough came at a secret meeting of finance ministers fromGermany,France,ItalyandSpainandseniorEuropeanofficials,attheSheratonHotelnexttoCharlesdeGaulleairportinParis(forgreaterdiscretion)onJune26th.ThediscussionfocusedonanotheroldFrenchdemand,thatthefirewallbeboostedbygivingtheESMabankinglicencesoitcouldborrowfromtheECB.Changing tack, PierreMoscovici, the new French financeminister, suggesteddirectbankrecapitalisationbytheESMtohelpSpain.HisGermancounterpart,WolfgangSchäuble,causedastirwhenhesuggesteditmightbepossible–butonlyifthereweredirectsupervisionofbanks.ThiswasinlinewithGermany’smantra: greater solidarity could only come with greater control. But wouldMerkelagreetoanyofthis?

TwoSuperMarios

TheEuropeanfootballchampionship,inwhichItalymetGermanyinthesemi-finalatthenationalstadiuminWarsawonJune28th2012,becameametaphorforthepoliticalbattletakingplacethesamenightinBrussels:northandsouth,discipline against guile, creditors versus debtors. The football-mad Merkelwouldstepoutof themeetingroomtowatchreplaysofkeymoments,suchasMarioBalotelli’swinninggoal for Italy in the36thminute. In the summit she

wasconfrontedbyanotherSuperMario,theItalianprimeminister,MarioMonti.Hisgamewasaformofcatenaccio,theunyieldingItaliandefence,playedwithhis Spanish colleague. They stubbornly blocked agreement on the finalcommuniqué, including Hollande’s “growth pact”, until the chancellor hadagreed to their demands. Rajoy wanted the direct recapitalisation of SpanishbanksbytheEFSF;Montiwantedanautomaticmechanismtohelpbringdowntheborrowingcostsofvulnerablebut“virtuous”countries(thatis,Italy).

ForItaly,inparticular,thiswasanunusualchangeofbehaviour.Berlusconi,though dominant for years in domestic politics, typically said very little atEuropeansummits.Now the technocratwhohad succeededhimwasdaring toplayhardballagainstthemightyGermans.Thedifference,perhaps,wasdowntothefactthatItalyunderMontihadregainedsomecredibility,andthereforesomeroom for manoeuvre. With some skilful bureaucratic midfield play by seniorofficials in Brussels, Monti and Rajoy got their way at around 4am, havingovercome a sustained rearguard action by Finland and the Netherlands (onesenioreurozoneofficialcalledtheselasttwoemmerdeurs,afruityFrenchwordthattranslatesroughlyas“painsinthearse”.)

Thustheopeningsentenceoftheeurozonestatementdeclaredgrandly:“Weaffirm that it is imperative to break the vicious circle between banks andsovereigns.”3Leadersagreedtosetupasinglesupervisor,basedattheECB,tooverseetheeurozone’s6,000-oddbanks.Thereafter,therescuefundscouldbeused to recapitalise troubled banks directly. Ireland was also promisedunspecifiedhelp,intacitrecognitionthatithadbeenforcedtotakeonmuchofitsbanks’debts.ThesecondconcessionwastoallowtheEFSF,andinfuturetheESM,tointervenetostabilisebondmarketsformembersrespectingalonglistofEuropeancommitmentswithoutafull-blowntroika-monitoredprogramme.

Rajoy probably scored the winning goal on the night, but Monti was theplaymaker. He certainly acted as the victor, as he emerged from the summitspeaking teasingly about “many important discussions, sometimes tense, withmanyemotional aspects, often concentratedon football”; his supporterswouldlater say thatanoblique reference in thecommunique to theECB’s roleasan“agent”forbond-buyingbytherescuefundswastheharbingerofabiggerrolefor the ECB. Across Europe, newspapers could not resist parallels betweenGermany’s defeat in European football andMerkel’s concession in Europeanpolitics.Pro-Berlusconipapers,no fansofMonti,wereparticularlycrude.Oneshowed Balotelli kicking a football in the shape of Merkel’s head; anothersplashed with the headline “Ciao, Ciao Culona” (“Bye Bye Fat Arse”), a

reference to an intercepted phone call in which Berlusconi is alleged havedescribedtheGermanchancellorinparticularlycrudeterms.4

The euro zone was crossing an important threshold: responsibility for thebanksmightnowbeshared.SomeEUofficialsspokeofthesummitasthemostimportantactofintegrationsincetheMaastrichttreaty.Ofitself,thecreationofa single supervisor would amount to a substantial surrender of nationalsovereignty. The change would be greater still if and when other pillars ofbanking union were created: a eurozone resolution authority with access to acommon pot of money to wind up bust banks; a single deposit-guaranteescheme; and a common fiscal backstop. The US Federal Deposit InsuranceCorporation(FDIC) issetupalongsuch lines,able todrawona lineofcreditfromtheTreasuryifnecessary.Fromthestartofthefinancialcrisistotheendof2013, ithaswoundupmore than400 (mostly small)banks, incontrastwithahandfulinEurope(andabout40banksthathavereceivedstateaid).Merkelmayhave told members of her coalition that she could not envisage wholesaleEurobondsinherlifetime.Butjointliabilityofadifferentformmightnowcomeviathebackdoorofthebanks.Intheend,theneedfortaxpayersultimatelytostandbehindthebankingsystemmeansthatarealbankingunionwouldbecomeasteptowardsafiscalunion.

Stillnotenough

Yet the euphoria in the markets was short-lived. Part of the blame lies withEuropean leaders’ love of bickering. The Dutch prime minister, Mark Rutte,tried to peg back Monti’s exuberance, insisting countries would still faceconditionsifhelpedbythefund.Finlanddemandedcollateral,andlaterseemedtomuseabout leaving theeuro (officials saidcomments to this effectby JuttaUrpilainen, the financeminister,hadbeenmistranslated).Germanyputout themessage that, even in the case of direct recapitalisation, national governmentswouldbeliableforanybankinglosses.Andtherewasanotherworry.Germany’sconstitutional court was due to deliver its verdict on the legality of thepermanentnewrescuefund,theEuropeanStabilityMechanism,inSeptember.Anegativedecisionwouldremovetheeurozone’ssafetynet,inadequateasitmayhave been. More bad news came from Moody’s, a ratings agency, whichannouncedithadplacedtheAAAcreditratingofGermany,theNetherlandsandLuxembourgon“negativeoutlook”becauseofthedangeroffinancialinstability

ifGreecelefttheeuro,andthepossiblecostsofhelpingSpainandItaly.5On top of this was the chronic, seemingly insoluble problem of Greece.

Despite two bailouts, two rounds of debt restructuring and, as in Italy, theappointmentofa technocrat tohead thegovernment,Greeceneededstillmorebillions to avoiddefault.All attempts at reformhad come to ahalt during theGreek election campaign. The second ballot on June 17th allowed AntonisSamaras, leader ofNewDemocracy, to cobble together a broad coalitionwithhisarch-rival,Pasok.YetSamaraswaspoorlyregardedbyEuropeanleaders.Inoppositionhis refusal to support the firstbailoutwasdeemed tohavecrippledPapandreou.Later,whenhebackedtheunitygovernmentofLucasPapademos,Samaraswasevasiveaboutthetermsofthesecondrescue.Andbyforcingearlyelectionsinthemidstofawrenchingadjustment,hewasblamedforopeningthedoortoextremists.

Forbetterorworse,SamaraswasnowthelasthopeforGreece.Barrosoflewto Athens to warn him to stop talking about renegotiating Greece’s bailoutconditions.Inprivateandinpublic,hetoldhim:“Deliver,deliver,deliver.”TotheoutrageofmanyinBrussels,Merkel’sgovernmentcontinuedtoentertaintheideaofpushingGreeceout,eventhoughitscitizenshadvotedforpro-Europeanparties. PhilippRösler, leader ofGermany’s liberal FreeDemocrats,Merkel’sjunior coalition partner, declared on July 22nd: “Awithdrawal of Greece haslongsincelostitsterror.”BythenSpanishten-yearbondyieldshadpassedthepsychologicalthresholdof7%,andItalianoneswerenotfarbehind.Terrorhadreturnedtotheeurozone.

Whateverittakes

Tosome,Cannesanditsaftermathinlate2011wasthecruellestmomentoftheentire crisis. To many others, the moment of greatest despair came in thesummerof2012.Draghi,spendingafewdaysinLondonattheendofJuly,wasworriedaboutfinancialdata:economicfundamentalshadnotchangedandtherewasampleliquidity.Yetmoneywasfleeingnorth,regulatorsweretellingbankstokeep theirmoneywithinnationalborders,cross-borderbank lendinghadallbutstopped,andsovereignspreadswererisingalongwithcredit-defaultswaps.To the ECB this was evidence of the euro zone moving towards the “badequilibrium”evokedbyPaulDeGrauwe, thenaprofessorofeconomicsat theCatholic University of Leuven. He had argued in 2011 that, unless the ECBacted as a lender of last resort, countries in the euro zone were effectively

borrowing in a foreign currency and could easily be pushed into default bypanickedmarkets.Draghithoughtthatfearoftheeuro’sbreak-upwasbecomingaself-fulfillingprocess.OnlytheECBcouldputanendtothe“redenominationrisk”.

OnJuly26th,theeveofthesummer’sotherbigsportingfestival,theLondonOlympics,Draghi addressed a group of investors gathered in the splendour ofLancasterHouse inLondon. The single currency, he recalled,6 had once beendescribedasabumblebeewhich,asscientificlorehadit,shouldnotbeabletofly.Theeuroareawas“much,muchstrongerthanpeopleacknowledgetoday”;outsiderswereunderestimatingrecentreformsandthepoliticalwilltomaketheeuro irreversible. Then came a seemingly unscripted sentence that made hisaudiencesitup.“Withinourmandate,theECBisreadytodowhateverittakestopreserve theeuro,” saidDraghi,pausing foramoment. “Andbelieveme, itwill be enough.” Dealing withmarkets’ fear of “convertibility risk”, declaredDraghi,waswithintheremitoftheECB.

Marketshadusuallyignoredleaders’promisestodowhateverittooktosavethecurrency.ButDraghi’swordshadanimmediateeffect,eventhoughnobodywas quite sure what would follow – not even all members of the ECB’sexecutive board. There could not simply be a return to Trichet’s SecuritiesMarketProgramme (SMP),bynowregardedasanexpensivemistake thathadlumbered theECBwithmore than €200 billion-worth of vulnerable bonds, tolittleeffect.DraghineverforgothowBerlusconihadrenegedonhispromisesofreformthepreviousyear.TheECBconcludedthat theSMPhadsufferedfrommultipleflaws.Ithadnomeansofcompellingcountriestoreform.Itwaslimitedin scope, so never amounted to the “big bazooka” needed to ward offspeculators.Itsresourceswerescatteredacrossarangeofmaturities.AnditlefttheECBexposedpolitically.

SonowDraghireinventedtheformula.Hisnewpolicyofoutrightmonetarytransactions (OMT), outlined on August 4th and then set out in detail onSeptember 6th, would require countries seeking ECB intervention to requesthelp from the rescue fund and sign up to a macroeconomic adjustmentprogramme.Thefundwouldhavetointerveneintheprimarybondmarket.OnlythenwouldtheECBdecidewhethertointerveneinthesecondarymarket,whereitwould concentrate onbuying short-datedbondswith amaturity of less thanthreeyears.Crucially, therewouldbenopre-set limit to thequantities itcouldbuy.Inotherwords,itwouldbelefttogovernmentstodecidewhetheracountrywassolvent,andovertlytoimposereforms,ratherthanleavingtheECBtosend

outsecretletters.AndtheECBwouldconcentrateitspotentiallyhugefirepoweronanarrowfrontofthebondmarket.

Evenso,OMTwasresistedbytheBundesbank’spresident,JensWeidmann,whovotedagainst thepolicy,sayingitwasakin toprintingmoney.Butunlikehispredecessor,AxelWeber, hedidnot resign.Tellingly, his colleagues fromFinlandandtheNetherlands–thetraditionalemmerdeurs–votedinfavour.AndtheGermangovernmentmadeclearitssupportforDraghi.Weidmannsoundedincreasinglylikeaprophetinthewilderness,declaringthatsavingtheeurowasajobforelectedleaders,notcentralbankers.Atonepointhecouchedhiscriticismin literary terms, by quoting Goethe’s Faust: in the play the Holy RomanEmperor complains of being short of gold; Mephistopheles persuades him tosignadocumentwhichis thenreproducedanddistributedaspapermoney;butaftertheinitialeconomicupswingcomesinevitableinflationandcollapse.7Thelesson, said Weidmann, was that central banks must avoid the temptation ofsolving short-term problems by creating money lest they create long-termdamage. Towhich the ECB’s insiders retorted: the Bundesbank always has asolutionforthelongterm,neverfortheshortterm.

The impact of OMT exceeded all expectations. From the end of Julyonwards, bond yields of the most troubled states came down almostcontinuously.Bytheendof2012ItalianandSpanishbondyieldshadfallentoabout5%each(thespreadoverGermanbondswasstill200basispoints).Moregood news came inSeptember,whenGermany’s constitutional court gave thego-aheadfortheratificationoftheESM,thepermanentrescuefund,subjecttominorcaveats.ThefundcameintoexistenceinearlyOctober.Basedonpaid-incapital rather thanguarantees, theESMwasamorerobust instrument than theEFSFitwasreplacing(thetwowilloverlapforsomeyears).

Draghiwouldlatertellsenioreurozonepolicymakersthatthecommitmenttostart a banking union had created the conditions for OMT. As another ECBinsiderputit:

Wewerewillingtobuildabridge,butitcouldnotbeabridgetonowhere.Theleadershadtobuildaroadontheotherside.

At the time of writing, markets had not called Draghi’s bluff. OMT,according tooneECBinsider,was“by far themost significant interventionofmonetary history.” It had not cost a cent, and did not stoke inflation. EvenWeidmannwouldadmit,inprivate,thatithadworkedbetterthanhewouldhave

expected.

NoGrexit

Even with the ECB’s intervention, the future of the euro zone could not besettleduntilthequestionofGreecewasresolved.Whattodo?MerkelhadneverbeenamongthosemostmilitantlypushingfortheexpulsionofGreece;shehadevendescribedherself inprivate conversationsas theonlyperson inGermanystillwillingtokeeptheGreeksin.AsshetoldtheBundestaginFebruary2012,“Ishouldandhave to takerisks,but Icannotembarkonadventures.”ShehadallowedherministerstousethethreatofexpulsiontoexertpressureonGreeceto abide by its programme and, latterly, to convince voters to support pro-Europeanparties.

Throughout the crisis, Merkel had received contradictory advice, both athomeandabroad.SomeattheIMFthoughtGreecewouldbebetteroffreturningtothedrachmagiventheeurozone’smuddledpolicies.Atthesametime,JoséManuel Barroso, president of the European Commission, warnedMerkel thatGrexitmightcause somuchpolitical instabilityas toprovokeanothermilitaryintervention. But during August 2012 Merkel made a firm decision: Greecewouldstayintheeuro,evenifthattookmoremoney.Somethinkthemomentofclarity came during herwalking holiday in the ItalianAlps, or soon after herreturn to Berlin. Others suggest the final decision was taken during a trip toChinaat theendof themonth,whenshewasgrilledbyChinese leadersaboutthefutureoftheeurozone.WhatmadeuphermindwereherconversationswithWeidmann and the ECB’s Jörg Asmussen. Neither could offer any assurancethattheconsequencesofGrexitcouldbecontained.

When the newly elected Samaras, recovering from eye surgery, visitedBerlinonAugust24th,Merkelalreadysoundedmuchmoresympathetic to theplight of Greece. She told him privately she was ready to “help” if Greecewanted to leave the euro; but if itwanted to stay, she needed assurances thatSamaraswould deliver reformand fiscal discipline.TheGreekprimeministersaidGrexitwasinconceivable,andhewouldresignimmediatelyifitwereeveronthecards.

The strongest signal that Greece would stay came on October 9th, whenMerkelmadeherfirsttriptoGreece,expressedherdesirethatthecountryshouldstay in and offered “practical” assistance with structural reforms, such asGerman experts to help overhaul tax administration and modernise local

government. Her attempt to empathise with the Greeks was not universallywelcomed.Protestersoutsideparliamentwavedbannersdeclaring“Angelayouarenotwelcome”.MunicipalworkersinfullNaziuniform,oneofthemwithaHitler moustache, drove a jeep flying swastika flags through the streets as areminder of the German occupation in the second world war. Riot policeresorted to tear gas and stun grenades to keep protesters from the parliamentbuilding.

Although Germany no longer wanted to throwGreece out, it still did notwant to lend it more billions to keep it in. A third programmewould not godownwell in theBundestag.SoGreecehad to find largesavings (worthmorethan7%ofGDP) in2013and2014 tomakeupfor the time lostearlier in theyearand todealwith theconsequencesofadeeper-than-expected recession. Itwouldbegiventwomoreyearstoreachitstargetofaprimarybudgetsurplusof4.5%ofGDPin2016insteadof2014.Thatwouldrequiremoreloansinfuture,andmoreloanswouldraisethedebt.Fornowthemostcontentiousissuewasthetug-of-warbetween the IMFand theeurozoneover thesizeofGreece’sdebt.Greece’seconomicoutlookwassopoor that itwouldprobablymissbya longshotthetargetofbringingdebtdownto120%ofGDPby2020.Thefigurewasnowexpectedtobe144%ofGDP.TheIMFsoughtoutrightforgivenessofdebt,now mostly held by the official lenders (hence the term official sectorinvolvement,orOSI).Itsaidawrite-offwouldbethestrongestpossiblesignalof the euro zone’s intent to keep Greece in, and so would boost investorconfidence.YetOSIwasunacceptableaheadofGermany’sgeneralelection inSeptember2013;itwouldhavevindicatedcriticswhosaidmoneylenttoGreecewouldneverberepaid.

Aftermuchwrangling,adealinNovemberagaincutGreece’sinterestrate,deferredpaymentfortenyearsanddoubledmaturitiesto30years.ItincludedacommitmenttocutGreece’sdebtto124%ofGDPin2020andto“substantiallybelow”110%ofGDP twoyears later,with thepromise to takemoreaction ifnecessary once Greece reached a primary budget surplus. Nevertheless, animportant line had been crossed.Without saying so too loudly, the euro zonewasreadytopay tokeepGreece in thecurrency.SpainandItalywerealreadylendingtoGreeceatalowerratethantheycouldborrow.

Bankingdisunion

The largestcloudover theunaccustomedoptimismin theautumnof2012was

Germany’s backtracking on banking union. The Commission rushed out itslegislative proposals for a single bank supervisor in September but Germanymadesurethatkeypartsofthedocument,suchasatimetableforthecreationofa common deposit-insurance system, were excised. There was only a vaguecommitment to creating a bank-resolution authority for the euro zone tocomplement the supervisor. The immediate focus would be on harmonisingnationalbankingrulesacrosstheEUasawhole,including“bail-in”proceduresto impose losseson shareholders,bondholdersand largedepositors inorder tosparethetaxpayer.

EventhesupervisorwasnotentirelytoGermany’sliking.TheCommissionwanted the ECB-based supervisor to oversee all 6,000-plus banks in the eurozone. Germany insisted it should focus only on the bigger “systemic” banks,leaving supervision of smaller banks, including its own often-troubledSparkassen and Landesbanken, in national hands – even though Spain’sexperience showed that trouble in small lenders could become systemic.Germany also slowed down the timetable for the supervisor to start work(originallyJanuary1st2013)onthegroundsthatsuchanimportanttaskshouldnot be rushed. Thereafter, direct bank recapitalisation should only take placeoncethesystemhadshownitselftobe“effective”.

Worsewas to come.On September 25thWolfgang Schäuble, theGermanfinance minister, and his Dutch and Finnish colleagues sought to limit thecommitmenttodirectrecapitalisation:itshouldapplyonlytonewproblems,not“legacyassets”,andshouldonlybea“lastresort”,afterusingprivatecapitalandthen national funds. Spain gave up on the idea of direct recapitalisation of itsbanks.InDecemberitborrowed€41billionofthe€100billionallocatedbytheeurozone,whichwould increase itsdebt ratiobyabout4%ofGDP. Ireland’shopethatitsbankdebtwouldbetakenoverretroactivelywassimilarlydashed.

Attheendof2012financeministersreachedacompromiseonthescopeofthenewsupervisor:itwoulddirectlyoverseethebiggest“systemic”banksintheeurozone(about130),whileday-to-daycontrolofsmallerlenderswouldbeleftto national regulators, subject to central rules and the right of the eurozonesupervisor to assume oversight of any bank if deemed necessary. Beyondbanking union, the other pillars of Van Rompuy’s “genuine” economic andmonetaryunionwerealsocrumbling. InOctoberhehaddropped the ideaofatimetableforEurobonds.AtasummitinDecemberhetriedtopushtheconceptof“fiscalcapacity”,aFrench-sponsoredideatocreateacentralbudgettoactasa counter-cyclical economic tool to stabilise countries undergoing a downturn,

maybebyprovidingbenefits forshort-termunemployment.But thiswaskilledtoo.

WhatremainedofVanRompuy’sroadmapwasonlyatimetableforthenextstep on banking union – the creation of a bank-resolutionmechanism– alongwith thewispofaGerman idea tohave“contracts”betweengovernmentsandtheCommission topromotestructural reforms. Inanod toFrance, thesecouldincludesomeextramoney.ThiswaslessambitiousthanearlyGermanideastoestablishsomekindofsystemoftransferstohelpthemosttroubledcountries.Itwas certainly not the French idea of an automatic stabiliser. TheCommissionpublished its own “blueprint” for reform inNovember to try to keep some ofthese ideas alive, but EU leaders had lost interest in making great federalistleaps,iftheyeverharbouredthenotioninthefirstplace.AheadoftheGermanelectiondue inSeptember2013,Merkelwaswaryof takingonnewliabilities.She had already lost her “chancellor’s majority” in votes to approve bailoutprogrammes, meaning that she now had to rely on votes from the oppositionSocialDemocrats.

InsomewaysDraghi’sthreatofunlimitedinterventionworkedtoowell.Aspressurefrommarketseased,sodidthepressuretofixtheeurozone.Thedangerofmoralhazarddidnotapplyjusttodebtors;itappliedtocreditorcountriestoo.Leadersmay have pledged to do “whatever it takes”, butmore often itwas amatterofdoing“aslittleaswecangetawaywith”.

UglinessonAphrodite’sislandThenewdoctrinesofbankingunionwouldbetestedsoonerthanexpected,inthecaseofCyprus.TheCommission’sproposedruleson“bail-in”werepencilledintoapplyfrom2018.Germanywantedthemin2015.ButinCyprusbail-inwouldbeappliedimmediately,andinthemostchaoticmannerpossible.

The easternmost country in the European Union, closer to Syria than toBelgium,FranceorGermany,Cyprushasalwaysbeenanawkwardmember.ItenteredtheEUin2004asadividedisland,votersintheGreek-CypriotrepublichavingrejectedaUNplantoreunitewiththeTurkish-Cypriotnorth(wheretheplanwas supported)on theeveof its accession to theEU.TheGreek-CypriotgovernmentusedandabusedEUinstitutions towage its feudwith itsnorthernrival and Turkey, and to lend support to Russia.With an oversized financialsector (more than eight times GDP), catering mostly for Russian expatriates,Cypruswasvulnerablewhenthefinancialcrisisstruckin2008.Itwasshutoutofmarkets inMay2011and thensufferedadoubleblow: itsbanks took large

lossesasaresultoftheirexposuretoGreece(includinglossesequivalentto25%ofGDPasaresultofthehaircutonGreekbonds);andthemainpowerstation,generatingabouthalfofCyprus’selectricity,wasdestroyedbytheexplosionofacacheofweaponsstoredcarelesslynearby.

Cyprus’spre-crisisboomwasclearlyunsustainable.Along-runningcurrent-account deficit gaped ever wider. Companies and households were hugely indebt.And government debt, though comparatively low,was rising because ofovergenerous civil-service pay and benefits (including index-linked pay risestwice a year).With a short-term loan from Russia running out, and a ratingsdowngrade thatmeantCypriot debtwas no longer eligible as collateral at theECB,Cyprusbelatedly turned to theEU forhelp in June2012, just as it tookover therotatingEUpresidency.Negotiationsprogressedslowly.Aheadof thepresidential election in January 2013, the communist incumbent, DemetrisChristofias,saidhewouldnotstandagain.Butherefusedtoentertainthefiscalcuts the troikawoulddemand;andhewasfirmlyopposed toanyprivatisation.Theeurozonewasinnorush:ithadenoughonitsplatewithGreeceandSpain,and nobodywas keen to bail out banks stuffedwithRussianmoney, some ofwhichmighthavebeenthefruitofcorruptdealings.Bettertowaituntilaftertheelection,manyfelt.

MerkelhadbeenamongleadersoftheconservativeEuropeanPeople’sPartywhowent to Cyprus to support NicosAnastasiades, leader of the centre-rightDISY party, a month before he comfortably won the presidential election inFebruary2013.Buthispolitical“family”waslessthangenerouswhenitcametonegotiatingabailout.The IMF,now lessmalleable as a resultof the fiasco inGreece,saidlendingCyprusthe€17billionneededtorecapitaliseitsbanksandfinancepublicspendingwouldmakeitsdebtunsustainable.Greek-stylehaircutsongovernmentbondswereunappealing,becausemuchofthedebtwasheldbyCypriotbanks.Moreover,theeurozonehadvowedthattheGreekPSIwouldbean exception. The expected bounty of natural gas off Cyprus’s coast was toouncertain, and the prospect of commercial exploitation too tangled in regionalgeopolitics.Soalargeshareofthemoneywouldhavetocomefromthetwobigbanks:BankofCyprusandCyprusPopularBank,knownasLaiki.

OnMarch16thAnastasiadesstayedinBrusselsattheendofanEUsummittobeonhand forbailoutnegotiations.The talks turneduglywhenhe rejectedanylarge-scalehitondepositors, theECBthreatenedtocutoff liquidity to thelarge Cypriot banks, and Anastasiades threatened to leave the euro. Acompromisewasfound,butitwasabadone.Alldepositorswouldbesubjectto

aone-off“levy”:9.9%onlargedepositsand6.75%onthosebelowthe€100,000deposit-guarantee limit.Somehowtheeurozone,workinglateatnightandrunby a novice (Jeroen Dijsselbloem, the Dutch finance minister, had recentlybecomechairmanoftheEurogroup),agreedtoraidthesavingsofgrandmothersratherthanimposeabiggerhaircutonRussianoligarchs.Themesscamedownto a fetish about round numbers. Germany said the euro zone would lend nomorethan€10billion; theIMFinsisted the island’sdebtshouldbekeptbelow100% of GDP by 2020 (a more exacting standard than for Greece, on thegrounds that itwasasmalleconomy);andAnastasiadeswasadamant thatanytaxonbigdepositorsshouldbebelow10%.

AsbankswereshutinCyprustoavoidanoutrushofmoney,therefollowedaweekofbrinkmanship,includinga36–0voteintheCypriotparliamenttorejectthe terms,streetprotests,afailedattemptbyCyprus to throwitselfatRussia’sfeetandapublicultimatumbytheECB.VanRompuysteppedintotrytofixthemess.OnMarch24thAnastasiadeswasflownbacktoBrusselsonaBelgianairforceplane.HeresistedtheIMF’sattempttowindupbothBankofCyprusandLaiki.Thatwouldcrushtheisland’seconomy,hesaid.IntheendheagreedtosacrificeLaikitosavearumpofBankofCyprus.Laiki’sbadassetsandallitsuninsured deposits were put into a “bad bank”. Its viable assets and insureddepositswereputintoa“goodbank”andtransferredtoBankofCyprus(alongwith,questionably,Laiki’sobligationtorepaytheECB’sliquidityloans).BankofCypruswouldberestructuredbywipingoutshareholders.Juniorandseniorbondholders were bailed in and given equity. Uninsured depositors weresubjected to haircuts of 47.5%, also in exchange for equity. The remainingdeposits were for the most part put into term deposit accounts for up to twoyears.

The new deal was better than the old one, in that it protected insureddepositorsandconcentrated thepainon the twolargestbanks,whichhadbeenthe cause of the problem. It restored a sensible hierarchy of creditors in bankresolution, whereas under the previous agreement, senior bondholders wouldhave been spared but small depositors hit. But it came at a cost. TheCyprioteconomywas pushed into a deep slump, albeit perhaps not as catastrophic assome feared. The euro zone for the first time introduced capital controls,meaning that a euro in Cyprus no longer carried the same value as a euroelsewhere.The reputation of the euro zone inmanaging the crisiswas furthertarnished. And the judgment of the ECB, now charged with supervising thebiggest banks, was also questioned. It had provided liquidity to Laiki, even

though itwasbust,and then insistedonbeing repaid fullywhen thebankwaswoundup.Moreover,ithadbeenpartytotheoriginaldealthatunderminedtheEU-wide€100,000guaranteetodepositors.

HadCypruswalked out of the euro, as some expected, European officialswerereadywithaproposalsforablanketguaranteeonalldeposits in theeurozone and the activation ofOMT. Such ideaswere dismissed by theGermans.The proposition was never tested, as Anastasiades caved in. Tellingly,sovereign-andcorporate-bondmarketsweresanguinethroughouttheweek-longstandoff.Draghi’sfirewallheldfirm.Plainly,Cyprexitin2013didnotholdthesameterrorasGrexithadin2011or2012.

Goodnews,atlastLittleseemed toscare theeurozoneanymore.Thepossibilityofabailout forSlovenia,whichwasgrapplingwiththecollapseof itsopaquebankingsystem,part of a web of political patronage, was treated as a tidying-up exercise.Through 2013 bond yields in peripheral countries declined gradually butsteadily, perturbed only on occasion. Spreads over German bonds, which hadexceeded600basispointsforSpainand500forItalyinJuly2012,fellsteadilytobelow200basispoints forbothbyFebruary2014.Theirbondyieldsfell topre-crisis levels (see Figure 6.2). EvenGreece,whose spread peaked at 2,900basis points in June 2012, was down to about 650. And, haltingly at first,economicgrowth returned to the euro zone.Nocountryhad left the euro, andseveral still wanted to join. Latvia, the poster-child for hard, front-loadedausteritywithafixedcurrency(itscurrencywaspeggedto theeuro) joinedonJanuary1st2014,followingEstonia,whichenteredin2011.Lithuaniawantstobenext.

FIG6.2SafelandingTen-yeargovernment-bondyields,July2011-December2013,%

Source:ThompsonReuters

Current-accountdeficitsintheperipherynarrowed,notjustbecauseimportscollapsedbutalsobecauseexportswererising.Withtheeasingofthefinancialcrisis,thepaceofausteritywassensiblyrelaxed.InMay2013France,SpainandSlovenia were given an extra two years to meet their deficit target of 3% ofGDP. The Netherlands and Portugal got an extra year. Italy came out of itsexcessivedeficitprocedureinJune.Thatsaid,tougherfiscalrulesknownasthe“two-pack”cameintoforceintheautumnof2013,obligingcountriestosubmittheirdraftbudgetsfor2014totheCommissionforcommentbeforebeingsenttonational parliaments. Increasingly, the Commission focused its yearly policyrecommendations on promoting structural reforms, though even that wasresented by France, with Hollande telling Brussels not to “dictate” specificreforms.TotheirritationofMerkel’sgovernment, theCommissionpluckedupthe courage inNovember to launch an in-depth studyofGermany’s large andpersistentcurrent-accountsurplus.

BothIrelandandSpainoptedfora“clean”endtotheirbailoutprogrammesat theendof2013.Themovemayyetprovetobehubristic. IMFprogrammesusually endwith a line of credit to facilitate a full return tomarket financing.IrelandandSpainmaynothavehadmuchchoiceinthematter.Merkelwasnotkeen toask theBundestag formoremoney. It suitedher tohave the strongestpossibledemonstrationofthesuccessofthepoliciesshehadenacted(andoftenchanged). And it suited her Irish and Spanish counterparts to boast that theywerefreeofthedreadedtroika.ButtheiremancipationmayresultinprolongedservitudeforPortugal.Despite itscompliancewithbailoutconditions,Portugal

suffered awobble in the spring of 2013when its constitutional court blockedsome deficit-cuttingmeasures. Its deficit is lower than Spain’s but its debt islargerand itsgrowthweaker. Ifa stigma isattached toaprecautionary lineofcredit,Portugalmightyetbepushedintoasecondbailout.

Thewoodenunion

AfteralongpausecausedbytheGermanelectioninSeptember2013,whichsawMerkel returned to power at the head of a grand coalition with the SocialDemocrats, the euro zone resumed work on banking union in the autumn of2013.Atitsheart,bankingunionrequirestrust.Germanymustfeelabletoshareliabilitiesforeverybody’sbanks.Andallcountriesmustagreetostopcoddlingtheirbankssothatmorepan-Europeanlenderscanemerge.

