What we’re not yet sure of is just what
will take its place. The complexity and breadth of the unfolding European
financial crisis, with another imminent flash point seemingly around every
corner, have made it particularly difficult to distinguish noise from signal and
the valuable data from the spin in each day’s headlines. In particular, the
news focus on daily – or hourly – developments in the crisis often obscures
the broader dynamics that will shape the European response over the next few
months, which will in turn shape Europe itself over the next few decades.

Here are 12 key trends to watch over the
next few weeks for help in projecting what the new Europe will look like if it finally emerges from the mire.

1. Continuing
Greek dysfunction.
Pundits and analysts are waiting with bated breath for the results of Greece’s
elections on June 17, with many declaring it as a virtual referendum on whether
the country will remain in the eurozone. But here’s the truth: The
possible outcomes are narrower than people think, ranging only from pretty bad
to worse.

If the Coalition of the Radical Left (Syriza) gets the
most votes, even with the 50-vote bonus for finishing first, a fractured
electorate and lack of suitable coalition partners make its prospects of
forming a workable government slim. But even if an ostensibly "pro-bailout"
combination of New Democracy and former ruling party PASOK was to squeak
through with a collective majority, the effectiveness of their coalition will
be severely limited and Greece’s future far from clarified. These two parties
are once and future rivals, and in actuality they agree on very little. Expecting
that they can quickly reach consensus on the specifics of some 15 billion euros
in austerity measures over the next two years is highly doubtful.

Any renegotiation of the terms of Greece’s bailout,
moreover, will be merely a matter of spreading the pain over an additional year
or two, ensuring continued political deadlock and a disgruntled electorate. Besides,
the math doesn’t work, and every day the country remains politically paralyzed,
the costs to the country and its creditors increase. The upshot is that
regardless of the election’s outcome, Greece and its European partners are in for
an almost unimaginable set of politically unpalatable choices. The likelihood
of an election that definitively ensures that Greece remains in the eurozone is
very low.

2. Spanish
banks as catalyst.
Some in Greece think that Athens can successfully blackmail its European
partners into caving and lightening conditions on the country, lest Greece blow
up and take the rest of the eurozone with it. They are probably miscalculating.
Greece is, in the grand scheme of things, too small to sink the European
experiment. But Spain (in part because it is too grande to fail) actually does hold
some pretty daunting cards, as demonstrated by the rescue package it received
over the weekend. The dynamics to watch now are how Europe’s official sector
lenders proceed. Although the basics of the Spanish rescue were announced, the
plan is far from fleshed out, with crucial details – like where’s the money coming
from and on what terms will it be disbursed – remaining unresolved. When
providing Spain its lifeline, policymakers are acutely conscious of the
precedent that this rescue will set.

This "conditionality-lite"
Spanish program (with the Germans emphasizing the "conditionality" and Spanish
Prime Minister Mariano Rajoy the "lite") might conceivably provide political
cover for the Spanish government while maintaining the "no money without
strings attached" restrictions required by the Germans. It could also, however,
catalyze a more far-reaching process of reform: federalizing banking supervision and
regulation within the eurozone, the possible migration of bank deposit
guarantee schemes from the auspices of national governments to a pan-European
one, some form of Eurobonds, and, in the end, fiscal union. Recall that the U.S.
Constitutional Convention was held in part because the Articles of
Confederation weren’t sufficient to resolve conflicts between
those states that had repaid their Revolutionary War debts and those that
couldn’t or wouldn’t. The Articles of Confederation’s drafters did not envisage
a federalized entity any more than the crafters of the Maastricht Treaty
foresaw a "United States of Europe." The Spanish banking crisis won’t trigger a
formal constitutional convention, but it could have much the same effect,
setting in motion a more dramatic shift in how Europe operates for decades to
come.

3. Rise of extremist parties. They seem to be ascendant everywhere in Europe these
days, on the right and on the left. In Greece, Syriza threatens the bailout while
the neo-Nazi Golden Dawn received nearly 7 percent of the vote in May’s
elections. In Germany, the idiosyncratic Pirate Party has drawn a significant
following. In France, Marine Le Pen’s far-right National Front and Jean-Luc
Mélenchon’s Left Front are actually battling over the same voters, while in
Italy, even corruption scandals and the resignation of its longtime leader,
Umberto Bossi, hasn’t stopped the virulently anti-immigrant Northern League
from playing a role in Italian politics. And Geert Wilders’s PVV has already
caused one Dutch government to fall and continues to play an outsized role in
the Netherlands.

