How seriously can investors take Draghi’s assurances?

ECB president, Mario Draghi, has repeatedly claimed that the central bank will do everything necessary to save the euro. Nothing has been formally agreed yet, but the ECB is expected to announce a new government bond-buying programme following next week’s meeting of its Governing Council. To have a significant impact on Italian and Spanish borrowing costs, the latest effort must be big enough to dispel the convertibility risk that lies behind the extreme polarisation of government bond yields across the eurozone: investors are loath to hold Spanish and Italian debt because they fear that the two countries’ membership of the currency union might be unsustainable. Unfortunately, the ECB is highly unlikely to do enough to convince investors that membership is unequivocally forever, not least because the Bundesbank opposes any open-ended commitment to cap borrowing costs.

Spain, Italy and the periphery of the eurozone face unprecedentedly high real borrowing costs, which are preventing a recovery in investment and hence economic growth. Without a return to growth, they will fail to dispel investor fears over the sustainability of their public finances and the solvency of their banking sectors. The Italian and Spanish governments argue that their high borrowing costs largely reflect convertibility risks and that the ECB should do as much as necessary to address these fears. The eurozone’s members that currently benefit from exceptionally low borrowing costs – Germany, Austria, Finland, the Netherlands and to a lesser extent France – maintain that very high Italian and Spanish borrowing costs largely reflect these countries’ failure to reform their economies and strengthen their public finances. There is merit in both these positions, but much more to the Spanish and Italian argument than the opposing one.

Opponents of open-ended ECB action argue that Italian and Spanish borrowing costs are not actually that high. Interest rates have just returned to levels seen in the run-up to the introduction of the euro, when investors distinguished properly between the countries that now share the euro. High borrowing costs are needed to focus minds and instil discipline. Were the ECB to take aggressive action to bring down borrowing costs, it would create so-called moral hazard; countries would be free to delay reforms in the knowledge that they will not be punished for it by having to pay high borrowing costs. According to this argument, it is a positive development that investors are now differentiating so strongly between the risks of lending to various governments. After all, the failure to do so in the run-up to the crisis contributed to the under-pricing of risk across the eurozone and reduced pressure on governments to reform their economies.

In nominal terms Italian and Spanish borrowing are indeed comparable to the levels of the late 1990s. But it is real cost of capital (that is, adjusted for inflation), that is crucial, and not the nominal cost. Both countries face much higher real borrowing costs than they did in the run-up to their adoption of the euro. Moreover, it is erroneous to compare the present with the late 1990s. Italy and Spain are at very different points of the economic cycle now than they were then. In the late 1990s both economies were growing, in the Spanish case rapidly, whereas now they face slump and mounting risk of deflation. Countries facing depressions and rapidly weakening inflation typically face very low borrowing costs: investors invest in government bonds for a want of profitable alternatives. This is what we see in the UK and US; borrowing costs remain at all-times low despite the extreme weakness of both countries’ public finances and poor growth prospects. Investors certainly need to differentiate between eurozone governments, in order to ensure that risk is correctly priced. The Italian and Spanish authorities acknowledge this. But the current spread between the yield on German government debt and that of the Italian and Spanish governments wildly exceeds what is required to make sure investors differentiate appropriately.

The polarisation of borrowing costs has politically explosive distributional effects: Germany is borrowing and refinancing its existing debt at artificially low interest rates. According to the German Institute for the World Economy, investor flight from the government debt markets of the eurozone’s struggling members to Germany has already saved the German government almost €70bn. Other countries face ruinously high borrowing costs, which are simultaneously increasing the scale of their reform challenges and narrowing their political scope to make the necessary reforms. The longer Italian and Spanish borrowing costs remain at such elevated levels, the greater the economic damage to those economies will be and the harder it will become for the two countries’ governments to shore up the necessary political support for further reforms.

Why have government borrowing costs across the eurozone diverged so much? The principal reason for the size of the spread between the periphery and Germany is convertibility risk. Investors believe that there is a chance that Italy and Spain will ultimately be forced out of the currency union and are thus demanding a hefty premium to insure against this eventuality. This feeds the convertibility risk by weakening countries’ fiscal positions and raising private sector borrowing costs (government bond yields set the cost of capital for the private sector). With private and public consumption in both Italy and Spain set to remain depressed for years to come, economic recovery requires stronger investment and exports. But borrowing costs are crippling and credit scarce. In a vicious cycle, the steep fall in the value of Italian and Spanish banks’ holding of government debt, combined with mounting bad debts as a result of recessions made worse by punitive borrowing costs, are forcing the banks to further rein in business lending. 

The ECB’s latest programme of bond purchases will be big enough to ensure that Mario Draghi does not lose face. But it will not be big enough to dispel convertibility risk and hence demonstrate its credibility as a lender of last resort. And it is this credibility problem, rather than the relative ‘credibility’ or otherwise of member-states policies, that is the principal reason for the unsustainably high borrowing costs faced by Italy and Spain.

Simon Tilford is chief economist at the Centre for European Reform.

Will a new German constitution save the euro?

If the Social Democrats win next year’s general election in Germany, they will ask voters to adopt a new constitution in a referendum. The new document, so they plan, would remove the legal fetters that currently prevent Chancellor Angela Merkel agreeing to eurobonds or joint deposit guarantees. Not only the Social Democratic Party (SPD), also politicians from Merkel’s ruling coalition are now speaking out in favour of a referendum. Some analysts are rejoicing that Berlin is finally preparing the ground for the fiscal union that will save the euro. But this is Germany, where policymaking is complex and slow. The debate about a new constitution might sap political energies without contributing much to the stability of the single currency.

German politicians mean different things when they talk about a euro-related referendum. Sigmar Gabriel and his fellow leaders of the SPD say they want voters’ consent to a eurozone fiscal union that involves not only debt mutualisation but also joint budget-planning, harmonised tax rates and tough financial regulation. Some pro-European MPs in Merkel’s own Christian Democratic Union (CDU) agree on the need for a new constitution. But many others insist that the current document leaves enough leeway for euro rescue measures. Some CDU politicians use talk about a referendum mainly as a warning shot to the constitutional court: if you judges continue constraining Merkel’s euro policies, a new constitution will restore power to elected politicians. Finance Minister Wolfgang Schäuble predicts that a constitutional referendum will happen “quicker than I would have expected a couple of months ago”. But he does not say what it would entail.

Horst Seehofer, leader of the traditionally euro-wary Christian Social Union (CSU), the CDU’s smaller Bavarian sister party, wants a referendum each time the EU assumes new powers, bails out a struggling member or admits new countries. And he probably hopes voters will say no to these. Foreign Minister Guido Westerwelle from the Free Democratic Party (FDP, another coalition member), contemplates not a German but a Europe-wide referendum on euro rescue measures. All parties are spooked by the recent successes of the Pirate party which campaigns for more country-wide referendums.

Even if Germany’s politicians could agree on a referendum strategy, this would not be a quick fix to save the euro.

