Cameron's referendum on the future of the U.K. is descending into a slanging match over immigration.
ALAIN JOCARD AFP/Getty Images
By Geoffrey Smith
December 23, 2015

The electoral calendar may be light and the economy may be growing, but there’s no chance of 2016 being a quiet year for Europe. It may not be a 1914-style powder-keg, but the continent is going to have to work harder than ever to defend—let alone build on—its achievements of the last 60 years. Here are just a few things that could go badly wrong in the next 12 months.

Brexit

An unfamiliar word today, you’ll be sick of the sound of it by June. The U.K. will hold a referendum, possibly as early as the middle of 2016, on whether to leave the E.U. It should be (and in fleeting moments of sanity it is) a discussion on what kind of relationship Britain—which opposes deeper E.U. integration—should have with a Eurozone that needs it to survive. Instead, it has been reduced to a shouting match over whether London should be able to stop immigrants from Poland, Romania, and elsewhere claiming welfare benefits. As Simon Tilford from the Center for European Reform argues, if Britain votes to leave the E.U., it will be “because membership has become synonymous in many voters’ minds with uncontrolled immigration,” and that in turn has happened because political parties have found it easier to blame immigrants for social problems, such as inadequate housing and overstretched public services, than to address the problems themselves.

Pragmatists console themselves with the thought that, even if the U.K. votes to leave, it and the rest of Europe need each other so much that common sense will keep disruptions to trade and investment to a minimum. But the Single Market, the E.U.’s most important economic achievement, would shrink by 16% overnight. European financial markets would be disrupted by the severing of London, the E.U.’s financial head, from its economic body on the Continent. And the sight of a country leaving the E.U. for the first time since its founding in 1957 would embolden forces all over the Union who think that breaking up existing political structures is their best chance for happiness (think Scotland, Catalonia, and Flanders for starters). The ensuing instability could hurt growth prospects for years.

Austerity and Reform Fatigue

Even without the contribution of the U.K., the forces acting to pull apart the Eurozone, the E.U.’s economic heart, are still as strong as ever. As long as the European Central Bank continues to smother systemic risks with unlimited liquidity, the worst should be avoided, the economy should continue to grow, and unemployment should continue to fall.

But the underlying problems are not going away: Greece is still a mess; in a reworking of the old Soviet paradigm, the creditors pretend it’s solvent, and the country pretends to reform. In Portugal in October, and Spain last weekend, general elections rejected the austerity imposed by bailouts in 2011 and 2012, but failed to vote for anything coherent to replace it. Ireland, the only Eurozone member to have national elections next year, is set to do likewise. In Portugal, a three-party left-wing coalition has taken power but is already cracking under the pressure of a botched bank bailout (more on that below). In Spain, the only workable options seem to be a minority government under Mariano Rajoy, a corruption-tainted lame duck, or a “Grand Coalition” of left and right without him that would be beset by huge internal contradictions. Either way, a continuation of the rapid growth that made Spain’s economy the Eurozone’s best performer this year seems unlikely.

Terrorism

The aftershocks of the Paris attacks will continue to work through Europe’s economy, and will be amplified if terrorists pull off another high-impact attack. Inbound tourism, which generated $450 billion for the E.U. economy in 2013, will suffer badly if major destinations like Paris become routine soft targets for Islamic State and its sympathizers. Cross-border trade could also suffer if heightened demands for security (coupled with alarm at large inflows of Muslim migrants) causes any more internal borders to be revived. The Schengen Agreement on free movement within the E.U. is, along with the euro and the Single Market, a pillar of modern Europe. And although E.U. politicians fiercely deny it, it is now largely dependent for its survival on an unpredictable Turkey holding back refugees from Syria, Afghanistan, and elsewhere. A euphoric surge of compassion in Germany helped absorb a million migrants this year. It’s highly unlikely that that will be repeated next year.

Libya

E.U. countries are doing their damnedest not to commit ground troops to a multi-sided civil war in Syria that is only getting worse. But they will struggle to avoid getting sucked into Libya if Islamic State expands its toe-hold on southern Europe’s doorstep. Its oil and gas is crucial to Europe’s economy (especially Italy’s). And Europe’s worst nightmare would be for Islamic State to destabilize the southern Mediterranean coast from Egypt to Algeria, causing yet another new wave of refugees, migrants, and (smuggled in amongst them) jihadists. An intervention would be fraught with risk, especially if E.U. countries stay around long enough to try to rebuild a stable state and government. But then, the risks of not intervening hardly seem lower.

Banks

Lovers of drama will be delighted that 2016 will be the year when the new E.U. Bank Resolution and Recovery Directive comes into force. As of January 1, regulators (that’s the ECB for most of the banks that matter) will get sweeping new powers to close down insolvent or undercapitalized banks, ‘bailing in’ even senior bondholders and large depositors if need be. It’s meant to weed out the zombie banks from the healthy ones. But clean-ups like this invariably mean brutal transfers of wealth from one class to another, causing the kind of political storm hated by governments and feared by gray-suited regulatory bean-counters with limited political authority.

Recent test cases don’t augur well. In Portugal this week, the government opted for yet another taxpayer-funded bailout rather than impose losses on retail savers who didn’t read the small print of investment products that they thought were deposits (and thus insured), but turned out to be subordinated debt (which weren’t). A similar drama played out in Italy during the fall, when furor over the restructuring of four local banks led Prime Minister Matteo Renzi to step in to protect small investors. Francesco Galleotti of the Rome-based think-tank Policy Sonar says Renzi’s tactic of blaming the Bank of Italy and stock market regulator Consob for the mess amounted to an admission of criminal wrongdoing at the banks in the past, coupled with a grant of immunity and willful damage to the image of the country’s regulators. “Rather than instilling confidence, it’s done the opposite,” he says.

After looking on aghast at this mess, Germany has again halted what was in any case only half-hearted work on the creation of a Eurozone-wide deposit insurance scheme. As such, question marks will remain suspended like Swords of Damocles over the heads of banks in the periphery of the Eurozone. Deposits will only be as safe as the assets that the banks invest in. In Italy’s case, that means non-performing loans equivalent to over 20% of GDP, and another €400 billion tied up in bonds issued by a government that is on a slow, grinding path to bankruptcy.

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