Europe
is not about to lurch dramatically left or right. But the rise of these and
similar extreme parties pose two big problems – one short-term and the other
long-term. First, they drastically increase the difficulty of forming
stable coalitions, which in the European periphery makes imposing structural
reforms and fiscal discipline hard and in the core makes agreement on
comprehensive solutions even harder. The parliamentary structure of most
European governments provides these smaller parties with disproportionate
influence, as they are needed to create majority coalitions. Second, the
extreme parties, both left and right, tend to be populist and anti-immigrant. Europe’s
economic woes are already decreasing its attractiveness as a destination for
immigrants; xenophobia only exacerbates this dynamic. But Europe desperately
needs immigration to combat its declining demography and rejuvenate
economic growth.

4. Merkel gets bold. Perhaps more than Greek elections or Spanish balance
sheets, German domestic politics may be the single-most crucial factor in
shaping the response to the crisis. With federal elections scheduled for autumn
of next year, Chancellor Angela Merkel, her allies, and their challengers gauge
every move and its impact on that vote – and the regional and local ones in
the interim. Merkel has stepped up to a leadership role that few would have
predicted only a year ago. But her calm and deliberate leadership style is calculated
to kick the can down the road while ensuring that she can deliver her party and
the German people. Merkel may well move to support a more ambitious and robust
response, especially around federalizing eurozone banking-sector governance,
and garner support from center-left parties (the Social Democratic Party and
the Greens) that would set herself up to take the helm of a grand coalition
government following next year’s elections, if she’s unable to win outright.

But Merkel’s current governing coalition includes her
own Christian Democratic Union (CDU) and its partner, the Free Democratic Party
(FDP) – a far less popular party rapidly plummeting in the polls. The FDP
remains staunchly opposed to any move that smacks of European fiscal union, and
Merkel’s CDU boasts a large contingent of skeptics as well. If she bucks her
own party and the FDP, Merkel could potentially save Europe. But that would be
a bold move from a chancellor who has rooted her effectiveness and popularity
in incrementalism.

5. The
United States keeps quiet.
Here’s a not-so-well-kept secret: The United States doesn’t possess the
inclination, the ideas, or the financial capacity to materially influence the
endgame in Europe. Here’s an even less-well-kept one: The White House is
enormously concerned about a European implosion damaging the fragile U.S.
economy and taking President Barack Obama’s reelection chances with it. The Federal
Reserve has played an enormously important and somewhat unsung role in Europe,
keeping large U.S. dollar swap lines open for the European Central Bank that
have been crucial for supporting banks in the European periphery. But the Obama
administration maintains a public stance that the Europe crisis is largely for
Europe to solve on its own. Not only are U.S. coffers empty, but even benign
efforts to think creatively about ways to address Europe’s problems often meet
with public criticism on the continent, with the oft-repeated refrain "Get your
own house in order first."

In any case, despite Obama’s speech
last Friday, June 8, you won’t hear much about Europe on the campaign trail. The
president will limit talk about it for fear of highlighting America’s inability
to solve a major economic crisis with its European brethren, while Republican presidential candidate Mitt Romney
doesn’t want to appear to give the president an "out" on responsibility for any
setbacks in the U.S. economy. All in all, Washington will be speaking softly,
but without any stick to back it up.

6.
Rating
agencies get tough. Let’s face it. More often than not over the past two years, the
"solutions" presented by European leaders to drag the eurozone back from the
abyss have involved more than a dollop of ambiguity. European leaders have
announced big headline numbers at the last minute to calm markets, almost
always on weekends (see Spanish bank announcement on Saturday) and sometimes in
the dead of night on an early Monday morning
just before Asian markets open, as was the case with the creation of the European
Financial Stability Facility (EFSF) and its successor, the European Stability Mechanism (ESM).
But regardless of when these announcements are made, these crisis responses usually
are based in large part on rhetorical announcements designed to trigger
a favorable market reaction, not on binding financial commitments backed up by
real cash.