Germans are having this debate right now because the constitutional court has indicated that EU integration could not go much further on the basis of the current constitution. Stricter budgetary oversight from Brussels, as envisaged by the fiscal compact, could be problematic. Eurobonds or any other kind of unlimited liability involved in a fiscal or banking union would be incompatible with the constitution. These would undermine Germany’s statehood and democracy by constraining parliament. If politicians cannot promise different fiscal policies, voters are deprived of a real choice and democracy suffers.

These constraints cannot be removed easily because the German constitution contains an ‘eternity clause’ (Article 79) that sets in stone certain principles, notably democracy, federalism and the market economy. No parliamentary majority and no referendum can alter these principles. Hence, the only way for Germany to accede to a fiscal union is to convene a constitutional assembly, work out a new constitution and put it to a referendum.

Some lawyers say this could be done quickly: only the eternity clause and the one detailing how Germany transfers powers to international organisations (Article 23) need to be tweaked. But more likely the constitutional assembly would be inundated with calls for more extensive social rights, a reform of federalism and a new voting system, to name but a few. “This would be an extremely long process”, predicts a constitutional expert.

Nor is it assured that Germans would vote yes in the ensuing referendum. Eurosceptics will argue that the new constitution will lead Germany into the dreaded transfer union, characterised by permanent money flows from Germany to the eurozone’s South. And even if a new constitution was adopted, who says there would be a political majority for eurobonds? Most Germans are against debt mutualisation even if it comes with tough budgetary oversight, according to a recent Emnid poll. Even among SPD voters, less than 40 per cent are in favour. “It’s not that if we had a new constitutional clause we would just wave through debt mutualisation”, says one CDU advisor.

And there is a last hurdle: Germany might adopt a plan for fiscal union only to be blocked by Austria, Finland or the Netherlands. After all, this is not really a debate about the German constitution but the future shape of Europe.

Nevertheless, the constitutional debate will continue because it suits both the opposition and the government. The SPD seeks to sharpen its political profile ahead of the 2013 election. It has so far loyally supported Merkel’s euro policies in parliament. Now many voters complain that they no longer know what the SDP stands for. The SDP is trying to change that, not by blocking Merkel’s policies but by going beyond them.

The CDU also gains from the constitutional debate. The opposition accuses Merkel of lacking a blueprint for the euro, of reacting to market panics, and of recklessly putting taxpayers’ money at risk without delivering more European integration. By talking about a new pro-European constitution, the government looks like it has a plan while it can put off hard decisions until after the 2013 election.

Now all eyes are on the constitutional court again. On September 12th the judges will issue a preliminary verdict on the European Stability Mechanism and the fiscal compact. They are unlikely to strike them down. But they will define conditions for making the ESM and the compact compatible with the constitution.

Some constitutional experts expect that the court will use the occasion to pronounce on what a process of constitutional renewal might look like. Others think that the court will shy away from encouraging such a process and instead widen the government’s room for manoeuvre within the current basic law.

Whatever the court does, the debate about a new, pro-European constitution will hot up this autumn. But do not be fooled: Germany is still a very long way from agreeing to eurobonds.

 Katinka Barysch is deputy director of the Centre for European Reform.

Burma: An EU foreign policy success

Disunity is bad but pluralism is good. The story of EU policy on Burma illustrates this point. Disunity is normal: sovereign states with varied histories and traditions might be expected to disagree. The remarkable thing is that in the end, on Burma as on much else, the EU manages to achieve a common policy. The policy may even be better for being the product of disagreement and debate. Unfortunately the EU tends to do its disagreeing in public but when it reaches a sensible consensus often conceals the fact.

On Burma the disagreements start with the name. EU documents refer to Burma/Myanmar. Can one really have a policy on a country when one cannot agree on the name?

This disagreement is in fact not so unreasonable. On one side is the argument that if the UN, its neighbours and some people in the country call it Myanmar, the EU should follow suit.  But the argument on the other side is also strong: an early act of the State Law and Order Restoration Council (SLORC), one of the nastier manifestations of the military in its 50-year term of office, was to change the official name in English to Myanmar. The SLORC claimed that this name had the advantage of including minorities not from the predominant Bamar (or Burman) ethnic group. But this argument is largely false since ‘Burma’ is in fact a colloquial form of ‘Myanmar’ and the one the British rulers opted for. Furthermore, Aung San Suu Kyi and her supporters gave the name political significance by refusing to follow the SLORC’s decree. The lady now uses Myanmar when speaking the Burmese (or Myanmar) language, thereby offending some of her supporters, but insists on using Burma in English, thereby offending some generals. Too much energy has been wasted on this rather unimportant issue.

On the more critical issue of sanctions there are respectable cases to be made both for and against. Let us leave aside the EU’s visa bans and asset freezes on members of the regime, which have certainly discomforted those targeted. The arguments against broad sanctions are that they corrupt and distort an economy; they impoverish people; they often create illegal trade from which the primary beneficiaries are those in power; and they provide a convenient alibi for the government’s own economic mismanagement. If sanctions bite, the intention is that they will hurt people and thus encourage them to overthrow the government through elections or revolution.  That makes them particularly ineffective when dealing with military regimes. Besides, it is contact, not isolation that brings about change. Trade leads to more extensive relations with other countries; it opens countries up, eventually creating the middle class that is essential for democracy.

But there are also valid arguments on the other side. The damage done to the Burmese economy by EU sanctions has always been small compared with the damage inflicted by the military government. Spending on health and education has been minimal, while the defence budget as a proportion of GDP – officially 4.9 per cent, though the true figure is certainly much higher – surpasses that of any other country in the Association of South-East Asia Nations (Indonesia and the Philippines both spend 1 per cent, Malaysia and Thailand 1.5 per cent, Vietnam 2.5 per cent and Singapore 3.6 per cent, according to the International Institute for Strategic Studies). 

The sanctions did have one powerful effect, namely, to signal to European companies that the Burmese regime was unacceptable, and that they should stay away. Almost universally, they took this advice. The sanctions also gave moral support to the opposition, thousands of whose members have been beaten and locked up.
The arguments of those who opposed sanctions nevertheless had an impact on what the EU did. Its sanctions were designed to limit direct damage to the livelihoods of ordinary Burmese. They were selective and targeted on the extractive industries – mainly timber and gem stones – where the military and their cronies are dominant (though the sanctions’ effectiveness was impaired by some of these goods being rebadged and exported via Thailand).
The EU matched sanctions with a commitment to provide humanitarian support, not just at the time of cyclone Nargis in 2008, but on a continuing basis, with an emphasis on health and rural poverty. The US chose a very different path, applying an enormous and complex web of sanctions to Burma, similar to those in force against Iran. The US blocked World Bank lending and cut off Burmese banks from the international financial system. Congressional restrictions obliged the Global Fund (which ran programmes to fight malaria, tuberculosis and AIDS) to pull out of Burma in 2005. The EU led a consortium to replace the work of the Global Fund. In sympathy with those who argued against having anything to do with the Burmese regime, the EU ran all its programmes through NGOs.
Western sanctions were probably not the main cause of the thaw in Burma. When authoritarian regimes decide upon profound reform, foreign pressure may be a factor but is often less important than the ambitions of key leaders. Mikhail Gorbachev pursued glasnost and perestroika because he was a communist patriot.  In South Africa, F W de Klerk saw that his country had no future with apartheid. U Thein Sein, who became Burma’s president in March 2011, appears to be a man who wants the best for his country, and who knows that he cannot tackle poverty and under-development without first engaging in political reform and reconnecting Burma to the world.

