No easy options on horizon as crisis raises spectre of euro area fragmentation

The EU and euro area continue to face the most serious crisis in the history of integration. The European Union is in a period of transition that will mould the kind of political and economic order that it becomes in the 2020s. Scenarios enable us to think about the future in a structured manner by providing a framework for dealing with the high level of uncertainty associated with the euro. I suggest four scenarios for the future of the EU: disintegration, piecemeal adjustment, functional federalism and a federal Europe.

Scholars of integration have paid insufficient attention to the prospect of disintegration, ranging from fragmentation to system failure. The likelihood of fragmentation grew in 2013. David Cameron’s speech in January on EU-UK relations introduced a high level of contingency to this crucial relationship. Some form of renegotiation of the terms of UK membership is on the cards and this may lead to exit.

The prospect of system-wide failure is more difficult to judge. The collapse of the euro would represent major system failure with incalculable repercussions for the member states, the EU and the global economy. It cannot be ruled out because the euro status quo is neither stable nor sustainable. Short of system failure, fragmentation within the euro area remains on the cards.

Piecemeal adjustment
The euro area's response to the evolving crisis has been best characterised by muddling through, an approach to decision making characterized by incrementalism and "satisficing" rather than comprehensive solutions. The management of the crisis was driven by the creditor countries, especially Germany, and the ECB. The debtor countries were in a weak bargaining position and the creditor countries were only prepared to do the minimum necessary to stave off system failure and sustain the euro.

Every time the inter-related crisis for sovereigns or the financial system became acute, the euro area acted. Buying time remains the most palatable approach politically but was not designed to provide the optimal support to the debtor countries either on timing or terms. Domestic political considerations in the creditor countries have overshadowed the need for a more robust response. Although the crisis has stabilised, the economic performance and prospects for the periphery are dismal and the social costs, particularly unemployment, continue to mount. The euro area has turned its attention to addressing the design faults, which brings us to functional federalism.

Functional federalism
In 2012, the president of the European Council, Herman Van Rompuy, was mandated by the council to prepare a time-bound road-map for the creation of what has been termed a Genuine Economic and Monetary Union (GEMU), the euro mark 2. The report identified four pillars of a future EMU: banking union, fiscal union, economic union and political union. Putting in place the institutions and policy toolkit for GEMU is the core of the EU agenda for the next five years. The political and policy attention is now on banking union, without which the other aspects of euro mark 2 will not be addressed. Yet it is proving very difficult to get agreement on the more fraught issues to do with banking union, notably the single resolution mechanism. Beyond this is the need for a euro area fiscal capacity. The functional pressures for a more robust policy toolkit within the euro area are strong but only time will tell if the political capacity exists to overcome the deep cleavages on these questions.

A federal Europe
Jacques Delors was the first European politician to use the term "federation of nation states" in the 1990s. It was deliberately ambiguous and an attempt to square the circle by emphasising the collective, the federation, but also the nation states. In this way, a federal Europe could be reconciled with the member states as nation-states. The Van Rompuy report stressed the need for strong mechanisms of accountability and legitimacy. The focus of EU insiders tends to be on institutional and procedural innovation rather than on the politics of integration. Europe's elites will not be able to achieve a federation even of nation states without the active engagement and consent of their electorates. The challenge is not so much about building a federation of member states but building one with Europe's electorates.

The politics of the present
Of the four scenarios, the political and policy battle at present is between piecemeal adjustment and stronger functional federalism. Piecemeal adjustment has delivered a low-trust regime that has taken a very heavy political and social toll in the periphery and greatly exacerbated economic divergence in the EU. The status quo is not sustainable. The pivotal country influencing the timing and shape of euro area developments is undoubtedly Germany. Yet for reasons of history, economic ideology and domestic institutions, it is a country that is struggling to come to terms with what it must do. It is in Germany's long-term interest to take on more of the burden of adjustment as the euro crisis is a crisis of interdependence. If the periphery fails, the euro fails and Germany would not escape the fallout.