A Widening Split in the European Union

9 MINS READJul 13, 2012 | 10:31 GMT
Euro symbol in front of the European Central Bank headquarters in Frankfurt, Germany

Despite its complexity, the European sovereign debt crisis stems from a singular event: the formation of the currency union. As the crisis worsens and existing EU mechanisms meant to stem the crisis fail, solutions increasingly will focus on tightening the eurozone. This will alienate the 10 EU member states that have not adopted the euro. 

Such an arrangement would yield differing results among the 10 EU states outside the eurozone. Countries with strong economies could benefit from dissociation with the eurozone, but countries still highly dependent on EU financial assistance could falter economically. Importantly, a widening rift between the eurozone and the wider European Union would also validate security concerns long harbored by Eastern European and Nordic states.

The financial crisis will slowly drive apart the constituent members of the European Union and the eurozone. Several European countries already are forming regional subgroups based on corresponding economic, political and security concerns. As these groupings form and solidify, they will mark the first appreciable structural change in the European Union.

The euro promised to streamline and further integrate the European economy by eliminating risks associated with exchange rates and by allocating capital more efficiently. Consequently, the currency union raised the exchange rate in peripheral eurozone countries — Portugal, Ireland, Greece, Italy, Spain, Cyprus, Slovakia, Estonia, Malta and Slovenia — while lowering it in the eurozone core. With the adoption of the euro, peripheral eurozone countries had access to more credit than they had ever had before.

EU/Eurozone Rift

071212 EU/Eurozone Rift

One of the biggest beneficiaries of the new system was Germany, which could more easily export goods with the weaker exchange rate. In fact, eurozone members encountered no exchange rates when they traded with one another. Combined with a robust industrial sector and the relatively slow appreciation of wages in Germany, the new trading scheme gave Berlin massive trade surpluses with most of its trade partners.

Concurrently, peripheral eurozone countries were ill equipped to handle the flood of credit into their economies. The credit boom pushed wages higher. Hobbled also by a comparatively higher exchange rate, the periphery steadily became less competitive. These countries ran major trade and fiscal deficits, accrued unsustainable debt and saw their credit bubbles burst — all to the detriment of their banking sectors.

The crisis also affected countries outside the eurozone. As eurozone banks repatriated capital to help redress their domestic financial issues, several Central European countries, including Hungary and the Czech Republic, had their currencies devalued and faced a credit crunch.

Central Europe notwithstanding, much of Europe's financial hardship has been contained within the 17 members of the eurozone, which inadvertently created those problems when it came together.

Eurozone Centralization

Eurozone members cannot implement their own sovereign monetary policies; they must rely on EU supranational instruments to address Europe's outstanding financial issues. Eurozone members, while subject to the will of their respective electorates, are expected to adjust their economies in accordance with these supranational instruments.

Examples of such supranational instruments abound. The European Financial Stability Facility and the European Stability Mechanism are emergency response funds tailored for and voted on by eurozone members to alleviate the crises in the eurozone's weaker economies. Other crisis management instruments are even more explicitly eurozone-centric. Sovereign and corporate debt purchasing by the Securities Markets Program and Covered Bond Purchase Program are managed by the European Central Bank, which has a eurozone-exclusive mandate.

In fact, as more solutions to the eurozone crisis are introduced, those solutions increasingly exclude the considerations of non-eurozone members. For example, the June 28 EU summit was celebrated as a successful leap toward tighter European integration, yet every significant proposal broached at the meeting concerned the eurozone. These proposals included the establishment of a bank regulator to be headquartered in Brussels; the participation of the European Stability Mechanism in primary and secondary bond purchases; and the renegotiation of previous bailout terms for eurozone nations.

In theory, the proposed banking union would govern the entire European Union, but it has little chance of taking hold outside the eurozone. Currently, the leading candidate for administering the union is the European Central Bank, and the only net creditor country apparently in favor of the scheme is Germany. (Notably, German banks do not favor the scheme.) While Germany relies on the eurozone for its economic survival, non-eurozone creditors and those with the financial resources and the independent monetary policy to handle their own banking sector problems see little upside to the sovereignty issues the banking union would introduce.

So far Germany has laid out the most coherent plan to deal with the European crisis. Berlin believes tighter fiscal and political EU integration will beget a financial transfer union that will alleviate the effects of trade imbalances, lack of competitiveness and debt overhang in the periphery. The German plan is tightly focused on eurozone nations, which are locked in a monetary union with export-dependent Germany. It is these countries, rather than the 10 members of the European Union outside the eurozone, that would suffer if they resisted the German plan. Therefore, any new institution introduced will be customized to fit the needs of eurozone members.

Dissatisfaction Outside the Eurozone

The growing isolationism of the eurozone is a delicate issue for the remaining EU countries — the United Kingdom, the Czech Republic, Poland, Hungary, Lithuania, Latvia, Denmark, Sweden, Bulgaria and Romania. While the EU-10 share some characteristics — all can control their own currency policy — the group's members have no common policies toward the eurozone.