Perhaps change would have happened without sanctions. But if so it would have happened differently. It is hard to imagine that representatives of the National League for Democracy (the NLD, the party led by Aung San Suu Kyi) would have spent hours in the Ministry of the Interior going through lists of political prisoners if their release had not been one of the conditions for suspending sanctions. And would the NLD have even been there at all? It was always an EU demand that all political forces should participate in the political process. That was code for Aung San Suu Kyi and the NLD, as well as Burma’s too-often forgotten ethnic minorities.

Then there is the China factor. Burma’s leaders were becoming worried about not only their economic dependency on China – a major trading partner and source of investment – but also their reliance on its diplomatic protection in international organisations. They wanted to balance the ties to Beijing with closer ties to the West, and that required reforms that would persuade the EU and the US to remove sanctions.

As it turns out, Western sanctions provided not only the opposition with a card it could play, but also reformists within the government. A government trying to reform cannot easily show benefits to sceptical conservatives, at least in the early stages. But greater respect from foreign powers – Hillary Clinton, David Cameron and Catherine Ashton have been among the recent visitors – and the removal of sanctions are visible rewards that a government can point to when it is fighting difficult internal battles.

In the case of Burma the opposition has been a cause worth supporting. Not only Aung San Suu Kyi herself, but also her supporters are fully committed to democracy and the rule of law. She has shown that she is ready to compromise – contrary to the propaganda persistently put about by the regime. Her approach to the government, the constitution and the parliament has involved many compromises. And on the question of sanctions, she and her party have, understandably, been somewhat ambiguous. She believes that Burma has a long way to go before it is free and democratic, and she has not called for the US to end all sanctions. But she has gone along with the EU’s suspension of sanctions and favours responsible foreign investment to create jobs.

On certain points, such as corruption and the fair conduct of elections, Aung San Suu Kyi remains immovable. This should be welcome; too many countries in Asia have become accustomed to a kind of semi-democracy, in which elections are held but are not particularly fair, in which the rule of law functions but not in quite the same way if you have friends in high places, and in which corruption is a part of the system. It is good that for once that a senior political figure in Asia is supporting high standards. If the Burmese are lucky, eventually she will prevail – and hopefully set an example to other Asian countries.

The Burmese government’s announcement this month that it is scrapping press censorship suggests that it is still bent on reform. But in June, violence between the Muslim Rohingya minority and Buddhists in the western province of Rakhine left dozens dead and nearly a hundred thousand homeless. Burma’s leadership continues to ignore the basic rights of Rohingyas. The opposition says too little about their plight – and some of its leaders have even questioned whether the Rohingyas belong in Burma. Several other ethnic conflicts continue to fester in various corners of the country. Further EU development aid should be conditional not only on continuing progress on human rights, but also on the regime seeking to achieve reconciliation with the ethnic groups.

The EU can offer its own expertise – from countries such as Spain – in building political structures that accommodate minorities. The EU should also encourage the army to retreat from political life, while recognising that this process will inevitably be slow. In Turkey the army has spent more than 50 years – with many ups and downs – gradually relaxing its grip on the political system. One suspects that Egypt’s generals will continue to control large swathes of that country’s economy for several years to come.

This year the EU has, to its credit, stepped up aid and opened an office in Rangoon. Its policy on Burma has looked a bit messy: in the past, pursuing sanctions but not across the board, and giving aid but not working with the government; and now, suspending rather than lifting sanctions while not insisting that every single political prisoner should first be released – while continuing to press the case of those who remain. Messy is what you expect when 27 countries debate and compromise. But the common line forged by the EU has helped to change Burma for the better.

Charles Grant is director of the Centre for European Reform.

The Commission should stand firm on Iceland’s accession negotiations

Iceland is the world’s longest running democracy. At a time when some member-states are struggling with democracy in the face of economic crisis, and the European institutions are still being criticised for a democratic deficit, Iceland would therefore be a valuable and welcome member of the club. Iceland also has much to teach the EU about energy policy: it generates three quarters of its electricity from hydroelectricity, and the rest from geothermal plants. All of its heat comes from geothermal.  However, the European Commission should remain firm on its negotiating demands on fishing and whaling.

Iceland applied to join the EU in 2009, in the aftermath of its banking crisis. The island saw EU membership as a source of stability and economic recovery. Out of the 35 negotiating chapters, 18 have been opened. Ten of these have been provisionally completed. Enlargement Commissioner Stefan Füle hopes that accession negotiations will be completed in 2013 – though the most difficult chapters, on agriculture, environment and fisheries, have not been negotiated yet.  As a member of the European Economic Area (EEA) and Schengen, Iceland has already adopted two-thirds of the acquis.

Iceland’s accession bid has quite broad support among member-states. The main obstacle to its accession is that Icelanders themselves are likely to reject it. Once negotiations are completed, Icelanders will vote in a referendum on whether or not to join the EU. Polls suggest that only around a quarter support EU membership, with over half against and around a fifth undecided. The level of support for membership has fallen since negotiations began in 2009. This is in part because Iceland’s economy has recovered from the serious 2008 banking and debt crises, and is now growing at over four per cent per year. And EU membership is no longer seen as a source of stability.  But support for membership has also fallen because of the European Commission’s perceived (by Icelanders) unfairness towards Iceland over the Icesave  settlement and the current “mackerel war”. And the totemic issue of whaling remains to be confronted.

Icesave was an online facility run by the Icelandic bank Landsbanki between 2006 and 2008. It gained over 300,000 customers in the UK, and over 125,000 in the Netherlands. But in 2008 Landsbanki was placed into receivership. The British and Dutch governments argue that the Icelandic government is obliged to pay at least €20,000 to each depositor, and that Icelandic and foreign depositors must be treated in the same way. Reykjavik disagrees. It argues that, had the restructured bank been obliged to bear the full cost of the debt, it would have had a negative equity of €2.6 billion, which would have had to be paid by Icelandic taxpayers.

Half the Icesave debt to depositors has now been repaid. The EFTA Court will hear legal argument about the remainder on September 18th.  The time for negotiation over Icesave has passed, since the matter is now before a court. So the key negotiating issues are fishing and whaling. The European Commission should remain firm on these issues. It would be counter-productive to lower existing EU standards to attract a new member. If this firmness leads to Iceland voting no in a referendum, so be it.