LegalworkonthesinglesupervisorwasfinalisedinNovember.Itwasduetobe fully operational a year later, with Danièle Nouy, secretary-general ofFrance’s bank and insurance supervisor, as its first boss. The next stage,potentiallyinvolvingpublicmoney,wasmoredifficult: thecreationofasingleresolution mechanism to wind up or restructure bust banks. Germany hadstubbornlyopposedacentralauthoritywithaccesstopooledfunds(leviedfromthe banks), pushing instead for a network thatwould leaveGermanmoney inGerman hands. Wolfgang Schäuble, reappointed as German finance ministeraftertheelection,hadsaidinMaythattheeurozoneshouldstartwitha“timber-framed” banking union; a steel one would require changing the treaties.8 Butwiththeapproachofanend-of-yeardeadline,Germanybegantoshift.

First,commonbail-inrulesthatwouldapplytoallEUcountries–whetherinoroutoftheeurozone–wereapprovedinDecember.ThesewouldensuretherecouldnotbeanotherCyprus-style fiasco.Shareholdersandbondholderswouldhave to take the first losses–up to8%of thebank’s totalassets–beforeanyresolutionfundscouldcommitted.Thereaftertherewouldbeaclearhierarchyofcreditors, so that senior bondholderswould take the hit before depositors, anddepositsbelow€100,000wouldbeprotectedatalltimes.

ThenSchäublemadeanimportantconcession.Thejointeurozoneresolutionfundwouldstartwithnational“compartments”,butoveraten-yearperiodthesewouldbeprogressivelypooleduntil therewasasingleEuropeanfundofabout€55billion ($60billion). Inotherwords,heagreed tomutualise themoneyofGermanbanks, ifnotyet thatofGerman taxpayers.AndGermany’sanswer tothe question of trust was to give the new supervisor time to root out the

problems.Theprinciplecouldonedaybeapplied toother reforms:howaboutthe phased introduction of Eurobonds? For now, Schäuble’s legal nitpickingproducedacomplexlegalstructure(mixingEUtreatyprovisionsfor thesinglemarketwithaninter-governmentaltreaty).Thedecision-makingprocesstowindupabankwouldbealmostcomicallyconvoluted,raisingworriesaboutwhetherafailingbankcouldreallybedealtwithoveraweekend.

After some brinkmanship, the European Parliament and Council agreed acompromiseonMarch20th2014,concludingbankingunion in just twoyears.MEPs objected to inter-governmentalism but relented because the alternativewas to have no resolution mechanism at all. In return they obtained somestreamlining of decision-making.With backing from the ECB, they shortenedtheperiod for thepoolingof funds (from ten toeightyears)andpermitted thefundtoborrowmoneyonthemarkets.AllknewthatiftheissuewerenotsettledbeforetheMay2014Europeanelections,itriskedbeingdelayedindefinitely.

Despite heady talk of “a revolution”, banking union remained incomplete.There was still no single deposit-guarantee scheme. The promise of directrecapitalisation was remote: first losses had to be borne by shareholders andcreditors; the burden would then be taken up by governments and only inextremisbytheeurozonerescuefund.Themostglaringflawwasthelackofacommonbackstop,lefttobedecidedatafuturedate.Inthetransition,nationaltreasuries would step in if the resolution fund ran out of money; only if theburden threatened to ruin a country could it turn to the ESM. The obvioussolution,toallowtheESMtoextendalineofcredittotheresolutionfund,astheUS Treasury does to the FDIC, was rejected by Germany. Saving taxpayers’money is a laudable aim.But banking union cannot be crediblewithout someassurancethattaxpayerscollectivelystandbehinditifabigcrisisstrikes.

BankinguniondidnotliveuptothepromisetohelpSpainorIrelandinthecurrentcrisis.Norwillitbemuchuseshouldthenewsupervisorfindlargeholesin the bankswhen it publishes the results of a thorough examination of bankbalancesheetsat theendof2014.Atbest, andonly ifdoneproperly,bankingunioncouldhelppreventandlowerthecostofafuturecrisis.Fortheforeseeablefuturebankingunion,likethecurrencyunionitself,willremainatimber-framedconstruction.

BewareofEurophoria

Afterthelongcrisis,marketsseemedinthegripof“Europhoria”byearly2014,

particularly as their worries shifted to emerging economies. The elation wasprobablyoverdone.Theeurozonewashardlyingoodhealth.

Theeurozonestoppedshrinkinginthefirsthalfof2013butwasforecasttogrowonlyslowlyin2014,whenjustCyprusandSloveniawerestillexpectedtobeinrecession.Aweakrecoverylefttheeurozonevulnerabletoanotherslump.Unemployment in the periphery remained atworryingly high levels. Financialmarkets had been fragmented by the crisis,with firms in the periphery of theeuro zone paying higher rates of interest for their loans – that is,when creditcould be obtained at all – than equivalent companies in “core” economies.Comparablebusinessoneithersideof,say,theborderbetweenItalyandAustriacouldpaymarkedlydifferentinterestratesonbankloans,asFigure6.3shows.

FIG6.3Thenorth-southgapInterestonloanstonon-financialcorporationsupto€1m,2007–14,%

Source:ECB

Beyond this, the danger of Japan-style deflation began to worrypolicymakersbyearly2014, as the inflation rate for the eurozoneas awholeslowedto0.7%inFebruary,wellbelowtheECB’salreadyconservativetargetofholdinginflationinthemediumtermatclosetobutbelow2%.Fallingprices–alreadya reality inGreece,Cyprus,Portugal andSlovakia–hamper recovery,prompt consumers to postpone purchases in expectation of lower prices andincrease the burden of debt on national economies.AsChristine Lagarde, theIMFboss,putitinJanuary2014:“Ifinflationisthegenie,thendeflationistheogrethatmustbefoughtdecisively.”

Two issues, in particular, highlighted the fragility of the euro zone’scondition. First was the oldest and most intractable problem: Greece.Astonishingly,poorblightedGreecemadeittoaprimarybudgetsurplus(beforeinterest)attheendof2013,foronceexceedingexpectations,thanksinparttoabumpertouristseason.Thiswasdespitelosingaquarterofitseconomicoutputsince the start of the crisis, and with 27% of its workforce unemployed. InGermany, Samaras was being hailed as one of the saviours of the euro. Thisshouldhavebroughtcloserthepromiseddaywhentheeurozonewouldeaseitsburdenofdebt,forecasttoreach176%ofGDPattheendof2013.

But at the beginning of 2014, just as Greece took over the rotatingpresidencyof theEU, things started to sour again.Germany said itwouldnottalkofdealingwithGreece’sdebtuntilthesecondhalfoftheyear,thatis,untilaftertheEuropeanelection.ThedelaymighthelptheGermangovernmentstemtheriseofthenewanti-euroAlternativeforGermanyparty,butwouldmakeitharder for Samaras to resist the more dangerous charge of the radical leftistparty, Syriza, which was leading in opinion polls.Moreover, the negotiationswiththetroika,inparticulartheIMF,gotbadlystuck.

On the face of it, the argumentwith the troikawas aboutwhetherGreeceshouldcontinuethe longyearsoffiscalconsolidation.Greecehadashort-termproblem,with a small gap in its financing requirements in the second half of2014,andalonger-termproblemoverhowtoreachaprimarybudgetsurplusof4.5%ofGDPby2016,asforeseeninitstroikaprogramme.

Samaras, having survived thus far with an ever-shrinking parliamentarymajority, announced he could no longer take any across-the-board austeritymeasures.Henceforth,hisgovernmentsaid,thebuddingrecoveryshouldnotbestifled;Greecewouldsimplygrowitswaytothepromisedsurplus.ForveteransoftheIMF,stilldefensiveabouthavingbadlymisjudgedthefirstGreekbailout,optimisticgrowthforecastsdidnotamounttoacrediblepolicy.

Beneath the question of how much more belt-tightening Greece wouldrequirelaydeeperproblems.OnewaswhetherGreece’sdebtrelief,ifandwhenitwasagreed,shouldbe in the formofawrite-off in thenominalvalueof thedebt, or whether softening the terms of its already soft loans by extendingmaturities and reducing interest would be good enough. The IMF thought awrite-off would boost confidence among investors; the creditor countries saidthatwaspoliticallyunacceptable.So“extendandpretend”seemedlikelytowin.

AmoreworryingissuewasthatGreece,eventhoughithadlargelycompliedwiththedemandsoffiscalconsolidation,wasfarbehindinitspromisestoenact

structural reforms and privatise state assets. Some of these had an impact onfiscal matters. But the more important ones had to do with liberalising thecountry’sscleroticeconomytoreleaseitsgrowthpotential.

Greecehas sharplycut itsunit-labour costs, butmostlyby reducingwagesrather thanby raisingproductivity.Anddespite the fall in labour costs,Greekexportswerefallingoncethemurkytradeinfuelandvolatiletourismrevenueswerestrippedoutofthedata.Thiswasalarming.InSpain,PortugalandIrelandlowerlabourcostsboostedexports.SomeGreeksblamedalackofcredit.Othersnotedthatthecountry’smainexportmarket,theEU,hadbeeninrecession.Buttherealproblemwasaneconomythatproducedfewtradablegoods.Greecehadshotup theWorldBank’sranksfor theeaseofstartingfirms;but in thewidermeasure of ease of doing business, it ranked 72nd in the world, behindAzerbaijan, Kyrgyzstan, Belarus and Kazakhstan. All this was evidence of acountrystillinneedoffar-reachingstructuralreformifitwastosurvivewithahard currency, at a timewhen its political systemwas running out ofwill forfurther change. European countries were pushing the IMF to give Greece abreak,at leastaheadof theEuropeanelections.But thiswasaparticularlyoddrequest,giventheunwillingnessofcreditorcountriestohelpSamarasbygivinghimearlydebtrelief.

TheothercloudovertheeurozonewasthefutureofDraghi’s“whateverittakes” promise to intervene in bondmarkets through his policy ofOMT.Thelong-delayed judgment by Germany’s constitutional court was issued onFebruary 14th, and it turned out to be a scathing denunciation of OMT. Thecourt said it saw “important reasons to assume that it exceeds the EuropeanCentralBank’smonetary policymandate and thus infringes the powers of thememberstates,andthat itviolatestheprohibitionofmonetaryfinancingofthebudget”. The court refrained from telling German institutions to stopimplementingthepolicy,butreservedtherighttodosoafterreferringthecasetotheEuropeanCourtofJustice(ECJ).ThisboughtOMTatleastanotheryear,andtheECJmaywellsupporttheECB’scontentionthatthepolicyfallswithinits remit.Nevertheless, theKarlsruhecourthas introducedanoteofdoubt thatmayprovedangerousshouldthedebtcrisiseverreignite.

7Thechangingbalanceofpower

ASWELLASCONSTITUTINGTHEMOSTSERIOUSCHALLENGEtotheEuropeanprojectsince its inception, the euro crisis has had a huge impact on its political andeconomicbalance,ateverylevel.Amongcountries,ithashugelyincreasedtheinfluence of some, notably Germany, and decreased that of others, notablyFrance. It has fostered a growing north–south divide in the European Union,whichhastoanextentreplacedthepreviouseast–westone.Ithassharpenedthedivision between those countries that are in the euro and those that are not.AmongtheEUinstitutions,ithasstrengthenedtheroleoftheEuropeanCouncilattheexpenseoftheEuropeanCommissionandtheEuropeanParliament.Andalthoughithasledtodeeperintegrationofsorts,especiallyinfiscalpolicy,ithasalsoreducedthepoliticalweightofthecentralEUbodiesandincreasedthatofnationalgovernments.Manyifnotalloftheseshiftsinpowerwillendure.MostwillprofoundlyaffecttheworkingsofthewiderEUaswellastheeurozone.

Startwith the institutions.Throughout the history of theEuropean project,thebalanceofpoweramongthemandbetweenthemandnationalgovernmentshas altered, sometimes for structural reasons, sometimes as a reflection ofindividual personalities. In its early years the Commission was especiallyimportant: many new rules and directives were needed, there was no directlyelected parliament and European leaders did not yet meet in the EuropeanCouncil. Yet the French president, Charles de Gaulle, who mistrusted theCommissionandmuchpreferredinter-governmentalism,washugelyimportant.ItwasdeGaullewhoin1965precipitatedthe“emptychair”crisiswhenFrancerefused to accept a treaty-prescribed move towards majority voting in theCouncilofMinisters.AfteralongFrenchboycottofEUmeetings,theeventualoutcomewasthe1966Luxembourgcompromisewhich,atleastaccordingtotheFrenchinterpretation(nowsharedbytheBritish),preservesthenationalvetoifa

country invokes its “vital national interests” even in legislation meant to bedecidedbythesystemofqualified-majorityvotingenshrinedintheRometreatyandlaterstrengthenedintheSingleEuropeanAct.

The influence and power of later Commissions have fluctuated, but theinstitutionreacheditsapogeeunderthepresidencyofJacquesDelorsafter1984.Hewasadriving forcebehindboth the singlemarketand the singlecurrency;indeed,inthelate1980sheturnedintoahate-figureforBritishanti-Europeans(and forMargaret Thatcher) after he addressed the TradesUnionCongress in1988.Hewashugely important for theadoptionofEMU.Yethis influence inBrusselshaddiminished longbeforehesteppeddownfrom the job, somewhatdisillusioned, in1994.1Andneitherofhis first two successors asCommissionpresident, Jacques Santer and Romano Prodi, was able to re-establish theinstitution’spreviouspre-eminence.

When the Portuguese prime minister, José Manuel Barroso, took over asCommission president in 2004, he allied himself firmly with liberalisingcountries such as the UK, the Netherlands and, to a lesser extent, Germany(while not neglecting the interests of his own country). Under him theCommission has continued to play a crucial role in providing analysis,implementing the rules and drawing up legislative compromises, as well asprotecting the interests of smaller countries and of awiderEurope.But it hasproved hard to restore the Commission’s political clout at a time of risingscepticisminpublicviewsoftheEuropeanUnion.ManynationalgovernmentshavecometoseetheCommissionastookeenonpettyregulationandtooreadytoappease theEuropeanParliament,movingaway from its supposedlyneutralposition betweenParliament andCouncil – a perception that is likely to grownowthat,undertheLisbontreaty,theParliamenthasbeengiventheexplicitroleof“electing” theCommissionpresidentafterheor shehasbeennominatedbyheadsofgovernment.2

As the Commission’s political influence has waned, the Parliament’s haswaxed.Besides its new role in the choice of a new president, the co-decisionprocedure for almost all legislation under the Lisbon treaty has given it extrapowers. In its work on the new excessive-deficits procedure during the eurocrisis,theParliamentplayedapositiverole,especiallyoverthenewsix-andtwo-pack legislation, which its economic and monetary affairs committee under aBritishMEP,SharonBowles,helpedtoshape.YetnationalgovernmentsandEUleaders, even those traditionally keen to give theParliamentmore powers, arenowadaysincreasinglydisillusionedwithit.Thiswasespeciallyobviousduring

repeated rows over the EU budget and the multi-annual financial frameworkduring2013:theParliament’sinstinctivepushforevenmoreEUspendingthanthe Commission had asked for won it few friends among net contributorcountries. The growing presence of populist and extremist parties in theParliament,whilemakingitmorerepresentative,willnotimproveitsimagewithnationalgovernments.3

ThebiggestwinnerfromtheeurocrisisamongtheEUinstitutionshasbeenthe European Council of heads of state and government, because it bringstogether the 28national leaders.That is partly becauseHermanVanRompuy,thelittle-known,haiku-writingBelgianprimeministerwhowaspickedtobetheEuropean Council’s first permanent president (and was promptly accused byNigelFarage,leaderoftheUKIndependenceParty,ofhaving“allthecharismaofadampragandtheappearanceofalow-gradebankclerk”),hasinfactprovedan adept choice. As an economist from a euro-zone country, he was good atdiagnosingtheeuro’sills;hehasoftenpointedtothemadnessofnotwatchingmore carefully the rise in current-account deficits. From his background inBelgianpoliticshehasalsolearnttheartofpoliticalcompromise.HisabilitytospeakEnglish,FrenchandGerman,sharedalsowithJean-ClaudeJuncker,whochaired the Eurogroup, has been useful. The jobs of European Council andEurogroup summit president (which he added) have become more significantpartlybecauseofhowhehasdonethem.And,forthemostpart,hehasforgedagood working relationship with Barroso, with the Commission continuing toprovidemuchof the technical and legal support for theworkof theEuropeanCouncil.

Themainreason theEuropeanCouncil iswhere theactionnowhappens isthat the euro crisis has increased the clout of national governments. This islargelybecauseonlynationalgovernmentscancommand the resourcesneededtobailoutexcessivelyindebtedcountriesorbanks.Itisalsobecause,toraisethenecessarymoney,mostgovernmentshaveneededtosecuretheconsentoftheirnationalparliaments.Ineffect,theeurocrisishaslaidbareatendencythatcouldbedetectedlongbefore2009.Thisisthatnationalgovernmentsandtheirleaders(with an increasingly large role played by financeministers at the expense offoreignministers,formerlythemainactorsinBrussels)havebecomethedrivingforceoftheeurozoneand,byextension,oftheEUasawhole.

Broad political power is thus shifting from the supranational Europeaninstitutions and towards national governments thanks to the euro crisis.Yet atthe same timemanymore intrusive powers are being vested at the EU level,

because the euro zone has been forced to move in the direction of greaterpoliticalaswellaseconomicintegration.TheECBistakingonthesupervisionofmosteuro-zonebanks,forexample,anditwillalsogainthepowertorequirethemto increase theircapitalor, insomecases, toshut themdown.Aspartofthe European semester, the Commission is getting extensive new monitoringpowers, including the possibility of sanctions, over national budgets. TheParliamentisarrogatingtoitselfthejobofscrutinisingcontractsforreformthatarebeingdebatedandcouldyetbedrawnupbetweennationalgovernmentsandBrussels.WhatexplainstheparadoxicalcombinationofgreaterintrusivepowerswithintheeurozoneandthedeclininginfluenceoftheEUinstitutions?

Country-clubrulesTheansweristobefoundintheshiftingbalanceofpoweramongEUcountries,which isperhapswhere thegreatest impactof theeurocrisiscanbeseen.TheunderlyingfictionoftheEuropeanprojectfromthebeginningwasthatmembercountries were broadly equal. Most institutions worked on the basis of onerepresentative per country, although until the Nice treaty big countries wereentitled to two commissioners. Admittedly, qualified-majority voting in theCouncilgavemoreweighttobigthantosmallcountries,butthesystemwasstillbiasedtowardsthesmall–andthemostimportantdecisionswerealmostalwaystakenunanimously.SeatsintheParliamentdoreflectpopulationsize,buteventhere small countries have tended to be overrepresented (Malta hasproportionatelyfivetimesasmanyMEPsasGermany).

Yet despite all this, the notion of equality within the EU remains largelyfalse.Inpractice,twocountrieshavealwaysactedastheprincipalengineintheEuropeanmotor:FranceandGermany.Italy,theotherbigcountryintheoriginalsix,hasneverbeenabletomatchthecloutofthesetwo,partlybecauseformanyyears itspolitical system led to frequent electionsand innumerablechangesofprimeminister,andpartlybecause,aftera longperiodofcatch-upgrowth thatlasted into the1980s, its economicperformancehasbeen sodismal.AlthoughtheNetherlandshasoccasionallydissented,andhasalso in recentyears turnednoticeably more sceptical towards the European institutions, the Benelux triohavegenerallybeenwillingtogoalongwithFranco-Germanleadership.Ithasbeenhardforanynewcomers,includinglargishcountriessuchastheUK,SpainandPoland,tobreakin.

IntheearlyyearsoftheEuropeanproject,especiallyaftertheElyséetreatyof1963 thatcemented linksbetween the twocountries, itwasFrance thatsaw

itselfasintheleadpolitically,leavingthethenWestGermanytopaymostofthebills.Indeed,thiswasonereasontheFrenchwerereluctanttolettheUKjoinintheearly1960s:inthewordsoftheFrenchforeignministeratthetime,theydidnot want another cock on the dunghill. The EU institutions, includingcommissioners and their cabinets,were largely designed on French lines. TheCommission’s first secretary-general was French. The common agriculturalpolicy,thecommonfisheriespolicy,thecustomsunionandthebudgetwerealldrawn up in many ways to the benefit of the French at the expense of theGermans(and,sottovoce,oftheBritishwhentheywereeventuallyletintotheclubin1973).

BythentherelationshipacrosstheRhinehadbecomemoreoneofequals,as(West) German economic power asserted itself. The response of successiveFrench presidents and German chancellors was to forge still closer bilaterallinks, even though they often came from opposing political families: ValéryGiscardd’EstaingwithHelmutSchmidt,FrançoisMitterrandwithHelmutKohl,JacquesChiracwithGerhardSchröder.Itbecameunderstoodthat,ifFranceandGermanycouldagreeonsomething,so(mostof the time)could therest.Evenwhenthepersonalrelationshipwasscratchy,theinstitutionalbondbetweenthetwo countries was close. The UK’s attempts to insert itself into a possibletrilateral relationship usually failed: the prime minister who came closest topulling this off was Tony Blair, but his European credentials were tarnishedwhentheUKdeclinedtojointheeuro,andevenmoresowhenhelaterbackedGeorgeBush’swarinIraq,vehementlyopposedbyboththeFrenchandGermanleaders.

Bythistime,however,theFranco-Germanrelationshipwasbecomingmoreobviously lopsided. The turning point camewithGerman unification in 1990,whichmadeGermanysignificantlybiggerthanFrancebothinpopulationandineconomicweight.Thatwas indeedonereasonMitterrandpushedsohardforasingle European currency: he hoped that it would give France more say ineconomicandmonetarypolicy,whichwasincreasinglybeingdictatedforallEUmembersbytheGermanBundesbank.Butastheyearswentby,itbecameevermore obvious that the Franco-German relationship had become a mechanismthatwasdeployedtodisguiseGermanstrengthandFrenchweakness.

TherewasabriefrespiteatthestartoftheeurowhentheGermaneconomylooked particularly weak, partly because Germany had joined the euro at arelatively high parity. The Economist, echoing Hans-Werner Sinn, a Germaneconomist, calledGermany the sickman of Europe as recently as 2003.4 But

German industry responded to thechallengebydeterminedlycuttingcostsandholdingdownwages,whiletheSchrödergovernment’sAgenda2010reformsofthe labour market and welfare system increased the German economy’sflexibility. Rising demand from China for German-made machine tools andotherproductsalsoboostedGermanexports.Theresultwasthat,bythetimetheeuro crisis broke out openly in 2009–10, the gap in economic and financialstrength between the two leading countries in the euro had become gapinglywide.

Germany’smomentThispresentedabignewchallengetothenextincarnationofthedualleadership,after May 2007: Nicolas Sarkozy as French president and Angela Merkel asGermanchancellor.Truetoformanddespitebothcomingfromthecentre-right,their relationship got off to a rocky start, not least because they were polaropposites in style. Sarkozy is a nervy, hyperactive showman. Merkel was acautious, somewhat dour scientist. The two were known to find each otherunbearableeventhoughtheyhadtoworktogether–inEnglish,noless,becauseneitherspoketheother’slanguage.TheyquicklyclashedafterSarkozybecamepresidentwhenhefloatedplansforanew“MediterraneanUnion”thatappearedtobemeanttoexcludeGermany.Butitwastheglobalfinancialcrisisthatreallytestedthem.

At firstFranceseemed to farebetterduring thecrunch thanGermany (andindeedtheUK),withamuchsmallerlossofGDPin2008–09.5AlongwiththeBritishprimeminister,GordonBrown,SarkozyplayedabigroleinmeetingsoftheG8andG20thattriedtoco-ordinateaninternationalfiscalboosttostopthecrisisturninganinevitablerecessionintoadeep1930s-styledepression.Atonepoint, he even cheekily announced to the press that France was acting whileGermanywasmerelythinkingaboutit.Butwhentheeurocrisiseruptedin2010thestructuralweaknessandrelativelygreaterindebtednessofFrancecomparedwithGermanysoonbecameahugeproblem.

Likesomanyofhispredecessors,Sarkozy’sresponsewastotrytogetclosertoMerkel.HeplayedupFrance’sAAAratingasakeyassetunderpinning thesuccessiverescuefundsthathadtobedevisedforGreece,Ireland,PortugalandlaterSpainandCyprus.HeandMerkeljoinedforcestosuggestpolicychangessuchas,atDeauvilleinOctober2010,theinvoluntaryinvolvementoftheprivatesector infuturedebtrestructurings.HepushedGerman-inspiredfiscalausterity

anddidnotpresshardforanimmediateagreementtotheissuanceofEurobonds.Themarketsbegantotalkof“Merkozy”asthekeytandemseekingtosteertheeurozoneoutofitsdebtandgrowthcrises.Andthetwoleadersplayedacrucialrole in 2011 in engineering the departures of Silvio Berlusconi in Italy andGeorge Papandreou in Greece and their replacement by technocrat-ledgovernments.

Yet as the crisis dragged on, the pretence that France counted asmuch asGermanyworethin.Increasingly,itwasthechancellery,theBundestagandtheGermanconstitutionalcourtinKarlsruhe,aswellaspublicopinioninGermany,thatweredoing themost todetermine the shape and speedof the euro zone’svarious rescuepackages.Asother countries, especiallybutnotonly those thathad been bailed out, cut public spending, reduced budget deficits and pushedthroughstructuralreforms,anunchangedandunchangingFranceseemedtobeturning into part of theproblem rather thanpart of the solution.ToSarkozy’sembarrassment,FrancelostitsfirstAAAratinginearly2011.Andthen,inMay2012, he lost the presidential election to the Socialist candidate, FrançoisHollande.

Hollandewasastrongerpro-EuropeanthanSarkozy,aswellasbeingeasiertodealwithonapersonal level.AlthoughhecamefromtheoppositepoliticalcamptoMerkel,hewasontherightofhisSocialistParty.YetasthemanwholedthepartywhenitsplitoverthereferendumontheEU’sconstitutionaltreatyin2005,hewaswaryofanynewtreatychanges that theGermansmightseek.Moreover, beforehis electionhe spokeout strongly againstMerkel’s austeritypolicies and in favour of more growth; he wanted to see some form of debtmutualisation,whichwasanathematoMerkel;andduringthecampaignhesaidnexttonothingabouttheneedforstructuralreformsorpublic-spendingcutsathome,insteadproposingtaxincreases,includinganew75%toprateofincometax.6 After he came to power, far from seeking to reinvigorate the Franco-German axis, he tried to make common cause with the Italian and Spanishleadersinurgingmoregrowth-orientedpoliciesinplaceofexcessiveausterity.

The response fromGermanywas frigid in the extreme.After twoyears ofcrisis-fighting, the last thing Merkel wanted was to see a weakened Francedeserting the “northern” campof creditor countries likeGermany,Austria, theNetherlands and Finland and joining instead the “southern” camp of debtors,whoseinstinctiveanswertoanyproblemwastoborrowandspendmore.France,itwas noted darkly inGermany, had not balanced its budget since 1974.Onereason theGermansdecidedduring2012 that itwouldbe toodangerous to let

anycountry,evenGreece,leavetheeurowasbecausetheyfearedthatitmightleadtothecurrencyeventuallyunravellingallthewayuptotheRhine.

Inshort,Francehadnowbecome,inGermaneyes,partoftheproblemandnot of the solution. At a budget summit in February 2013 Hollande was sodistant fromtheGermanposition thatheevenfailed toshowupforabilateralmeeting with Merkel, something unheard of before. As one observer of EUsummitsnoted,everybodyalwaysstoppedtolistentoMerkel;nobodypaidanyattentionwhenHollandetookthefloor,insteadfiddlingwiththeirBlackBerriesandiPhones.ThemarginalisationofFranceisalsodentingpublicopinioninthatcountry, which is increasingly turning against both the euro and the EU. TheFrenchindustryminister,ArnaudMontebourg,hastakentoattackingtheEUforits “free-market fundamentalism”. Another striking example even among thepro-European elite was a 2013 book by François Heisbourg, from theFoundation forStrategicResearch, inwhichheargued that theeuroshouldbescrappedinordertopreservetheEuropeanUnion.7

Angelaalone

Ineffect,EuropeonceagainhaswhathistorianshavecalledaGermanproblem(withplentyofreasontohopethatthesolutionwillbemorepeacefulthaninthepast). The revival of a German problem is not at all comfortable forMerkel.Following the departure of Jean-Claude Juncker as prime minister ofLuxembourg in late 2013 and of Estonia’s Anders Ansip in 2014, she is thelongest-servingnationalleaderintheEU.WithFrancesoweakandHollandesoineffectual, she is also theunchallengedheadof thenorthern creditor camp inEurope.AndwithGermanunemploymentandyouthunemploymentbothat20-year lows,GDP back above pre-crisis levels, a budget close to balance and acontinuing huge current-account surplus, her country is the uncontestedeconomichegemonofEurope.FranceandItalyare,atbest,bystanders;atworst,largelyirrelevant.

YetGermany remainsa reluctanthegemon,not least forhistorical reasons.Its foreign and defence policies are inward-looking, commercially driven andinstinctivelypacifist,unliketheUK’sandFrance’s.MerkelmayenjoywieldingpowerinEurope,andbeingseenbytherestoftheworldasthecontinent’smostimportantleader,butneithershenorhercountryisentirelyhappybeingtreatedtooopenlyas such.Post-warGermanchancellorshave traditionally seenmoreEuropeastheanswertotheGermanproblem.ButtocriticsofMerkel,especially

duringtheeurocrisis,hercallformoreEuropehasoftenseemedlikeacallforamoreGermanEurope,aneffort to transformalleuro-zonecountries intomini-Germanys. The sensitivity this arouses was well demonstrated in November2011 when a public claim by Volker Kauder, chairman of the Bundestag’sforeign affairs committee, that “suddenly, Europe is speaking German” wasswiftlydisownedbymostofhiscolleagues.8

Germany, in short, remains highly attuned to outside criticism. It also hasmanyblindspotseconomically.ThisnotonlyembracesthecrudecaricaturesofMerkelwithamoustacheandtalkofanewThirdReichthatareseenandheardinGreeceandelsewhere.Italsoincludesmoreseriouscomplaintsfromthelikesof the IMFand theUSTreasury thatGermanyrelies toomuchonexportsandtoolittleondomesticconsumptionforgrowth;andthat,byrunningsuchalargecurrent-account surplus, determinedly holding down wages and failing togeneratesufficientinternaldemand,theGermanscontributedtotheproblemsoftheeurozoneinthefirstplace.

SuchclaimsarevigorouslyrejectedinGermany.EversincetheGreekcrisiserupted in late 2009, theGermans have seen two roots of the problem: fiscalprofligacyandalossofcompetitiveness.Onthisdiagnosis,thecureforthefirstispublic-spendingcutsand tax rises; for the second, it is structural reforms tolabour and product markets to reduce unit labour costs and restorecompetitiveness.GermanyhaslongkeptitspublicfinancesunderbettercontrolthanothersanditalsopushedthroughtheAgenda2010reformsin2003.Othereuro-zonecountriessimplyhavetocopythisexample.ThenotionthatGermanymight need to do more, for instance increasing wages or public spending, orboostingdomesticinvestment,isoftengreetedwithdisbelief.Germanbusiness,it is said in reply,must compete on a global stage; trying to rebalancewithinEurope by making it less competitive externally would be disastrous for theentirecontinent.ThatthecoalitionagreementinGermanymayhavethiseffect,byintroducingahighminimumwageandloweringtheretirementageforcertainworkers,reflectspoliticsratherthanpolicychoices.

AsMerkel has come increasingly to be the main or even only voice thatcountsintheeurocrisis,shehasalsobecomemoredubiousaboutthevalueofthe EU institutions. Admittedly, she has quietly sided with the ECB againstcriticisms from theBundesbank, evenwhen twoofhermost loyal lieutenants,AxelWeberandJürgenStark,resignedinprotest.Butshehasdraggedherfeetonbankingunion,andherresponsetocallsfromtheCommissionorfromotherEuropeancountriesfordebtmutualisationhasbeencold.Forher,keepinginline

with public opinion at home and satisfying both the Bundestag and theconstitutionalcourtinKarlsruhematterfarmorethananydreamyeuro-federalistvision.ShehasattimesbeencriticisedbysuchpredecessorsasHelmutKohlandHelmutSchmidtforthis.ThecurrentcoalitionagreementsuggestsanumberofchangestotheCommission,includingreducingitspropensitytoregulate.

Itmust be conceded that, at least forMerkel, this approach toEurope hasworkedwonders.Forallthebrickbatshurledather,especiallyfromabroad,forbeingtooslowtomove,tooeagertoimposeausterityontheMediterranean,toounwillingtoboostdemandathomeandtooleeryofexplainingtoGermanshowmuchtheywould lose if theeurowere tobreakup,shehasretainedenormouspopularityathome.Almostallothereuro-zonecountrieshaveseentheirleaderspushed out by voters as a result of the euro crisis.Merkel, however, took animpressive42%of thevote in thefederalelection inSeptember2013,andshehas since gone on to form a grand coalition with the Social Democrats thatclearly leaves her and her finance minister,Wolfgang Schäuble, in charge ofGermanpolicyontheeuro.Germanvoters,itseems,instinctivelytrustherbothtodotherightthingandtoprotecttheirinterests.

