Troubles in the eurozone

By Ian Bremmer and David Gordon

2010 was a difficult year for Europe, and things won’t get easier in 2011. The eurozone will remain intact, but there’s a serious risk that the debt crisis will become increasingly unmanageable this year. As peripheral countries struggle to implement structural reforms, the politics of austerity will put additional public pressure on supporters of the EU project in core countries like Germany and France.

In recent weeks, the EU has done little to allay investors’ fears about the solvency of both sovereigns and banking systems in a number of peripheral eurozone countries. Key questions on the nature and timing of future financial bailouts remain unanswered, and important potential remedies, like increasing the European Financial Stability Facility (EFSF) and introducing new eurozone bonds, have been taken off the table, at least for now.

At the moment, the core countries, led by Germany, are committed to the euro and the European integration project, even as they avoid efforts to find systemic solutions to the crisis. In Spain and Portugal, governments are moving to fast-track fiscal consolidation and structural reform in an effort to preempt market pressures. While markets remain skeptical, the hope in Brussels, Berlin, and Paris is that this is just the beginning of a sustained rebalancing that will help stabilize the eurozone. In this view, the European economic crisis is the catalyst needed to restore policy convergence within the eurozone and to enforce peripheral Europe’s compliance with the "Lisbon agenda" of labor and product market reform. Yet the idea that the EU, the ECB, and national governments can rapidly remake fiscal patterns of peripheral Europe — let alone their labor markets and regulatory regimes — strains credulity. That’s especially true given the weak economic forecast for these countries and their inability to undertake currency devaluations.

Ireland, Greece, Portugal, and Spain have all taken impressive first steps on the fiscal side, but policy sustainability remains an open question. Politicians in each of these governments will have a hard time enforcing cuts to wages and entitlements that erode their nations’ standards of living. Structural reforms like privatization and trade union regulation will threaten well-organized groups, which will mobilize in opposition. The result will not be explicit rejection of these programs, let alone an exodus from the eurozone. Peripheral Europe is more likely to take a page from developing countries in how they manage relations with the International Monetary Fund and World Bank — with a lot of fudging and passive opting out of important parts of their plans.

The political challenges facing reform in the periphery will make it more difficult for defenders of financial bailouts within core countries, and we’re likely to see new political fissures on this issue, especially in Germany. This problem will heighten the sense of broader political conflict on the continent, increase policy coordination risk (especially between Berlin and Paris), and undermine market confidence in the EU’s ability to sort out the crisis.

All of this leads to the real danger: that the eurozone countries big enough to matter in global finance — namely, Spain and Italy — will find it increasingly difficult to borrow at rates that are financially sustainable. If that happens, the chances of a systemic crisis will grow dramatically.

On Wednesday, we’ll look at no. 3 on our list of Top Risks for 2011: the geopolitics of cybersecurity.

Ian Bremmer is president of Eurasia Group. David Gordon is the firm’s head of research.