Fishing has always been a bone of contention between Iceland and other European countries. The Common Fisheries Policy is not included in the EEA, so Iceland can set its own policy. The fishing industry provides 40 per cent of Iceland’s export earnings, and eight per cent of employment on the island.  The current dispute focuses on mackerel. Iceland has increased its annual quota for mackerel catch enormously – from 2,000 tonnes to 146,000 tonnes. Reykjavik argues that this is sustainable because climate change is resulting in more mackerel in its waters. The Commission disagrees, and argues that Iceland’s quota is 36 per cent higher than it should be to be sustainable. Ireland, France, Portugal and Spain are demanding sanctions. The Commission has threatened to block Icelandic ships from unloading mackerel at EU ports.

The EU and Ice­land (plus the Far­oe Islands and Nor­way) will meet in Lon­don in Sep­tem­ber to try to reach agreement.  Some movement by the Commission, to defuse the argument and avoid conflict, would be understandable. But the Commission should not move much. It should continue to base its position on its scientific estimate of a sustainable catch.

On whaling, the Commission should not move at all. In 2006 Iceland resumed commercial whaling of fin whales and minke whales. Thus it joined Norway in defying the international moratorium on commercial whaling.  Iceland has always caught some minke whales for “scientific research”.  So the 2006 decision made little practical difference on minke – it simply represented Iceland becoming more open about its reasons for whaling. But it did represent a restart of fin whale hunting. Fin whales are an endangered species. Iceland maintains that there are enough fin whales in Icelandic waters for a small catch to be sustainable. This may or may not be correct, but is anyway not relevant to EU negotiations. EU law prevents the killing of any whales, even those which (like minke) are relatively numerous.  EU law is based partly on the need to protect biological diversity, but partly also on the need to prevent animal suffering.  Being killed by harpoons is a particularly painful, and often slow, way for an animal to die.

By no means all Icelanders favour whaling. Whale watching is an important part of their tourism industry – and increased tourism is one of the drivers of economic recovery. Yet some Icelanders argue that whaling is an important part of their culture and tradition. Culture is important, and European integration must respect most cultural traditions. But not all, and not those which involve cruelty. Iceland has an impressive culture –and has produced some of the world’s greatest literature. So it ought to be possible, in the twenty-first century, for Icelanders to separate their cultural heritage from whaling. If this is not possible, EU membership should also not be possible.

In any case, the ongoing dispute about Icesave and the Icelandic economic recovery may well result in Iceland voting no to EU membership, whatever concessions the Commission has offered on fish and whales. The EU should not lower its standards whatever the rewards. To lower them and get no reward would be particularly unwise.

Stephen Tindale is an associate fellow at the Centre for European Reform 

Can 'good Italy' triumph over 'bad Italy'?

The key battles for the survival of the euro will be fought in Italy more than anywhere else. Mario Monti’s technocratic government is struggling to push through sufficient reforms to convince financial markets that economic growth will return and thus erode the country’s mountain of public debt. Unless EU institutions intervene in government bond markets to lower the country’s cost of borrowing, Italy may soon be frozen out of those markets. The EU’s bail-out funds may just have enough money to provide Spain’s financing needs for the next few years, but they would then have no spare capacity to save the larger Italian economy. So Italy’s inability to borrow could lead to the euro unravelling – unless the Germans suddenly agree to bigger bail-out funds or the mutualisation of eurozone debt.

When the euro was conceived, more than 20 years ago, many economists thought the Italian economy ill-suited to take part. Then Italy’s reformist governments in the 1990s did just enough to convince the EU’s leading member-states that it should be allowed into the single currency. But after the launch of the euro in 1999, with Silvio Berlusconi prime minister for much of the time, reform more or less stopped.

Bill Emmott’s new book, ‘Good Italy, Bad Italy: why Italy must conquer its demons to face the future’ (Yale University Press), provides an excellent account of what is rotten in the state of Italy. When editor of The Economist, in 2001, Emmott started to run a series of investigative stories that exposed Berlusconi’s questionable financial dealings. One cover proclaimed: “Why Silvio Berlusconi is unfit to lead Italy”. The Italian prime minister, unamused, complained of an “E-Communist plot” against himself, pointed out that Emmott looked like Lenin and launched two libel actions that The Economist fought and won (though one of these is still subject to appeal).

Emmott’s book is particularly good on the sorry story of the Italian economy. Only Haiti and Zimbabwe grew more slowly in the period 2000-10. He describes how archaic labour market rules that prevent employers of more than 15 people from firing workers have kept companies small and thus damaged productivity. The lack of competition in the economy is a major cause of Italy’s service firms being inefficient. As a result, businesses pay more than they should for logistics, information and communications technology, marketing, transport and legal advice. There are 290 lawyers for every 100,000 Italian citizens, compared with just 22 in Britain. Emmott explains how an ageing population, unmeritocratic universities, low levels of foreign direct investment and the high level of public debt (over 120 per cent of GDP) depress the economy. Meanwhile a black economy amounting to 20-25 per cent of GDP weakens the state.

Emmott defines ‘Bad Italy’ as “the urge to seek power in order to use it for self-interested purposes, to amass power to reward friends, family, bag-carriers and sexual partners regardless of merit or ability, and by doing so to build clans and other networks that are beholden to you, and that live by enriching themselves at the expense of others, by closing doors rather than opening them, by excluding rather than including…This sort of selfishness involves a special and even wilfully destructive disregard for a wider community or, especially, national interests, institutions, laws and values.”

The roots of Bad Italy are embedded in the political system and the nature of Italian society. Emmott’s descriptions of these are not as profound as his economic analysis. He does not say a great deal about the centre-left, which held power from 1995-2001 and again from 2006-08 but reformed very little (though its record is somewhat better than that of the centre-right). He might have examined why the Italian centre-left is so weak and fragmented, compared with that in Britain, France or Germany. However, Emmott is good on the nefarious influence of the Catholic Church on politics: for many years it supported Berlusconi because of his stance on gay marriage and in vitro fertilisation – and because he exempted Church property from taxation.

Emmott could have focused more on the many vested interests that profit from the current system and have been so successful in blocking reform. But he implies that they can be overcome because half the book is about ‘Good Italy’, the Italy that draws its strength from civil society, promotes vigorous entrepreneurialism and thinks globally. One of the book’s merits is to point out that Bad Italy is not synonymous with the south of the country, nor Good Italy with the north. Emmott takes the reader on a tour of success stories, to ‘Addiopizzo’, an anti-mafia NGO in Sicily; the Tecnam sports aircraft manufacturer near Naples; the Brunello Cucinelli cashmere clothing company near Perugia; Rainbow, a world-beating maker of animated children’s cartoons near Ancona; the Slow Food movement in Turin; and well-known firms such as Luxottica (sunglasses) in Milan and Ferrero (chocolates) in the Langhe region of Piedmont.

Emmott shows that energetic companies, usually led by brilliant individuals, can beat the system and succeed. He sets out a list of reforms that Mario Monti – or the next prime minister – should seek to achieve, to tilt the system in favour of Good Italy. But he does not attempt to say how a reformist government should seek to overcome the vested interests of Bad Italy, or why Good Italy will ultimately triumph.