Mediterraneanangst,northernbravadoWorriesaboutFrenchweaknessandaboutbeinglonelyatthetophavepromptedtheGermanstolookaroundforotherpotentialpartnersintheEuropeanUnion.The UK is out, as it is seen as too semi-detached from the project. TheMediterraneancountriesarealsobroadlynogood.MostofthemhavereceivedhelpfromEuropeanbail-outfundsandarestillstrugglingtocomplywiththeirreform programmes and sort out their banks. Spain is likely to be the first tocomegoodbutstillfacessevereeconomicandpoliticaldifficulties.OnlyIrelandhas become theGermanposter-child for how a bailed-out country can changeitself.

ItalyistheperpetualunderperformerintheEU:abigeconomy,secondonlyto Germany in manufacturing, but seemingly incapable of reforming itself toregain lost competitiveness. Alone among euro-zone countries its income perhead is lower now than when the euro began in 1999. During his brieftechnocraticadministrationin2011–12,MarioMontipromisedtobeafirmallyofMerkel’s, andhe tried,withonlypartial success, topush through structuralreforms,includingtopensions.ButatEUmeetingshetendedtosidewiththosecriticising Germany for not doing enough to boost domestic demand and theECB for failing to act to lower interest rates in the periphery. Italy has

traditionally favoured ever-closer union in Europe, on the basis that manyItalians prefer rule fromBrussels to rule fromRome, but such an approach isnowoutoffavourinGermany.

MontiwasforcedtocallanelectioninFebruary2013inwhichhedidbadly.After complex bargaining, Enrico Letta, the young deputy leader of Italy’scentre-left Democratic Party, succeeded in putting together a broad coalitiontogetherwithBerlusconi’s People of Freedom (PdL) party and a scattering ofcentrists– the samebroadcoalition thathadbackedMonti.Thecountry cameoutofitsexcessivedeficitprocedureinJune,givingLettaapoliticalboost,butItaly’s politics remained as dysfunctional as ever. Letta found it no easier toenact reforms than didMonti. He survived an attempt byBerlusconi to bringdownthegovernmentinOctober,justbeforetheoldroguelosthisparliamentaryimmunity following conviction on charges of fraud. Berlusconi’s movebackfired; instead of bringing down the government, his own PdL party split,withafactionofmoderatesstickingwithLetta.ButLettathenfacedadeadlierchallenge from his own side. The turbo-charged former mayor of Florence,MatteoRenzi, took over the leadership of theDemocratic Party inDecember,andthenpushedLettaoutofpowerinFebruary2014.

LikeMonti,LettahadbeenpopularwithMerkelpartlybecausehewasnotBerlusconi andpartly becauseheunderstood the case for structural reforms athome. ButMerkel was never confident of seeingmuch in the way of radicalreform fromhisbaggy left-right coalition. It remains tobe seenwhat shewillmakeofRenzi.Thisyoungandenergeticnew leader isnowwidely seenbothinsideandoutsideItalyasthelastgreathopeofhiscountry’sreformers.ButhiscoalitionisnotmuchstrongerthanLetta’s,andheisvulnerabletothechargeofbeingyetanotherunelectedleaderimposedonItalianvoters.

That leaves thenortherngroup in theeurozone,mostofwhicharenaturalalliesofGermany.Austria,FinlandandLuxembourgare theonlyotherAAA-ratedcountriesthathelptosustaintheratingofeuro-zonerescuefunds.Butallaresmall.TheDutchandFinnsusuallysupportGermancallsforausterity.Yetthe Netherlands was downgraded in 2013 as the Dutch economy struggled toovercometheafter-effectsofahousingbust.Theeasternnewcomerstotheeuro,Slovakia,Slovenia,Estoniaand(fromJanuary2014)Latvia,aresmallcountriesas well, and Slovenia has hovered on the brink of needing a bail-out for itsindebtedbanks.However, thesetwogroupsgivepowerfulsupporttothebroadGerman narrative, which is that the cure for the euro crisis is to be found infiscal austerity and structural reform at home. TheBaltic countries, especially

Latvia,went throughalmost aswrenchinganadjustment in theearly2000sasGreece, andwithout provoking riots. They are among the strongest advocatesthat other heavily indebted countries should follow suit. Latvia’s is now thefastest-growingeconomyintheEU.

What theeurocrisishasclearlydone is tobreakwhatused tobe theEU’seast–westdivision.Mostofthecountriesthatjoinedin2004,andevenmoresoBulgaria andRomania,which joined in2007, remain significantlypoorer thantheothers,buttheyarecatchingupastheybenefitfromEUstructuralfunds.TheneweconomicandpoliticaldivisioninEuropeisincreasinglyanorth–southone.This is potentially troubling for the entire project. For its first 50 years until2007, italwaysfunctionedon thebasis that itwasbringingaboutconvergencebetweenmembercountries.Sincetheeurocrisishit, thepatternhasbeenmoreoneofdivergence.AndthatcouldeasilystirupstillmorepopularresentmentoftheEUinthesouth.

Germany is also looking to some non-euro countries as potential newpartners,especiallyPolandand,toalesserextent,Sweden.Indeed,werePolandtojointhesinglecurrency,itisnottoofancifultoseeitvyingwithFranceandtheUKasGermany’smainallies(Frenchsuspicionofeasternenlargementwasoften attributable to its worry about losing influence within the club toGermany).BilateralGerman–Polishrelationsarewarmerthantheyhavebeenin500years.MerkelrespectsDonaldTusk,thePolishprimeminister,somuchthatshe briefly toyed with putting him forward for the Commission presidency.RadekSikorski, theforeignminister,hasbeenwidelytoutedasacandidateforone of the top EU jobs, at least since his notable November 2011 speech inBerlinwhenheannouncedthathewas“probablythefirstPolishforeignministerinhistorytosaythis,buthereitis:IfearGermanpowerlessthanIambeginningtofearGermaninactivity”.9

TheincreasinginfluenceofPolanddoes,however,throwthespotlightontheremainingbigdivisionintheEU,besidesaneconomicnorth-southone.Thisisbetweenthe18euro-zoneinsandthetenouts.Astheeurozonepursuesdeeperpoliticalintegration,includingoffiscalpolicyandbankingregulation,andeventoys with setting up its own separate institutions, it is becoming increasinglyclear that the single currency is the most important subgroup in the broaderEuropeanclub.Thatraiseshugedangersforthemaintenanceofthewidersinglemarketat28,andespeciallyforthepositionofthemostrecalcitrantcountryofall:theUK.

8In,out,shakeitallabout

UNTIL EUROPEAN ECONOMIC AND MONETARY UNION (EMU) came along with theMaastrichttreaty,thegeneralassumptionwasthatallmembersoftheEuropeanclubwould participate in all its formations and policies. Naturally there wereexceptions: Irelandwas neutral, sowhen it joined in 1973 it became the onlymembernotinNATO;andtheUKandIrelandstayedoutofattemptstosetuppassport-free travel through theSchengen treaty.Some innerclubssuchas theBeneluxtrioalsoexisted.ButMaastrichtmarkedthefirstoccasionwhensomeEUcountries,inthiscasefirsttheUKandlaterDenmark,specificallyoptedoutofatreatyobligationtojoinamajorEuropeanproject,thesinglecurrency.AlsoinMaastricht, the UK opted out of the so-called social chapter of social andemployment legislation. Moreover, the treaty clearly envisaged that not allEuropean Union members would qualify for EMU. Thus was born a newconceptfortheEuropeanproject:thatmostwereinbutsomewouldstayoutofcertainprojects.

Thenewcomers to theEuropeanclub in1973,followedbyGreece in1981and,toalesserextent,SpainandPortugalin1986,hadlongbeenanirritanttothemoreferventEurophilesfromtheoriginalsix,especiallythosewhobelievedthattheywerecommittedtoapaththatwouldleadtoafederalUnitedStatesofEurope.Byjoiningthe thenEEC,allcountriesacceptedthegoalsetout in thepreamble to the Treaty of Rome, of an “ever closer union”. But, except forIreland and, later, Spain and Portugal, all of them were more or lessunenthusiasticaboutthisobjective.TheUKespeciallycametobeseen,notablyduring the years of Margaret Thatcher, as a backslider in Europe and anincreasingly Eurosceptic country. That became evenmore obvious during thepainfullyprotractedprocessofratificationoftheMaastrichttreatybytheBritishParliamentintheyearsoftheJohnMajorgovernmentbetween1992and1994.

Thisperception,combinedwiththesimplefactoftheEuropeanUnionthencomprising12ratherthansixmembers(soontobecome15,aftertheaccessionofAustria, Finland and Sweden in 1995), led some to ponder themerits of aEurope that would move at different speeds or even towards differentdestinations.Theideathatasmallgroupofcountriesmightgofasterthanothershadbeenfloatedasfarbackasthe1970sbyLeoTindemans,thenBelgianprimeminister, but without finding favour.1 In 1994 two leading German ChristianDemocrats,Wolfgang Schäuble (who became the German financeminister in2009)andKarlLamers,publishedapaper inwhichtheyrevivedthenotionbysuggestingthat,ratherthanalwaysbeingforcedtogoatthepaceoftheslowest,a“hardcore”ofcountriesmightmoveaheadwithdeeperintegration,lettingthebackmarkerscatchuplater(orperhapsnotatall).2

The concept was taken a stage further in the 1997 Amsterdam treaty.Denmark,IrelandandtheUKinsistedontherighttooptoutoffuturejusticeandhomeaffairs lawsif theywanted to.Andanewtreatyprovisionwasapprovedthat specifically provided for the possibility of “enhanced co-operation”,meaningthatasubsetofEUmemberscouldgoaheadwithstepstowardsgreaterintegrationwithouthaving towait forall toagree.By this time thenotionhadacquiredmanydifferent labels.Besideshardcores andenhancedco-operation,these included variable geometry, avant-garde, pioneer groups, flexibility,concentric circles,multi-speed, two-speed,multi-tier, two-tier. The exact labelused often depended on its user’s views: integrationists tended to preferlanguagethatimplieddifferentclassesorspeedsofEUmembership,whereastheBritish(andDanes)generallypreferredwordingthatsimplyconnotedvariationsinthetermsofacountry’smembership.

FormostareasofEUpolicy,havingsomecountriesinbutothersoutcanbeseen as a detail, perhaps a slight annoyance, but not otherwise a huge issue.There are few real concerns in Europe over the UK and Ireland insisting, asislands that lack compulsory identity cards, that they want to stay out of theSchengenpassport-freezone,whichanywayincludessuchnon-EUcountriesasNorway and Switzerland. Similarly, nobodyworriesmuch thatDenmark doesnotparticipateinmostEUmilitaryordefence-relatedactivities.TheAmsterdamprovisionsforenhancedco-operationthemselveshavebeenusedonlytwice,forameasureondivorceand for theEUpatent (which ItalyandSpain refused tojoinonlinguisticgrounds),withoutupsettingtheentiresystem.

EMUis,however,moreserious,mainlybecauseitsostronglyaffectsotherEuropean policies. Of course it was always going to be a clubwithin a club,

sincetheMaastrichtcriteriaweredesignedfromthestarttorestrictmembershipofthesinglecurrencytothosethatqualified.Greecefailedin1998,forexample,thoughastheCommissionsaidinitsopiniononthematteritarguablystillfailedmostofthecriteriawhenitjoinedin2001.Butsomecountriesthatcouldhavesigned up for stage three of EMU (adopting the single currency) deliberatelychose not to. TheUK andDenmark had treaty opt-outs.AlthoughTonyBlairseemedforatimehopefulofjoiningafterhebecameprimeministerin1997,hischancellorof theexchequer,GordonBrown,wasagainst.The“five tests” thatBrown devised for membership (on business cycles, flexibility, investment,financialservicesandgrowth)mayhavebeenmoresensiblethantheMaastrichtcriteria, but they also proved impossible to pass.Denmark put thematter to areferendum in September 2000, which returned a negative majority. Sweden,whichwaslegallyobligedtojoinbythetermsofitsaccessiontreaty,chosealsotoput the issue to itspeople,whovotedno inSeptember2003.Thus theeurobeganlifewiththree“voluntary”non-membersfromtheEU.

AllcountriesthataccedetotheEuropeanUnionarenowlegallyrequiredbytheir accession treaties also to join the euro (something that would apply,incidentally, to an independent Scotland). But they have to take the step onlywhentheyarereadyandwhentheymeettheMaastrichtcriteria.Inpractice,thishasmeantthatnocountrycanbeforcedintotheeuroifitchoosesnottoadoptit.Moreover,theprocesswasalwaysgoingtotakesometimeforthemainlycentralandeasternEuropeancountries that joined theEUin2004and2007.Sloveniawasthefirstnewentranttojointheeuro,in2007.IthassincebeenfollowedbyCyprus andMalta (2008), Slovakia (2009), Estonia (2011) andLatvia (2014).This means that 18 of the European Union’s 28 member countries are alsomembers of the euro, while ten remain, at least for now, outside the singlecurrency.3

Whenintrumpsout

This division into ins and outs is, of course, somewhat blurred and fluid.BecauseitshadowstheeuroandtheECBsoclosely,Denmarkalreadyfunctionsas if it is in, though itwouldneedanother referendumbefore itcouldactuallyjoin – and that seems unlikely for now.Butmost of the “outs” are, in effect,“pre-ins”. Lithuaniawill clearly follow the other twoBaltic republics into theeuroassoonasitcan,probablyin2015.Polandwilltakequitealotlonger,butits intention to joinatsomepoint isclear.Bulgaria,RomaniaandCroatiamay

well need a long period before they are deemed ready to take on the euro’sobligations. Of the recent entrants, only the Czech Republic and perhapsHungaryseemtobeunsure inprinciplewhether to join theeuro,putting themclosertothesamecampasSwedenandtheUK.

Whydoesanyofthismatter?Therearethreebroadanswers.Thefirstisthat,as theeurocrisishaspushed itsmembers towardsdeeper integration, so ithasinexorably started tomakemembership of the single currencymore importantthananyotheraspectoftheEuropeanUnion.Asnotedinpreviouschapters,inthefouryearsto2014thetaskofsavingtheeurohasbeenoverwhelminglythemainEuropeanbusiness forGermany’sAngelaMerkel, as forothereuro-zoneleaders.Similarly,thepressureonbailed-outcountriestocomplywithcreditors’demands for fiscal retrenchment and structural reforms has overwhelmed anyotherEUactionsandpolicies.Althoughthetwoareinpracticeoftenconflated,tocitizensofGreeceorPortugalitistheeuroandnottheEUthatisseentohavemadetheirlivesamisery.YetitistheEU,notthesinglecurrency,againstwhichtheytendtofulminatemostloudly(opinionpollsinmostcountriescontinuetofindmajoritiesforstayingintheeuro).

Second,institutionalandotherchangesadoptedbyandfortheeurocanhavea direct impact on the structure of the wider club, sometimes to the latter’sdisadvantage.Theemergenceof theEurogroup,whichwasfiercelyresistedbymost of the outs, especially the UK, has clearly reduced the significance ofEcoFin meetings of finance ministers, just as the outs predicted. Now eurosummitsthreatentodothesametoEuropeanCouncils,onereasonwhyDonaldTusk, thePolish primeminister, greeted their establishmentwith bitterwords,addressed toMerkel, “Arewe getting in your way?You are humiliating us.”Otherinstitutionalchangesoverrecentyears,includingthesetting-upoftheeurozone’svariousbail-out funds, the fiscalcompact treatyand thebankingunion,under which bank supervision for euro-zone countries ismoving to the ECB,willnot apply to several countriesnot in theeuro.Future ideascouldgoevenfurther: a euro-zone budget or insurance fund, or a separate euro-zoneCommissionandParliament,wouldclearlydowngradetheroleandsignificanceoftheirwiderEUequivalents.

Third,andrelatedtothis,theeuroandthepoliciesadoptedforitcanaffectpoliciesthattouchonallEUcountries,includingouts.Themostobviousriskisthatdecisions takenbytheeurozoneonissues like taxationcouldspill intoorevendamagethewidersinglemarket.UndertheprovisionsoftheLisbontreaty,from 2015 onwards the 18 euro-zone countries will constitute a “qualified

majority” in themselves.Thismeans that if theywere to formacaucusbeforemeetingsofthefull28-memberCouncilofMinisters,theycould,ineffect,takeadecisionthatwouldthenwilly-nillybeimposedontherest.Inrecognitionofthis,theUKinsistedthatintheEuropeanBankingAuthority,whichisbasedinLondon,decisionsshouldbetakenbya“doublemajority”systemthatprotectsthe position of outs by requiring measures to have majority support of bothgroups – though asmore outs join the euro, this systemwill losemuch of itspotencyanditwillstopworkingaltogetherwhenfewerthanfourcountriesareout.

A couple of considerationsmake these three pointsmoreworrying for thefuture.Thefirstisthatthereisasubtleideologicaldifferencebetweenthe18insand the ten outs. The first group has a slightly more protectionist, anti-freemarket bent, largely because it counts theMediterranean countries andFranceamongitsmost importantmembers.Bycontrast, theouts includealmostalloftheEU’smostliberalfreetraders,includingtheUK,DenmarkandSwedenfromoldermembersandPolandandtheCzechRepublicfromnewerones.Merkelforone is fully aware of this, which is why she has always remained keen topreserve single-market policy decisions for the full 28, not the narrower 18, agroupinwhichshehasfewernaturalallies.4Thesecondconsiderationisthatthedividebetweeninsandouts is likely topersist forsometime,andconceivablyforever.Whenanyof theoutshaveraisedconcernsaboutbeingdisadvantagedbytheirstatus,oneeasyresponsehasalwaysbeentopointtoasimplesolutiontotheirworries:theyshouldjointheeuro.Andindeed,asalreadynoted,manyof theoutsarepre-ins thatareplanning todo just that.But theeurocrisishasmadeseveralcountriesextremelynervousaboutplungingintoosoon.Ithasalsoledtheinstobemorecarefulaboutwhomtheyadmit–manynowbelievethatitwasamistaketoletinGreece,forexample.Someoftheouts,includingSwedenandDenmark,mustalsowinreferendumsbeforetheycanjoin.Aboveall,thereisoneout,indeedthebiggestofthemall,thatishighlyunlikelytojointheeurofortheforeseeablefuture,ifever:theUK.

ThosepeskyBrits

Itmayseemoddforabooklookingmainlyat thecausesandconsequencesofthe euro crisis to devote much space to a country that has no intention ofadoptingit.ButtheillsofthesinglecurrencyandhowtheyareresolvedcouldhaveaprofoundeffectontheUKdebateaboutwhethertostayintheclub.And

thatdebateinturnwillaffecttheeurozone,foritishardtoseeeitheritorthewider EU going ahead unaffected if a huffyUKwere to pick up its toys andwalkout,whichhasbecomeadistinctpossibility.

TheUKhasalwaysbeenthemostawkwardmemberoftheEuropeanclub.ThisgoesbackatleastasfarasChurchill’s1946Zurichspeech,whenhecalledforamorepoliticallyintegratedEuropebutmadeclearthattheUKwouldnotbepartofit,aswellastothedetachmentoftheBritishrepresentativeatthe1956Messinaconference.Itwasonlyin1961thattheBritishgovernmentdecideditshould get more involved, but by then France was led by de Gaulle, whoimplacably(if,perhaps,understandably,onthegroundsthattheUKhadintereststhatweremoreAtlanticist thancontinental) twicevetoedBritishentry– to thechagrinoftheotherfivemembers.

EvenafterEdwardHeathtriumphantlytooktheUKintotheEECin1973,itsreputationasareluctantmemberendured.HisLabouropponent,HaroldWilson,hadopposedtheentrytermsand,whenhewonelectionin1974,setaboutwhathe called a “renegotiation”, largely as a political gesturemeant to appease hisparty’s fiercest anti-marketeers (a tale thatmay sound familiar to observers oftheBritishConservativeParty40yearson).Heknewthathecouldnotpushtheidea too far,however, sohestoppedshortofcalling for further treatychangesand settled for mostly cosmetic measures that were enough to secure anoverwhelmingyesvoteforcontinuingmembershipinareferendumheldinJune1975.

ThisbynomeansendedBritishgrumpiness,however.Afteritlostthe1979election,theLabourPartymovedintoastronganti-Europeanposition.Undertheleadership ofMichael Foot from 1980, it campaigned for (and lost) the 1983election on a manifesto promising immediate withdrawal from the EEC. ButEuropeansdidnotfindthenominallypro-EuropeanTorygovernmentelectedin1979aneasypartner,either.MargaretThatcherbeganhertimeasprimeministerbydemandinghermoneybackfromtheEuropeanbudgetandendedit11yearslater by crying “no, no, no” to suggestions that the European project mightevolve towards a closer federal union, with the Commission acting as agovernment,theParliamentasalowerchamberandtheCouncilofMinistersasanupperhouse–anincidentthatcontributeddirectlytotherebellionwithinthepartywhichledtoherremovalfromoffice.

So it has been with the UK and the single currency, almost from itsbeginnings, and to an extent so it is today. From the original opt-out atMaastricht, which John Major, Thatcher’s successor, secured, until the

establishment of the euro in 1999, the British government and public haveremaineddeeplydubiousaboutboththewisdomofsettingitupanditsprospectsof survival. Indeed, in 1994Major himself expressed his scepticism about thechances of the single currency ever coming into being: writing in TheEconomist,hetalkedofthosewhocontinuedtorecitethemantraoffullEMUashaving“allthequaintnessofaraindanceandaboutthesamepotency”.5Whentheeurodulyarrived fiveyears later,manyBritonswere surprised–and theywereevenmoreastonishedwhenitsurviveditsfirsttenyears.

Against thisbackground, itwas tobeexpected thatmostBritishobservers,andevenmanyBritishpoliticians,reacteddifferentlyfromtherestofEuropetotheeruptionoftheeurocrisisin2009.Withastrongfeelingof“Itoldyouso”,manyappearedatfirsttowelcomethesinglecurrency’stravailsandtoforecastitsearlydemise.SincetheUKhadlongwarnedagainstthefollyoftheeuro,itchose – unlike, say, Poland andSweden – to distance itself frommost rescuepackagesforindividualcountries(savethatforIreland,withwhichtheUKhasobviousstrong links)aswellas tostandaside fromany institutionalor treaty-based response.That the euro crisis coincidedwith the arrival of anewTory-LiberalcoalitionledbyDavidCameroninMay2010madetheBritishpositioneven tougher, for since themid-1990s theConservativeshave takenover fromLabourasthemainstreampartythatmostlovestohateEurope.

Indeed,CameronhasbeenunderpressurefromhisEuroscepticbackbencherstodosomethingonEuropeeversincehebecameprimeminister.Asacandidatefor the party leadership in 2005, he had promised to pull out of theEuropeanPeople’sParty,themaintransnationalcentre-rightpoliticalgroup,anddidsoin2009, annoying Merkel in particular, as well as weakening both his and hiscountry’sinfluenceintheEU.HealsopromisedtoputthenewLisbontreatytoa referendum, but later abandoned that pledge because the treaty had beenratifiedby the timehe tookoffice. Insteadhepassed theEuropeanUnionAct,which requires that any further EU treaty that transfers significant powers toBrusselsmustbeapprovedbyanationalreferendum.

The Cameron government also took a different attitude from its Labourpredecessortowardseffortstoresolvetheeurocrisis.Althoughitstuckfirmlytotheprinciplethatitwas,essentially,noneoftheUK’sbusinessandthusnotfortheUKtojoininhelpingtosolve,itquicklygraspedthatameltdownoftheeurowouldbehighlydamagingtotheBritishaswellastotheEuropeaneconomies.So from quite an early stage Cameron and his chancellor of the exchequer,GeorgeOsborne,urgedtheeurozonetotakewhateverstepswerenecessaryto

resolve the crisis, including pushing for deeper political and fiscal integrationfromwhich theUKwouldstandaside.Thiswasabigchange fromtraditionalBritishpolicy,whichhadalwaysbeentoremainascloselyinvolvedaspossiblein all EU and euro-zone actions, often in the hope of slowing them down asmuchaspossible.

This was still, however, not enough for Cameron’s Euroscepticbackbenchers. Frightened also by the growing appeal of Nigel Farage’s UKIndependence Party (UKIP), which stood explicitly for withdrawal from theEuropean Union, they still craved some kind of confrontation. They weregranted their wish in December 2011 when the European Council wished toadoptthefiscalcompact,atreatycementingnewrulesonfiscalpolicyandalsorequiring national governments to insert “debt brakes” limiting budget deficitsintotheirconstitutions.CameroncametoBrusselsthreateningtovetothistreatyunless he was given assurances protecting the City of London from possiblefuturechangesinfinancialregulations.Yetwhenhetabledhissuggestions,theothergovernmentsignoredhisrequestandsimplyadoptedthefiscalcompactasan inter-governmental treaty outside the normal EU framework. Nor didCameron winmuch support in his refusal to sign up: ultimately 25 countriesratifiedthefiscalcompact, includingeightnon-euromembers, leavingonlytheUKandtheCzechRepublicasnon-signatories(althoughtheCzechsnowplantosigntoo).

Eventhatwasnot theendofCameron’sEuropeanadventures.He took thehardestpossiblelineonnegotiationsoverthe2014–20EUbudgetthatwentbythe unlovely name of the “multiannual financial framework”. Rather thanreopeningthequestionofwhat theEUbudgetwasforandwhetheritcouldbespentmoreefficaciously,agoal thatmighthavebeeneasier toachievehadhebeenwillingtogiveupsomeoftheUKrebate,hesethimselfthepublicgoalofsimplycuttingthebudgetinrealterms.WithsupportfromMerkel,heeventuallygothisway,butatthepricenotjustofpreservingfarmspendingbroadlyintactbutalsoannoyingboththeEuropeanParliamentandpotentialcentralEuropeanallieslikePoland.

The budgetwrangle did little to improve themood of Eurosceptics in theTory party. They still wanted some commitment to renegotiate the UK’smembershipandpromisevotersan in/out referendum.Cameronfendedoff thepressureforaslongashecould,buteventuallyhefeltthathehadtosetouthisplans.Inhisso-calledBloombergspeechinJanuary2013(giveninLondonafterrepeated failed efforts to find a suitable continental location), he called for

substantial reforms to the EU, including less regulation, a completion of thesinglemarket,amoregrowth-enhancingagendaandastreamlinedbureaucracy.HerejectedtheideathattheUKmightadopttheNorwegianorSwissoptionsofbeingoutsidetheEUbutsubjecttomostofitsrules.Hesuggestedabiggerrolefor national parliaments and some (unspecified) passing of powers back fromEuropean to national level. Although he carefully avoided specific Britishdemands,heannouncedtheestablishmentofanewauditofEUcompetencestoseewhetherandwherepolicyareashadstretchedtoomuch(thusfarithasfoundremarkably fewcases).Andheadded thatat thenextelectionhispartywouldcampaignforthesereformstobemadeby2017and,onthebasisofareformedEU,puttheissueoftheUK’scontinuingmembershiptoareferendum.6

Backtoinsandouts

ThisiswheretheUK’sargumentoveritsfutureimpingesbothonthefutureofthe euro and on the relationship between ins and outs.Cameronmay notwinenoughvotesin2015toformasingle-partygovernment,sohisthreattoholdareferendum in 2017may becomemoot.Both the othermain party leaders arerefusing to offer a referendum unless there is a substantial new treatytransferringpowers toBrussels, but pressureon them is likely togrow.Eitherway,questionsabouttheUK’scontinuingmembershiparelikelytopersist.YettheattentionofmostotherEuropeanleaderswillcontinuetobefocusedmoreonfixingtheeurocrisisthanonwhatsortofconcessionstokeeptheUKintheEUmightbeacceptable.

Most EU leaders, especially Merkel, would like to keep the UK in.Moreover,severalcountries,includingtheNetherlands,SwedenandDenmarkaswell as Germany, are sympathetic to much of Cameron’s agenda. There is ageneraldesire tocutbackexcessiveEUregulationandtorein in theEuropeanCommissionandEuropeanParliament.YetthereisalimittothechangesothercountriesmightbewillingtomaketokeeptheUKin,andcertainlynodesiretogiveitspecialopt-outsorotherarrangementsthatmightbenefitonecountryattheapparentexpenseofothers.Andthereisaconcernthat,whateverisofferedtotheUK,itsvotersmightchoosetoleavetheEUanyway,aneventualitythatsomewhatweakensBritishbargainingpowerinnegotiatinganewdeal.

Whatmightclinchthatoutcomeisanygrowthinfeelingthattheeuro-zoneinsaredeterminedtogoaheadwithintegrationistmeasures, includingpossiblyfurther changes applying to them alone, that ignore thewishes or interests of

non-eurocountries.Bynot joiningtheeuro, theBritishgovernmenthasshownitselftobecontenttobeintheoutercircleofaEuropeofconcentriccircles.Butthatdoesnotinevitablyhavetomeanbeingleftonthefringesofallpolicy-anddecision-making. In his first big speech on Europe in January 2014, Osborneexpressedhisownconcernsabout theoutsbeingdiscriminatedagainst,addingthat without reform, the UKmight face the choice between joining the euro,which it would never do, and leaving the EU. Perhaps ironically, given thisworry,healsosuggestedthatinsomecasesactionstodeepenthesinglemarketcouldbetakenbyusingenhancedco-operation.7

Iftheoutsaretofeelprotected,however,policiesinareasasdiverseasthesingle market, the environment, taxation, trade and transport should largelycontinuetobemadeat28,asmoreobviouslyshouldforeignandsecuritypolicy.IfMerkelandheralliesaccepttheideaofmakingpolicyinanyoftheseareasat18,theriskoftheUK’sexitfromthebroaderEUcanonlyincrease,asOsborneargued. The broader worries of the outs would increase as well. The French“Eiffel” group has proposed strengthening euro-zone institutions, making thisproblempotentiallyevenworse.All this suggests thatan importantpartof theagenda for euro-zone countries in the next few years should be a betterarrangementofrelationsbetweeninsandouts.

The fear of outs that in future policiesmay bemade by ins without theirhavingmuchorevenanysayechoesabroaderfearofvoters: thatincreasinglytheEuropeanUnion and the euro zone are decidingmatterswithout sufficientdemocraticcontrol.Astheeurozoneintegratesfurtherandmoreintrusively,itisrunning into a huge potential row about the legitimacy and democraticaccountabilityofitsactions.Indeed,itisthis,ratherthanthefinancialmarkets,thatcouldposeoneofthebiggestriskstotheEU’sfuture.

9Democracyanditsdiscontents

THENOTIONTHATTHERE ISADEMOCRATICDEFIGT inEurope isalmostasoldastheEuropeanprojectitself.Until1979,whenthefirstelectionstotheEuropeanParliamentwere held, none of theEuropean institutionswere directly elected,andthegapbetweenordinarycitizensanddecisionstakeninBrusselswasseento be a yawning one. National governments, which are elected, are of courserepresented in the Council ofMinisters, the senior legislative body. Butmosthavetendedtokeepquietabouttheirbargainingandfewareheldtoaccountforactions inBrusselsby theirownnationalparliaments.Moreover, the spreadofqualified-majority voting has meant that individual governments can now beforcedtoacceptpoliciesthattheyhavethemselvesopposed.1

Over time, various suggestions have beenmade for filling this democraticdeficit. Increasing thepowersof theEuropeanParliament isone thathasbeenpursued through almost every treaty. Greater transparency in both theCommission and the Council has long been another favourite. GreaterdemocraticinputintotheCouncilofMinistersthroughnationalparliamentshasoften been urged. So sometimes has the idea of somebody thatmore directlyinvolvesnationallegislatures.Andthereisincreasingrecoursetoreferendumstoapprove new treaties: no fewer than ten were promised for the abortiveconstitutional treaty, compared with just one for the Single European Act of1987.

None of these has proved satisfactory as a remedy for the deficit. TheEuropean Parliament has continued to disappoint even its most ardentsupporters. Transparency has been improved, but few ordinary citizensunderstand even the basics of how the EUworks; indeed,most have no ideawhat the difference is between theCommission and theCouncil ofMinisters.

Most national parliaments remain bad at holding ministers to account fordecisionsmadeinCouncilmeetings,andattemptstogetthemtoworktogetherhavelargelyfailed.Asforreferendums,almostasmanyhavebeenlostaswon,somostgovernmentsfeeldecidedlynervousaboutholdinganymore.

It is true that public scepticism about institutions has been as strong (orsometimesevenstronger)atnationalasatEuropeanlevel.Inmanycountries,thelossoffaithintheEuropeanParliament,forinstance,ismatchedbyasimilarorevengreaterlossofbeliefintheefficacyofthenationalparliament.Moreover,inmanycountriesduties thatoncedevolvedondirectlyelectedgovernments–monetary policy, exchange-rate policy or competition policy, say – have beenhandedtounelectedbodiesonthebasisthattheywillbedonebetter.Yetthereisstill a bigger cause for concern when something similar happens at Europeanlevel.Evenwhencitizensarefedupwiththeirowngovernmentorparliament,theydonotquestiontheirlegitimacyortheircontinuingexistence.ButwhenithappensatEuropeanlevel,whichseemsmoreforeign,manyqueryboth.

Following the national model, some commentators have accordinglysuggested as an alternative that theEuropeanUnion should rest on a differentideaaltogether:thatofoutputratherthaninputlegitimacy.Onthisbasis,thereisnorealneedtogethungupaboutdemocraticaccountabilityassuch.Rather,theEuropeanprojectcanbeexpected togainand retainpublic support–and thusendupacquiringgreaterlegitimacy–simplybydeliveringgoodresults.Ifvoterscan see that, thanks to theEU, their economies aremore successful than theywouldbewithoutit,theywillbecontent.Inthiscontextithelpswhenthereareconcrete results from EU actions to point to: lower airfares or mobile-phoneroamingcharges,say.

