The fate of Europe will become more visible in 2013. The European Stability Mechanism and the European Central Bank’s ability to intervene in bond markets will continue to play an important role in holding European institutions together this year. And while the survival of the eurozone is no small achievement, these short-term remedies are piling over the deep structural aspects of the crisis that will only intensify in 2013. These include rising unemployment, rising social discontent, declining competiveness and the fundamental tension between integration and sovereignty in times of austerity.

While social unrest in the periphery will be particularly noticeable, the economic crisis will also penetrate the core, with both Germany and France facing economic stagnation. France will see a lot more union-led protests this year, which will add to the political tension between Paris and Berlin. Political fragmentation will also spread beyond the eurozone as the United Kingdom, Central and Eastern European countries become more alienated from the decision-making of the core. Political resistance in northern Europe to bailouts will build, but in the end the European Union will provide financial assistance where needed for the sake of maintaining the integrity of the European Union.

 

Three aspects to look for

First, the European crisis is fundamentally a crisis of competitiveness. The economies of the eurozone's south, which were seen as creditworthy before the crisis, are not as dynamic and competitive as the economies of the north and manufacturing bases that emerged in Asia over the past decade. In the past, the peripheral economies could implement monetary policy to address their lack of competitiveness, but that option is not available since the introduction of the euro. As a result, the only alternative for these peripheral economies is fiscal policy -- which over the past few years has taken the form of painful austerity measures and wage suppression.Second, the crisis has a political aspect. The European Union is not a federation but a collection of nation-states bound together by international treaties. This means that decision-making in the European Union is always a delicate balance between integration and sovereignty. All the policies emanating from Brussels to mitigate the effects of the crisis involve the transfer of sovereignty to a supranational entity -- either to provide financial assistance to countries in distress or to put national budgets under the supervision of supranational institutions. Because of their supranational nature, these policies often generate political tensions between countries (as they seek to protect their national interests) and within countries (within national governments or among the population).

Third, the European crisis is threatening the social stability in some countries, especially in the eurozone's periphery. The austerity measures that Brussels has requested are generating growing social discontent that threatens the longstanding hold on power of the traditional political parties and that strengthens extremist parties on the left and the right.

This triple dimension of the European crisis, which intensified in 2012, will influence the coming year.

 

The Crisis Reaches the Core

In 2012, the economies of the northern eurozone (especially Germany, France, the Netherlands, Austria and Finland) were less affected by the crisis than were their southern neighbors. They experienced relatively low levels of unemployment and some of them saw modest growth. In this regard, the economic crisis was largely focused on the eurozone periphery. In 2013, the two largest economies of the eurozone (Germany and France) will face low growth or even stagnation. This will have negative effects across Europe.

Paris will react to the crisis by designing structural reforms in an effort to improve the competitiveness of the French economy and to boost economic activity. These measures, which will include labor market reforms, will not please the French unions. The discontent of the unions and the slowdown in the French economy in 2013 will lead to major protests in France.

Economic stagnation in Germany is unlikely to lead to radical changes in domestic policy, since the slowdown will be gradual and unemployment will rise slowly from a relatively low level. Moreover, the parliamentary elections -- which are expected in September or October -- will slow the decision-making process in Germany substantially, so no fundamental changes in foreign policy will be made before the elections.

The German elections will in turn slow the decision-making process at the European level. The EU leaders will likely discuss several institutional reforms -- including a modification of the EU treaties and crucial policies such as the creation of eurobonds -- but there will be no substantial institutional reforms in 2013. Agreements on other smaller issues, such as the technical aspects of the banking union and reforms of the EU budget, are likely in 2013.

At the same time, the economic slowdown in Northern Europe will make these countries more reluctant to provide financial aid to the periphery. But we expect the European Union to continue assisting the troubled economies as needed.

Conditions in the Eurozone Periphery

Greece, Spain, Portugal and Italy will see their economies shrink and unemployment rates rise. In all these countries, the social unrest will grow and the year will be marked by protests and strikes.

The divide between the ruling elite and the populations of the periphery will be a key element in 2013, and some governments might even fall. But even if opposition parties take power, they will face the same constraints as the governments that preceded them. In other words, a change in politicians will not bring a substantial change in policies regarding the European Union. Largely, these countries will still be applying austerity measures next year, although I do expect these countries to be more vocal in their requests for concessions from their lenders. Under the threat of an escalation of the crisis, the European institutions are likely to make such concessions.

Although extremist or anti-establishment parties will gain influence over the political debate, they will not be strong enough to take power in any eurozone country. Each electoral cycle weakens popular support for mainstream parties in Europe, but the traditional elites will manage to stay in charge in 2013.

Political and social instability will be particularly acute in Greece, but the country will manage to remain in the eurozone in 2013. The Greek government will continue to receive European financial assistance in 2013 -- something that will prevent the country from leaving the eurozone. Moreover, Athens is likely to receive concessions from the European Union (likely a renegotiation or softening of the country's fiscal and economic targets) if necessary. During 2013, Spain will probably need further financial assistance from the European Union; we expect Madrid to reach an agreement with its lenders, since Brussels is interested in containing the effects of the Spanish economic crisis and preventing it from spreading to the rest of the eurozone.

The only country in the eurozone periphery that has scheduled elections is Italy (in February). If the next Italian government fails to achieve political stability and apply economic reforms, the increased market pressure on Italy will make Rome more likely to require financial assistance from Brussels. If that happens, Italy and the European Union are very likely to reach an agreement.

 

Political Fragmentation

In addition to the existing differences between eurozone and non-eurozone countries, political fragmentation will take place within the eurozone. France will be more vocal in its demands for greater economic solidarity in Europe through eurobonds or analog mechanisms -- something that will generate tensions with Germany. During an election year, Paris and Berlin are unlikely to reach an agreement on these issues.

Outside the eurozone, the United Kingdom will seek to protect its sovereignty and renegotiate its status within the European Union. But London will not leave the European Union in 2013. As eurozone countries increase their collaboration to overcome the structural deficiencies in the monetary union, Eastern and Central European countries outside the eurozone will balance their desire for a stronger participation in the decision-making with the advantages of not being a part of the common currency.

In short, the integrity of the European Union will be preserved, but Europe will also suffer the consequences of the deeper political and social aspects of the crisis that have not been addressed.

 

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