Mario Monti, a brilliant economist and the incarnation of the hopes of Good Italy, would surely agree with Emmott’s analysis. But his government is embattled. Within Italy, trade unions, professional associations and other conservative lobbies have diluted many of Monti’s reforms. In democratic countries, the most able governments find it hard to introduce structural economic reforms, even when economies are growing; the losers feel the pain immediately while the benefits take years to emerge. When an economy is shrinking – as is the case in Italy, partly because of excessively tight fiscal policies across the EU – it is almost impossible to implement structural reforms.

Monti’s noble efforts to reform Italy may have come too late. Bad Italy is extraordinarily resilient. Even if Monti’s government survives until the elections that are due in spring 2013, the entrenched power of Bad Italy may yet force Italy out of the euro. And if Italy and the other southerners quit, the EU’s leaders may find it hard to convince financial markets that France – which though a much stronger economy than Italy, suffers from some of the same ailments – can stay in the euro.

Charles Grant is director of the Centre for European Reform.

A similar article appears in the August 2012 edition of the Literary Review.

What Central Europe thinks of Britain and why

Britain's Conservative Party is committed to repatriating powers from the EU. On July 12th, Foreign Secretary William Hague launched a review of the EU's competences. This would, he told Parliament, be an "audit of…where competence lies, how the EU's competences, whether exclusive, shared or supporting, are used, and what that means for our national interest." Many Conservatives expect this audit to prepare the ground for a manifesto commitment to renegotiate the terms of Britain's EU membership. They hope that Britain can obtain opt-outs in areas such as financial services, judicial co-operation, employment, migration, regional policy or fisheries. They argue that Britain's partners will wish to change the EU treaties to cope with the eurozone crisis, and that Britain can trade off the repatriation of powers in return for its signature.

However, any British opt-out would require the unanimous agreement of every other member-state. Conversations with diplomats from Central Europe suggest that there is very little goodwill towards London, even among its formerly stalwart allies.

The Central Europeans see the UK as an important partner. When David Cameron circulated a letter in February 2012 outlining single market reforms that would revive the European economy, five of the eleven co-signatories came from Central Europe, with Germany and France the notable absentees. The new member-states sided with London against Paris and Berlin over the Iraq war, and the UK shares their desire to bring more Balkan countries into the EU – again, against much scepticism from many continental countries.

And yet the UK cannot count on all Central Europeans to support its demand for opt-outs from EU legislation. This is for two reasons: Germany has become the central focus of the region’s foreign policies, and Britain has come to be seen by other member-states as taking advantage of the common currency's existential troubles to defend its narrow interests.

Germany is by far the largest investor in Central Europe, and its economy is deeply embedded in the wider region. When I asked a former finance minister from Central Europe to predict his country's growth rate, he replied "take Germany’s number and add one percentage point". Most Central European governments also assume that there is a possibility of the eurozone fracturing and losing some of its member-states. If and when it happens, they want to remain a part of the Berlin-led economic core. London will be of little help in such a crisis – it is too far away, has too few investments in Central Europe, and wants to have less and less to do with the EU in general. So the new member-states (and others in similar situations such as Denmark or the Netherlands) will have few reasons for wanting to spend political capital on supporting UK demands for exemptions from EU legislation, especially if Germany opposes them (and senior officials in Berlin take a hard line in opposing British attempts to repatriate powers).

Furthermore, the UK offers nothing in return (it is not contributing to the eurozone bailout fund) and Britain’s exemptions may adversely affect other countries’ economies. They fear, for example, that if the UK relaxes social protection for workers (a key Conservative demand), businesses elsewhere in Europe will migrate to the UK. "London is engaging in 'beggar-thy-neighbour' tactics", one official from Central Europe told me (though France and others say the same of the new member-states' low corporate tax rate). In December 2011 Britain threatened to veto the proposed ‘fiscal compact’ to secure an opt-out from rules governing financial services. But the tactic misfired – the rest of the EU minus the Czech Republic agreed to form the compact anyway; they did so outside existing EU treaties and without Britain. Any future banking or fiscal union will almost certainly be organised in a similar way, a Baltic diplomat told me, because the UK and the Czech Republic – and possibly others – do not want closer integration. This leaves London without any good means to pressure others to secure its opt-outs. "The rest of the EU now knows that it is possible to isolate Britain, and they are more willing than ever to do so. It is not clear that Britain realises that", the official said.

Nothing has hurt Britain's image elsewhere in Europe more than the perception that London is failing to help to end the crisis and – worse – that the UK is taking advantage of others' woes. A Polish official told me that during the December 2011 negotiations London lobbied Warsaw to stay out of the fiscal compact. Its creation is a key part of the member-states’ efforts to stop the run on their sovereign debt. The fact that Britain not only decided against joining it but sought to discourage other non-euro countries from doing so – presumably to avoid being isolated – has been seen by many as an act of remarkable ill will. According to a senior Baltic official "Britain is a nuisance; it imposes an additional burden on us of having to go around it, complicating negotiations". This is not entirely fair: British proposals on how to stimulate economic growth, which many Central European governments signed, are among the most thoughtful of such contributions. But European diplomats think that London puts a lot more energy into demanding special deals for itself than solving the crisis.

The Central European officials I interviewed sounded genuinely regretful of Britain's growing estrangement from the EU – there was no sense of 'good riddance' or gloating. But Britain’s likely demands for opt-outs from EU policies will have very little support from them (with the possible exception of the Czech Republic). A dangerous situation has emerged. Even though the government in London seems likely to attempt to unpick some of its ties, rather than sever them all, it risks rejection. And would a bruised UK want to remain in the EU? The Central Europeans fear that Britain may drop out in anger, in effect leaving the EU by accident rather than by design. But, as one Polish official acknowledged "as long as the eurozone is a mess, Britain will not want to be shackled to a sinking ship. We need to sort out our banks and economies first, thus giving London the reason to stay".

Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.

Has the eurozone reached the limits of the politically possible?

June's EU summit was the first to agree measures that address the core of the crisis: inflated government borrowing costs that weaken public finances and ultimately make sovereign insolvency self-fulfilling; and a vicious cycle in which worries about bank and sovereign solvency feed on and amplify each other. Unfortunately, the agreed measures were modest and have already prompted a backlash in various countries, not least in Germany and the Netherlands. Indeed, much of what was agreed at the summit is unlikely to come into effect. All this suggests that the limits of the politically possible may already have been reached.

Many commentators have raised the possibility of a grand bargain under which the Germans sign up to debt mutualisation and the French agree to cede sovereignty over budgetary policy. Germany has not ruled out debt mutualisation and a banking union, but argues that there must be a political union first. The problem with Germany's position is that the French have never ruled-out a loss of budgetary sovereignty in return for a proper fiscal union. Nor have the Spanish or the Italians. They are not opposed to political union, but argue that there must be crisis management first. 

This French-Italian-Spanish argument makes sense; there is not time to create a political union before acting. Also, countries cannot cede sovereignty without getting something immediate in return. For example, if Mario Monti signed up to whatever the Germans mean by political union without extracting a concrete commitment to mutualise debt, he would be out of power very quickly. If the Germans offered some form of risk mutualisation in return for much closer political integration, the French, Italians and Spanish would no doubt readily sign up. The Germans know that. The problem is not how to strike a grand bargain; the question is whether the Germans want it or are able to deliver on their part of it.