Yetthreerelateddevelopmentshavelargelykyboshedeventhisnotion.Themostobviousisthat,farfrombeingseentodeliverconsistentlygoodresults,theEuropeanUnionandespeciallytheeuroarenowseenbylargenumbersofvotersto be deliveringmostly bad ones.Acrossmuch of the continent, Europe (andespeciallythesinglecurrency)istodayassociatedwithausterity,spendingcuts,tax increases, rising joblessnessandchronically slowgrowth.Debtorcountrieshave seenaparticularly sharp fall in enthusiasm for theEuropeanproject as aresult(seeFigure9.1).Butevenincreditorcountries,whichhavesufferedlesseconomically,Europeandtheeurohavelosttheirappeal,becausetheyarenowassociatedwithbail-outsandtransfersratherthanwithrisingprosperity.

FIG9.1Disaffection

PositiveopinionsoftheEU,2003–13,%polled

*SpringsurveySource:Eurobarometerautumnsurveys

This new mood music has become especially discordant for Europhiles.TheirmessagesthattheEUwouldboostgrowththroughitssinglemarket, thatthe euro would improve competitiveness by promoting reform, and that bothgroupswouldprotectEuropeancitizens from thepressureofglobalisationandthefalloutfromtheworldfinancialcrisishavefallenflat.Instead,Euroscepticseverywhere feel vindicated: their view that there is toomuch regulation by aremote EU bureaucracy and their warnings about the insanity of adopting asingle currencywithout the right institutions, withoutmoves towards politicalunionandwithoutenoughdemocraticcontrol seem tohavebeenborneoutbyevents.

The second consequential development has been a sharp fall in thepopularityoftheEuropeanproject,rightacrossEurope.Pollstakenin2013byEurobarometer,theGermanMarshallFundandthePewGlobalAttitudessurveyhaveallcomeupwithsimilarfindings.2Especiallyinthesouth,butalsointhenorth, approval of the EU has declined fast in recent years. The number ofpeople who consider their country’s membership to be a good thing has alsofallen. The decline has been most precipitate in Mediterranean countries likeSpain and Greece. But it is also remarkable in France, where the latest PewsurveyfoundanevensmallerproportionofthepopulationapprovingoftheEUthaninthetraditionallyEuroscepticUK.

Thissharpdip in theEU’spopularity inopinionsurveys is reflected in theriseofpopulistpartiesthatareanti-euroandanti-EU.Someofthesepartiesare

fromthefarright,somefromthefarleft.Oftentheyareanti-freetradeandanti-globalisation. In many cases they are strongly against immigration, which isincreasinglyassociatedwiththeEUbecauseofitseastwardexpansiontotakeinnotjustthecentralEuropeancountriesbutalsoBulgariaandRomania,forwhichfree movement of labour arrived only in January 2014 (the British and someother governments are trying to curtail benefit entitlements for some specifiedgroupsofimmigrants).Anti-Islamfeelingsalsoplayarole.Buttheirnew-foundstrength owes most to the populists’ ability to channel growing anti-EUsentiment.

Thus Greece has seen the rise not just of Golden Dawn, an explicitlyextreme-right party, but alsoofSyriza, an anti-austerity left-wingparty that isrunningaheadof the rulingNewDemocracyparty inopinionpolls.SpainandPortugal have, so far, escaped the rise of populist parties of the right, but themoreextremeUnitedLeftpartyisdoingwell inSpainandsupportfor thetwomainstreamcentre-rightandcentre-leftpartieshascollapsed.ItalyhasseenthespectacularriseofBeppeGrillo’sFiveStarmovement,whichtookalmost25%ofthevote in theelectionofFebruary2013,forcingthecentre-leftandcentre-rightpartiesintoanuneasycoalition.InFrance,MarineLePen’sNationalFrontisrunningcloseto20%intheopinionpolls.

The rise of populists and extremists is not confined to troubled euro-zonecountries alone. InFinland, theTrueFinns (now theFinnsParty) underTimoSoini,whichcameoutofnowhere in2011, largely toprotestagainst theeuro,are scoring 20% or more in most opinion polls. In the Netherlands, GeertWilders’PartyofFreedom is also ridinghigh.Wildershas formedanalliancewithLePen for theEuropeanelections, campaigningonananti-EU,anti-europlatform.TheUKIndependencePartyhasrefusedtojointhisalliance,butittoohasbeenscoringhighlyinthepolls.AcrosscentralandeasternEuropeaswatheof extremist and populist parties, from Jobbik in Hungary to the League ofCatholicFamiliesinPoland,aresimilarlydoingwell.

Almosttheonlycountrynottohaveseenasharpupsurgeinapopulist,anti-eurooranti-EUpartyisGermany.ItisalsooneofthefewcountrieswherethenumberofpeoplewithafavourableopinionoftheEUhasnotfallensharplyinrecentyears.ResidualGermanwarguiltplaysapartinholdingdownextremistparties.Yetitis,onthefaceofit,surprisingthatanti-EUoranti-eurosentimenthasnotmadeitselffelt,astheGermanpublichasshownitselfdeeplyhostiletothe whole notion of bail-outs and transfers to Mediterranean countries.Moreover, a new party, Alternative for Germany, has been established and,

although it narrowly failed to get into the Bundestag in the September 2013election,itspollratingshavesincebeenrising.TherealreasonGermanylooksdifferent fromothercountriesmaybe that ithassuffered littleduring theeurocrisis.Besides,GermanvotershavecometotrustMerkelnottoletthemdown.

Thesearchforlegitimacy

Thethirdandperhapsmostdifficultchallengeisadirectresultoftheeurocrisisitself.Asdiscussedearlier,alargepartofthepolicyresponsehasbeentomovetowards deeper political integration in the euro zone. The fiscal compact, theEuropeansemester, the two-pack, thesix-packand the restaddup to farmoreintrusivemonitoringofnationalgovernments’fiscalandeconomicpolicies.TheCommissionnowhastheresponsibilitytovetand,ifneedbe,proposechangestonationalgovernments’budgetsevenbeforetheirparliamentshaveseenthem.Coming on top of the loss of monetary and exchange-rate policy due to theintroduction of the euro, the result is a significant transfer of power fromnationaltoEuropeanlevel.

It should not be a surprise that one consequence is a crisis of democraticaccountability. As a senior German finance ministry official put it to UlrikeGuérotandThomasKlauoftheEuropeanCouncilonForeignRelationsin2012,“theweaknessofthesystemisnotaboutspendingandhowtopromotegrowth,butaboutlegitimacy”.3SomeofthosewhopushedforasinglecurrencyatandbeforeMaastricht always thought itwould take closer political union for it towork satisfactorily – indeed, a few pressed for EMU precisely because theythoughtitwouldforcethecreationofaUnitedStatesofEurope.Butmostvotersandmost governments were not persuaded. Now a form of political union isindeed being brought in, not, however, as a positive result of careful nationaldebate and as a consequence of economic success, but rather as a negativeoutcome towardoffeconomic failure.Thatsurelywillmake itevenharder topersuadevoterstosupporttheentirenotionofpoliticalunion.

It does not help that in parts of Europe democracy is going throughsomethingofacrisisathome.Therearemanymanifestationsof this.Onewasthe fact that bothGreece and Italy had technocratic primeministers thrust onthemduring the euro crisis.Greeks have long been fed upwith their politicalleaders.InItaly,votershavebecomeincreasinglydisillusionedwiththeirentirepoliticalclass,oftenknownasLaCastaandwidelyreviledforitsexcessivecostandmanyprivileges.Yetneither countrywashappy tohaveunelected leaders

appointedinplaceofelectedones.Itwasthis,perhapsmorethanalostloveforEurope,thatledsomanyGreekstovoteforfringepartiesinMay2012andsomanyItalianstobackGrillo’sFiveStarmovementinFebruary2013.IneasternEurope,Bulgarianshavespentmostofthepasttwoyearsprotestinginthestreetsagainst theirgovernment.Romanians seemequally fedupwitha long-runningfeudbetweentheirpresidentandtheirprimeminister.

Hungary deserves a special mention here, as it has run into muchcondemnation in Brussels. Viktor Orban’s centre-right Fidesz party won asmashing electoral victory in 2010 after the outgoing Socialist governmentbecamediscredited.ButOrbanproceededtorewritetheconstitutioninwaysthatcemented Fidesz’s dominance overHungary’s institutions and its intimidatingcontrol of the country’s media. Although the EU has managed to get thegovernment to rewrite provisions impinging on central-bank and judicialindependence,ithasfounditsleverageoverthegovernmentworryinglylimited.Aswasdiscoveredas longagoas2000,when theEU tried to freeze relationswith an Austrian government that included the far-right Jörg Haider as acoalition partner, a country that is a full member is much less susceptible tooutsidepressurethananapplicant.Moreover,Orban’smembershipofthecentre-rightEuropeanPeople’sPartytransnationalgroupisoftensaidtohaverestrainedhis fellow heads of government from being too harsh on him. The result hasbeentodamagethecauseofliberaldemocracyinitsbroadestsense.4

Now the challenge from the euro crisis threatens to make matters worse.Indeed, in their first encounter with the European semester, several nationalleaders,eventhosenormallythoughtofaspro-European,wentoutoftheirwayto criticise the Commission for its intrusiveness. Spain’s Mariano Rajoyannounced in 2012 that it was for his government, not the Commission, todecidetherightleveloftheSpanishbudgetdeficit.InFrance,Hollandeearlyondeclared that, while the Commissionwaswithin its rights to demand pensionreform,hisgovernment shouldbe left todecidewhat sort of changes tomakeandhowquicklytomakethem.TheItaliangovernmentrejectedacriticismofitslonger-term debt sustainability. And when Belgium, the most pro-Europeancountry of all, was rebuked over its budget deficit, one Belgian governmentminister asked aloud: “Who is Olli Rehn?” (the economic-affairscommissioner).5

Yet it is too simple to see the problem as merely one of excessiveCommission interference inmattersbetter left toelectednationalgovernments.Thatwastosomeextenttruewhenitcametotheoperationofthestabilityand

growthpact.WhenGerhardSchröderandJacquesChiraccametogetherin2003to overturn any suggestion of Commission-imposed sanctions on their twocountriesforbreachingthetermsofthepact,theyweresimplyassertinggreaterlegitimacy for elected political leaders. Therewas little in theway of broadereconomicfallout.Indeed,thatispreciselywhytheircolleagues,withthepartialexceptionof the rule-lovingDutch,madeso little fussabout thedemiseof thepactatthetime.6

Buttheeurocrisishaschangedthiscompletely,bybringingintothepicturenationally sanctioned rescue funds. A bail-out of an excessively indebtedcountry has to be approved by national authorities, including nationalparliaments, because ultimately it must rest on the credit of sovereigns. AsbecameclearinMay2010,theEUbudgetistoosmallforthispurpose.Forsucha fund to attract its AAA rating, it requires guarantees from creditworthygovernments.And in national democracies, that needs the backing of nationalparliaments.ThisisonereasontheissueofdemocraticaccountabilityinEuropehas become so acute. When it is clear that something has to be decided atEuropeanlevel,theEUtreatieshaveasupranational,ifnotalwayssatisfactory,mechanismof accountability.Whendecisions arewholly national, similarly, anational system should work. But in the euro crisis decisions are, in effect,hybrid: they are taken at aEuropean level, but the fundsbeing committed areprovided nationally. In such cases issues of accountability and democraticcontrolcanalltooeasilyfallthroughthecracks.

Hence the experience of the Finnish parliament (Eduskunta), which hasrepeatedly demanded specific collateral for loans to Greece and others. AndhencealsothegrowingroleoftheGermanBundestagindemandingtherighttoapproveeverybail-outindividually.TheBundestag’sdemandforasayinbail-outs is strongly supported by another crucial German institution, theBundesverfassungsgericht, or constitutional court, based in Karlsruhe. Theconstitutional court has played a big role in the euro crisis, chiefly because anumberofplaintiffshaverepeatedlypetitionedittodeclarevariousdecisionstobeunconstitutionalbecausetheyinfringetheGermanbasiclaw–rangingfromthe first Greek bail-out to the establishment of the European StabilityMechanismto theECB’sprogrammeofoutrightmonetary transactions(OMT)to support sovereign-bond markets. So far the court has not ruled againstanything,butithasoftenhedgeditsverdictswithlanguagesuggestingthatthereare limits to how far the federal government in Berlin can go. In the case ofOMT, it made its disapproval clear but transferred the case to the European

Courtforaruling. Ithasalsomadeclear, includingin its rulingon theLisbontreaty, that it does not see the European Union’s democratic credentials assufficientlystrong.7

ManyEuro-enthusiastsarehorrifiedbothbytheKarlsruhecourtandbytheBundestag’s assertion of control over bail-out decisions. They see a creepingrenationalisationatwork,allofapiecewithMerkel’snew-foundenthusiasmforinter-governmentalismandthe“unionmethod”attheexpenseofthetraditionalcommunity method. Germany’s lack of enthusiasm for the EU institutions,notablytheCommissionbutalsotheEuropeanParliament,whichusedalwaystoattract strongGerman support, is to thempart of the samepattern.What suchenthusiasts tend to favour instead as a way to inject more democraticaccountability into EU-related decisions is to give a much greater role to theonlydirectlyelectedEUinstitution:theParliamentinStrasbourg.Yetthisrunsintohugeproblemsofitsown.

Strasbourgblues

TheParliamentiscertainlyreadyandeagertostepforward.Ithasalreadyplayeda constructive role in drawing up the necessary legislation for the Europeansemester. It wants to do more in the way of scrutiny of the Commission’sdecisions and of any contracts for reform that national governments mightaccept. Yet the notion that it can help to fill the gap in the euro zone’sdemocraticaccountabilityandinprovidinggreaterlegitimacyforthesystemtoordinaryvotersisfar-fetchedandmaybehighlydangerous,forfourreasons.

Thefirstisinstitutional.TheParliamentisquintessentiallyabodythatbringstogetherrepresentativesfromall28EUcountries.ItwasrelativelyeasyfortheCouncilofMinisterstoestablishasub-formationintheEurogroupandnowtheEurogroupsummit.Itisalsofairlysimpletoformatacitunderstandingthattheeconomicscommissioner aswell as theCommissionpresident should, like thepresidents of the ECB and of the European Council, come from a euro-zonecountry.ItismuchhardertodothesameintheParliament.Indeed,thechairoftheeconomicandmonetaryaffairscommitteeduringmostoftheeurocrisishasbeen Sharon Bowles, a British Liberal Democrat. Some have muttered aboutthis, and a few enthusiasts, including the French Eiffel group, have evensuggestedsettingupaseparateor“inner”euro-zoneparliament.Buttomostthiswouldexcessivelyinstitutionalisethealreadyworryingdividebetweeneuroinsandeuroouts.

AsecondobjectionisthattheParliamentitselflackslegitimacy.Ithasbeendirectlyelectedforthepast44years,yettheturnoutinsuccessiveelectionshassteadilyfallen.Europeanelectionseverywherearetreatedasessentiallynationalpolls, in which voters typically register protests against their governments orback populist parties. There is no sense among voters of any Europe-widepoliticalparties: fewhaveheardof themainpolitical groupsorhave anyclueaboutwhattheyactuallystandfor.TheresultsofEuropeanelectionsarenotseentotranslateinanywayintochangesofexecutivepowerwithintheEU;theydonot even determine the presidency of the Parliament, since this is dividedbetweenthetwobiggestgroupsforthetermofeachlegislature.Fewpeoplehaveany idea what the Parliament does or who their MEP is. In short, for mostordinaryEuropeans the Parliament seems to be part of the problemof remoteandlargelyunaccountableEUinstitutions,andnotpartofthesolution.

Variousremedieshavebeensuggestedfortheseills.Oneoldfavouriteistogive theParliamentmorepowers,whichhasbeendone somuch that formostpurposesithasbecomeaco-equallegislatorwiththeCouncilofMinisters.Theidea is that if theParliament is seen tobe exercising fuller powers in theEU,voterswilltakeitmoreseriously.AndindeedtheParliament,especiallythroughitscommittees,hasbecomeanimportantandattimesextremelyvaluablepartofthe legislative process, often improving directives and regulations moreeffectively than the Council. Many people cite the examples of the REACHchemicalsrulesandtheservicesdirective,whichwasinpartresurrectedbytheParliament,asexamples.

Yet evenEurophiles remain dissatisfiedwith theParliament.Abeliever indemocracy might expect the three biggest groups, the centre-right EuropeanPeople’s Party (EPP), the centre-left Progressive Alliance of Socialists andDemocrats (S&D) and the centrist Alliance of Liberals and Democrats forEurope (ALDE), to debate from their different political standpoints and voteaccordingly, as happens in national parliaments. But far more often the biggroups come together to make the Parliament more of a lobby or non-governmental organisation that sets itself up against the Commission and theCouncilofMinisters,ratherthanactinglikeanormallegislature.TheParliamentis fond of passing largelymeaningless foreign-policy resolutions.Unlikemostnationalparliaments, it alwayswantsbothmorepowers for itself andabiggerbudget–somethingfewofitsvoterswouldsupport.Thedividebetweenvotersand their MEPs was made starkly clear when the Dutch and Frenchoverwhelminglyrejected theconstitutional treaty,whichhadbeenapprovedby

almostalltheMEPsfromthosecountries.Another suggestion has been to give the Parliament a bigger and more

explicit role in choosing theCommission, especially its president. TheLisbontreatyprovides that theEuropeanCouncil, taking account of the results of theEuropean elections, should nominate a candidate,who is then “elected” by anabsolutemajorityoftheParliament.(TheParliamentisalsorequiredtoapprovetheentirecollegeofcommissioners,butnoteachindividual,thistimebysimplemajority.)MostofthepoliticalgroupshavetakenthislanguageasanexcusetoputforwardtheirpreferredcandidatefortheCommissionpresidencybeforetheEuropean elections. The S&D group, for instance, has proposed the currentpresidentoftheParliament,MartinSchulz;theALDEhasputforwarditsleader,GuyVerhofstadt;andtheEPPisproposingJean-ClaudeJuncker.Theideaisthatthisshouldmaketheelectionsmattermoretovoters,sincetheywill,ineffect,beindirectlychoosingthenextCommissionpresident.

Yetthissolutiontothedemocraticdeficitisunlikelytohelp.Mostordinarypeople remain profoundly ignorant both of the political groups that areproposingcandidatesandofthecandidatesthemselves: it ishardtoseeBritishLabourvoters,say,turningoutinlargenumbersbecausetheyareenthusedaboutthe prospect of Schulz as the Commission president. Worse, by making theCommissionmorebeholdentotheParliamentthanitalreadyis,theplanwouldupset the EU’s institutional structure. Unlike the Parliament, the Council ofMinisterscannotsacktheCommission;iftheParliamenthasthedecisivevoiceintheCommissionpresidency,thiswouldaggravatetheimbalance,makingitallthemorelikelythattheCommissionandParliamentwouldcometogethertoactagainstnationalgovernments.Andworstofall, theplanwouldsharply reducethe field of candidates to become president of theCommission: no incumbentgovernment leader would be ready to step down to campaign as part of theEuropeanelections.8

BesidestheEuropeanParliament’sownfailingsasaninstitutionthatcanfilltheEU’sandtheeurozone’sdemocraticdeficits,thereisathirdreasontodoubtthat it will be the answer. This is that an increasing number of populists andextremists are now represented in the Parliament.On one level, this could beseenaspositive:atleastthisstrandofopinion,oftenhostiletoboththeEUandtheeuro,willbefullyrepresentedintheEuropeaninstitutions.Butthepresenceofsuchadestructivegroupofoddballs,looniesandclosetracistsishardlylikelytoenhancethereputationoftheParliamentormakeiteasierforittoplayaroleinholdingtheEU’spolicymakerstoaccount.

Andthereisyetanother,fourthreason,whytheParliamentwillneverbetheanswertolegitimacyanddemocracyintheeurozone.Thisisthatdecisionsovereuro-zonebail-outs,therescueofEuropeanbanksorfiscaltransferstotroubledcountries will always involve national taxpayers’ money. The Bundestag’sinsistence on approving suchmeasures is not mainly a symptom of a suddenEuroscepticisminGermany.It issomethingfarsimpler: thenotion that,wherenationaltaxpayers’money(orcredit)isbeingused,theremustbesomenationalcontroloverwhat it isbeingused for–andalso somenational accountability.There isnoway inwhichaEuropean-levelbodycould supplyeitherof these,leastofallonewhoseraisond’êtreisalwaystoincreaseitspowersandtospendmore.

Backtonationaldemocracy

This points to another answer to Europe’s democratic deficit: greater nationalinvolvement.ThespreadofnationalreferendumsonEuropeanissues ispartofthis:besides the twohabitualpractitioners,DenmarkandIreland,severalothercountriesnowput substantial newEU treatiesor decisions such aswhether tojoin the euro to popular vote. France and Austria have, at various times,suggestedthatadecisiontoadmitTurkeytotheEUwouldhavetobeapprovedsimilarly (France put the issue of UK membership to a referendum in 1972,securing a large “yes” majority). Under its European Union Act, the UK isrequiredtoputanytreatyinvolvingasignificanttransferofpowertoBrusselstoa referendum. And David Cameron has promised that, if he is re-elected asprime minister in 2015, he will ask the British people to decide whether toremaininareformedEU.

Referendums are, however, always chancy affairs. So it is really nationalparliamentsthatarebestplacedtoimprovedemocraticinputandaccountabilityintheEUandtheeurozone.TheirroleintheEUmachineryhasbeenincreasedby successive treaties.Since theLisbon treaty, national parliaments havebeengiven specific powers to police “subsidiarity”, the provision that decisionsshould be taken at the lowest possible level. Under a yellow/orange-cardprocedure, national parliaments acting together can ask for Commissionproposalsforlegislationtobewithdrawn.ThetreatyalsorecognisesCOSAC,aco-ordinatingbodyofEuropeancommitteesfromnationalparliaments,mostofwhichmaintainofficesintheEuropeanParliamentbuildinginBrussels.ThereisincreasinginterestinthemoreeffectiveformsofnationalscrutinyofEuropean

legislation, with themost popularmodels beingDenmark and Finland, whereparliamentarycommitteesholdthegovernmenttoaccountfordecisionsittakesintheCouncilofMinisters.

Theeurocrisishasputrenewedemphasisontheroleofnationalparliaments.The Bundestag, the Eduskunta, the Dutch Tweede Kammer and others haveassertedadirectinterestinapprovinganydecisionsthatrelyontheirtaxpayers’credit or money. And the new powers of the Commission to scrutinise draftnationalbudgets, to issue recommendations tocountrieswithexcessivebudgetdeficits or with large current-account deficits (or surpluses) are inevitablyimpinging on national parliamentary authority over public spending andtaxation. For this reason it has become desirable, indeed essential, that theCommissionshouldengagewithnationalparliaments.Sofar,itsresponsetotheyellow-card procedure has been disappointing: only one proposal has beenwithdrawn, and the Commission disgracefully ignored a complaint from 18different parliamentary chambers about the legal basis for a European publicprosecutor.Butasthesystembedsdown,theCommissionshouldendupdoingmore at the behest of national parliaments, and it must be expected that thecommissioner for economic andmonetary affairs and his or her officials willhavetoappearbeforethemmoreoften.

Yeteventhismightnotbeenoughtolendgreaterdemocraticlegitimacytoafarmoreintrusivesystemofeconomiccontrol.Thatiswhyseveralanalystsandcommentators have at various times suggested much greater moves towardsfuller political union, with an elected Commission that includes a financeminister,oratleastanelectedpresidentoftheCommissionand,asanecessaryadjunct,asubstantialeuro-zonebudget.Nodoubt if theEuropeanprojectwereto take a leap into full political union, some kind of federal election wouldbecome necessary. But at least for the foreseeable future, neither Europeanvoters,nornationalgovernments,norEurope’spolitical leadersseemremotelyreadyforanysuchsteps.9

10Howtheeurospoiltanyotherbusiness

ITWOULDBEEASYTOFORMTHEIMPRESSIONthat,atleastsincelate2009,nothingmuch has happened in the European Union except for the euro crisis and itseconomicandfinancialrepercussions.YetthenormalbusinessoftheEuropeaninstitutions in such areas as competition policy, policing the single market,agriculture,transport,socialandemploymentregulation,andtradehasperforcecontinued. The budget has continued to be spent and, especially in thenegotiationsfor2014–20,quarrelledover.TheEuropeanCouncilhasalso,fromtimetotime,beensummonedtodiscussmattersotherthantheeconomyandtheeuro,evenifithasquicklyrevertedtothesemoremomentousissues.Therehasbeen less EU legislation than before, in part because governments have longmadeclearthattheywantedless.Evenso,overallitisundeniablethattheeurocrisishasspiltdamaginglyintomanyotherareasofEUactivity.

One example is climate change, an issue where the Europeans have for alongtimepridedthemselvesonbeingintheleadglobally.TheEUwasapioneernot just in signing theKyotoprotocoloncarbon-dioxideemissionsbutalso insettinguptheworld’sfirstemissions-tradingscheme(ETS).In2008itadopteda“20–20–20” strategy: setting 2020 as a target date bywhich all EUmembersundertook to cut greenhouse-gas emissions by 20%, to raise the share ofrenewablesinenergyconsumptionby20%andtoimproveenergyefficiencyby20%.Yet partly thanks to its economicwoes, the EU’s influence at the 2009Copenhagenenvironment summit, andagain at the2013Warsawenvironmentsummit,wasminimal.TheETShaslargelybeenafailure,astoomanypermitswereissuedandtoomanyindustriesexempted.Carbonpricesundertheschemehavedroppedtoolowtomakemuchdifference.

Popular enthusiasm for curbing climate change has faded, even though,thankstoitsrecession,theEUasawholewilljustabouthitthe20–20–20target.

In part the feeling has grown that there is little point in pursuing thiswithoutfurther action by the United States and China. But loss of interest in climatechange also reflects Europeans’ preoccupation with the euro crisis and risingjoblessness,creatingastrongdesirenottoharmcompetitivenesswithtoomany“green”taxes.Asitis,EuropeanindustriespayfourtimesasmuchforgasandtwiceasmuchforelectricityastheirAmericanrivals,whicharebenefitingfromcheapshalegas. In its January2014proposals fornewclimate-change targets,the Commission suggested only that all EU members should aim to cutgreenhouse-gas emissions by 40% by 2040; it dropped national targets forrenewables,proposingonly that theEUasawholeshouldpushitsshareupto27%onthesametimescale.1

Energypolicymorebroadlyhasalsosufferedfromneglect, inpartbecauseof the euro crisis. In 2009, shortly before it broke, the EU adopted a “thirdenergypackage”thatenvisagedamuchtougherapproachtoliberalisinggasandelectricitymarkets, includingseparatingproduction,transmissionandsupply(aprocessknownasunbundling).Variousregulationsanddirectivestoimplementthis package have since been adopted.And theCommission has also initiatedcompetitionproceedingsagainstGazprom,Russia’senergygiant.TheRussianshave been lobbying hard for changes to the third energy package. But partlybecauseEurope’seconomicwoesraisednewconcernsabouthighenergycosts,progresstowardsimplementingunbundlinghasbeenslowornon-existent.

A similar story couldbe told inmanyother areasofEUbusiness, rangingfrom transport to agricultural to industrial policy. Partly because the 28commissionersallwanttohavesomethingtodo,thereisnoshortageofpapersanddraftproposals for legislationon the table.But theenthusiasmwithwhichthey are pursued and the attention paid to themby national governments, andespeciallybyleadersintheEuropeanCouncil,hasofnecessitybeenlimitedbytheneed to focuson theirmorepressingconcerns for theeuro. Inmanycasesthis hasmattered only a little. Indeed, less regulation in unnecessary places isnowwidelyseenasadesirableandnotabadoutcome.But ina fewareas thelackofattentionfromthetophasbeenpositivelydamaging.

A prime example is efforts to strengthen and complete the single market.After the 2005 fiasco over the “Bolkestein” directive to open up servicesmarkets, named after the Dutch commissioner then in charge, which wasdemonised as a Frankenstein directive in the French referendum campaign onthe EU constitution and linked to a supposed influx of Polish plumbers, theeventual text was much watered down, leaving a single market in services

largelyincomplete.2Thedigitaleconomyisalsonotproperlycoveredbysingle-market rules: price-comparison websites remain fiercely national, as do mostconsumer-protectionlaws,taxes,electronic-wasterulesandpostalsystems.Theresult is that e-commerce,which hasmushroomed in theUnitedStates and inseveral individualEuropeancountries, isnotablyundevelopedacrossEuropeanborders.

Yetover thepastfewyearsmost talkofextendingthesinglemarket,oftenpromotedbyliberalcountriesliketheUKandSweden,hasbeendrownedoutbyfears associated with recession and rising unemployment. The fate of MarioMonti’s 2010 report, A New Strategy for the Single Market, is particularlyinstructive.3 The report was commissioned by José Manuel Barroso, theEuropean Commission president, long before Monti became Italian primeminister,whenhewas thought of as just another former commissioner. In thereport,Monti proposed furtherwork to complete the singlemarket in energy,digitalandservices,andalsosuggestedwaystobolsterthegreeneconomyandtoimprovefreemovementofpeopleandcapital(includingsomeelementsoftaxharmonisation).

Byacruelirony,however,thereportwaspublishedonthesamedayastheGreekbail-outwasagreed.TheEuropeanCouncilhadearlier in thesameyearproposed a new EU 2020 strategy to follow from the earlier Lisbon strategy,which was meant to create the world’s “most competitive and dynamicknowledge-basedeconomy”by2010.But,justastheLisbonstrategyhadneverreallybeenimplemented,partlybecauseneitherFrancenorGermanyseemedtobelieveinit,sotheEU2020strategyseemstohavebeenquietlyabandoned.TheEuropeanCouncildulyendorsed theMonti report,but littlemorewasdone topursueit.Montihimselfhasgonefurther:hehaswarnedthatbecauseoftheeurocrisis, repatriation of bank lending, different interest rates round Europe andrisingprotectionistpressures,thereisarealriskthatthesinglemarketcouldgothroughaperiodof“rollbackandevendisintegration”.4

Thepriceofinaction

OnecouldrunthroughalmostanyareaofEUbusinessinthepastfiveyearsandreach similar conclusions. Normal activity has continued and there have evenbeensomenoteworthypolicysuccesses,forexampleinreformingthecommonfisheries policy to end the practice of discarding catches. But time and again

work has stalled as commissioners, officials and nationalministers have beensidetracked into efforts to resolve the euro crisis. The single market remainsincomplete,partlybecausetheattentionofthecommissionerconcerned,MichelBarnier, has been focusedmainly on bank and financial regulation. Althoughalmost all governments have called for less as well as better regulation, theCommission’s sausage machine has continued to churn out unwanted rules.Tradepolicyhasbeenactive,withseveral free-tradedealsnegotiatedor in thepipeline.But the involvementofEU leadershasbeennoticeablemainlyby itsabsence.

The decision in 2013 to launch talks towards a Transatlantic Trade andInvestmentPartnership (TTIP)wasdriven in largepartby theEuropeans,whoweremainlyconcernednottoloseoutfromBarackObama’snewfocusonAsia.But theworry is thatconcernsaboutEurope’seconomies,highunemploymentand the futureof the single currencymaywell continue todivert political andmediaattentionawayfromtheimportantdetailsintheTTIP.Alltradetalksruninto trouble,with special interests sheltering such things as agriculture, audio-visualservices,rulesonpublicprocurement,andfoodandveterinarystandards.Already there are signs of emerging doubts about the TTIP’s chances on theEuropean side. On the American side, the US Congress has not even givenObama the trade promotion authority that he needs to pass a deal.TheWorldTradeOrganisation’sDoha round largely fell apart, withwhatwas eventuallyenacted being more of a mouse than an elephant – though that was mainlybecause of objections from emerging countries like India, not because of theEuropeans.ThereiseverychancethatthesamecouldhappenwiththeTTIP.

That would be a double missed opportunity, for as well as boostingeconomicgrowth,theTTIPcouldbethelastchancethatEuropeandtheUnitedStateswillgettosetstandardsandrulesforworldtradebeforeanewlypowerfulChina exerts its influence. And yet, even before the talks began, the Frenchmanaged to block any discussion of their notorious cultural exception, underwhichprotectionofaudio-visualproductssuchasfilmsisalloweddespitefree-traderules.Transatlanticdifferencesovertelecoms,internetandbankregulation,andover the rulesgoverningairlinesandshipping, remainwide.Phytosanitaryrulesontheuseofhormonesinmeatorforgeneticallymodifiedcropsarealsopotential stumbling blocks. With the euro continuing to divert everybody’sattention,EuropeanelectionsandthechoiceofanewCommissionapproaching,and Obama still denied fast-track authority by Congress, the chances of asuccessfuloutcometotheTTIPtalksdonotlookallthathigh.

