Europe’s Danube Blues

What will spread the pain far beyond the banking sectors of overexposed countries like Austria, Sweden and Belgium is the recession now accelerating across Europe. EU GDP is forecast to shrink by 3 percent in 2009, versus 2 percent in the U.S., according to London-based Capital Economics. In Eastern Europe, some countries' GDP will shrink at a double-digit rate this year. This, combined with the implosion of the region's currencies—which is slashing purchasing power—will wreak further havoc in the West, which sends a large chunk of its exports to the region. In 2007 Germany alone shipped 16 percent of its exports to the region, accounting for 6 percent of its GDP.

Old EU members face the stark choice of making the crisis worse by circling the wagons around themselves, or better, by making sure capital and trade continue to flow between East and West, and by bailing out the most-vulnerable nations. So far they've been making it worse. Their leaders have said in speeches that protectionism is not the answer. But several countries' finance ministries, including Britain's and Greece's, have told banks to lend at home and not use public bailout money to fund their subsidiaries in Eastern Europe. This is choking off the flow of needed capital to the East, since many of these countries' financial sectors are 80 or 90 percent owned by Western banks. French President Nicolas Sarkozy terrified Easterners when he told French automakers that they should use their new €6 billion state subsidy to keep French factories open and close Czech ones instead. Last month EU Competition Commissioner Neely Kroes declared such conditions attached to French subsidies illegal under the bloc's single-market rules, but the French government was quick to retort that even if the legal requirement is struck, French companies' "moral obligations" remain. Translation: shut those Czech factories, or we'll be sure to shut you out of our next round of subsidies.

If Sarkozy's vision of a protectionist Europe of subsidized companies and an unraveling single market prevails, it will mean the likely death of Eastern Europe's economic-development model of tying into the global economy via Western neighbors. Ultimately, though, the closing of markets and shutting off of capital flows will ricochet back to the West—via collapsing exports and defaulted loans, not to mention new waves of migrants from down-and-out countries like Romania, Bulgaria and Ukraine.

Amazingly, for all its collective wealth and power, the EU has few provisions for its members to help each other in such times of crisis. Brussels has a meager €25 billion emergency stabilization fund, much of which has already been spent bailing out Hungary and Latvia. In October, the European Central Bank funneled an emergency €5 billion loan to Hungary as well. Everything else has to be decided collectively by the member states, or individually among groups of the willing. Not surprisingly, Austria has been beating the drum for a €150 billion EU-funded bailout of Eastern Europe, but has found few donors other than itself.

With Britain, Italy and Spain all but paralyzed by their exploding government deficits—and France off on its protectionist course—it will likely be up to Germany to fill this leadership vacuum and persuade its partners to keep the European economy unified. That would be in the Germans' own interest: their economy is more than 40 percent dependent on foreign trade and can't afford the raising of old borders; political leadership now would also earn Germany future good will among many of its EU allies.

That scenario began to emerge on Feb. 16, when Germany's finance minister, Peer Steinbrück, suggested that Germany would help bail out any euro-zone member threatened by a payment crisis. Late last week Chancellor Angela Merkel called on the East Europeans to come up with plans around the issue for the EU to consider at its March 19 summit. Of course, the outcome is anything but clear—if the situation takes a turn for the worse and more banks and countries need bailouts, it will make it even more difficult for the EU to find the necessary funds, and like everyone else, the Germans too have a careful political course to tread between voters clamoring for protection and the long-term benefits of keeping West and East unified. Nonetheless, the signs of German leadership are "a game changer," says Daniel Gros, director of the Center for European Policy Studies in Brussels, and could be the first good news coming out of Europe in months. There is hope yet that the 20th anniversary of the fall of the Berlin Wall in November will be a happy one, even if the downturn will be far from over.

© 2009