The necessary institutional reform can hardly be pushed through under the radar, but must win democratic approval. This will clearly not be easy to secure. Of course, while Germany is running a big trade surplus with the rest of the eurozone which Germany's private sector is no longer willing to finance, transfers of one sort or another are inevitable. But no-one should be under any illusions about how difficult this is for politicians to explain to their electorates, even if they understand themselves. In the public's eyes and in the minds of many politicians, a trade surplus just shows that their country is more competitive. What could be wrong with that?

And the Germans and others do have legitimate concerns about the sustainability of a fiscal union. It will require a high degree of solidarity between its component parts. We see that solidarity within Germany, or in the UK or US, but it is less clear that it exists in the eurozone. Even if they could win democratic approval for such measures, German politicians understandably fear that a fiscal union would be difficult to sustain politically. This would especially be the case if the performance of eurozone's southern members failed to improve, creating a kind of giant Mezzogiorno. German politicians fear that this could give rise to populism and anti-EU feeling. There are similar concerns in the Netherlands and elsewhere.

In short, there is a far from negligible risk that the Germans and their allies are not going to move far enough to save the euro, or that they fail to get the necessary political buy-in for whatever they do agree to. Under such a scenario the euro really could unravel. If – and it is hard to see how they can avoid it under the current policies – Spain and Italy get caught in a vicious cycle of slump and rising debt, Spanish and Italian borrowing costs will continue to rise, shutting them out of the market. The ESM is too small to bail-out them out, and there is no chance of it being granted a bank license so as to borrow unlimited sums from the ECB. The ECB itself could enter the market itself and buy large volumes of Spanish and Italian debt, but the central bank may not be able to do this in the face of staunch opposition from Germany and a number of others. Could Germany and its allies be outvoted on the ECB? This is possible. But if they were, this would put paid to the possibility of the Germans, Dutch and other sceptical countries making concessions on the institutional questions, so it could prove a pyrrhic victory.

At this point the politics would start to look decidedly dicey in the struggling economies, and between them and the core of the eurozone. Politicians may start to feel trapped. Italy could prove pivotal. With Monti gone and replaced by a more populist leader, at the head of a coalition including the new anti-euro movement led by Beppe Grillo, the Italians could threaten to quit the euro unless the costs of sharing the currency are pooled. This would be a credible threat. Italy has a primary budget surplus (that is, a surplus before the payment of interest). The Italians would be loath to play such a card, but Italy could come to perceive departure as the lesser of two evils. If Italy withdrew, so would Spain. France would then come under massive pressure. The Germans would probably offer France a debt union, but would the latter go for it? They would have a hugely overvalued currency and would be a very junior partner.

To many this scenario will sound far-fetched – how could something that will have such far-reaching implications for the European economy, the region's political stability and its security, be allowed to happen? Because the solution to the crisis requires governments to do things for which they have no mandate. And the longer the crisis festers, the more difficult it will be to win such a mandate. This is the tragedy of the eurozone's handling of the crisis. Had the ECB been allowed to intervene in the markets and dispel fears for the solvency of the Spain and Italy, and had the region's creditor countries refrained from imposing self-defeating fiscal austerity on the struggling economies, the eurozone would have had much more time to prepare the ground for the necessary institutional reforms, which could have been implemented incrementally. But the crisis has now deepened to such a point that only big institutional steps will restore the credibility of the eurozone. This puts politicians in the eurozone's creditor countries in an invidious position: save the euro and be voted out of office, or open the way for an unravelling of the single currency with all the resulting economic and political fall-out. 

Simon Tilford is chief economist at the Centre for European Reform.

Britain should not go Swiss

British eurosceptics want to renegotiate the UK’s relationship with the EU. They divide into two camps. There are those who want Britain to stay in the EU, but win opt-outs from social and employment legislation and from justice and home affairs policy. This includes most Conservative government ministers. A second group, which includes many Conservative backbenchers, wants a looser relationship still. This camp seeks a British withdrawal from the EU.

The second group is vaguer about the terms on which the UK would carry on its trade with continental Europe after withdrawal. Some speak of a Norwegian arrangement, which would involve the UK joining the European Economic Area (EEA). Alternatively, the UK could sign a bilateral free trade agreement, under which Britain would be free to regulate its own markets as it sees fit. For most people in this camp, EU membership burdens the UK with too many regulations. If the UK left the EU, British products would still be in high demand, and the UK could carry on trading, but free of the EU’s supposedly constraining rules. And without those rules, the UK could concentrate on chasing growing demand in Brazil, China and the rest. The UK could become Norway or Switzerland – that is, in Europe but not in the EU, and freer and more prosperous as a result.

There are three flaws in this analysis, which arise from confusion about the nature of the single market, a failure to be hard-headed about its costs and benefits, and a lazy assumption that the UK can become Norway or Switzerland.

To take the last point first: Norway and Switzerland have a semi-detached relationship with the EU. But they are more attached than some eurosceptics imagine. As a member of the European Economic Area, Norway (along with Iceland and Liechtenstein) has access to the EU’s single market, and Norwegian citizens have the right to travel and work in the EU. Norway, moreover, has opt-outs from EU policies it does not like – like the EU’s common fisheries policy. But Norway’s special arrangements come at a price: the country must implement the EU’s single market legislation – including the social policies so disliked in Britain – but is excluded from decision-making on the rules. Norway must also contribute to the EU budget for structural funds and regional development.

If Britain withdrew from the EU and joined the EEA, it would be able to opt out of the common agricultural and fisheries policies. This would save a modest amount (around £1.1 billion a year, or 0.07 per cent of GDP) because Britain pays more into these programmes than it gets out. But Westminster would still have to sign all single market legislation into law, including social and employment policies.

What about Switzerland’s arrangements with the EU? Switzerland is not in the EEA, but has negotiated a series of bilateral agreements to get access to some areas of the single market. Switzerland must largely accept EU legislation pertaining to the markets it wants access to.

But is this not precisely the relationship the eurosceptics want? Could the UK, like Switzerland, have its fondue (the ability to sell to the rest of Europe) and eat it (avoiding those Brussels directives it dislikes)? Unfortunately, the answer is no. Switzerland signed up to the EU’s customs union in 1972, which abolished subsidy and tariff barriers. Since then, it has also decided to sign up to the majority of the single market: it is a full member of the single market for goods, a signatory to the Schengen agreement, and it has signed up to most of the single market for capital. In many areas, therefore, Switzerland is effectively a member of the single market. But like Norway, it does not have the ability to affect the rules that govern it.

Swiss firms are asking for further integration, too. Switzerland decided not to sign up to a range of financial services legislation in the 2000s, and was frozen out of some EU markets as a result. Swiss fund managers were prevented from offering asset management across the EU. Swiss banks are now starting to put pressure on the government to sign up to the EU’s post-crash financial rules.