AlastareawheretheEUhasmanagedlessthanitmighthavedoneoverthepastfiveyearsisjusticeandhomeaffairs(JHA).UndertheLisbontreaty,mostactivity in JHA has moved from being done inter-governmentally and byunanimity to being carried out by the communitymethod, and thus subject toqualified-majorityvotingandco-decisionwiththeEuropeanParliament.VivianeReding,thejusticecommissioner,hasproducedanumberofproposals,suchasarevised European arrest warrant, a European public prosecutor’s office, newextraditionarrangements,andcommon immigrationandasylumrules.Yet fewof these have made much progress, not only because the UK, Denmark andIrelandhaveopt-outs (and theUK isoptingoutenbloc fromall JHArules in2014),butalsobecauseofthegeneraldistractionoftheeurocrisis.5

The other reason JHA has proved disappointing is that immigration hassuddenly become such a toxic issue in many countries. The rise of populistparties has been driven in many cases by increasing voter hostility toimmigration, even within the EU. The belief that migrants from central andeasternEuropearetakingjobsorclaiminggenerouswelfarebenefitshasbecomewidespread.TheBritish,DutchandGermansarealltalkingofintroducingnewrules to stop “benefit tourism”. Opinion pollsters have found that by far thebiggestreasonBritishvotersgiveforbackingtheUKIndependencePartyisnotitsanti-EUpolicybutitsanti-immigrationone.

Somepoliticalleaders,includingtheUK’sDavidCameron,havequestionedthe principle of free movement of labour within the EU, on the grounds thatwhenitwasenshrinednobodyexpectedtheclubtoincludesuchrelativelylow-income countries as Romania and Bulgaria. Cameron has suggested that anyfuture enlargement to take innewcountriesmighthave tobeaccompaniedbypermanentcontrolsonfreemovementofpeople–anironygiventhattheUKhastraditionally been the strongest supporter of EU expansion to admit newmembers.TheSwissvote inFebruary2014toputquotasonimmigrationevenfromwithin theEUwasnot justabreachofSwitzerland’svariousagreementswiththeEUthatcouldthreatenthecountry’saccesstothesinglemarket;itwasalsoaharbingerofsimilarthinkingwithintheEUitself.

ACommissionofneglect

Theeurocrisishas,inshort,managedtodistractattentionfrommuchoftherestof the agenda of the Commission, national governments and the EuropeanParliament since 2009. Economic difficulties have inevitably sapped the

European Union of much of its broader influence in the world. And becauseEurope’spoliticalleadershavespentsomuchtimetryingtorepairthedefectsintheirsinglecurrency, theyhavedevotedmuch lessattention toconsidering thefuture shape and direction of the EU. As the immediate worry that the euromightcollapsedissipatesandwiththeprospectofanewCommissionandnewEuropeanParliamentjustahead,BrusselsisleftwithaEuropeanprojectthatisitselfinsomedangeroffallingapartduetopoliticalneglect.

Somehave suggested that agoodplace to start improving thingsmightbewiththeCommissionitself.IntheUKandmanynortherncountries,thenotionthat the Commission should be doing less but also doing it better is widelyshared: even Barroso has expressed a similar wish. The Dutch and Germanshavebeenespeciallyvociferousindemandinglessredtapeandbureaucracy,andmoreattentiontotheprincipleofsubsidiarity,whichprovidesthatactionshouldbetakenatEuropeanlevelonlyif it ismoreefficaciousthanactingatnationallevel. But even across southern Europe, the feeling that sometimes theCommissionandtheEuropeanParliamentaretoointrusivehasspread.

OnereasontheCommissionhastraditionallyfoundithardtorespondtocallsforittodolessisthattherearetoomanycommissioners.Thereisawidespreadconsensus that 28 is too big a number for the college. Not surprisingly, eachcommissioner wants to make his or her mark with legislation. Worse, partlybecausetheCommissiondoesnotactlikeagovernment,thereisnorealsystemforco-ordinatingandprioritisingitsactions.Instead,theCommissionoperatesina silo-like way, with individual directorates operating largely without muchreference to each other or to the president. The proposal in the constitutionaltreatyandthentheLisbontreatythatthereshouldbefewercommissionersthanonepercountrywasquietlyshelvedasagesturetosecureIrishapprovalofthetreaty the second time round.At least somegovernmentswould like to find awaytoreviveitsspirit,perhapsbycreatingseniorandjuniorcommissioners.

11Europe’splaceintheworld

THEEUROPEANUNION’SHOPES that theLisbon treatywould enable it toplay abiggerglobalpoliticalroletomatchitseconomicweightweredealtacruelblowby the onset of the euro crisis. That the Greek problem surfaced just as EUleaders were about to pick a new foreign-policy boss was especially galling.OverthepastfewyearsEUforeignpolicyhassufferednotjustbecausetheeurocrisishasbeenadistraction,butalsobecauseithaseatenawayattherespectthattherestoftheworldpreviouslyhadforaEuropethathadlongbeenconsideredaneconomicgiantbutapoliticalpygmy.

TheMaastricht treaty in1992,buildingonarrangementspreviouslyknownas European Political Co-operation, established a European Common ForeignandSecurityPolicy(CFSP)aswhatwasthencalledtheEU’s“secondpillar”,tobeoperatedinitiallyonanintergovernmentalbasis.Successivetreatiesexpandedthe scope and role of the CFSP, which was later brought under the normalcommunityrules,thoughalwayssubjecttounanimousnotmajorityvoting.The2009Lisbon treaty thencreated thepostofhigh representative for foreignandsecurity policy, to be in charge of a new European External Action Service(EEAS).This formaliseda job thatwaspreviouslyoccupiedbySpain’s JavierSolana, a former secretary-general of the North Atlantic Treaty Organisation(NATO).

Yet for all the aspirations of the treaties and despite the creation of newinstitutions,ithasalwaysbeenhardtosecuretheconsentofmembercountriestoagenuinecommon foreignpolicy.Themainproblemhasbeenwith the largermembers, notably the UK and France, which continue to see themselves ashavingaglobalroleoftheirown.Botharenuclearpowers,aswellaspermanentmembersoftheUNSecurityCouncil.TheUK,inparticular,hasoftenfrustratedhopesoftheEUplayingabiggersecurityordefencerole,forinstanceblocking

any suggestion of setting up an EU military headquarters. Although FranceunderSarkozyrejoinedNATO’smilitarystructureandhasembarkedondirectmilitaryco-operationwiththeUK,ittoohascontinuedtoaspiretoaglobalroleofitsown,especiallyinAfrica.

Butithasoftenbeenalmostasdifficulttofindunanimousagreementamongother countries. Even as Maastricht was being negotiated and ratified, forexample,theoutbreakofwarintheBalkansprovidedafirstbigtestthatEuropelargelyfailed.ItwastheGermanswhoinsistedin1991ontheearlyrecognitionofCroatia, followedby other ex-Yugoslavian states; and itwas JacquesPoos,the foreign minister of Luxembourg, who proclaimed this to be “the hour ofEurope”.1YetsubsequentlytheEuropeanscouldnotagreeonwhetherorwhento intervene in their ownbackyard, and it took theAmericans to knockheadstogether and secure the Dayton agreement in 1995 that stopped most of thefightinginBosnia.

Although in subsequent years there were more successful efforts to findconsensuswithin the EU on smaller foreign-policy issues, it has often provedimpossibleonlargerones.TherehavebeenbigdifferencesamongthelargerEUcountries on policy towards Russia, for instance, which the Russians underVladimirPutinhavegleefully exploited.And, as theBalkans showed,when itcomes towar, theEuropeans havemore often been divided than united.Mostobviously, the EU split over Iraq in 2003, with Germany and France joiningRussia in opposing the war, while the UK, Italy, Spain and several countriesfromeasternEuropesupportedit(thiswasthetimewhentheAmericandefencesecretary,DonaldRumsfeld,spokeoftherebeinganewandanoldEurope).Amore recentexampleofdivisioncameover the2011war inLibya,whichwasprosecutedvigorouslybytheUKandFrancebutopposedbyGermany.

Foreignpolicyblues

The EU’s aspirations to build a stronger andmore cohesive foreign policy toincreaseitsinfluenceintheworldwereneverlikelytobeallthatsuccessful.Butthey have taken a further knock because of the euro crisis.By an unfortunatecoincidence, the choice of the first new high representative came at the sametime. The bargaining over names for jobswas, as usual, a shambles,with theUK’s primeminister,GordonBrown, first trying to pushDavidMiliband, theforeignsecretary,intothejob.IntheendMilibandrejecteditandthepostwentinstead to the little-known Catherine Ashton, a former trade commissioner

whosepreviouspublic-policylifewaslimitedtorunningahealthauthorityandserving in the UK’s House of Lords, and who had limited knowledge of orexperienceinforeignaffairs.

Predictably, the establishment of the new EEAS and the experiment withAshton as a more powerful EU high representative have both beendisappointing.Apart fromher own limitations, the job has become almost toobig for one person to do.Aswell as being high representative, she is a vice-presidentoftheCommission,shechairstheForeignAffairsCouncilandsheisaguardianofBritish interests inBrussels.Shewasnotgivenanydeputies,eventhough theexigenciesof the joboften requireher tobe in twoplacesatonce.Everything has taken longer than expected and Ashton has continued to beovershadowed not just by national foreignministers but also by JoséManuelBarroso,presidentoftheEuropeanCommission,andHermanVanRompuy,thefirstpermanentpresidentof theEuropeanCouncil.TheCFSPwassupposedtosharpen the way the EU represented itself in the world, but the results havefrequentlyseemedtodo theopposite:bothpresidentsaswellasAshtonattendbilateralsummitswiththeAmericans,RussiansandChinese,forexample.AndtheEUhascontinuedtofieldtoomanyassortedleadersatG8andG20summitmeetings.

Even so, over the past year,Ashton has recorded some notable successes.These include a groundbreaking deal between Serbia and Kosovo that hasenabledthefirsttoopenmembershipnegotiationsandthesecondtobegivenamembershipperspective,aheadofBosnia.AshtonhasalsobeenakeymemberoftheteamnegotiatingatentativenucleardealwithIran,whichwasinpartherown personal achievement. She has become an indispensable partner ofsuccessive American secretaries of state, first Hillary Clinton and later JohnKerry, with whom she has far more contact than most European foreignministers ever do. She was the only diplomatic leader to meet the deposedEgyptian president, Muhammad Morsi, after his imprisonment. And she hasplayedaleadingroleinnegotiationstoendthewarinSyria.Yetdespitealltheseachievements, the overall record of the EU in foreign policy has not been astrongone– andpart of the reason for this hasbeen theEU’spoor economicperformanceand thedistractionof theeurocrisis,whichhasreducedEurope’soverallinfluence.2

A further consequence of that crisis has been that defence budgets acrossEurope, already strained, have been further cut. In 2009 a European CouncilsummitagreedtostepupEurope’smilitaryambitions,withsometalkofbeing

abletodeploy60,000troopswithin60days.Butfiveyearsonlittlehascomeofthis.TheEU ismeant tohave two1,500-strongbattlegroupsavailableat shortnotice,butnonehaseverbeenused.Overall,EUcountriesspendlessthan1.5%ofGDPondefence,farbelowboththeagreedNATOtargetof2%andthe4%-plus spent by the United States. Defence spending has shrunk as a share ofpublicspending.Andthemoneyisnotspentaseffectivelyas itcouldbewerethere to be more collaboration across borders.3 Successive American defencesecretaries have continued to voice frustration as Europe has become in theireyesmoreofaconsumerthanaproviderofsecurity,agrowingproblemastheAmericanspivottheirattentiontowardsAsia.

The experiencewith the onset of theArab spring in January 2011, whichcoincidedwith one of theworstmoments of the euro crisis,was illuminating.The Europeans, like the Americans, were taken by surprise by the suddenupsurge of people power, first in Tunisia and then in Egypt. The subsequentdecisiontointerveneinLibyatostopapossiblemassacreinBenghazibytroopsloyal toMuammarQaddafiwas takenby theBritish andFrenchgovernments,with theGermansagainst (indeed,Germanychose toabstain in thevote in theUNSecurityCouncil,ofwhichitwasatemporarymember).Butafteronlyafewdays the two biggest European military powers were forced to call for moreAmericanhelp,includingtheprovisionofdrones,air-to-airrefuellingandstocksof smart bombs.4 Later, EUmembers were divided over whether and how tointerveneinSyria,withtheUKandFranceshowingmostinterestinarmingtherebelsagainsttheAssadregime,butGermanyandothersbeingbroadlyagainst(though the August 2013 vote of the UK House of Commons againstinterventioninSyriahascurbedBritishenthusiasmforanymilitaryadventures).

Ineconomicterms,theEUhasalsoshownitselfunablealwaystoworkoutthemost sensible response to theArab spring.Grand talk by theCommissionand the EEAS of the threeMs –money,markets andmigration – has all toooftenrunintothesand.Partlybecauseoftheeurocrisis,therewasnevermuchonoffer to supportapolicy thatbecameknownas“more formore”: themoreArab countries democratised, themore the EUwould help them.Money wasshort.Fullermarketaccess,particularlyforagriculturalproducts,hasalsobeennotable largely by its absence: three years after the Arab spring began, onlyMoroccohasevenbegunnegotiationsonadeepfree-tradedealwiththeEU.

Asformigration,hostilitytowardsithasgrownastheeurocrisishasledtorising unemployment, especially in the southernMediterranean countries. Farfromprovidingmore routes to legalmigration, evermore resourceshavebeen

poured into tightening controls on illegal immigration. Leaky boats carryingwould-be immigrants continue to sink in theMediterranean around the ItalianislandofLampedusa,oneof thenearestpartsof theEU tonorthAfrica.Overmigration,indeed,theEUnowstandstowardsnorthAfricaratherastheUnitedStates stands towards Mexico – and a part of the reason for this is the direeconomicconsequencesoftheeurocrisisintermsofjobsandgrowthathome.

Easternquestions

The EU’s relationship with countries to its east has also become moreproblematic in the past few years. One reason for this is that the traditionalpolicyofenlargementtoadmitnewcountrieshasrunintotrouble.Enlargementhas often been described as the EU’s most successful foreign policy. In the1980s,takingincountrieslikeGreece,SpainandPortugalwashugelyimportantinsecuringtheirtransitionfrommilitarydictatorshiptodemocraticgovernment.EvenmorespectacularwastheprocessafterthecollapseoftheSovietUnionoflettingmostofthecentralandeasternEuropeancountriesthathadformerlybeenunderitsswayintotheEuropeanclub.Thetransitionofthesecountriestofree-marketeconomiesandliberaldemocracywouldhavebeenfarmessierandmightnothavehappenedinallcaseshaditnotbeenforthepowerfullureofeventualEUmembership.The contrast betweenEurope’s successwith transforming itseasternneighboursandtheUnitedStates’failurewithitssouthernneighboursistelling.

Since theadmissionofBulgariaandRomania in2007,however, theentirepolicyofenlargementhasbeenundersomethreat.PartoftheproblemhasbeenagrowingdisillusionmentwithpastexpansionsoftheEU.It iswidelythoughtthatRomania andBulgariawere taken in asmembers before theywere reallyready; some of their present difficulties with a corrupt judiciary and politicalclasscouldhavebeenpredictedinadvance.Equally,Cypruswasallowedtojoinin2004eventhoughtheisland’sdivisionbetweenaGreek-CypriotsouthandaTurkish-Cypriotnorthremainedunsolved.BoththecontinuingCyprusproblemandHungary’sprecariousdemocracyhaveremindedtheEUthattheleverageithasoveritsmembersisfarlesspotentthanitsleverageoverapplicants.Andformuch of public opinion in Europe, enlargement has become fatally linked tonewlyunpopularimmigration,especiallyfromBulgariaandRomaniafollowingthe lifting of remaining controls on free movement of labour on January 1st2014.

Despite all this, the Commission argues forcefully that the enlargementprocess is continuing.Croatiawas admitted as the EU’s 28thmember in July2013,andmembershiptalkscontinuewithTurkeyandMontenegro(thoughtalkswith Iceland have been suspended). It is clear that the other western BalkancountrieswilleventuallyjointheEU,ifonlybecausetheyhavenowhereelsetogo. Indeed, it is only this prospect that has secured peace and stability in theregion.Without the lure of EUmembership, it would undoubtedly have beenimpossible to broker the 2013 deal between Serbia and its breakaway formerprovinceofKosovo.Yet the reality is that theeurocrisis, thebroadermalaiseacross the EU and increasing public hostility to unlimited immigration havecombinedtocastapalloverfutureenlargement.5

WholostTurkey…andUkraine?ThisisseenmostclearlyinrelationtotheEU’stwobiggesteasternneighbours,Turkey and Ukraine. After years of prevarication, including a negativeCommission opinion on itsmembership application in 1987, it was seen as atriumph forboth sideswhenat long lastTurkey’s applicationwas accepted in2004andmembershipnegotiationswereformallyopenedinOctober2005.TheTurkish government, led by Recep Tayyip Erdogan, was eagerly pushingthroughbigeconomic,socialandpoliticalreformstopreparethecountryforEUmembership. Although substantial opposition persisted, especially in France,Germany and Austria, and although a disunited Cyprus remained a largeobstacle, therewasagenuineoptimismthat,maybeafteranotherdecadeorso,TurkeymightactuallyjointheEuropeanclub.

Yet eight years on fewpeople evenpretend that the talkswithTurkey aregoinganywhere.Halfofthe33chaptersofthenegotiationsremainfrozen,eitherby Cyprus, or by France or by the EU as a whole, because Turkey has notimplemented theAnkara protocol requiring it to open its ports and airports toGreek-Cypriotvessels.Onlyonechapterhasbeenclosed;and, in thepast twoyears, only one has been opened. Several EU countries havemade clear that,partly in response to their current economic difficulties, they are much lesspreparedtotakethegambleoflettingTurkeyin.Europeanleaders,distractedbytheeurocrisis,havebarelyengagedwiththeissueoftheirrelationswithTurkey,whichhavesouredspectacularly.Understandably,manyTurksseemtohavelostinterestinanEUthattheybelievehasrejectedthem,perhapsoutofanti-Muslimprejudice. And the EU has in turn lost much of the old leverage it had to

encourage further reform in Turkey, which has drifted under Erdogan in anauthoritariandirection,especiallysincetheGeziParkprotestsofJune2013andthe corruption scandal that broke in December 2013. Erdogan’s attempt torekindlethemembershiptalksbyvisitingBrusselsandBerlininearly2014andhelping to revive talksonaCyprus settlementhavenotdoneenough to repairTurkey’s damaged image inEurope.Recent stories of corruption in the rulingparty, and the country’s growing economic difficulties, are creating renewedworriesaboutTurkey’ssuitabilityasanEUaspirant.6

A similarly sad story can be told for the six countries of theEU’s easternpartnership: Armenia, Azerbaijan, Belarus, Georgia, Moldova and Ukraine.After the Rose and Orange revolutions in Georgia and Ukraine, followed byRussia’swarwithGeorgiain2008,itlookedasif,despitetheRussianblockageonfurtherexpandingNATO,theCommissionwouldatleastbeabletoholdouta long-term prospect of EU membership to these countries. Yet once againEuropeanleaderstooktheireyesofftheball,partlybecauseofthedistractionoftheeurocrisis.AttheVilniussummitinNovember2013,severalcountries,thebiggest and most important of which was Ukraine, were meant to signassociationagreementswiththeEUthatcould,eventually,havebecomeabasisforpossiblemembership.Instead,RussianpressureonUkraineandsomeothercountries to lean eastward paid off. Only the relatively small Georgia andMoldovawerepersuadedtosticktotheirEuropeanambitions.

The sight of thousandsof protesters on the streets and squaresof a snowyKiev, allwavingEU flags to show their displeasurewith thedecisionof theirthuggishpresident,ViktorYanukovych,torejecttheEUassociationagreementin favourofcloser linkswithRussia,was inspiringbutalsodepressing. Itwasinspiring,becauseitshowedhowstrongtheappealoftieswiththeEUstillistocountries from the formerSovietblock.But itwasalsodepressingbecause, atleast inpartduetotheirowneconomicandpoliticalproblems,EUleadershadpaidtoolittleattentiontotheadmittedlydispiritinginternalpoliticsofUkraine,allowingRussiaquietlyand insidiously to regain influence.Russia’spresident,VladimirPutin,wasable toderailUkrainianplans tomovetowardsEuropebythesimpleexpedientofofferingano-strings-attachedloanandasharpcutinthegasprice,whichtheEUsimplycouldnotmatch.7

ThatUkraine subsequently grabbed thewholeworld’s attention, especiallyduring the 2014 Sochi winter Olympics, was more to do with its owndysfunctional politics and the bravery of its protesters thanwith the EU. TheAmericanswokeuptothesituation,andespeciallytotheinterferenceofPutin,

earlierthantheEuropeans;atruththatbecamestarkerwhenaleakedrecording,presumably made by Russian security services, showed Victoria Nuland, theassistantsecretaryforEuropeintheStateDepartment,sayingtoherambassadorinKiev:“FucktheEU.”Whenafewdays laterYanukovych’sgoonsbegantokillpeopleinKievandelsewhere,mattersrapidlyspunoutofhiscontrol.Soonenough he had been chased out of the capital and a new government wasinstalled that may yet turn back towards the EU. But determined not to loseUkraine, Putin promptly launched an invasion ofCrimea. Inmid-March 2014Crimea,underthegazeofoccupyingRussiantroops,declareditsindependencefromUkraineandaskedtojointheRussianFederationinstead.TheEUandtheUnited States responded with a visa freeze and other sanctions on namedindividuals,asRussianforcesgatheredthreateninglyontheborderwitheasternUkraine.Theeventualoutcome inUkraine remainshighlyuncertain.Butwhatseemsclear is that theEU(and theWest)drifted into itsbiggestconfrontationwithRussiasincethecoldwarinpartasanaccidentalby-productofitseasternneighbourhoodpolicy,whichdistractedpolitical leadershad left largely in thehandsofCommissionofficials.

The EU’s hopes of playing a bigger role in the world and in itsneighbourhoodwerealwaysgoingtobehardtorealise.Adecliningshareoftheworld’spopulationandGDP, the riseofcountries likeBrazil,ChinaandIndiaandadiminishingappetite formilitary interventionhave inevitably taken theirtoll.Yet theEU is still theworld’sbiggest economyand single tradingblock.Had the crisis not sapped its economic power and its political will, it surelywould have been able to exert a bigger foreign-policy influence than it hasmanagedoverthepastfiveyears,especiallyinitsownneighbourhood.Inshort,thebalefuleffectsoftheeurocrisishavebeenseennotjustathome,butalsointheEU’sfadingglobalclout.

12Afterthestorm

SOWERETHESCEPTICSRIGHTALLALONG?Itishardtoavoidtheconclusionthatthesinglecurrencyhasbeenaterriblefolly.ItsfailingshavebroughtmiserytomanypartsofEuropeandgravelydamaged thepost-warEuropeanproject.Attheheightofthefinancialcrisis,inearly2009,Jean-ClaudeTrichet,presidentoftheECB,couldplausiblyargue:“Instormyseas,it’sbettertobeonalargeshipthaninasmallboat.”Buttheeuroturnedouttobenomightyoceanliner;itwasjustapleasureboat,goodforshowingoffinshelteredwatersbutdangerousontheopenseas,lackingbulkheads,lifeboatsorevenatrainedskipperandcrew.

Being locked in a single currencymade it too easy, almost inevitable, fordeficit countries to build up large imbalances in good times (pumped by thesavingsofsurpluscountries)andagonisinglydifficultforthemtoadjustinhardtimes. William Hague, the UK’s foreign secretary, was prescient when hepredictedbefore thestartofEMU(hewas then theConservativeParty leader)thatthecurrencyzonewouldprovetobe“aburningbuildingwithnoexits”.OrasSilvioBerlusconi,thenItaly’sprimeminister,putitduringthecrisis,theeuroisa“strangecurrencythatdoesnotconvinceanybody”.

With national currencies bond markets would have been more alert,demanding higher interest rates long before weaker countries could build upsuchlargeexternaldeficits.Andwhenthecrisiscame,devaluationmighthaveallowedthemtoregaincompetitivenessmoreeasily.Butthisjudgmenthastobetempered. First, any gains from devaluation might have been frittered awaythoughinflation;andinflationwouldhavepushedupborrowingcosts.Second,itislikelythatEurope’scurrencieswouldhavebeenlinkedinsomeway,andthatthesystemwouldhavebeenrippedapartwhenthefinancialstormblewin,withtheDeutschmarkappreciatingsharply,theItalianliradevaluingandtheFrenchfranc torn between the two. Third, currency chaosmight easily have led to a

protectionistfree-for-all,underminingthesinglemarket.Inoneformoranother,majorturmoilwasprobablyunavoidableinEurope.

What might once have been a currency crisis became, with the euro, a debtcrisis.Theeuroallowedcountriesaccustomedtohighinflationtoavoidreformin thegoodyearsas theybenefitedfromlowinterest rates.Brutally,nodoubt,thehardest-hiteconomieshavebeenforcedintooverduereforms,forinstanceinIrelandandSpain.NowadaysitisItalyandFrance,lesstraumatisedbutalsolessreformedthanothercountries,whichpresentsomeofthebiggestdangerstothefutureoftheeuro.Theyaretoobigtofail,toobigtosaveandtoobigtobullyfromBrussels.

Europe’s real follywasnot to look for thegains froma singlecurrency interms of trade, financial integration, exchange-rate stability and economicefficiency,eveniftheymighthavebeenoverstated.Themadnesswastobelievethat these benefits could be obtained on the cheap, without the politicalconstraints, economic flexibility, financial transfers and risk-sharingmechanismsofgenuinefederations.Whatstandsbehindtheeuro?Germany?Uptoapoint.TheECB?Onlysortof.

Almosteverybodyknewthattheeurowasincompletewhenitwaslaunchedin1999.Thosewhospokeupabouttheflawswerelargelyignored.Thosewhokept quiet hoped that the problems would be repaired as and when theyappeared. It was not an unreasonable assumption. The European project hasalwaysadvanced throughhalf-steps, in theknowledge that inadequacieswouldeventually require further half-steps to be made good. As Jean Monnet, afoundingfather,onceputit:“Europewillbebuiltthroughcrises.”Theproblemisthat,whentheeurocrisisstruck,itturnedouttobefarbiggerthananyonehadimagined.Thedebtorsscreamedforhelp,but thecreditors fearedbeingpulledunder.

Yetthedoomsayerswerewronginonecrucialrespect:theyunderestimatedEU leaders’ commitment to the European project. The euro has somehowsurvived, and many a short-seller has lost money betting on its demise. Theeuro’s failings have been compensated by sheer political will and the fear ofwhatmighthappenifitbrokeapart.AngelaMerkel,theGermanchancellor,hasstaked hundreds of billions of euros-worth of German taxpayers’ money torescueothercountries,whilekeepinghervoters’trust.SheheldbackthosewhowantedtopushoutGreece.TheGreeksunderwentappallinghardshipstostayin.Cyprusdidnotwalkoutevenafter itsbankswerecrushed.TheECBstretcheditsmandatetomakesurethattheeurowouldnotbreakapart.Andcountriesare

stilllininguptojoin:Latviahasjustdoneso,Lithuaniamayfollowin2015.Sointheend,itwasthosewhosubscribedtothe“coronation”theoryofthe

singlecurrencywhowereclosesttothecorrectanswer:monetaryunionshouldhavebeentheculminationofpoliticalunion,notthemeanstoachieveit.Doesthat mean it is time to break up the misbegotten euro, just as countriesabandonedthegoldstandardinthe1930s?

Redenomination would be acutely painful. Changing currency is differentfromleavinga fixedpeg.Whetherdonebyreturning tonationalmoney,orbycreating a Germanic northern euro and a Latin southern one, redenominationwouldmeanthatcurrencies,assetsandliabilitieswouldallberepricedabruptly.Some companies, in both creditor and debtor countries, would go bust. Somecountries that devaluedwould be crushed by their euro-denominated debt anddefault.Andtherecouldbebankrunsasdepositorsinsoutherncountriesrushedtomovetheirsavingstonorthernones.Thedislocationwouldbemostacuteforthe deficit countries. If the euro has to be split, it would probably be leastdisruptive ifGermanywere to leave, either alone orwith a group of northernneighbours, allowing the rest to devalue. But Germany would not avoideconomicpain,andaeurowithouttheEU’slargesteconomywouldmakelittlesense.

ItisalsounlikelythattheEU’ssinglemarketwouldsurvivetheimplosion,asitwouldprobablybefollowedbycapitalcontrols,tradebarriersand,possibly,a wave of migration. Without the euro or the single market, the EU wouldbecome irrelevant.Andvulnerabledemocracies ineasternEurope,andeven inthe south, could lose their political anchors. The tow-line that is pulling theBalkancountries towards theEUcouldsnap. Inshort, itmuststillbebetter torefittheeurothantoscrapit;andbetterstilltodoitduringthecurrentlullratherthanwaitforthenextstorm.

Themeasureoffailure

Theeurozonehasundergoneextensivepatching.Itnowhasapermanentrescuefund;tougherrulestomonitorbudgetsandeconomicimbalances,withthethreatof semi-automatic sanctions; and national balanced-budget rules through thefiscalcompact.Inprinciple,allrecognisetheneedforstructuralreformtoregaincompetitiveness and enhancegrowth. InSeptember2013,WolfgangSchäuble,theGermanfinanceminister,boastedthattheslowreturntogrowthintheeurozone,andtherebalancingofcurrentaccountsindeficitcountries,wasproofthat

themuch-criticisedmedicinewasworking:1

Systemsadapt,downturnsbottomout,trendsturn.Inotherwords,whatisbrokencanberepaired.Europetodayistheproof.

Yetthisistomissthepoint.Theeuro’sisastoryofsurvival,notofsuccess.Although it is limping back to growth, itsweakermembers have sunk deeperintodebt.MassunemploymentanddebtdeflationinGreecearehardlyevidenceof successful adjustment. The question is not whether economies eventuallybottomout,butwhetherpoliticianslimitorworsenthedamage.Oneansweristocomparetheeurozone’sperformancewiththatoftheUnitedStates(seeFigure12.1).European leaders like to blame theUnitedStates for their crisis, and toboastthataggregatepublicdebtsandbudgetdeficitsarehealthierthanthoseoftheUnitedStates.SowhyistheUnitedStatesdoingsomuchbetterthantheeurozone?USoutputhassurpasseditspre-crisispeakandisgrowingmoderately;theeuro zone has yet to make up the lost ground and growth is still fragile.Unemploymentwasabove9%onbothsidesof theAtlantic in2009,but ithassince fallenclose to7% in theUnitedStates and risenabove12% in the eurozone.Intheperipherythenumbersaremuchworse.EuropeasawholehasalessfavourabledemographicprofilethantheUnitedStates,sointermsofGDPperhead the growth figures are a bit less dire. Nevertheless, the differences inperformanceareglaring.

FIG12.1ThecostoffailureEurozoneandUSGDPatconstantprices,2007–14,2007=100

*Forecast

Source:IMFWorldEconomicOutlookdatabase,autumn2013

Acatalogueoferrors

Europe’s response has been slow, partial and often baffling to outsiders. Theadjustmenthasbeenneedlesslypainfulforthedebtors,andprobablyneedlesslyexpensive for the creditors. Leaders of the euro zone are unlikely toacknowledgetheirerrors,buttheirmanychangesofpolicyamounttoanimplicitadmissionofthem.

Who is to blame for the fiasco?Thosewho created such a death trapof acurrency union, to begin with, followed by the reckless borrowers and theirresponsiblelendersofthefirstdecadeofEMU.Therulersofdeficitcountriesfoolishlythought theycouldlive inaGermaniccurrencyunion,andenjoylowinterestrates,withoutbecomingmoreGermanicintheirattitudetobudgetsandwages. Certainly, deficits in the peripheryweremirrored by surpluses in coreeconomies.Butthetruthisthatrunninglargeexternaldeficitsismoredangerousthanhavingsurpluseswhenacrisishits.

Once the crisis began, though, it is the creditor countries that must bearprime responsibility. They were best placed to limit the fallout, becauseeverybody needed theirmoney, but theymade itworse.Above all thismeanslookingattheroleplayedbyGermany.Itiswrongtoaccuseitofselfishnessor,worse,oftryingtodominateEurope.Germanyhasundoubtedlystakedmuchofitstreasure(ashaveothercountries)onsavingtheeurozone.Butitmadeseriouserrors.Ittreatedthecrisisforfartoolongasaquestionoffiscalprofligacy,andofindividualcountries.MarioMontiwouldquipthatforGermany“economicsisabranchofmoralphilosophy”.Fiscalsinnershadtoatone,andtherightfulhadnothingtoapologisefor.FrequentlyinGermanyeconomicswasalsoaquestionof extreme legalism.Many of themost senior officials in theGerman financeministryarelawyers,noteconomists,startingwithSchäublehimself.

Itwasonlyin thesummerof2012thatGermanystartedtounderstandthatthestructureoftheeurozoneitselfwasunstable,andcamearoundtoacceptingtheneed for a bankingunion.Even then it dragged its feet over anything thatimpliedcommonliabilities,andinsistedonaworryinglycomplexlegalstructurefortheresolutionmechanism.