Monetary control has helped some EU-10 countries maintain a degree of competitiveness in regional and international markets as well as flexibility in their response to the financial crisis. For the countries that have been relatively less affected by the financial downturn, further integration with the eurozone model would seem to curtail a significant advantage they have maintained throughout the crisis. Poland and the Czech Republic have in fact placed their eurozone accession schedules on hold until the financial and political future of the grouping becomes clearer.

Sweden, Poland, the Czech Republic and the United Kingdom outspokenly oppose the creation of a pan-European Union banking regulator. They prefer the office's powers to be limited to the eurozone. These countries already have relatively well-capitalized banking sectors that are less connected to eurozone financial markets and they see little need to submit to extra oversight. The United Kingdom has been especially vocal in its criticism of the plan. The British see it as a threat to their banking sector, which is prized for its contribution to national wealth.

Even the fiscal compact, which was originally proposed as an EU treaty, was eventually downgraded to an intergovernmental treaty and signed by 25 member states. The two countries that did not sign the treaty, the United Kingdom and the Czech Republic, are not members of the eurozone, further evidencing the eurozone's exclusionary policies.

However, many recently integrated EU countries (or countries soon to be integrated), such as Romania, Bulgaria and Croatia, still depend on EU financial assistance to develop their own economies and infrastructure. Were Brussels to turn increasingly inward, these countries would find it harder to secure funding and insert their products and workforce into the eurozone market. The European Union already has shown that it is highly reluctant to pay for high-cost infrastructure and development projects in Central Europe, particularly in the energy sphere.

This partly explains Romania and Croatia's opposition to what they call a two-speed Europe — a concept that refers to uneven integration among member states. This is not a new concern, but it has grown as a result of the financial crisis.

Further Fragmentation?

In many ways, the divergence of the European Union and the eurozone will prompt non-eurozone countries to seek alternative economic, political and security arrangements, particularly by looking to form and develop regional groupings.

With Europe's core focused on salvaging the eurozone, the remaining members of the European Union, especially Central European states, are becoming increasingly financially and politically alienated. Some of the states still face the threat of a resurgent Moscow, which has taken advantage of Western Europe's relative disinterest in Russia's former Soviet periphery.

Of course, the European Union was never a security guarantor on the Continent. However, it worked alongside NATO and the United States. As Central Europe has become more disillusioned with U.S. and NATO efforts to maintain a buffer against Russia, several Central European countries over the past three years have sought security alternatives within the EU framework. So far, these efforts have been unsuccessful.

In addition to security issues, several former Soviet satellite countries are disenchanted with the European Union's political demands. These states have been forced to implement substantial and unpopular institutional reforms in order to qualify for EU accession. They believe they are suffering the negative consequences of association with the European Union before ever having a chance to reap the benefits of EU membership. Indeed, Romania and Bulgaria are not members of the Schengen agreement.

EU Regionalization

071212 EU Regionalization

Such discontent with the European Union likely will result in the eventual formation of regional groupings. Were this to happen, the two most likely arrangements would coalesce around Nordic countries and around the Pannonian plain in Central Europe. Both regions already hold primarily nominal security groupings within the EU framework, but economic and political integration has not moved beyond a nascent stage.

The first arrangement would group the traditionally strong and integrated economies of Scandinavia with the dynamic countries of the Baltics and Northern Central Europe (Poland, Lithuania, Latvia and Estonia). These countries share a growing economic and political skepticism toward the European Union, as well as an uneasiness regarding the resurgence of Russia.

The second grouping would coalesce around the Visegrad nations of Central Europe (Slovakia, the Czech Republic, Hungary and Poland, which is bidding for a leading role in both the Visegrad and Nordic groups). This group could eventually extend to countries just north of the Balkans, including Bulgaria, Romania, Slovenia and Croatia. These countries are more heavily dependent on trade with capital-rich Germany. Currently they have weaker and less integrated domestic and regional economies than their northern counterparts.

In the past year there has been a strong drive to integrate the energy markets of Slovakia, Hungary and the Czech Republic, particularly with the integration of their natural gas distribution networks via pipeline interconnectors. These arrangements bolstered the liberalization of the regional natural gas market and are a first step toward a more balanced relationship with Russia on the energy front. We have also seen a relatively high number of economic and political bilateral agreements in Central Europe since 2008.  

The polarization of the eurozone and the EU-10 is just beginning, but it is a trend that can be expected to grow. Regardless of how the eurozone crisis is resolved, the remaining EU members will increasingly have to look outside the eurozone to pursue their economic and security interests.

While most of this dissociation will proceed under the auspices of the European Union, the 27-nation bloc will become increasingly fragmented as the eurozone solidifies into a relatively independent block and the remaining countries coalesce into smaller regional groupings.

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