All of which brings us to what the single market is, and why the UK needs it. Among developed countries, the biggest remaining obstacles to trade are non-tariff barriers like different national regulatory regimes. Eliminating tariffs and subsidies will only get you so far: if drugs have not been licensed for sale in another country, they cannot be exported. The single market aims to eliminate non-tariff barriers to trade by establishing common minimum standards, then forcing member-states to open their markets to foreign firms.
Yes, the EU’s approach to this has created some economic costs in the form of regulation (partly to soothe workers’ fears of competition run amok). But it is hard to argue that they are particularly large: under the working time directive, people have the right not to work more than 48 hours, and if they want to work more they are allowed to do so. Meanwhile, the benefits of single market membership are enormous. In principle, British firms have access to a huge market for their products, without 27 different sets of national barriers getting in the way. And foreign firms can enter our markets, forcing domestic companies to improve their performance.

It is difficult to imagine that the rest of the EU would cheerily say goodbye to Britain, but then let it have access to the single market without keeping the rules it has already signed up to, and agreeing to sign future rules into national law. And unlike Norway, the UK is a big and diverse trader. It does not specialise in oil: the UK is a big trader in many services, including telecoms, business consultancy, software and computing, law, financial services, publishing, design and much else. It also exports many high-technology goods, especially pharmaceuticals, chemicals and photographic equipment. Common regulations in each of these sectors allow UK firms to export without adapting their products and services to meet the rules of every country. This is not to suggest that foreign imports are not also good for the UK economy. British firms that cater for domestic markets are challenged by other European firms, forcing them to be more productive and innovative. Therefore, if it left the EU, it would still be in the UK’s interest to sign up to many of the EU’s rules.

In any event, it is almost certain that Britain’s eurosceptics will not get what they want: access to the single market without having to respect the common rules that make it work, or the policing of those rules by the Commission and the Court of Justice. Britain’s partners do accept its opting out of the single currency and some justice and home affairs policy. But they will not let Britain have something for nothing.

John Springford is a research fellow at the Centre for European Reform

Are Europeans a better transatlantic security partner than meets the eye?

The latest wave of European military spending cuts is swelling the ranks of Americans who believe that Europeans are not contributing enough to global security. But this assessment is too harsh. It is true that Europeans spend less on defence than their American counterparts. They have also been less willing to use force in recent years. But the US itself is reassessing the merit of its military interventions over the last decade. And when one takes into account policies that are not strictly military, such as aid, sanctions and homeland security, Europeans are making some significant contributions to international stability.

A number of European countries are undoubtedly falling short of their NATO and EU promises to develop a global military reach. Many governments have been slow to transform their militaries from immobile forces designed to counter a Soviet invasion into rapidly deployable combat troops. Even prior to the economic crisis, most European NATO allies had stopped spending the alliance's agreed benchmark of 2 per cent of GDP on defence. And Nicolas Gros-Verheyde, the influential French blogger, estimates that the economic downturn will lead to a 30 per cent drop in total military spending by EU member-states between 2006 and 2014. As a result, even if America cuts its own defence budget by $1 trillion over the next decade – as Congress is currently considering – the US military will still receive more than twice as much as the armed forces of all EU countries combined. 

Since the end of the Cold War, a number of European countries have also been reluctant to deploy troops, particularly for heavy combat operations. Many governments have refused to send their soldiers to the most dangerous parts of Afghanistan. More than half of the European countries in NATO did not participate in the deployment to Libya. And many EU military and civilian missions have been too small to make a significant impact. Washington critics are particularly dismissive of the 60 EU officials advising Iraqis on how to improve their criminal justice system and the approximately 500 EU police trainers in Afghanistan.

Europe's recent military track record derives from the fact that most Europeans have not felt threatened. Many also do not believe that war should be used to obtain 'justice'. In a recent GMF survey of the US and 12 EU countries, only 33 per cent of Europeans believed that war is sometimes necessary to obtain justice – in contrast to 75 per cent of Americans. In addition, Europeans have been particularly doubtful of the merit of Washington's use of force over the past decade, be it Afghanistan or Iraq.

In light of this mindset, Europeans have actually been quite active on the military front. According to the Stockholm International Peace Research Institute, in 2011, Britain, France and Germany were still amongst the ten largest military spenders in the world (ranking third, fourth and eighth). The combined defence expenditure of European NATO members is still more than twice what China spends – even though Europeans do not reap the full benefits of it because they duplicate many of their military efforts. 

For several years, European troops made up more than half of NATO's mission in Afghanistan. And on a per capita basis, Denmark and Estonia have suffered more casualties there than the US. Europeans undertook 90 per cent of the strike missions in Libya. In addition, many of the EU's missions, even if modest, are still helping to stabilise countries across the world. In the Gulf of Aden, an EU naval force protects vulnerable boats from pirates, including the World Food Programme vessels which deliver food to Somali people. In the months to come, the EU will deploy civilians to help the government in Niger reform its security sector (a country where, according to European governments, Islamist militants threaten international security). EU experts will also soon help improve the security at the international airport in Juba, the capital of newly independent South Sudan.

In any case, American policy-makers are themselves reconsidering the merits of how the US has used force over the last decade. The Obama administration has been extricating US armed forces from Iraq and Afghanistan – even though in both countries, the US has not achieved the level of stability which it had initially aspired to. The government's new defence guidance stresses that the US does not intend to deploy similar missions in future. It also argues that America cannot meet its security challenges through military force alone and that it must strengthen all the 'tools' of American power, including diplomacy, development, intelligence and homeland security. 

These are areas in which Europeans are significant players. Combined, the EU institutions and member-states are the largest aid donor in the world. According to the OECD, they spent €69 billion in 2011 – notwithstanding the fact that some European countries reduced their budgets because of the economic crisis. This is more than twice the amount the US gave. Between 2002 and 2013, the EU institutions and member-states will notably have provided €11 billion in aid to Afghanistan. And in response to the Arab Spring, the EU institutions alone have offered nearly €7 billion over three years. 

Europeans also invest significant resources in homeland security, even if budgets risk declining somewhat over the next few years because of the economic turmoil. Based on the latest OECD figures, the 21 EU member-states which belong to the organisation spent nearly €240 billion on 'public order and safety' in 2010 – nearly 90 per cent of what the US spent. This covers police forces, intelligence services, the judiciary and ministries of internal affairs. The US is a beneficiary of this spending too – in addition to supporting Europe's internal stability, these bodies tackle the international terrorism and organised crime that afflict Europeans and their allies alike. 

European countries are also increasing the EU's involvement in security matters – including through the EU's bilateral ties with third countries. One EU agency, Frontex, monitors the Union's southern and eastern border, while another, Europol, tackles organised crime. EU funds for homeland security, although still modest, are increasing despite the economic crisis. From 2014 to 2020, the EU is expected to spend nearly €10 billion in this field. The money will notably fund research into intelligent maritime surveillance systems and help partner countries across the world fight criminal networks and monitor their borders more effectively.