The incoherence can be understood only in the light of Germany’s twinterrors: the fear of moral hazard and the fear of collapse. These are bestencapsulatedbytwodictums:“chacunsamerde”,NicolasSarkozy’ssummary

of Merkel’s rejection of a joint bank rescue in 2008; and “ultima ratio”,Merkel’s justificationforbailingoutGreece in2010.Inotherwords,countriesmustdealwiththeirproblemsontheirown,andshouldbehelpedonlyasalastresortwhentheeuro’ssurvivalisatstake.Theconstraintsaremeanttolimittheliabilitiesofcreditorsandmaintainpressureondebtorstoreform.Buttheyhaveraised the cost and length of the crisis, and allowed doubts about the euro’sfuturetofester,therebyhamperingtherecoveryintheperipheryandacceleratingfinancialfragmentation.

Onthefaceofit,theheroesofthecrisisarethetwopresidentsoftheECB,TrichetandespeciallyMarioDraghi,whoseinterventionskeptthesystemgoingwhenthepoliticianswereateachothers’throats.TheECBgavetimelywarningsofthedangerofimbalances,andrespondeddecisivelytothefinancialcrisis.Butonce the trouble spread to sovereigns, it becamemuchmore cautious. It waswilling to provide liquidity to banks, even those that were patently bust, buthesitated to do so overtly, even for solvent sovereigns. The Eurosystem ofcentral banks cushioned the blow on deficit countries by accumulating largeimbalancesintheeurozone’spaymentsettlementsystem,knownas“TargetII”.Attheheightofthecrisisin2012,Germany’sBundesbankhad,controversially,accumulatedclaimsworthmorethan€750billionagainsttheECB.Sooverandabove the visible taxpayer-funded bailout by the German government,economistsarguedbitterlyoverwhether therewasalsoa largestealthybailoutviatheBundesbank.TheTargetIIimbalanceisperhapsbestseenasareflectionofcapitalflightfromthetroubledperiphery,andraisesthequestionofwhethercentral banks in creditor countrieswould have to take large losses should theeurobreakupandthedebtorcountriesrefusetosettletheirTargetIIliabilities.Intheevent, theimbalancedeclinedsteadilyafterDraghi’s“whateverit takes”speech in London in July 2012 restored confidence in the future of the eurozone.

That said, theECB resisted for far too long theneed to cutGreece’sdebt,andrefusedtoletIrelandimposelossesonbondholders.Itdevisedaneffectivemeansofhaltingcontagiononlyinthesummerof2012,aftertwoyearsofcrisisand half-hearted interventions in bondmarkets. If governments responded toolate, the ECB often responded even later. It feared that if it acted too soon,governmentswouldbeonlytoohappytoleaveitalonetodealwiththecrisis.Inthedarkestdaysof thecrisis, frustratedofficialswould tellTrichet:“Youmayendupbeingacentralbankwithoutacurrency.”Towhichhewouldreply:“Andyoumayenduphavingacurrencywithoutacentralbank.”

TheECBhad its own twin fears, both of themGerman.Theywere called“Bundesbank” and “Karlsruhe”. The inflation-busting tradition of theBundesbankmeantthattheECBwouldratherflirtwithdeflationthanletpricesrisetoohighinGermany,orupsetGermansaversbymoreaggressiveloweringofinterestrates.Itneverdaredengageintheaggressivelooseningofmonetarypolicy, known as “quantitative easing” (involving the purchase of governmentbondsandotherassets),longpursuedbytheUSFederalReserveandtheBankofEngland.Excessively lowinflation,overly tightmonetarypolicyandahighexchange rate made it even harder for the periphery to adjust relative toGermany.TheBundesbank openly opposed any resort to bond-buying to holddown borrowing costs. And the ECB soon ran up against the even greaterintransigence of the German constitutional court, which ruled that Draghi’spolicyofoutrightmonetary transactions (OMT), theone true firewall thathadarrestedthefinancialblaze,wasillegal(thoughitofferedastayofexecutionbypassingthecaseontotheEuropeanCourtofJustice).

ThefactthatthecrisisstartedinGreece,theclearestcaseofpublicspendinggonewildandofagovernmentunwillingorunabletoenactreform,didmuchtoreinforcetheprejudicesandfearsofGermanyandtheECB.Itisplaintoallinretrospect–andprobablytothosewhoknewtherealnumbersatthetime–thatthe first Greek bailout was ill-conceived. It treated Greece as a problem ofliquidity rather than of solvency. The distinction is often hard to make, as itdependslargelyonacountry’sprospectsforfuturegrowthandtheinterestratethat investors demand to hold its bonds.ButGreecewas plainly bankrupt. Itsdebt should have been cut early and decisively rather than late and messily,therebygivingprivatecreditorsthechancetodumpGreekbonds.

Greecewaspushedintopanickedandexcessiveausterity–partlybecauseitsdebtwassohigh,andpartlybecauseofa lackofcredible tools tostabilise theeurozone.Andwhentheprogrammefailed,throughacombinationofGreece’sshortcomings and those of its creditors, the threat of Grexit made everythingmuch worse. The same was true, to a lesser extent, of other programmecountries. The bailouts were all too optimistic in their assumptions about therecessionary impact of austerity, and put too much faith in the notion thathairshirteconomicswouldrestoremarketconfidence.TheeconomiesofGreece,IrelandandPortugalallperformedworsethanforecast:recessionsweredeeperandunemploymentwashigher.Perhapsmoststrikingisthesharpworseningofdebt-to-GDPratios.Thisisonlypartlybecausedeficitswereincreasingthedebt,orthenumerator.Abiggerfactorwasthatrecessionwasshrinkingoutput,orthe

denominator. The numbers for Greece were especially dire – its debt ratioreached 176%ofGDP and joblessness passed 27% in 2013 (see Figures 12.2and12.3)–eventhoughtheonethingGreecedidachievewasareductioninthedeficitmoreorlessaccordingtoplan.

FIG12.2Thesinsofthefathers…Publicdebt,1999–2014,%ofGDP

*ForecastSources:Eurostat;EuropeanCommissionautumnforecast2013

FIG12.3…visiteduponthesons?Unemploymentrate,1999–2014,%

*Forecast

Sources:Eurostat;EuropeanCommissionautumnforecast2013

Countriesinbailoutprogrammeswereatfirstmadetopaypunitiveratesofinterest. It was only comparatively late that the focus shifted from fiscalconsolidation to structural reforms to make labour markets more flexible andenhancepotentialgrowth.

Of themembers of the troika that negotiated the programmes, perhaps thebiggest culprit is theEuropeanCommission. Ithad little experienceofdealingwith balance-of-payments crises and, under pressure from Germany, sufferedfromtunnelvisiononfiscalrules.

Evenso,theIMFcannotescapeallblame.Itsexpertisewasmostneededatthe start of the Greek programme, yet it had signed up to a deeply flawedprogramme. The IMF did, at least, try to redeem itself. Subsequent debt-sustainabilityassessmentsforGreeceandCyprusweremoresober.Itpublishedalessons-learntreportonGreecerecognisingthatthecountry’sdebtshouldhavebeencutearlier.2 IMFeconomistsadmitted that inappropriatefiscalmultipliershad been used in forecasting the impact of austerity. And it has done muchvaluablefuture-orientedthinking,forinstanceonthedesignofabankingunionand a putative future euro-zone budget. Such a spirit of self-examination andopeninquiryhassofarlargelyeludedtheCommission.

Membersof theEuropeanParliament,whohave started to inquire into thetroika’s workings, dream that it will be replaced one day by a fully fledgedEuropeanMonetaryFund(builtaround therescuefund, theEuropeanStabilityMechanism) that dispenseswith the IMF.But itwill be some time before thetreatiescanbechangedtocreatesuchabody,andevenlongerforittobuildupthenecessarycredibility.

It is tempting to argue that the euro-zone crisis would have been handledbetter if left entirely in the hands of the IMF. But given the size andinterconnectedness of the euro zone’s economies, and the slow pace ofadjustmentinvolvedin“internaldevaluation”withafixedcurrency,thetaskwasprobably beyond the IMF’s resources. It would probably always requiresubstantialeuro-zonefundstorunsuchbailoutprogrammes.

Awkwardco-operationbetweentheEuropeansandtheIMFmaythereforebeneeded for years to come. But the presence of the ECB in the troika is ananomaly. The central bank’s mandate should not stretch to bargaining overbudgetcutsandreformstolabourmarkets,orthreateningtocutoffliquiditytobanks if a countrydoes not complywith itswishes.As theECBbecomes the

eurozone’smainbanksupervisor, theconflictof interest isglaring. It is time,surely,forittodepart.OneadvantageisthattheIMF,unshackledfromtheECB,mightbeinabetterpositiontopushthecentralbanktoloosenmonetarypolicy.

To enumerate the errors of the troika is not to absolve Greece, and itsByzantine polity. It has proven obduratewhen it comes to structural reforms.NothingwouldhavesparedGreecetheneedforanagonisingfiscaladjustment.ButmorecoherenceinthetroikaprogrammemighthavegivenGreeceagreaterchanceofsuccess,andavoidedthedeathspiralthatthreatenedtosuckdownthewhole euro zone.Austeritywas pursued too zealously, but given the levels ofdebt in the euro zone and the danger of losing access to markets in severalcountries,therewaslittlespaceforanyone,apartfromthelikesofGermany,toengageinfiscalstimulus.

Itisofcourseeasiertobewiseinretrospect.Oneexplanationforthemuddlewastherealfearoffinancialinstability.IfGreecedefaultedimmediately,othercountries might be pushed into bankruptcy too. Better to fudge the Greeknumbers,buytimeandwaitforconditionstoimproveandgrowthtoreturn.Thisargumentwouldbestrongerhadtheeurozonereallyusedthetimetoredesignitselfmoreprofoundly.True,itcobbledtogetheraninadequatebailoutfund.Butitundid itsowneffortswithaham-fistedbargainatDeauvilleand ignored thebankingcrisisfortwoyears.

Perhaps the kindest thing that can be said is that the euro-zone’spolicymakers, confrontedwith their firstmajorcrisis,had to learnby trial anderror.ToborrowChurchill’sapocryphalbonmotaboutAmericans,theGermanscan always be relied upon to do the right thing after they have exhausted allpossiblealternatives.

HamiltonandtheF-wordThe euro zone should look to the United States and ask itself: why does theprospectofdefaultbyonestatenotcallintoquestiontheexistenceofthedollar?WhyistheeurosoflimsythatadefaultbyGreece,accountingforlessthan3%of the euro zone’s GDP, should have been seen as an existential threat? TheshortansweristhattheUnitedStatesisasinglefederalcountry,whiletheeurozoneisamuchlooserconfederationofsovereigncountries.Itmayuseasinglecurrency, but it has 18 national governments with 18 different economicpolicies.

The euro zone’s financial system was sufficiently integrated to spreadcontagion, but not integrated enough to provide resilience. It has no central

budget or other means of absorbing asymmetric shocks that hit one or twocountriesdisproportionately.UntiltheECBcameupwiththepolicyofOMT,ithadnoeffectivelenderoflastresort,socountrieswereineffectborrowinginaforeign currency. These faults meant that the no-bail-out rule, althoughenshrinedintheMaastrichttreaty,wasnotcrediblewhenthecrisishit.Yettheeurozonehadnomeansofgivingassistance tocountries thatgot into trouble.Bycontrast,theUSfederalgovernmenthassuccessfullyresistedbailingoutanyofthestatessincethe1840s,leavingthemarketstoimposefiscaldiscipline.

Repeated bailouts in the euro zone have, inevitably, led to more centralcontrolsonfiscalandeconomicpolicies.The“economicgovernance”createdinrecent years is a soup of incomprehensible jargon: six-pack, two-pack, fiscalcompact,EuroPlusPact,European semester, annual growth survey, excessivedeficit procedure, macroeconomic imbalances procedure, “contractualarrangements”forreform,andmuchmore.Allthisamountstoanunprecedentedintrusion by an unaccountable EU bureaucracy that satisifes nobody: theCommissionisaccusedbythedebtorsofdoingthecreditors’bidding,andbythecreditorsof being too soft on the sinners.This system is ultimatelyuntenable.True,theIMFalsoimposespainfulreformswhenitiscalledintohelp.ButtheIMFisaforeigndoctorwhoeventuallygoesaway.Intheeurozone,thehealthinspectorsmoveintothehouseforever.

Initsweirdhybridconstruct,partUnitedNationsandpartUnitedStates,theeurozoneoftensuffersfromtheworstfeaturesofboth.Electedgovernmentsarebeinghollowedoutbya lossofpower toBrussels;butcitizenshavenodirectsayondecisions taken inBrussels.At somepoint the euro zonewill discoversomething of the truths set out more than two centuries ago by AlexanderHamilton, the firstAmerican treasurysecretary, in the federalistpapers thatheco-authored:tryingtocoercesovereignstatestofollowcommonruleseventuallyleadstoconflict.Afederalsystemmustthusactdirectlyonthecitizen,notthecomponent states. Having created what is essentially a federal currency forEurope, the countries of the euro zone have much to learn from studyingHamilton, particularly the way he got the American federal government toassume the war debts of the former colonies and issue new national bondsbacked by direct taxes. His new financial system helped transform the youngrepublicfromabasketcaseintoaneconomicpowerhouse.3

Bringbacknobailout

Sowhat is theway forward? In the longer term, the onlyworkable answer issurelytorestorethecredibilityoftheno-bail-outruleandallowcountriestogobustifandwhentheygetintotrouble.Thequestionis,canitbedoneundertheMaastricht model of autonomous national economies, now modified by ahandfulof stricter centralised rules anda safetynetbasedonultimaratio?Ordoes it require more US-style fiscal federalism, involving the sharing ofliabilities through autonomous central bodies? Put another way, should“solidarity” in theeurozonehappenonly inextremis,afteracountrygets intotrouble, in the form of “mutual assurance” by governments offering help inreturnfortoughconditions?4Orshouldittakeplaceautomatically,forinstanceraising European taxes to deal with banking risks or, say, unemploymentinsurance?

Expert opinion is divided. Ashoka Mody, a former senior IMF official,argues in a 2013 paper for Bruegel, a think-tank in Brussels, that Europeanofficialsshouldrecognisethatthefederalistimpulseisatastandstill.5Germanyandothersurpluscountrieswillnotacceptanymutualisationofrisk,beitintheformofjointdebtor joint liabilityforthebanks.Instead, theeurozoneshouldconcentrate on making it easier to restructure unpayable debt. Banks shouldissuecontingentconvertiblebondsthatcanturndebtintoequitywhentheygetintotrouble,soabsorbinglosses.Andsovereignbondsshouldincludeprovisionsformaturitiestobeextendedwhendebtexceedsacertainlevel.Bycontrast,theGlienickergroup,acollectionof11pro-EuropeanGermaneconomists,lawyersandpoliticalscientists,ispushingforastrongerdoseoffederalism.6Itcallsfora“robust” banking union, a “controlled transfermechanism” including commonunemployment insurance and a common budget to promote public goods.SimilarconclusionswerereachedbyaFrenchgatheringcallingitselfthe“EiffelGroup”.7 Economic logic points to greater federalism in fiscal and bankingaffairs.Butpoliticalrealityisthatthewallet,andthepowertotax,willremainnational.Theeurozonewillthereforeremainhybridfortheforeseeablefuture.

Besidestheriskofpoliticalbacklashagainsteconomicgovernance,thereareotherreasonstoworrythatthecurrentmodelisunstable.TheECB’spositionaslender of last resort remains ambiguous.MarioDraghi’s great bluff, theOMTpolicy,maynotholdforever.Moreover,theECB’sone-size-fits-allinterestrateis a one-size-fits-none arrangement that has a tendency to amplify economicdivergence. It is now too low for Germany and too high for Mediterraneancountries,whereas the situationswere reversedwhen the euro began in 1999.Similar arguments apply to the common exchange rate, which has tended to

favourhigh-endGermanexportsover,forexample,moreprice-sensitiveItalianones.Someworrythat,asaresultofthecrisismoney,productioncapacityandskilledworkersareshiftingpermanentlytocoreeconomiesthroughtheso-called“agglomerationeffect”,withnotransferstosoftentheblowtotheperiphery.

Without a largeAmerican-style federal budget, countries of the euro zoneneed other means to adjust: more flexible markets for labour, products andservices; greater mobility of workers; and more cross-border ownership ofassets.But inall these respects,EUcountriesarea lot less integrated than theUnitedStates.Theprincipalshockabsorberisnationalborrowing.Butintimesof high debt, borrowing is a limited instrument, and may even becounterproductiveifmarketsdoubtacountry’ssolvency.

The IMF notes that federations such as the United States, Canada andGermany are able to absorb about 80% of economic shocks in their states orprovinces,8whereas theeurozonemanages tosmooth just40%ofasymmetricshocks. In other words, a 1% drop in GDP results in household consumptionshrinkingby0.2%infederationsand0.6%intheeurozone.Itisthusapparentthattheeurozoneshouldbecome,insomeaspects,morefederaliftheeuroistofunctionmoreeffectively.AsintheUnitedStatesorCanada,theaimshouldbeto create a European system that is resilient enough to allow each country tomake its own choices, and bear the consequences when things go wrong.Disciplineisbestexertedbymarkets,notEurocrats.AstheIMFpapernotes,no-bail-out rules are more credible when there are risk-sharing mechanisms tocontaintheimpactofdefault.

Seen this way, more federalism in some domains is a means of restoringchoicetogovernments,notoftakingitaway.Itwouldrelievedeficitcountriesofevermoreintrusivecentralcontrols,andsurpluscountriesofthedutytorescueothers. Fiscal federalism does not imply that the EU (or euro zone) has tobecome the United States of Europe. Some powers could and should berepatriatedaspartofthebargain.ForgetaboutaEuropeanarmy(itwouldneverleavebarracks)or a singleEUseat at theUN.Europedoesnotneed to speakwithonevoice.But itneedstheeurozonetooperateasonecoherentfinancialsystem.Preciselyhowfarintegrationmustgoremainssomethingofaguessinggame.Buthereareafewpriorities.

Completebankingunion

Beginwitha realbankingunion.Theeurozone’s trouble startedasabanking

crisis and, in contrast with the United States, it has yet to be resolved. Theuncertainty over unseen losses in banks is hampering recovery. A newsupervisor has been created and bail-in rules have been agreed. Germany hasbelatedly agreed to a complex bank-resolutionmechanism and a pooled bank-resolutionfund,paidforbybanks,thatwillbecreatedoverseveralyears.Thatisaprecedentformutualisation.

Itisrightthatbanksandtheircreditorsbearthebruntofbankfailures.Buttobecomestable,bankingunionneeds a taxpayer-fundedbackstop if abig crisisstrikes. A common deposit-insurance system would help to provide greaterstability.Ahalf-bakedbankingunionwillnotbreak theviciouscirclebetweenweakbanksandweaksovereigns.

Cutunpayabledebt

Sovereigndebtistheotherendofbank-sovereignloop.Ithasrisentoitshighestlevelsincethesecondworldwar,andatthebeginningof2014stoodat95%ofGDPonaverageintheeurozone–Greecewasat176%,Italyat133%.Privatedebtisalsohighinmanycountries.

One lesson of the crisis, especially inGreece, is the need for a clear-eyeddistinctionbetweenproblemsofliquidityandproblemsofsolvency.Fudgingtheassessmentofacountry’sdebtandhopingforthebestisabadchoicefordebtorandcreditoralike.Inanyfuturebailoutitisbettertocutunpayabledebtfromtheoutset.Thelosseswouldthusfallonthosethatlentthemoneytouncreditworthycountries.Adjustmentprogrammesneedtohavesufficientmarginstodealwithproblemswhenforecastsinevitablygowrong.Itisbetterforacountrytoexceeditstargetsthanconsistentlyundershootthem.

Havingmadetheerror,officialcreditorsshouldlifttheburdenonGreece,aspromised, now that it has reached a primary budget surplus (that is, beforeinterestpayments).Adebtwrite-offwouldbebetterthananendlessprocessof“extendandpretend” that leavesaperpetualcloudofuncertaintyoverGreece.Thesoonerandmoreexplicitlyitisdone,thestrongerthesignaltomarketsthatGreeceiscomingoutofitsmisery.

Moreover,asimilarprinciplecouldbeextendedtootherrescuedcountries:the terms of their bailout loans should be softened once they have got intoprimary surplus. This is especially justified in the case of Ireland, whichwaspreventedfromwipingoutseniorbondholdersofitsbustbanks,eventhoughthishas become an aimof banking union. Italy,Europe’s biggest debtor, needs to

embark on sustained privatisation to pay off debt and encourage morecompetition.

Othermeasurestomakeiteasiertorestructuredebt,bothprivateandpublic,wouldbesensible.

Bondtogether

In the longer term, the euro zone should move towards some form ofmutualisationofdebt.Onereasonistolimitexcessiveborrowingcosts;anotheristosendapoliticalsignalofcommitmenttothecommoncurrency;athirdistocreate a safe asset for banks to hold, so helping to break the doom-loopwithsovereigns.

TherearenowmanyproposalsforEurobonds.A2010paperbyJakobvonWeizsäckerandJacquesDelplafortheBruegelthink-tankinBrusselsproposesahybrid “blue bond, red bond” system: countries would issue joint bonds,guaranteed jointlyand severallybyall euro-zonemembers (bluebonds),up tothe “good” debt threshold of 60%ofGDP; beyond that countrieswould issueriskier national bonds (red bonds). Another idea, proposed by the Germangovernment’sofficialcouncilofeconomicadvisers,wasinspiredbyAlexanderHamilton: it would pool the “bad” debt above the Maastricht threshold in atemporary debt redemption fund that would be guaranteed by all, with acommitmentbyeachmember topayoff its shareover20years.9The latter isless complicated in legal terms andmay be a good starting point. If such anassumption of debt could be achieved with another Hamiltonian touch, bysimultaneously restructuring the debt to lighten the burden, it would be evenbetter.

Butsuchideasforcommonbondsrunintoahugeobjection:whyshouldthethrifty guarantee debts accumulated by the profligate? Texas does not standbehind California’s debt. American treasuries are federal debt, paid for byfederal taxes.Embryonic formsofEuropeandebt already exist, such as bondsissuedby the rescue funds.But grantingEuropean institutions the authority toissue debt and raise taxeswould be contentious. Euro-zone “treasuries” couldstartinalimitedmanner,forinstancebyissuingshort-datedbills.Moralhazardisarealproblem;afterall, theeurozone’s imbalancesbuiltupata timewhenmarketsbehavedasifEurobondswerealreadyinexistence.Clearqualificationcriteria could mitigate the risk and give countries good reasons to reform.Vulnerablecountriesneedincentivesaswellasthreatsandrulestosticktothe

pathofreform.

Theneedtobalance

So far the burden of adjustment has been placedmainly on deficit countries,while Germany’s current-account surplus has continued to grow (see Figure12.4), to the point where the US Treasury complains that it is hamperingrecovery,bothintheeurozoneandglobally.

FIG12.4AlongclimbCurrent-accountbalance,2004–14,%ofGDP

*ForecastSources:Eurostat;EuropeanCommission

InanopentradingareatheconnectionbetweenGermany’ssurplusandothercountries’deficitsiscomplex.BoostingdemandinGermany–saybyincreasinginvestment, allowingwages to rise or granting a tax cut –might suck importsfrom the United States, China or eastern Europe more than from theMediterranean.Evensoitwouldhelp,notleastbecauseitcouldhelptoweakentheeuro’sexchangerate(thoughabetterwayofachievingthiswouldbethroughloosermonetarypolicy).Inpoliticalterms,though,unlessGermanyisseentodomoretohelptheeurozone’seconomicrebalancing,itwillfacestrongercallsforsome system of permanent fiscal transfers. It is striking that China has done

more to reduce its surplus and rebalance the global economy, by raising itsexchangerateandstimulatingtheeconomy,thanGermany.

Astrongercentre

Fully fledged federationshaveacentralbudget thatprovidespublicgoodsandredistributes income between rich and poor citizens (and states). The budgethelps to absorb the shockwhen one or other region suffers a downturn. Evenwhen local tax revenues drop, the federal government continues to spend ondefence, capital projects, unemployment insurance and, often, health care.Federalbudgetsinvariablyactasthebackstopforthebanks.Bycontrast,theEUhasatinybudget,nopoweroftaxationandnopowerstoborrow.Andtheeurozonehasnobudgetatall.

Does the euro zone need a central pot of money? France wants commonshort-termunemploymentbenefitsacrosstheeurozone.Germanywantsamorelimitedandconditionalmodel:providingatmostsmalltransferstocountriesaspart of “contracts” for structural reforms. The IMF has suggested a modest“rainy-day” fund, a collective savings account that couldmake transferswhencountriessufferadownturn.

Butevenasmallfundrunsintoabigobstacle.Euro-zonecountriesalreadyhavelargenationalbudgets,consumingabout50%ofGDP.Spendingbyfederaland state governments in theUnitedStates amounts to just 38%ofGDP, and33%ofGDP inSwitzerland.TheEU’s budget amounts to about 1%ofGDP.Measured another way, federal spending accounts for 55% of total publicspending in theUnitedStates and43% inSwitzerland.The1977MacDougallreport suggested a central budget of 5–7% of GDP in the early stages of aEuropean federation. Even Canada’s relatively small federal governmentaccounts for34%of totalpublicspending.Theequivalent figurefor theEUiscurrently2%ofGDP.Anyeuro-zonefundwouldthereforerequireaddingtoanalreadyheavytaxburden,orshiftingspendingfromnationaltoEuropeanlevel,orsharplycuttingtherestoftheEUbudget.Noneofthesewouldbeeasy.

TheIMFthinksaeuro-zonerainy-dayfund,madeupofannualcontributionsof between 1.5% and 2.5%ofGDP (that is, about twice as large as theEU’sbudget), would be enough to give the euro zone a similar level of shock-absorptionasotherfederationsandwouldroughlyevenouttransfersovertime.Had it been created in 1999, almost all countries (except tiny Luxembourg,whichboaststheEU’srichestpopulation)wouldhavereceivedroughlythesame

astheyhadputin.Germanywouldhavebenefitedwhenitwasregardedasthe“sickman of Europe”. Such an automatic systemwould providemore timelyhelp than a bailout fund and avoid disputes over conditions imposed onrecipients. If theEuropeanfundcouldalso issuebonds, itcouldrunacounter-cyclicalEuropean-level economicpolicyduring a general recession,making iteasierforcountriestosticktobalanced-budgetrules.

Theproblemwitharainy-dayfundis that it ishardtoassesstheeconomiccycle in real time, so deciding when to make payments, and how large theyshould be, could be tricky. The French idea of an unemployment-insurancesystemcouldactasaproxy.Nationalgovernmentswouldstillpayforlong-termjoblessness,which reflects national labour-market rigidities,while a Europeanfund could top up benefits for the first sixmonths of unemployment that aremore likely to reflect the short-term cycle. It is unlikely thatGermanywouldever agree to this without a high degree of harmonisation in labour-marketpractices.TheGlienickergroupwouldextendunemploymentinsuranceonlyto“countries that organise their labour market in line with the needs of themonetaryunion”.Yetdoneproperlyandwithclearlimitsandconditions,suchasystem could satisfy France’s desire for a “social” dimension to Europe andGermany’s insistence on labour-market reformswith the euro-zone’s need formobilityofworkers.

Amorecentralbank

Visibleprogress towardsintegrationwouldgivetheECBgreaterconfidencetointerveneasaguardianoftheeurowhilereformsareenacted.Ifafutureeuro-zone fund acted as a backstop for banks and issued European debt, the ECBcouldincreasinglyactasalenderoflastresorttotheEuropeanfund,ratherthanto national governments, thus freeing it from the uncomfortable business ofsetting conditions, directly or indirectly, in return formonetary action to helpvulnerablecountries.

Assupervisorofeuro-zonebanks,theECBshouldensurethatbondholdingsare diversified and encourage cross-border bank mergers, to help break thedoom-loop between banks and sovereigns.And given that its supervisory rolealreadyraisesquestionsaboutitspoliticalindependence,notleastbecausebankfailures have an impact on national treasuries, the ECB should get out of theentanglementofthetroika.

For now, theECBmust have the courage to loosenmonetary policymore

aggressively,despiteGermancomplaints thatsavingsarebeingundermined, toavert the threatofdeflation.AdoseofAmerican-stylequantitativeeasingmaybeinorder.Onceagain,though,itwouldbeeasieriftheECBhadEurobondstobuyinsteadofhavingtopickandchoosewhichcountry’sdebttobuyandwhichtoexclude.

Narrowthedemocraticdeficit

Theintegrationoftheeurozone,theintrusionofEuropeanbodiesintonationaleconomic policymaking and the growing popular disenchantment with theEuropean project require the democratic deficit to be addressedmore urgentlythanever.

Butfortheforeseeablefuture–foraslongasrealpower,budgetaryauthorityandlegitimacyliewithnationalgovernments–it isbesttoenhancetheroleofnational parliaments and perhaps even downgrade that of the EuropeanParliament.Thiscanbedonebygivingnationalparliamentsgreaterauthoritytoscrutinise the decisions taken by national ministers, prime ministers andpresidentsinBrussels.NationalparliamentscanalsobegivengreaterpowerstovetoormodifyEuropeanlegislation.Moreover,therecouldbescopeforajointbodyofnationalMPstoexamineinter-governmentaldecisions,suchasbailoutdecisionsbythetroikaandtheEurogroup.

Giving the systemgreater national democratic legitimacywouldbe a hugestepintherightdirection.ButeventhismaynotbeenoughtolegitimisethefullpanoplyofmeasuresandproceduresintheEuropeansemesteranditsassociatedpacts. If, as seems likely, national politics at some stage reasserts itself byreclaiming fiscal and economic autonomy fromBrussels, it will be thatmuchmore important for parliaments to understand the European repercussions ofnational economic policies. Germany realised this when it insisted that debtbrakesbeintroducedinnationallegislationthroughthefiscalcompact.

If theeurozonewereevertoadopttrulyfederalelements,forinstanceif itwere given a central budget or the power to raise taxes, these powers wouldcertainlyneed tobeheld toaccountby theEuropeanParliament.At thatpointtheremay even be scope for the direct election of some jobs inBrussels. Fornow, the indirect election of candidates for president of the EuropeanCommission,asenvisagedbytheEuropeanParliament,isatravesty.VotersarenotbeingofferedarealchancetoinfluenceEUpolicies,buttheexperimentwithSpitzenkandidaten (leading candidates) risks calling into question the

impartialityoftheCommissiononawholeseriesoffunctionswhereitneedstoact as a referee – not least in assessing the economic policies of individualcountries.

AfitterCommission

TheCommission remains the engineof theEU.But enlargement of theunionhas turned the cosy old college system into an unwieldy bureaucracywith 28commissioners, each a little baron seeking to push pet projects, resulting inlegislative overreach.Especially as theCommission gains powers to influencenational economicpolicies, it shouldget out of thebusiness of settingout theminutiaeofregulation.Theso-calledREFITinitiativetocutredtape,suchasasillyproposal tobanhairdressers fromwearinghighheels, isagoodstart.ButmuchmorecanbedonetomakearealityofJoséManuelBarroso’sdictumthat“theEUneedstobebigonbigthings,andsmalleronsmallerthings”.Thatsaid,deepeningthesinglemarketbynecessityrequiresEuropean-levelregulation, ifonlytocutthroughthethicketsof28differentsetsofnationallaws.

ItistimetorevivethenotionofamorestreamlinedCommission,perhapsbyhaving senior and junior commissioners, which might make it easier to slimdownthevolumeofCommissionactivity–solongasitcanfreeitselffromthecontrol of the European Parliament, which favours more legislation, not less.The Germans and the British have also suggested that all draft legislation,whetherdirectivesorregulations,shouldbedroppedattheendofeverytermofaCommission,ashappensinmostnationallegislatures.10

IfgovernmentswantagoodCommission,agoodplacetostartwouldbeforthemtoappointcompetentcommissionersratherthanuseBrusselsasadumpinggroundforsecond-divisionpoliticalhacks.

Chartthecourse

Creatingamorestableandintegratedeurozonewillrequireseveralbigbargains– between creditors and debtors, between older and newermembers, betweeneuro ins and outs. Therewill need to bemuchmoreEurope in some areas inreturnformuchlessinothers.Andastheeurozoneintegrates,thereshouldbemore integration of the single market. To navigate through these treacherouswaters, European countries need a clearer destination. TheMonnetmethod of

integrationstep-by-step,sector-by-sector,withanambiguous finalobjective, isreachingitslimits.Theeuronowaffectsthecoreofnationalpolitics,soitcannotbedelegatedtotechnocratsindefinitely.Thesystemwillneedmoredemocracyandaccountability, thoughhow this is achievedmayultimatelydifferbetweenthe euro zone and the wider EU. Herman Van Rompuy, president of theEuropeanCouncil,wasthinkingalongtherightlineswhenheappointedhimselftodrawuphisabortiveroadmapfora“genuineeconomicandmonetaryunion”.

Membersoftheeurozonedonotyettrusteachotherenoughtotakeonbigliabilitiesinoneleap.Reformwillhavetobedoneinstagestobuildconfidence.To borrow Schäuble’s phrase about banking union, there could first be a“wooden”structure,followedbyasteelone.Butifdebtorsaretoagreetomorediscipline,theyneedconfidencethatasystemofgreatersolidaritywillfollow.