Grand pronouncements have worked fairly well and may
continue to do so – but only until third parties like credit-rating agencies pull
back the curtain and expose the schemes for what they are. Having suffered
serial blows to their credibility during the 2008 financial crisis and
beyond, the credit raters are more determined than ever not to let the smoke
get in their eyes, especially as they face increasing criticism from
politicians seeking to limit their authority and influence. But shooting the
messenger is not likely to solve Europe’s problems. Engaged and independent
rating agencies may provide more clarity to markets but also make political
deals with embedded ambiguity or internal inconsistencies – which are often
necessary in the absence of consensus – harder to craft and implement.

7.
The
fracturing troika.
Throughout the crisis, the IMF has sought
to maintain its critically important independence and market credibility while
working closely with the European Central Bank (ECB) and the European
Commission (EC) and its member states. Now, ECB-EC-IMF tensions revolve around
something much simpler: who pays.

Greece owes more than 300 billion euros to its
official sector lenders, and regardless of the outcomes of the Greek elections,
the country’s ability to pay it all back is seriously doubtful. Someone will
have to bear the brunt of these losses, and the private sector, which took a
large haircut in the recent restructuring, no longer holds enough debt to make
much of a dent in any future restructuring that may be necessary. But with the
IMF asserting its "preferred creditor status" and the ECB claiming a newly
created level of seniority just below the IMF (and refusing to discuss anything
that it deems to violate its prohibition against "monetary financing"), that
leaves European governments holding the bag.

And that’s just for Greece. Add in the potential costs
of Spain and Italy and the ongoing assistance to Portugal and Ireland, and the
numbers get pretty big pretty fast. What’s more, neither of the funding
programs the EU governments have set up – the EFSF and the ESM – have any significant
capital. They both rely on capital markets, leverage, and to some extent
"alchemy" to reach their headline funding capacity. At some point, bonds need
to be redeemed and debts paid. The Spanish bank recapitalization plan just
announced is noteworthy as it does not include funding commitments from either
the ECB or the IMF. It could well be the shape of things to come as the
appearance of a harmonious troika is likely to come under increasing internal
strain as the music comes closer to stopping and there aren’t enough chairs to
go round.

8.
Britain vs. Europe. Tensions between the 27-member European Union and the
17-member eurozone are increasingly causing a formal, two-track Europe to
become the rule, not the exception. The crisis has exposed in gory detail the
need to use the European Union to solve the problems of some, but not all, EU members.

In particular, Britain’s red lines against any outside
supervision of its financial sector, given the country’s dependence on the
City of London’s role as a global financial center, are likely to bring this division to
a head sooner than many imagine. The financial reforms likely to emerge as part
of a potential solution to the European crisis will bind the eurozone more
tightly together. But with Britain unwilling to subject its banks to European
regulatory oversight, transaction taxes, and other similar schemes, the Brits
(and other non-eurozone states) will find themselves further on the outside,
and the divisions between the European Union and the eurozone will become increasingly
apparent.

9. Italy’s
fragile future.
In many ways, Italy reflects the very same stresses that buffet Europe writ
large. It has a fractured political landscape, sharp economic divisions between
a prosperous and industrious north and a laggard south, severe demographic
challenges, and a crisis-enabled technocratic government – the effectiveness
of which is eroding by the day. Growth in
Italy has declined in an almost-straight line, from 5 percent in the 1950s to 4 percent in
the 1960s, 3 percent in the 1970s, 2 percent in the 1980s, 1 percent in the
1990s, and stagnation in the 2000s (though, of course, the food, wine, and
landscape are as wonderful as ever).

Italy’s story is not wholly that of Europe. Its north
has propped up the Mezzogiorno with an internal transfer union (from north to south)
for almost 150 years, and for the most part the country has hung together. But
the necessity for Prime Minister Mario Monti’s technocratic government to cut
political deals points to a broader truth: a non-elected technocratic
government can be a savior in times of imminent crisis, but is otherwise
constrained by a lack of democratic legitimacy and an inability to play the game
of politics. So Monti’s success in pushing through necessary structural
reforms as he navigates his way to next year’s elections may be a valuable
indicator of the ability of European supranational institutions to take
necessary measures even as they too are long on technocratic skill and a bit
lacking in democratic legitimacy.