European governments also leverage the EU's large common market to pursue their foreign policy objectives. They offer preferential trade ties to support the economic development of numerous fragile countries across the world, and to encourage them to improve their governance. Pakistan is one of the states which qualify for some of the EU's most generous trade concessions. EU countries also impose heavy sanctions on countries which they believe are undermining international security. Among other things, the EU recently introduced an oil embargo against Iran – even though the measure is inflicting significant economic hardship on Greece and other EU states which were already struggling with the financial crisis. And through the offer of EU and NATO membership, Europeans (and the US) have managed to spread stability across the European continent.

The fact that Europeans wield such extensive foreign policy 'tools' does not mean they always use them wisely. Nor should it allow Europeans to neglect their armed forces. Governments must ensure that their peacekeeping efforts are not hampered by inadequate military equipment, and that they retain the capacity to respond to a serious military threat if one were to emerge. But America is less alone in upholding global security than some in Washington would suggest.

Patryk Pawlak is a research fellow at the EU Institute for Security Studies and Clara Marina O'Donnell is a research fellow at the Centre for European Reform and a non-resident fellow at The Brookings Institution.

Needed: a Franco-German concordat

Like many other EU summits over the past two years, the European Council meeting in Brussels on June 28th and 29th has been billed as a ‘last chance’ to save the euro. With the situation in Greece, Spain and Italy causing alarm, EU leaders should present a credible plan to convince financial markets that they are serious about saving the euro. They are unlikely to do so. Although there will probably be other last chances, time is starting to run out. Unless France and Germany can soon agree on a grand bargain, disaster may loom.

Not only France but also Italy, Spain, the European Commission, the IMF and the Obama administration are urging Germany to accept ‘eurobonds’ (collective eurozone borrowing), bigger bail-out funds that can intervene in sovereign bond markets and a ‘banking union’ that would include common deposit insurance and bank recapitalisation schemes. For now, however, Chancellor Angela Merkel is not budging.

According to one EU official who has worked closely with Merkel, she reacts badly when other governments ‘gang up’ against her: recent public criticism from François Hollande, the French president, and Mario Monti, the Italian prime minister, has only made her more stubborn. But the official points out that since the euro crisis began she has carried out several U-turns (for example, by agreeing to set up bail-out funds). She has also told fellow EU leaders in private that the euro is in Germany’s national interest and that if, in a crisis, new measures are required, she will take them. What she will not do is spell out in public the steps she is prepared to take, lest that encourage other governments to relax their efforts to curb budget deficits and enact reforms.

When Merkel says that she will do whatever it takes to save the euro she is presumably sincere. But in a crisis would she be able to move quickly enough? She faces severe domestic political constraints. Many Bundestag members oppose greater generosity to southern Europe. In that they reflect German public opinion, which is becoming more hostile to bail-outs. Furthermore, Germany’s constitutional court could block further transfers of power to the European Union. Most of the eurobond schemes that have been mooted would be incompatible with Germany’s current constitution. The German constitution can be changed if two thirds of Bundestag members vote for an amendment. However, if Merkel required the votes of the opposition Social Democratic Party (SPD) to change the constitution, her coalition government would probably collapse.

Not unreasonably, most Germans are reluctant to support schemes such as eurobonds unless other eurozone countries are willing to submit their economic policies to more control by EU institutions. Otherwise the southern Europeans could borrow cheaply via eurobonds and then spend freely. Monti and Mariano Rajoy, the Spanish prime minister, are willing to accept more EU control. But Hollande has not yet indicated that he is willing to do so. Many senior figures in French politics, including the foreign minister, Laurent Fabius, oppose transferring more powers to the European Commission.

Hollande’s current policies are making it hard for Germany to change its stance on the euro. He appears allergic to the kinds of structural economic reform that would boost France’s waning competitiveness, such as deregulating labour markets (he is lowering the pension age while other European governments are raising it). He says he is committed to a budget deficit of 3 per cent next year – which would mean a restrictive fiscal policy – but has so far announced no spending cuts and several spending increases. State spending is 56 per cent of GDP (the highest in the EU after Denmark) and growing. A swathe of new taxes on business is likely to discourage investment and thus stunt economic growth. For the time being, Hollande appears no more willing than Nicolas Sarkozy was to give the EU a bigger say over French budgetary policy.

The story of the euro, like that of the EU itself, is one of Franco-German bargaining. The current disconnect between Paris and Berlin is destabilising the euro. In the long run the euro is not sustainable without a grand bargain between France and Germany. Germany will need to accept the principle of eurobonds, some sort of banking union, softer budgetary targets for the countries in difficulty, and the writing off of more of those countries’ debts. In return France and the other euro countries will have to swallow both structural reforms that would enhance productivity, and greater EU sway over budgets and other economic policies.

At the moment such a grand bargain is impossible, and not only because Paris and Berlin are far apart on policy. Merkel and Hollande do not trust each other. The history of Franco-German relations suggests that even when two leaders initially get on badly (think of Jacques Chirac and Gerhard Schröder, or Nicolas Sarkozy and Angela Merkel) they eventually find a way of working together.

However, the financial markets may not wait. The next eurozone crisis could be imminent, perhaps provoked by a bank run in Spain or Italy, or those countries having to pay so much to borrow that they are effectively frozen out of the bond markets. Those who wish the euro well must hope that in an emergency, Merkel and Holland will overcome their differences, act decisively and bring along the other leaders with them.

But the intrusion of democracy could spoil the best efforts to salvage the euro. In the Netherlands, parties that oppose austerity at home as well as more money for bail-outs could win September’s general election. Monti’s government of technocrats, increasingly unpopular in Italy, could fall long before the elections that are due next spring. Within the past few days both Wolfgang Schaüble, the German finance minister, and Sigmar Gabriel, the SPD leader, have said that big changes such as eurobonds could well require a referendum in Germany.

Many things can go wrong, but if France and Germany work together the euro has a sporting chance of survival. The EU institutions can play a role in bringing them together. Ever since the euro crisis began, the Commission, in particular, has been marginalised from some of the decision-making on the most important issues. The gravity of the current situation presents an opportunity for the institutions to reclaim some intellectual leadership. The ‘four presidents' report’, published on June 25th, shows that they are trying to do so.

Written by the presidents of the Commission, European Central Bank, Eurogroup and European Council – with Herman Van Rompuy, president of the European Council, in the lead – the report sketches a way forward on banking, fiscal and economic union. It calls for common systems for banking supervision, deposit insurance and bank resolution. It also suggests more EU control over national budgets and levels of debt, alongside tentative steps towards debt mutualisation (it mentions short-term ‘eurobills’ and a ‘debt redemption fund’, kinds of eurobond that may be compatible with the German constitution).

The four presidents’ report offers EU leaders a sensible roadmap for their future work. However, Merkel’s response, expressed to law-makers in Berlin on June 26th, was to say that she did not expect to see eurobonds in her lifetime. She is, in the words of the EU official quoted at the start of this piece, “practising brinkmanship, which of course entails the risk that one falls into the abyss”.

Parts of this article are based on a piece that appeared on the Guardian website on June 25th 2012.

Charles Grant is director of the Centre for European Reform.