Germany has every reason to worry about moral hazard. Weak countriesmightfailtoreformoncemarketpressureislifted.Butmoralhazardappliestothestrongtoo:nosoonerhadfearoftheeuro’sbreak-upsubsidedthanGermanystarted to water down banking union. A plan for greater sharing of liabilitiesmatched by the restoration of a credible no-bail-out rule could prove anattractivebargain.

One problem is that many changes would require treaty change. Mostleaders, like the institutions inBrussels, recoil at the idea of a big negotiationandmultiplereferendumsatatimewhenvotersarerestive,populistsareontherise and incumbents in trouble almost everywhere.Germany, conscious of thestricturesofitsconstitutionalcourt,ismoreopentoreformthroughasuccessionof small revisions under the “simplified procedure” that requires fewerreferendums. But such piecemeal reforms may not provide scope for thenecessary compromises. And there is always reluctance to give the UK theopportunitytocomplicatethingswithdemandsforrepatriationofpowers.

Afulltreatynegotiationmaybeinevitable,evendesirable,in2015and2016tosettlesomefundamentalquestionsandtoexplorewhethertheminimumthattheUKcanacceptcanbereconciledwiththemaximumthatotherEUcountriesarepreparedtooffer.Butiftheprocessgetsboggeddown,onewayaroundthesedifficultiesistonegotiateinter-governmentaldealsoutsidetheEU’streaties.EUpuristsand theEuropeanParliament intenselydislike inter-governmentalism.Itdetractsfromthe“communitymethod”,itdeniespowertotheParliamentanditcreatesmoreopportunityforbigcountriestobullysmallerones.Buttheaccordsestablishing the European StabilityMechanism (ESM) in 2011 and the fiscalcompact in 2012, both inter-governmental treaties, were negotiated easily and

quickly. And they brought an important innovation, common in otherinternational treaties (and indeed in the constitution of the United States), ofcomingintoforceonceathresholdnumberofratificationswasreached,thatis,without the requirement for unanimity. This reduces the scope for angryholdouts, be they referendum voters or obstreperous parliaments, to blockeverything.TheESMisalreadyacommonfundthatcanborrowonmarkets,socouldeasilybeexpandedtoincorporateotherfunctions.

Greater integration in the euro zone is bound to increase tensions betweenthe18 insand the tenouts.But relationswouldbeworsestill if theeurozonefailedtorightitself.ThetaskwillbetobindtheeurozoneclosertogetherwithinthewiderEU.Thetrickis that integrationof theeurozoneshouldgohand-in-hand with deepening the single market. But beyond this, safeguards will beneededtoensurethattheinsdonotgangupontheouts,andthattheeurozone’spolicies are open to newcomers. It is hard to see the euro zone consistentlyvotingasablock,butthehabitofco-ordination,andthefactthatmostcountriesstillwanttojointheeuro,willworrytheremainingouts.

TheUK’s future status is an acute headache that could come to dominatemuchEuropeanbusiness.Unlikemostouts, theUK ishalfoutof theEUasawhole,andDavidCameronisproposingareferendumonitsEUmembershipin2017.TheUKhasditheredoverhisdemandsinarenegotiation,partlybecauseitdoes not know what might be on offer. But a more complete single market,ambitioustradedeals,lighterEUregulation,curbingbenefitsformigrantsandasmallerEUbudget(sayiffarmspendingwerecuttomakeroomforaeuro-zonefund)mightbeachievable.ThedepartureoftheUKwouldbeagraveloss,notjust for the UK but also for the EU. Euro-zone countries need to liberalisemarkets,bothtopromotegrowthandtoenhancetheirabilitytoadjustwagesandprices.TheUK’sliberalisingzealwouldbeinvaluable.

Thetwindangersahead

Whichway is Europe heading? Its leaders have shown theywill act to avoidimminent shipwreck. This means that a sudden, catastrophic default andcurrency redenomination is improbable. For the same reason, countries areunlikelytoheedTrichet’sexhortations,atthestartofthecrisis,to“immediatelyjumpintopoliticalunion”.Even themorefocusedreformsproposedaboveareunlikely to happen spontaneously.Manywill see the economic sense in suchchanges, but they comewith a political cost to someor all governments.This

means that leaderswillactonlywhencompelled todosobyevents.Themostlikelycourse is todrift,withperiodsofcrisisandpiecemealreforms,followedbymoredrift.

Thenextcrisis–andtherewillsurelybeanextcrisis–couldcomefromanynumberofdirections.Itcouldbetriggered,asattheoutset,byaprobleminthebanks.Theeurozone’sfinancialsectorhashadmuchcapitalinjectedintoitbutbanksremainwobbly.Asuccessionofdiscreditedstresstestsmeansthatnobodyquite knows how many more losses are lurking in bank balance sheets. TheECB’s review of banks’ assets, due to be completed in 2014, might discoverlossesthatsovereignsareunabletobearandtheeurozoneisunwillingtotakeon.

The forthcoming turmoil might be precipitated by doubts cast on the onepolicythathasmostdecisivelyhaltedanyloomingcollapse:theECB’spromiseto intervene inbondmarkets ifneeded tostop theeuro frombreakingup.ThepolicyofOMTcouldyetbeunderminedbythelatest(orafuture)adverserulinginGermany’sconstitutionalcourt.EnactingOMTrequirescountriestoseek,andreceive, a rescue programme from the ESM, and often parliamentary votes.WouldtheBundestagvoteknowingitmightunleashtheECBagainstthewilloftheBundesbankand theKarlsruhecourt?Would theBundesbankcomplywithECBdemandstobuybonds?Conversely,willtheECBstandbackiftheeuroisindangerandpoliticiansfailtoact?NobodyknowswhethertheECB,insettingno limit for bond purchases, is genuinely ready to buy unlimited amounts ofdebt. In truth, the ECB’s policy of OMT is a bit like a nuclear weapon: adeterrentthatmayworkbestifitisnevertested.

Thetwomostobviousdangerstotheeurozoneareeconomicandpolitical.The euro zone faces a long period of stagnation. Weak recovery means thatcountrieswill struggle to reducemass joblessness inpartsof southernEurope,andtheycouldmoreeasilybepushedintoatriple-diprecession.Ifthathappens,whatchanceistherethattheirpeoplewillputupwithanotherroundofausterityandBrussels-imposed “economic governance”? Japanese-style deflationwas agrowingworryin2014.Inshort,themarket’soptimisminearly2014abouttheprospects for peripheral economies seemed overdone; bad news could bring asuddenreassessment,justasitdidin2010.

Evenwithoutsuchgrimscenarios,slowgrowthandhighunemploymentarealready radicalising politics and intensifying rejection of both national andEuropean politicians. So the next crisis may well be political. Anti-EU, anti-immigrant and anti-establishment parties of all colours are on the rise. The

European elections – usually a sideshow – of May 2014 are an importantmoment.Theriseofpopulistpartiesmaypointtoapressingneedtoreformthesystem; yet their strength might also make sensible changes hard or evenimpossible. Anti-EU parties are divided among themselves, and often moreinterestedinmegaphone(orYouTube)politicsthaninthedetailofpolicy.TheirdirectimpactonlegislationinBrusselsmaythereforebelimited,beyondmakingtheEuropeanParliamentnoisier.Butthepopulistpartiescouldchangenationalpolitical dynamics in several countries, so affecting European policies moreindirectly. Governments may feel under pressure to halt reforms, be theynationalorattheEuropeanlevel.

Thereafter, a national election in the south, say in Greece, could return aconstellationofpartiesthatrefusestocomplywithbailoutconditionsordecidesthatleavingtheeuroisthelesserevil.Oranexasperatedcreditorcountryinthenorth,saytheNetherlands,mightrefusetopayforthenextbailoutorjustrejectthedebtrestructuringthatGreeceneeds.Orthetroublemightcomefromanon-eurocountry,forinstanceifaBritishreferendumweretocomedowninfavourof leaving theEU, disrupting thewhole system.Or important countriesmightjustfailtomusterthepoliticalsupportforlong-delayedeconomicreforms.Italyistheperennialbackmarkerineconomicgrowth.Formanygovernments,Jean-ClaudeJuncker’sdictumaboutstructuralreformsstillholds:“Weallknowwhattodo,wejustdon’tknowhowtogetre-electedafterwe’vedoneit.”Evenattheheight of the crisis, and led by the reform-minded Mario Monti, the Italiangovernmentfounditeasiertoraisetaxesandcutspendingthanchallengevestedinterests by enacting structural reforms. In France, François Hollande hasbelatedly promised some still-vague supply-side reforms, but he may be tooenfeebled to deliver.With the far-rightNational Front gaining ground, FranceremainsacauseofacuteanxietyinbothGermanyandBrussels.

Alltheserisksoffergoodreasonsforearlyactiononthereformssetouthere.A sense of direction towards integration, even if slow and conditional, wouldhelp stabilise the euro zone, restore confidence in markets that it is beingrepaired, provide incentives for reform and give citizens in the most strickencountriesasenseofhopeforabetterfuture.Itcouldhelpavoidthenextcrisis,oratleastmitigateitsimpact.ButEurope’sleadershavenotproventobeendowedwithlong-termvision.Sothebestthatcanprobablybehopedforisthattheeurozone lurches from one crisis-induced reform to another. This will beunnecessarily costly and painful, butmight somehow lead to amore coherentandworkablesystem.Butthereisanotherpossibility:thattheeurozone,andthe

EUwithit,willstumblefromonecrisistothenextuntil,exhausted,oneorallofitsmemberslosethewilltopreservethesinglecurrency,andperhapsthewiderproject.

Europeans like to point out that it took the United States more than twocenturies, many crises and a civil war before it fully developed its model offederalism.To judgefromthe repeated flirtationwithself-inflicteddefault, theUSsystemcouldstillbeperfected.Europecanthereforebeforgivenifitmovesslowly and uncertainly. For all its flaws, the EU can claim to have helpedsupportpeaceamongitsmembersformorethansixdecades.

Europe’s model, if it survives, will be different from that of the UnitedStates.Europeisanoldercontinent,withamoreheterogeneouspopulationandadeeper sense of distinct national histories. As well as the push for Europeanintegration, there is a counter-current of disaggregation. Well before the UKholds its referendum on EU membership, Scotland will hold a ballot inSeptember2014onwhethertoremainwithintheUK.CataloniaisdemandingasimilarrighttoholdareferendumonwhethertoremainpartofSpain.

SotherewillnotbeaUnitedStatesofEurope,andnorneedtherebe.Thatsaid, Europeans should not waste the opportunity to learn from others whatworksandwhatdoesnot,particularlywhenitcomestocurrencyunions.

Aquestionof(German)historyEurope’s course will depend, in large part, on Germany – Europe’s mostpowerfuleconomyandbiggestcreditor.Inmanyways,thequestionoftheeurocomesback to the old questionofGermany, a country too strong to livewitheasily yet not strong enough to dominate permanently (or, indeed, to rescueeverybody). The single currency, like the European Union, was meant toreconcileGermanywithitsoldenemiesandharnessitsstrengthfor thebenefitofthecontinent.

Germany needs a political strategy for Europe. It has been conditioned toavoid any notion of leadership. But lead it must. Failure to do so also hasconsequences. Angela Merkel has won a third term and the respect of manyEuropeans. She is a pragmatic politician, not a visionary one. Her favouritedictumis“step-by-step”.Itistimeforhertosaywhereshewantstogo.

In2014 theworld looksback100years to commemorate the cataclysmofthe firstof twoworldwars, inwhich theheartof thematterwas thepowerofGermany. Two works of history conclude by reflecting on the lessons for

today’sleaders.Inone,publishedin2012,ChristopherClarknotes:11

Theactorsintheeuro-zonecrisis,likethosein1914,wereawarethattherewasapossibleoutcomethatwouldbegenerallycatastrophic(thefailureoftheeuro).Allthekeyprotagonistshopedthiswouldnothappen,butinadditiontothissharedinterest,theyallhadspecial–andconflicting–interestsoftheirown.

Inthesecond,publishedin2013,BrendanSimmsasks,morepointedly:12

WillBerlincometoacceptthatthealternativetoademocraticallycontrolledEuropeancurrencyisaGermaneconomichegemonythatwillinthelongrundestroytheEuropeanUnion?…Ifthathappens,historywilljudgetheEuropeanUnionanexpensiveyouthfulprankwhichthecontinentplayedinitsdotage.

ThefathersoftheEuropeanUnionfelt theweightofhistory.ThiswasstilltrueoftheKohl-Mitterrandgenerationthatcreatedtheeuro.Buttoday’scropofleaders, for the most part, sees the problems, inconvenience, constraints andthreatofEurope,ratherthanitspromise.Perhapstheylackthememoryofwar,and have lost the fear of history’s judgment. Or perhaps now that war seemsinconceivableanolderhistorycanreassertitself,oneinwhicholdnationsdonoteasilyabandontheirpowers,prerogativesandsenseof identity.OrperhapstheEuropeanprojecthasbeensolonginthemakingthatithaslostitsromance.

There isanasymmetryaboutEurope’scrisis.Theeurohas thepotential todestroytheEuropeanproject.Yetsavingthesinglecurrencyisapoorrallying-cry forEuropean integration.Sopressure frommarketsbringsonly short-termexpedients,notadesignforthefuture.Europe’sleadersfearundoingEuropeanintegration,butdarenotpromoteiteither.

Somethingofgreatvaluemaythusbelostthroughcarelessnessortimidity.The bestway to gauge the achievements of theEuropeanUnion is to visit itseasternborderlands.TheEUhashelpedtosolidifypost-communistdemocracies,many of which are among the fastest-growing economies in Europe. Herecountriesarestilllininguptojointheeuro,flawedasitmaybe,becauseoftheeconomicandpoliticalsecurityitstilloffersinanuncertainregion.Justbeyond,countriesareknockingatthedoortobeadmittedtotheEU.Thecountriesofthewestern Balkans, many of them traumatised by the violent break-up of the

former Yugoslavia, are still lured by the idea of belonging to Europe’scommunityofdemocracies.InUkraine,protestershaveformonthshelduptheEU’sblueflagasasymboloffreedom.DespitescoresofpeoplebeingshotdeadinKiev,theytoppledacorruptandineptgovernment–andprovokedaRussianmilitaryinterventionwhoseoutcomeremainsuncertain–intheattempttodrawtheircountryclosertoEurope.

Europe’smalaiseisnotonethattimealonecanheal.Delayislikelytomakethingsworse,notbetter.Thoughthefinancialpanicisinabeyance,theeconomicand political crises are far from over, and may well deepen. Right now thepoliticalmomentum is towards fragmentation, not integration.Unless the eurozoneisredesignedwithgreaterdetermination,inparticularthroughgreaterrisk-sharing, it isunlikely torecovereconomicvitality.Andunless theeurocanbeshown to deliver prosperity and well-being, public support for the EuropeanUnionwillinexorablyebbaway.

Notes

Preface

1 Leonard,M.,WhyEuropewillrunthe21stCentury,PublicAffairs(2005)

1Iftheeurofails,Europefails1 Meyer,T.,DerGeuro:EineParallelwährungfürGriechenland?(in

German),DeutscheBank,May2012,availableat:www.dbresearch.de/PROD/DBR_INTERNET_DE-PROD/PROD0000000000288868.pdf.SomeofMeyer’sargumentsarereportedinBusinessInsider,availableat:www.businessinsider.com/introducing-the-geuro-a-new-parallel-currency-to-solve-all-of-greeces-problems-2012-5.MeyerhimselfsetsoutsomeofhisviewsinthispiecefortheWallStreetJournal,availableat:online.wsj.com/news/articles/SB10001424127887324556304578116830518460210

2 RogerBootleetal.,LeavingtheEuro:APracticalGuide,CapitalEconomics,revisedsubmissiontothe2012WolfsonPrize.Thisandothersubmissionsareavailableat:www.policyexchange.org.uk/images/WolfsonPrize/wolfson%20economics%20prize%20winning%20entry.pdf

3 See“Tempted,Angela?”atwww.economist.com/node/215602694 Seepage22ofGill,I.S.andRaiser,M.,GoldenGrowth:Restoringthe

LustreoftheEuropeaneconomicmodel,WorldBank,2012(overview)http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/2013/11/15/000442464_20131115123906/Rendered/PDF/681680PUB0v10G00Box379791B00PUBLIC0.pdf

2FromtheoriginstoMaastricht

1 ChurchillZurichspeechavailableat:www.churchill-society-london.org.uk/astonish.html

2 Schumanspeechavailableat:europa.eu/about-eu/basic-information/symbols/europe-day/schuman-declaration/

3 EuropeanCoalandSteelCommunityavailableat:europa.eu/legislation_summaries/institutional_affairs/treaties/treaties_ecsc_en.htm

4 QuotedbyOtmarIssing,July2nd2013,availableat:www.project-syndicate.org/commentary/the-risk-of-european-centralization-by-otmar-issing

5 SeeDell,E.,TheSchumanPlanandtheBritishAbdicationofLeadershipinEurope,OxfordUniversityPress,1995,p.169.

6 QuotedinInwiththeEuro,OutwiththePoundbyChristopherJohnson(PenguinBooks,1996).

7 Crafts,N.,SavingtheEuro:aPyrrhicVictory,availableat:www.chathamhouse.org/publications/papers/view/195771

8 ThisstoryistoldinTheOfficialHistoryofBritainandtheEuropeanCommunity,VolumeIIbyStephenWall(Routledge,2013).

9 ThissectionhasdrawnonMakingtheEuropeanMonetaryUnionbyHaroldJames(HarvardUniversityPress,2012)andTheEuro:theBattlefortheNewGlobalCurrencybyDavidMarsh(YaleUniversityPress,2011).

10 Mundell,R.,ATheoryofOptimumCurrencyAreas,availableat:www.aeaweb.org/aer/top20/51.4.657-665.pdf

11 ReportofastudygroupontheroleofpublicfinanceinEuropeanintegration,availableat:ec.europa.eu/economy_finance/emu_history/documentation/chapter8/19770401en73macdougallrepvol1.pdf

12 Thestoryofthesinglemarketandthepathto1992istoldinEuropeRelaunched:TruthsandIllusionsontheWayto1992byNicolasColchesterandDavidBuchan(Hutchison,1990).

13 DavidCameron,speechtoWorldEconomicForuminDavos,January26th2012,availableat:www.politics.co.uk/comment-analysis/2012/01/26/david-cameron-s-davos-speech-in-full

14 “Bankingonacrisis?”,TheEconomist,October29th1998,availableat:www.economist.com/node/174327

15 Reportedinwww.causeur.fr/%C2%AB-on-ne-rejette-pas-platon-%C2%BB,12999

3Howitallworks

1 Appendix2summarisesthemaintreaties,regulationsandpactsgoverningtheEuropeanUnionandtheeuro.

2 ThissectionhasdrawnonthetwobestgeneralguidestotheEuropeanUnion:ThePenguinCompaniontoEuropeanUnionbyAnthonyTeasdaleandTimothyBainbridge(4thedition,Penguin,2012)andGuidetotheEuropeanUnionbyDickLeonard(10thedition,ProfileBooks,2010–11theditionduein2014).SeealsoThePassagetoEuropebyLuukvanMiddelaar(YaleUniversityPress,2013),especiallyfortheearlyyearsoftheEuropeanproject.

3 Theargumentwassetoutin“TheStabilityPact:MorethanaMinorNuisance”byBarryEichengreenandCharlesWyploszinBegg,D.etal.(eds),EMU:ProspectsandChallengesfortheEuro,Blackwell,1998.

4 See“Farewelltothestupiditypact”,October22nd2002,availableat:www.economist.com/node/1402102

5 Thestoryoftheconstitutionaltreatyistoldintwobooks:TheAccidentalConstitutionbyPeterNorman(Eurocomment,2005)andTheStruggleforEurope’sConstitutionbyAndrewDuff(FederalTrust,2005).

6 OntheBritishbudgetquestion,seeamongothers,AStrangerinEuropebyStephenWall(OxfordUniversityPress,2008)andBritain’sQuestforaRolebyDavidHannay(I.B.Tauris,2013).

4Build-uptoacrisis1 Gill,I.S.andRaiser,M.,GoldenGrowth:RestoringtheLustreofthe

Europeaneconomicmodel,WorldBank,2012,seewww.worldbank.org/en/region/eca/publication/golden-growth

2 Gros,D.,WillEMUsurvive2010?,CentreforEuropeanPolicyStudies,2006,availableat:www.ceps.be/ceps/dld/3059/pdf

3 Tilford,S.,WilltheEurozoneCrack?,CentreforEuropeanReform,September2006,availableat:www.cer.org.uk/sites/default/files/publications/attachments/pdf/2011/p_688_eurozone_crack_42-892.pdf

4 Veron,N.,IsEuropeReadyforaMajorBankingCrisis?,Bruegel,August2007,availableat:www.bruegel.org/download/parent/234-is-europe-ready-for-a-major-banking-crisis/file/659-is-europe-ready-for-a-major-banking-crisis-english/

5 EMU@10:SuccessesandchallengesaftertenyearsofEconomicandMonetaryUnion,EuropeanCommission,availableat:

ec.europa.eu/economy_finance/publications/publication12682_en.pdf6 Delors,J.,ReportoneconomicandmonetaryunionintheEuropean

Community,April1989,availableat:ec.europa.eu/economy_finance/publications/publication6161_en.pdf

5Trichet’stest1 Article125:“AMemberStateshallnotbeliablefororassumethe

commitmentsofcentralgovernments,regional,localorotherpublicauthorities,otherbodiesgovernedbypubliclaw,orpublicundertakingsofanotherMemberState,withoutprejudicetomutualfinancialguaranteesforthejointexecutionofaspecificproject.”

2 Article122.2:“WhereaMemberStateisindifficultiesorisseriouslythreatenedwithseveredifficultiescausedbynaturaldisastersorexceptionaloccurrencesbeyonditscontrol,theCouncil,onaproposalfromtheCommission,maygrant,undercertainconditions,UnionfinancialassistancetotheMemberStateconcerned.ThePresidentoftheCouncilshallinformtheEuropeanParliamentofthedecisiontaken.”

3 ThedetailswerereportedbytheWallStreetJournalmorethanthreeyearsaftertheevent,basedonaleakoftheboardminutes,see:online.wsj.com/news/articles/SB10001424052702304441404579119180237594344Theexcerptsfromtheminutesareworthreadingat:blogs.wsj.com/economics/2013/10/07/imf-document-excerpts-disagreements-revealed/

4 AnaccountoftheECB’sactionsinthiskeyweekendofMay2010isgiveninTheAlchemists:ThreeCentralBankersandtheWorldonFirebyNeilUrwin,VikingPress,2013.AnextractwasprintedbytheWashingtonPostat:www.washingtonpost.com/business/three-days-that-saved-the-world-financial-system/2013/03/28/d5b9a38c-94ef-11e2-b6f0-a5150a247b6a_print.html

5 “E-Bondswouldendthecrisis”,op-edintheFinancialTimes,availableat:www.ft.com/cms/s/0/540d41c2-009f-11e0-aa29-00144feab49a.html#axzz2mdxfF3bW

6SuperMario1 “Standard&Poor’sTakesVariousRatingActionsOn16Eurozone

SovereignGovernments”January13th2012,availableat:

www.standardandpoors.com/ratings/articles/en/us/?assetID=1245327295020

2 TowardsaGenuineEconomicandMonetaryUnion,availableat:ec.europa.eu/economy_finance/crisis/documents/131201_en.pdf

3 EuroAreaSummitStatement,June29th2012,availableat:www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131359.pdf

4 Berlusconideniesdescribingthechancellorasunaculonainchiavabile(an“unfuckablefat-arse”),thoughhissupportersarehappytoalludetotheterm.SeeIlFattoQuotidianoat:www.ilfattoquotidiano.it/2011/09/10/cucu-la-merkel-e-%E2%80%9Cinchiavabile%E2%80%9D/156545/

5 Moody’sannouncementonJuly23rd2012,availableat:www.moodys.com/research/Moodys-changes-the-outlook-to-negative-on-Germany-Netherlands-Luxembourg--PR_251214

6 SpeechbyMarioDraghi,presidentoftheEuropeanCentralBank,attheGlobalInvestmentConferenceinLondon,July26th2012,availableat:www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html

7 “MoneyCreationandResponsibility”,speechbyJensWeidmann,September18th2012,availableat:www.bundesbank.de/Redaktion/EN/Reden/2012/2012_09_20_weidmann_money_creaktion_and_responsibility.html

8 “Bankingunionmustbebuiltonfirmfoundations”,WolfgangSchäuble,FinancialTimes,May12th2013,availableat:www.ft.com/cms/s/0/8bdaf6e8-b89f-11e2-869f-00144feabdc0.html#axzz2uvQwaeg2

7Thechangingbalanceofpower1 ThebestaccountoftheDelorsperiodisDelors:InsidetheHousethat

JacquesBuiltbyCharlesGrant(NicholasBrealey,1994).2 Oneofthefirstproponentsofgettingparliamentarygroupstonominate

theircandidatesforthepresidencyoftheCommissionwasSimonHixinWhat’sWrongwithEuropeandHowtoFixIt(Polity,2008)

3 SeearticleonextremistpartiesinEuropepublishedinTheEconomist,January4th2014,availableat:www.economist.com/news/briefing/21592666-parties-nationalist-right-are-changing-terms-european-political-debate-does

4 ThisisdiscussedinCanGermanybeSaved?byHans-WernerSinn,availableat:www.cesifo-group.de/ifoHome/publications/individual-publications/Germany/Can-Germany-Be-Saved.html

5 See“Europe’snewpeckingorder”,availableat:www.economist.com/node/13610767

6 Apointmadein“France:aCountryinDenial”,availableat:www.economist.com/node/21551478

7 Heisbourg,F.,LaFinduRêveEuropéen,Stock,2013.8 Reportedat:www.spiegel.de/international/europe/now-europe-is-speaking-

german-merkel-ally-demands-that-britain-contribute-to-eu-success-a-798009.html

9 Acommentonthisspeechisavailableat:www.zukunftsdebatte.eu/home/aktuell/news//ecfr-why-poland-is-the-new-france-for-germany/

8In,out,shakeitallabout1 Tindemans,L.,AReportonEuropeanUnion,availableat:

bookshop.europa.eu/en/european-union-pbCBNF76001/2 TheSchäuble-Lamerspaperisavailable(inGerman)at:

www.cducsu.de/upload/schaeublelamers94.pdf3 Amorerecentadvocateofatwo-speedEurope,basingsomeofhis

argumentsontheeuro,isaformerCouncillegaladviser,Jean-ClaudePiris,inhisbookTheFutureofEurope(CambridgeUniversityPress,2012).

4 See“CanAngelaMerkelholdEuropetogether”,March10th2011,availableat:www.economist.com/node/18332786/

5 Quotedat:www.economist.com/node/3194456/6 DavidCameron’sspeechatBloombergisavailableat:

www.gov.uk/government/speeches/eu-speech-at-bloomberg7 GeorgeOsborne’sspeechtoOpenEurope/FreshStartconference,January

15th2014,availableat:www.gov.uk/government/speeches/extracts-from-the-chancellors-speech-on-europe

9Democracyanditsdiscontents1 Thissectiondrawsontheanalysisintwobookswithidenticaltitles:

DemocracyinEurope.OneisbyLarrySiedentop(AllenLane,2000),theotherbyVivienSchmidt(OxfordUniversityPress,2006).

2 SeePewGlobalAttitudesSurvey,May2013,availableat:www.pewglobal.org/2013/05/13/the-new-sick-man-of-europe-the-european-union/;andEurobarometer,at:

ec.europa.eu/public_opinion/archives/eb/eb79/eb79_publ_fr.pdf3 Guerot,U.andKlau,T.,AfterMerkozy:howFranceandGermanycan

makeEuropeWork,availableat:ecfr.eu/page/-/ECFR56_FRANCE_GERMANY_BRIEF_AW.pdf

4 See,forexample:www.globalpost.com/dispatch/news/regions/europe/130625/european-union-eastern-central-europe-accession

5 Reportsonthisinclude:www.telegraph.co.uk/finance/financialcrisis/10088005/François-Hollande-tells-European-Commission-it-cant-dictate-to-France.html

6 SeereportsonGerritZalm,forexampleat:www.europeanvoice.com/article/imported/colourful-money-man/50233.aspx

7 Germanconstitutionalcourtdecision,June30th2009,availableat:www.bverfg.de/entscheidungen/es20090630_2bve000208.html

8 SeeCERpaperbyHeatherGrabbeandStefanLehne,availableat:www.cer.org.uk/publications/archive/essay/2013/2014-european-elections-why-partisan-commission-president-would-be-b;andalsoanotebyCharlesGrant,availableat:www.cer.org.uk/in-the-press/how-reduce-eus-democratic-deficit

9 InhisinaugurallectureattheLondonSchoolofEconomics,RobertCooperadvocatedelectingtheEuropeanCommission.See:www.lse.ac.uk/newsAndMedia/videoAndAudio/channels/publicLecturesAndEvents/player.aspx?id=1585

10Howtheeurospoiltanyotherbusiness1 TheCommissionproposalscanbefoundat:

ec.europa.eu/energy/doc/2030/com_2014_15_en.pdf2 TheeventualtextoftheBolkesteindirectiveisavailableat:eur-

lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32006L0123:EN:HTML

3 TheMontireportcanbefoundat:ec.europa.eu/bepa/pdf/monti_report_final_10_05_2010_en.pdf

4 QuotedintheCharlemagnecolumn,October20th2012,see:www.economist.com/news/europe/21564851-euro-was-meant-underpin-single-market-it-may-end-up-undermining-it

5 SeePascouau,Y.,TheFutureoftheAreaofFreedom,SecurityAndJustice,

EuropeanPolicyCentre,Brussels,January2014,availableat:www.epc.eu/pub_details.php?cat_id=1&pub_id=4092

11Europe’splaceintheworld1 Seewww.nytimes.com/1991/06/29/world/conflict-in-yugoslavia-europeans-

send-high-level-team.html2 ThispointisalsomadeinTheUncertainLegacyofCrisis:European

ForeignPolicyFacestheFuturebyRichardYoungs(CarnegieEndowmentforInternationalPeace,2014).

3 See“Defenceless?”,Charlemagnecolumn,December21st2013,availableat:www.economist.com/news/europe/21591880-austerity-hollowing-out-europes-armies-defenceless

4 ThisledtoanespeciallyacerbicspeechbytheAmericandefencesecretary,RobertGates,availableat:www.defense.gov/speeches/speech.aspx?speechid=1581

5 ForoneexampleofmeasuresonBulgarianandRomanianimmigration,see:www.ukba.homeoffice.gov.uk/eucitizens/bulgaria-romania/

6 ThelatestEuropeanCommissionreportonenlargementtoTurkeyisavailableat:ec.europa.eu/enlargement/pdf/key_documents/2013/package/tr_rapport_2013.pdf

7 InformationontheEuropeanUnion’seasternneighbourhoodpolicycanbefoundat:www.eeas.europa.eu/enp/index_en.htm

12Afterthestorm1 Schäuble,W.,“IgnoretheDoomsayers.Europeisbeingfixed”,Financial

Times,September16th2013,availableat:www.ft.com/cms/s/0/e88c842a-1c67-11e3-a8a3-00144feab7de.html#axzz2nqL7SnRz

2 Greece:ExPostEvaluationofExceptionalAccessunderthe2010Stand-ByArrangement,IMF,June2013,availableat:www.imf.org/external/pubs/ft/scr/2013/cr13156.pdf

3 FiscalFederalism:USHistoryforArchitectsofEurope’sFiscalUnion”,byC.RandallHenningandMartinKessler,Bruegel,January2012,availableat:www.bruegel.org/publications/publication-detail/publication/669-fiscal-federalism-us-history-for-architects-of-europes-fiscal-union/

4 Agoodsummaryofthefederaland“mutualassurance”modelsisprovidedbyJeanPisani-Ferryinapaper(inFrench)forBruegel,AssuranceMutuelle

ouFédéralisme?laZoneEuroentreDeuxModèles,availableat:www.bruegel.org/download/parent/757-assurance-mutuelle-ou-federalisme-la-zone-euro-entre-deux-modeles/file/1623-assurance-mutuelle-ou-federalisme-la-zone-euro-entre-deux-modeles/.SomeofhisviewsaresetoutinEnglishinshorterforminanop-edforProjectSyndicate,availableat:www.project-syndicate.org/commentary/federalism-or-bust-for-europe-by-jean-pisani-ferry

5 Mody,A.,ASchumanCompactfortheEuroArea,Bruegel,November29th2013,availableat:www.bruegel.org/publications/publication-detail/publication/802-a-schuman-compact-for-the-euro-area/

6 GlienickerGroup,“TowardsaEuroUnion”,op-edinDieZeit,October17th2013,availableinEnglishviaBruegelat:www.bruegel.org/nc/blog/detail/article/1173-towards-a-euro-union/

7 PouruneCommunautépolitiquedel’euro,GroupeEiffelEurope,February2014.Englishversionavailableat:www.bruegel.org/nc/blog/detail/article/1250-for-a-euro-community/

8 Allart,C.etal.,TowardsaFiscalUnionfortheEuroArea,IMF,September25th2013.Paperandtechnicalnotesavailableat:www.imf.org/external/pubs/cat/longres.aspx?sk=40784

9 TheEuropeanCommissionlookedatvariousoptionsfor“stabilitybonds”inNovember2011(ec.europa.eu/commission_2010-2014/president/news/documents/pdf/green_en.pdf).Inthe“BlueBond”proposalforBruegel,JakobvonWeizsäckerandJacquesDelplaproposedmutualisingall“good”debtuptotheMaastrichtthresholdof60%ofGDP(www.bruegel.org/publications/publication-detail/publication/403-the-blue-bond-proposal/).TheGermanCouncilofEconomicExpertsproposedinsteadpooling“bad”debtabovethislevelinafundtobepaidoffover20years(www.sachverstaendigenrat-wirtschaft.de/aktuellesjahrsgutachten0.html).