10. Central Europe wins. As Germany picks up the
pieces, no matter what the outcome of the crisis, the former Soviet satellites
in Central Europe look to be potential winners. A weak euro bolsters German
exports, and the Czech Republic, Hungary, Poland, and Slovakia all have deep
connections to the German manufacturing machine. They could be collateral
beneficiaries from any resulting German export-led strength. These countries,
having emerged a scant two decades ago from behind the Iron Curtain, have less
skepticism of the European idea, attach a different valence to the meaning of
Europe, and, ironically – in part because many have yet to join the common
currency – have far less of the embedded economic problems of their Western
and Southern European counterparts.

In many ways, "new Europe" harks back to the old
"Old Europe." The newfound centrality of Central Europe is a return to the
Concert of the 19th and early 20th centuries, with the continent’s geographic
core setting the tone for the periphery. It bears reminding that the last
European transnational currency to collapse was the Austro-Hungarian crown
after World War I, which eventually set in motion the geopolitical dynamics
that led to the euro. Stresses on the eurozone could reorient Europe back
toward Mitteleuropa, leaving the Visegrád countries as the crisis’s
surprising winners.

11. The
Cyprus effect. It’s a bit odd that the
commentators who continually harp on the need to impose austerity on those who
"deserve it" and warn of the dangers of moral hazard don’t have Cyprus in their
sights. Most Europeans do not consider the Cypriots bad actors, and the Cypriot
economy is a rounding error within the context of the eurozone. Yet, with
enormous exposures to the Greek financial sector and Greece more broadly,
Cypriot banks have all the problems of their Greek counterparts, but no
access to the 50 billion euros for Greek bank recapitalization contained in the
troika program. Cyprus thus sits on a precarious perch, with the potential
spillovers from Greece, through both financial and economic channels, a very
real risk. A bailout request appears imminent.

The real story here is more geopolitical than
financial. The Cypriot economy, in particular the Cyprus’s financial
sector, has close ties to Russian finance – some openly acknowledged
(favorable tax treatment for Russian financial firms driving vast sums and
transactions through Cypriot banks) and some not (rumors of less savory
activities and murky accounts). The Kremlin will likely go a long way to ensure
that Cyprus remains stable, sovereign, and free from external monitoring (witness
the "no strings attached" 2.5 billion euros that Moscow lent to Nicosia last year).

Whether the Russians come to the country’s rescue
again, and on what terms, remains a strategic question mark. But Cyprus, as a
member of the European Union and eurozone with deep, somewhat opaque financial
ties to Russia, potentially opens another as-yet-untold chapter in the European
crisis. Russia has thus far been relatively silent and removed from direct
involvement. If that changes, the dynamic of the crisis and its potential
resolution would likely shift in unpredictable, but undoubtedly strategic ways.
And that’s not even mentioning the potential impact of Cyprus on Turkey, which
could see any European intervention in the historically conflict-prone country
as part of a broader conspiracy.

12. The Chinese shopping spree. Despite the headlines and
political rhetoric, China is not coming to Europe’s financial rescue. That’s
not to say that every time a senior Chinese economic official lands in a
European country promising increased investment, they’re lying. But there’s a
big difference between bailing out a country with huge amounts of cheap funding
for its sovereign and looking around for potential bargains once forced sellers
of distressed assets find themselves without other options. Beijing is also
free from blame in the eyes of European public opinion. That won’t change, and
it will allow China to become a player in the eurozone – just not necessarily in
the way that the Europeans want.

All the reasons that some Europeans see China as a
potential financial savior remain valid: It has liquid capital that it is
ready, willing, and able to deploy. China will likely use its war chest not
for bailouts, however. Instead, it will buy assets. Beijing may ultimately see
the crisis as a huge shopping opportunity in an enormous, generally stable,
rule-of-law-driven economic zone. Investment and influence are likely to follow.

The European Union remains one of the
greatest experiments in history. In little more than a half-century, Europe
evolved from a war-ravaged continent to the world’s largest economic zone and
the only place in the world where countries voluntarily agreed to pool major
elements of their sovereignty, on the principle that all countries are (more or
less) equal and should follow collectively agreed-upon rules and work through
supranational institutions. But the next version of Europe may well be created
not by great strategists and visionaries like Jean Monnet and Robert Schuman,
but rather by anonymous and impatient financial markets around the globe and by
the weekend crisis responses of bureaucrats, technocrats, and politicians in
Brussels, Berlin, and Frankfurt.


By: Douglas Rediker & David Gordon