10 BoththeseideasareproposedinHowtoBuildaModernEuropeanUnionbyCharlesGrantandothers(CentreforEuropeanReform,2013).

11 Clark,C.,TheSleepwalkers:HowEuropeWenttoWarin1914,AllenLane,2012.

12 Simms,B.,TheStruggleforSupremacy:Europefrom1453tothePresent,AllenLane,2013.

Appendices

Appendix1

Timeline

February1992 MaastrichttreatysignedJune1992 DenmarksaysnoSeptember1992 ERMcrisis,UKpoundandItalianliraoutMay1993 Danessayyeswithopt-outsOctober1993 MaastrichttreatyratifiedJune1997 StabilityandGrowthPactsignedJanuary1999 EMUbeginswith11countriesJanuary2001 GreecejoinsEMUJanuary2002 EuronotesandcoinsintroducedNovember2003 Germany and France breach stability pact.

Jean-Claude Trichet becomes ECBpresident

August2007 ECBliquidityinjectionbegins

September2008 LehmanBrotherscollapsesJanuary2009 GreecedowngradedNovember2009 New Greek government admits to bigger

budgetdeficitMay2010 FirstGreekbail-outOctober2010 Deauville deal on private-sector

involvementNovember2010 Irishbail-outMay2011 Portuguesebail-outJuly2011 SecondGreekbail-outAugust2011 ECBbuysItalianandSpanishbondsOctober2011 HaircutonGreekdebtNovember2011 George Papandreou and Silvio Berlusconi

forced out of office in Greece and Italyrespectively. Mario Draghi becomes ECBpresident

December2011 Draghi launches LTRO. Fiscal compacttreaty agreed. Mariano Rajoy becomesSpain’sprimeminister

February2012 RajoyadmitshigherSpanishbudgetdeficitMay2012 FrançoisHollandeelectedFrenchpresidentJune2012 Partial bail-out agreed for Spanish banks.

AgreementonbankingunionJuly2012 Draghigives“whateverittakes”speechAugust2012 ECBagreesOMTprogrammeOctober2012 AngelaMerkelvisitsAthensNovember2012 Greekdebt burden spreadout, interest-rate

cutDecember2012 European Council rejects Manuel Barroso

and Herman Van Rompuy’s plans forgreaterunion

February2013 IndecisiveItalianelectionMarch2013 First Cyprus bail-out, banks shut, revised

bail-out

April2013 EnricoLettabecomesItalianprimeministerSeptember2013 German election. Merkel wins and

negotiatesgrandcoalitionDecember2013 Ireland exits bail-out programme. Single

banksupervisoragreedJanuary2014 LatviajoinseuroFebruary2014 Matteo Renzi becomes Italian prime

minister

Appendix2Treaties,regulationsandpacts

TreatyofRome

The founding basis for the European Economic Community (EEC) and itsassociatedbodies.SignedinRomebytheoriginalsixcountries–France,WestGermany,Italy,Belgium,theNetherlandsandLuxembourg–inMarch1957.

SingleEuropeanAct

Thelegaldocumentthatunderpinsthe1992singlemarketbyprovidingformorewidespread use of qualified-majority voting. Agreed in Luxembourg inDecember1985,signedinFebruary1986andenteredintoforceinJuly1987.

Maastrichttreaty

Formally the Treaty on European Union. The founding legal document forEuropean economic and monetary union (EMU), agreed in Maastricht inDecember 1991, signed in February 1992 and ratified in October 1993. Thetreatylaysdownfive“convergencecriteria”tobefulfilledbycandidatestojoinEMU.DenmarkandtheUKweregrantedopt-outsfromstagethree,theadoptionofasinglecurrency.

TreatyofAmsterdam

Providesthelegalbasisfor justiceandhomeaffairsandforacommonforeignand security policy to become part of the EU. Agreed in Amsterdam in June

1997andenteredintoforceinMay1999.

TreatyofNiceChanged the votingweights and several EU institutions in preparation for the2004enlargementtotakeintennewmembers,mainlyfromcentralandeasternEurope.Agreed inNice inDecember2000 and entered into force inFebruary2003.

TreatyofLisbon

AftertheEuropeanconstitutionaltreatywasrejectedbyreferendumsin2005inFrance and the Netherlands, its essential elements were subsumed into theLisbon treaty, whichwas signed in December 2007 and entered into force inDecember2009.Thetreatychangesthevotingsystem,establishesapermanentpresident of the European Council and sets up a new external action serviceunderahighrepresentativeforforeignpolicy.

StabilityandGrowthPact

A set of regulations agreed in 1997 to impose budget discipline on euro-zonecountries,with thepossibilityof swingeing fineson thosewithbudgetdeficitsover3%ofGDP.AfterFranceandGermanybrokethepactin2003–04,itwassubsumed into a new excessive deficits procedure known as the six-pack (seebelow).

EuropeanFinancialStabilityFacility,EuropeanStabilityMechanismTheEuropeanFinancialStabilityFacility(EFSF)wassetupinMay2010asatemporary bail-out fund for the euro zone, used first for Greece. Its lendingcapacitywaslaterraisedto€440billion.In2012itwasreplacedbyapermanentEuropean StabilityMechanism (ESM), based on an inter-governmental treaty,withalendingcapacityinitiallyof€500billion.

Fiscalcompacttreaty

FormallyknownastheTreatyonStability,Co-ordinationandGovernanceinthe

Economic and Monetary Union, the fiscal compact was agreed in December2011andenteredintoforceinJanuary2013.Thetreatycommitssignatoriestoamend national law to guarantee budget balance, defining this as keepingcyclicallyadjustedstructuraldeficitsbelow0.5%ofGDP.BecausetheUKandthe Czech Republic refused to sign, the treaty was adopted as an inter-governmentaloneby25EUcountries.

Six-pack,two-pack,EuroPlusPactComplementingthefiscalcompacttreatyarerulesunderthe“excessivedeficitsprocedure”,agreedin2011and2012.Thesix-packreferstofiveregulationsandadirective tocontrolbudgetdeficits andmacroeconomic imbalances; the two-pack to provisions for the European Commission tomonitor and if necessaryrequire amendments to national budgets. The voting for sanctions is changedfrompositive tonegativequalifiedmajority: that is, itnowtakesamajorityofcountriestorejectratherthanapproveproposalsfromtheCommission.TheEuroPlus Pact, signed by six other EU countries besides the euro zone, concernsbroadereconomicco-ordination.Collectivelytheseprovisionsareknownasthe“Europeansemester”.

Bankingunion

Negotiations on the details of banking union are continuing, but a singlesupervisorymechanism(SSM)hasbeensetupandagreementhasbeenreachedonasingleresolutionmechanism(SRM).Thefirst transferssupervisionof themost important banks to the European Central Bank; the second sets outarrangements formanaging abank failure.These apply to euro-zone countriesand other EU countries that choose to join (the UK, the Czech Republic andSwedenwillnotdo so).TheEuropeanBankingAuthoritycontinues togovernallbanksintheEU.

Appendix3

Furtherreading

Despite the euro’s and the European Union’s relative youth, there is a vastamountof literatureonboth.Thefootnotes to the textciteseveralsources thathavebeenespeciallyhelpful.Below isa listof somebooks that readersmightwishtoconsult.

Almqvist,K.andLinklater,A.(eds),ThePursuitofEurope,AxelandMargaretAxsonJohnsonFoundation,2012

Authers,J.,Europe’sFinancialCrisis:AShortGuidetoHowtheEuroFellIntoCrisis,andtheConsequencesfortheWorld,PearsonEducation,2013

Bastasin,C.,SavingEurope:HowNationalPoliticsNearlyDestroyedtheEuro,BrookingsInstitutionsPress,2012

Booth,P.(ed.),TheEuro:theBeginning,theMiddle…andtheEnd?,IEA,2013Carswell, S., Anglo Republic, Inside the Bank that Broke Ireland, Penguin

Ireland2011Cornelius,S.,AngelaMerkel:TheAuthorisedBiography,AlmaBooks,2013Crawford, A. and Czuczka, T., Angela Merkel: A Chancellorship Forged in

Crisis,Wiley,2013DeGrauwe,P.,EconomicsofMonetaryUnion, 9thedition,OxfordUniversity

Press,2012Gammelin, C. and Löw, R., Europas Strippenzieher (in German), Ullstein

BuchverlageBerlin,2014Goulard, S. and Monti, M.,De la démocratie en Europe: Voir plus loin (in

French),Flammarion,2012Habermas,J.,TheCrisisoftheEuropeanUnion:AResponse,Polity,2012Heise,M,EmergingfromtheEuropeDebtCrisis,Springer,2013Hewitt,G.,TheLostContinent,Hodder&Stoughton,2013Issing,O.,TheBirthoftheEuro,CambridgeUniversityPress,2008James, H.,Making the EuropeanMonetary Union, Harvard University Press,

2012Legrain,P.,EuropeanSpring:WhyOurEconomicsandPoliticsareinaMess–

andHowtoPutThemRight,CBBooks(Amazon),2014Marsh,D.,Europe’sDeadlock,YaleUniversityPress,2013Marsh,D.,TheEuro: theBattle for aNewGlobalCurrency,YaleUniversity

Press,updated2011O’Toole,F.,ShipofFools:HowStupidityandCorruptionSanktheCelticTiger,

FaberandFaber,2009Pisani-Ferry, J., The Euro Crisis and its Aftermath, Oxford University Press,

2014Panagiotarea,E.,GreeceintheEuro,ECPRPress,2013Pryce,V.,Greekonomics,Biteback,updated2013Soros,G.,TheTragedyoftheEuropeanUnion,PublicAffairs,2014Tsoukalis, L. and Emmanouilidis, J. (eds), The Delphic Oracle on Europe,

OxfordUniversityPress,2011Tsoukalis, L., The Unhappy State of the European Union, Policy Network,

March2014VanMiddelaar,L.,ThePassagetoEurope,YaleUniversityPress,2013

Appendix4How The Economist saw it at the time

May1st–7th2010

July10th–16th2010

November20th–26th2010

December4th–10th2010

January15th–21st2011

March12th-18th2011

June11th-17th2011

June25th-July1st2011

October29th-November4th2011

November5th-11th2011

November12th-18th2011

November26th-December2nd2011

February18th–24th2012

March31st–April6th2012

May19th–25th2012

May26th-June1st2012

July28th-August3rd2012

August11th-17th2012

November17th-23rd2012

March23rd-29th2013

May25th–31st2013

September14th–20th2013

October26th-November1st2013

January4th-10th2014

Index

1974–75globalrecession10

A

accessiontreaties112accountability125–129,162AllianceofLiberalsandDemocratsforEurope(ALDE)130–131Alogoskoufis,George42Amsterdamtreaty111–112,193Anastasiades,Nicos2,86–88AngloIrishBank53Ansip,Anders104Arabspring145–146Argentina5,50Armenia149Ashton,Catherine28,43,144Asmussen,Jörg51,82Austria111,127influence108interestrates93

Azerbaijan149Aznar,JoséMaria17

B

Bagehot,Walter9bail-inrules83,90–91,165seealsoCyprus

bail-outsnationalapprovalrequirement127no-bail-outrule45,162,163–165

Balkanswar143BankofCyprus86–87BankofEngland47,157bankrecapitalisation58–59,74–77,84Bankia72bankingsectorcharacteristics35bankingsupervisionseefinancialsupervisionbankingunion23,74–75,77,83–85,90–92,106,165,195seealsodepositguarantees;financialsupervision

Barnier,Michel41,138Barroso,JoséManuelearlydaysofcrisis41EuropeanCommission97,98,141,172Greece3,78Italy63

Batista,PauloNogueira46Belarus149Belgium17,100,127Berlusconi,Silvioeurocurrencyview151Italy’sfailuretoreform59,60,62–63PeopleofFreedomparty(PdL)107resignation64

BlackWednesday16–17Blair,Tony28,112BNPParibas40

Bolkesteindirective137bondyields37,38,61,70,89bondspreads37,42,70,80,88Bootle,Roger1Bowles,Sharon98,129Brandt,Willy10BrettonWoods9–10Brown,Gordon24,41,48,102,112,144Bruegelthink-tank35,74,163,166budgetdeficitsMaastrichtceiling15timescalesformeetingtargets88–89seealsostabilityandgrowthpact

budgetsannual,European21,27,118central13,168–170federal164,168fiscalcapacity84

Bulgaria108,113,124,126,147Bundesbank16,23,157

C

Cameron,David14,17,64–65,117–119,132,140CannesG20summit(2011)62–64CapitalEconomics1CassisdeDijonjudgment21Catalonia178CEBS(CommitteeofEuropeanBankingSupervisors)35centralbanks,national22–23CentreforEuropeanPolicyStudies34CentreforEuropeanReform34CFSP(CommonForeignandSecurityPolicy)142,144China33,139,167Chirac,Jacques18,23,100,127Christofias,Demetris86Churchill,Winston7,115,161

Clark,Christopher178climatechange135–136Clinton,Hillary144Cockfield,Arthur13CommitteeofEuropeanBankingSupervisors(CEBS)35CommitteeofPermanentRepresentatives(COREPER)20CommitteeofRegions21commonfisheriespolicy100,138CommonForeignandSecurityPolicy(CFSP)142,144communitymethod19,21–22CompetitivenessPactseeEuroPlusPactcomplacencypre-crisis36–37Constâncio,Vítor34constitutionproposals26–27convergencecriteria14–16,41,112,193COREPER(CommitteeofPermanentRepresentatives)20COSAC (Conference of Community and European Affairs Committees of

ParliamentsoftheEuropeanUnion)133CouncilofMinisters20,121,130CounciloftheEuropeanUnionseeCouncilofMinistersCourtofAuditors21CourtofFirstInstance21Crafts,Nicholas9creditratings(countries)69,77–78,108Crimea150Croatia113,143,147current-account(im)balances25,31,88–89,167–168customsunion,German9Cyprusaccession147bail-out2,85–88entrytoeuro112financespre-crisis30

CyprusPopularBank(Laiki)86–88CzechRepublic113,118

D

Daytonagreement143deGaulle,Charles9,22,96deLarosière,Jacques41,74DeauvillemeetingbetweenSarkozyandMerkel51–52,102debtmutualisation74,103,166–167defenceandsecurity8,143,145deflation92Delors,Jacques11,37,97Delpla,Jacques167democraticaccountability125–129,162democraticdeficit121,129–132,162–163,171–172DenmarkEuropeanparticipation112justiceandhomeaffairs(JHA)111,139ministerialaccountability133opt-outs139referendums16,27,132shadowingofeuro113singlecurrencyopt-out110,115UKsympathies119

depositguarantees5,40–41,74,77,91Deutschmark10,12,16devaluation,internal31,65–66Dexia72Dijsselbloem,Jeroen24,87doublemajorityvoting20,114Draghi,Mario156appointmentasECBpresident23,68crisis-managementteam2demandforfiscalcompact64LongTermRefinancingOperations(LTRO)68–70outrightmonetarytransactions(OMT)78–81pressureonBerlusconi59“whateverittakes”Londonspeech79

Duisenberg,Wim23

E

e-commerce137east–westdivide108ECB(EuropeanCentralBank)bond-buying47–49,59–60crisis-managementplanning2,4delays156EuropeanSystemofCentralBanks22liquidityprovision40–42,68–70outrightmonetarytransactions(OMT)79–81,164,175–176roleandfunction22–24,39–40,170–171supervision6,99,175,195troikamembership160–161

EcoFinmeetings20,114EconomicandFinancialCommittee20economicandmonetaryunion(EMU)11,112EconomicandSocialCommittee21economicimbalances30–34TheEconomistonECBresponsibilities15fictitiousmemorandumtoAngelaMerkel1

ECSC(EuropeanCoalandSteelCommunity)7–8EEAS(EuropeanExternalActionService)142,144EEC(EuropeanEconomicCommunity)8EFSF(EuropeanFinancialStabilityFacility)26,48,55,60–61,81,194seealsoESM(EuropeanStabilityMechanism)

EFSM(EuropeanFinancialStabilisationMechanism)48Eiffelgroup120,129,164elections,European121,129–130Elyséetreaty100emissions-tradingscheme(ETS)135–136EMS(EuropeanMonetarySystem)creationof11exchange-ratemechanism16membership15

EMU(economicandmonetaryunion)11,112EMU@1036energypolicies136

enhancedco-operation111enlargement33,146–147environmentsummits135Erdogan,RecepTayyip148ESM(EuropeanStabilityMechanism)194establishment26,55,80–81operations58,75,76,91

Estonia65,108ETS(emissions-tradingscheme)135–136EU2020strategy137eurobreak-upcontingencyplans2–3convergencecriteria14–16,41,112,193crashdanger47–48introductionof4,18notesandcoins18specialcircumstances3–4

eurocrisiseffectonworldinfluence143–146errors155–161focusofattention135–141

EuroPlusPact55,195eurozone4economicdangers175–178increasingsignificanceofinstitutions113–114,120performancecomparedwithUS154–155politicaldangers175–178politicalintegration125trust173

Eurobonds54,59,74,166–167Eurogroupoffinanceministers24,114EuropeanBankingAuthority114,195EuropeanCentralBank(ECB)bond-buying47–49,59–60crisis-managementplanning2,4delays156EuropeanSystemofCentralBanks22

liquidityprovision40–42,68–70outrightmonetarytransactions(OMT)79–81,164,175–176roleandfunction22–24,39–40,170–171supervision6,99,175,195troikamembership160–161

EuropeanCoalandSteelCommunity(ECSC)7–8EuropeanCommissioncommissioners19,172errors160futuredirection171–172influenceandpower96–97,99,119,125intrusiveness127,140–141organisation19presidency131,144proposalsforeconomicgovernance50

EuropeanCommunity12EuropeanCouncil20,98–99EuropeanCourtofHumanRights21EuropeanCourtofJustice21EuropeanDefenceCommunity8EuropeanEconomicCommunity(EEC)8EuropeanExternalActionService(EEAS)142,144EuropeanFinancialStabilisationMechanism(EFSM)48EuropeanFinancialStabilityFacility(EFSF)26,48,55,60–61,81,194seealsoEuropeanStabilityMechanism(ESM)

EuropeanFinancialStabilityMechanism26seealsoEuropeanStabilityMechanism(ESM)

EuropeanInvestmentBank21EuropeanMonetaryInstitute22EuropeanMonetarySystem(EMS)creationof11exchange-ratemechanism16membership15

EuropeanParliament20–21,97–98,99,100,119,121,129–132,171EuropeanPeople’sParty117,127,130–131EuropeanPoliticalCo-operation142Europeansemester25,195

EuropeanStabilityMechanism(ESM)194establishment26,55,80–81operations58,75,76,91

EuropeanSystemicRiskBoard41EuropeanUniondrivingforcesformonetaryunion12–13expansion26historicalbackground7–12treatymaking26–28worldinfluence140,142–150

EuropeanUnionAct(2011)117,132Eurosceptics13,123FinnsParty124Jobbik125LeagueofCatholicFamilies125NationalFront124PartyofFreedom(PdL)124UKIndependenceParty(UKIP)118,125,140

excessivedeficitprocedure24,88–89,194,195exchange-ratesystems3,9–11exchangerates164

F

Farage,Nigel98,118FederalDepositInsuranceCorporation(FDIC)77FederalReserve(US)23,47,48,157federalism19,110,116,161–165,168–170,177–178financialintegration35–36financialsupervision195ECB6,99,175,195JacquesdeLarosièreproposals41national23,35singlesupervisor76–77,83–84,90

Finlandaccession26,111FinnsParty124

influence108ministerialaccountability133

fiscalcapacity84fiscalcompacttreaty25–26,64–65,118,194–195fiscalpolicy,focuson30–31FiveStarMovement124,126fixedexchange-ratesystems3,9–10Foot,Michael116forecasts,growth92foreignpolicy142–143Fouchetplan22Francecreditrating69,103current-accountbalance168EMSexchange-ratemechanism16excessivedeficitprocedure89GDPgrowth32andGreece44influence100–104,142–143Maastrichtdeal12,16publicdebt159publicopinionofEU123,124singlecurrencyviews16–17unemployment159vetoofUKentry115votetoblockEuropeanDefenceCommunity8

freedomsofmovement8,13

G

Gaulle,Charlesde9,22,96Gazprom136GDPgrowth32Georgia149Germany2013elections90,106,125bondyields37,89

Bundesbank16,23,157constitutional(Karlsruhe)court45,95,128,158creditrating69,77–78crisismanagementerrors155–156current-accountsurplus89,105,167–168demandspostGreekbail-out50–51economicstrengthsandweaknesses14GDPgrowth32andGreece44influence100–106Maastrichtdeal12,15–16nationalcontrolandaccountability128,133parliamentaryseats100politicalparties93,125publicdebt159publicopinionofEU123unemployment159unification16Zollverein9

Giscardd’Estaing,Valéry11,18,26,100Glienickergroup163,170goldstandard9–10GoldenDawn124governmentspending(worldwide)4governments,insolvencyof50greatmoderation31Greece2012election73,126bail-outdeal45–47,56–58,65–67,70,158bondyields37,61–62current-accountbalance168debtcrisis42–45euromembership18,112,115financespostbail-out93–94financespre-crisis30,71GDPgrowth32potentialeuroexit1–5,81–83

publicdebt159,166publicopinionofEUandeuro113,123,124referendumonbail-out2,61–62unemployment159

Gros,Daniel34

H

Hague,William151Haider,Jörg127Hamilton,Alexander162,167Heath,Edward10,116Heisbourg,François104Hollande,François73–74,89,103–104,127proposedreforms177

Hungary41,113,126,147HypoRealEstate41

I

Iceland53,147ideologicaldifferences114–115IKBDeutscheIndustriebank40immigration139–140,146,147impossibletrinity13inter-governmentalism96,128,174interestrates93,164internaldevaluation31,65–66InternationalMonetaryFund(IMF)bankingunion74crisis-managementplanning2,4–5Cyprus86–87errors160–161eurozonesupport48Greece44–46,56–57,66,83,93–95,160Latvia65

rainy-dayfunds169–170specialdrawingrights(SDR)63

Iraq143Ireland89,110bail-out53–54,56,57,89bankcrises40,71bondyields37,47,53,61,89current-accountbalance168financespre-crisis30GDPgrowth32influence107opt-outs111,139publicdebt159,166publicopinionofEU123referendums27,28,132unemployment159

Italy2013elections107,124,126bondyields37,61,89convergencecriteria17current-accountbalance168dangerofcollapse59EMSexchange-ratemechanism16excessivedeficitprocedure89GDPgrowth32influence100,104,107interestrates93publicdebt159,166publicopinionofEU123singlecurrencyviews17unemployment159

JJenkins,Roy11Jobbik125Juncker,Jean-Claude98,104,177candidateforCommissionPresidency131

EU2005budgetcrisis28Eurobonds54Eurogrouppresident24

justiceandhomeaffairs(JHA)139

K

Karamanlis,Kostas42Karlsruheconstitutionalcourt45,95,128,158Kauder,Volker105Kerry,John144Kohl,Helmut12,18,100

L

labourmarkets14,33–34Lagarde,Christine51,58,62,92Laiki86–88Lamers,Karl111Lamont,Norman17Larosière,Jacquesde41,74LatinMonetaryUnion9Latvia41,65,67,88,108Lawson,Nigel16LeagueofCatholicFamilies125legislativepath21–22LehmanBrothers,ECBreactiontocollapse4Letta,Enrico107–108Libya143,145Lipsky,John57Lisbontreaty28,45,194foreignpolicy142institutions20,131justiceandhomeaffairs(JHA)139subsidiarity133voting20,114

Lithuania88,113,153LongTermRefinancingOperations(LTRO)68–70,72Luxembourg77–78,100,108,169Luxembourgcompromise97

M

Maastrichttreaty11–12,15,22,142,193opt-outsandreferendums16,110–111

MacDougallreport(1977)13,169Major,John12,111,116Malta100,112Maroni,Roberto34Mayer,Thomas1McCreevy,Charlie41MEPs20–21,130Merkel,Angela2013re-election90bankingunion74–77CannesG20summit(2011)63–64crisisresponse40–41,44Europeanconstitution28fictitiousmemorandumto1futuredirection178powerandinfluence89,102–106,153Sarkozycollaboration60,61–62,102–103supportforCyprus86supportforGreece5,45,49–52,81–82supportforUK118–119unionmethod22,128votersupport125

Messinaconference8,115migration139–140,146,147Miliband,David144Mitterrand,François11,12,18,100Mody,Ashoka163Moldova149

Monnet,Jean8,152Montebourg,Arnaud104Montenegro147Monti,Mario64influence70,75–76,107ANewStrategyfortheSingleMarket(2010)137–138

Morocco146Morrison,Herbert8Morsi,Muhammad145Moscovici,Pierre75multi-annualfinancialframework21,27,118Mundell,Robert12–13mutualisationofdebt74,103,166–167

N

nationalbudgets89,125NationalFront124NATOdefencespendingtargets145Europeansecurity8membership110

Netherlandscreditrating77–78excessivedeficitprocedure89influence100,108ministerialaccountability133UKsympathies119

Nicetreaty194no-bail-outrule45,162,163–165north–southdivide33–34,108NorthernRock40notesandcoins18Nouy,Danièle90Nuland,Victoria149

O

Obama,Barack63officialsectorinvolvement(OSI)83OMT(outrightmonetarytransactions)79–81,164,175–176Germany’sconstitutionalcourtjudgment95,128

optimalcurrency-areatheory12–13,14–15Orban,Viktor126Osborne,George117,119OSI(officialsectorinvolvement)83outrightmonetarytransactions(OMT)79–81,164,175–176Germany’sconstitutionalcourtjudgment95,128

P

PactfortheEuroseeEuroPlusPactPapaconstantinou,George43Papademos,Lucas64Papandreou,George56,60election43Greekreferendum61–62resignation2,64

PartyofFreedom124Poland109,113PolicyExchange1politicalparties124–125,139–140politicalunion10,12,133–134Pompidou,Georges10Poos,Jacques143Portugal110bail-out54,57,89–90bondyields37,47,53,61,89publicopinionofEUandeuro113

power,balanceof99–101pricestabilitygoalofECB23private-sectorinvolvement(PSI)indebtrestructuring51–52

Prodi,Romano17,25,97ProgressiveAllianceofSocialistsandDemocrats(S&D)130–131publicdebt15,158–159seealsosovereigndebtpublicopinionofEUandeuro

121–124Putin,Vladimir149–150

Q

qualified-majorityvoting13,20,99,121negativequalified-majorityvoting25,195

quantitativeeasing(QE)47,15

R

Rajoy,Mariano70,75–76,127recapitalisation,bank58–59,74–77,84redenomination3–4,153–154,175Reding,Viviane139referendums27,28,121–122,132REFITinitiative172Regling,Klaus26Renzi,Matteo107–108rescuefundseeEuropeanStabilityMechanism(ESM)resolutionmechanism90–91,165,195singleresolutionmechanism(SRM)195singlesupervisorymechanism(SSM)195

Romania41,108,113,124,126,147Rometreaty8,97,110,193Rösler,Philipp78Rueff,Jacques9Rumsfeld,Donald143Russia,influenceonUkraine149–150Rutte,Mark77

S

Samaras,Antonis2,78,82,93–94Santer,Jacques97Sarkozy,Nicolascrisisresponse40–41,44economicgovernance49–50Europeanconstitution28LTROsandtheSarkozytrade69Merkelcollaboration51–52,60,61–62,102–103

Schäuble,Wolfgang62,75,84,90–91,106,111,154SchengenAgreement110,111–112Schmidt,Helmut11,100Schröder,Gerhard18,101,127Schulz,Martin131SchumanDay8Schuman,Robert7–8Scotland112,178SDR(specialdrawingrights)63SecuritiesMarketProgramme(SMP)48,79servicesdirective34Shafik,Nemat65Sikorski,Radek109Simitis,Costas18Simms,Brendan179singlecurrencybenefits152clubwithinaclub112drivingforces12–14importanceof113visionfor9seealsoeuro

SingleEuropeanAct13,193singlemarket4,137–138,174–175Sinn,Hans-Werner101six-pack25,50,195Slovakia112adoptionofeuro41influence108

Slovenia88–89,112influence108

SMP(SecuritiesMarketProgramme)48,79snakeinthetunnel10Solana,Javier142sovereigndebt165–166seealsopublicdebtSpain110bail-out70–73,89bankrecapitalisation84bondyields37,89CDSpremiums72current-accountbalance168dangerofcollapse59excessivedeficitprocedure89financespre-crisis30GDPgrowth32influence107publicdebt159publicopinionofEU123,124singlecurrencyviews17unemployment159

specialdrawingrights(SDR)63stabilityandgrowthpact18,24,29,50–51,127,194Stark,Jürgen59,106Steinbrück,Peer43Strauss-Kahn,Dominique24,44,57stresstests,bank72,175subsidiarity133,141Sweden109,111,112euroopt-out18,115UKsympathies119

Syria145Syriza124

T

TargetII157Thatcher,Margaret27,110,116

thirdenergypackage136Tilford,Simon34Tindemans,Leo111tradepolicy138TransatlanticTradeandInvestmentPartnership(TTIP)138–139treatymakingandchange26–27,173–174TreatyofAmsterdam111–112,193TreatyofLisbon28,45,194foreignpolicy142institutions20,131justiceandhomeaffairs(JHA)139subsidiarity133voting20,114

TreatyofNice194TreatyofRome8,97,110,193TreatyonEuropeanUnion(Maastrichttreaty)11–12,15,22,142,193opt-outsandreferendums16,110–111

TreatyonStability,Co-ordination andGovernance (TSCG) see fiscal compacttreatyTremonti,Giulio54,60

Trichet,Jean-Claude151,156bond-buying47–48,52–53crisis-managementplanning2earlywarnings39–40ECBpresident23IMF44Italy59

TrueFinns124Turkey132,147,148Tusk,Donald109,114two-pack25,89,195

U

UKIndependenceParty(UKIP)118,125,140Ukraine149–150,179–180unemployment158–159,170unionmethod19,22

UnitedKingdomcurrent-accountbalance168economicstrengthsandweaknesses14EMSexchange-ratemechanism16eurocrisisreaction117–118euromembership112Europeanbudgetcontribution27–28Europeaninvolvement8,10,12,115–119futurestatus174–175influence100–101,106,109,142–143initialapplicationtojoinEEC9opt-outs110–111,139publicopinionofEU123singlecurrencyviews17

UnitedLeftparty124UnitedStatesabandonmentofgoldstandard10federalismmodel177foreignpolicy143performancecomparedwitheurozone154–155

Urpilainen,Jutta77

VVanGendenLoosvNederlandseAdministratiederBelastingen(1963)21VanRompuy,Herman98crisis-managementplanning3Cyprus87EuropeanCouncilpresidency20,28Italy63roadmapforintegration74–75,84,173supportforGreece43–45

Venizelos,Evangelos57,62Verhofstadt,Guy131Véron,Nicolas35Vilniussummit149vonWeizsäcker,Jakob166

W

Waigel,Theo17–18WallStreetflashcrash47Weber,Axel49,56,106Weidmann,Jens40,80,82Weizsäcker,Jakobvon166Wernerreport(1971)10Wilson,Harold116WolfsonPrize1WorldBank33WorldTradeOrganisation138–139

Y

Yanukovych,Viktor149

Z

Zapatero,JoséLuisRodríguez59,62Zollverein9

PublicAffairsisapublishinghousefoundedin1997.Itisatributetothestandards,values,andflairofthreepersonswhohaveservedasmentorstocountlessreporters,writers,editors,andbookpeopleofallkinds,includingme.I.F.STONE,proprietorofI.F.Stone’sWeekly,combinedacommitmenttotheFirstAmendmentwithentrepreneurialzealandreportingskillandbecameoneofthegreatindependentjournalistsinAmericanhistory.Attheageofeighty,IzzypublishedTheTrialofSocrates,whichwasanationalbestseller.HewrotethebookafterhetaughthimselfancientGreek.BENJAMINC.BRADLEEwasfornearlythirtyyearsthecharismaticeditorialleaderofTheWashingtonPost.ItwasBenwhogavethePosttherangeandcouragetopursuesuchhistoricissuesasWatergate.Hesupportedhisreporterswithatenacitythatmadethemfearlessanditisnoaccidentthatsomanybecameauthorsofinfluential,bestsellingbooks.ROBERTL.BERNSTEIN,thechiefexecutiveofRandomHouseformorethanaquartercentury,guidedoneofthenation’spremierpublishinghouses.Bobwaspersonallyresponsibleformanybooksofpoliticaldissentandargumentthatchallengedtyrannyaroundtheglobe.HeisalsothefounderandlongtimechairofHumanRightsWatch,oneofthemostrespectedhumanrightsorganizationsintheworld.

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