Murder on the EU Express

The Euro symbol illuminated on an Estonian building in January 2011. Raigo Pajula / AFP-Getty Images

You remember Agatha Christie's classic whodunit Murder on the Orient Express? The problem for the great Belgian sleuth Hercule Poirot was that there were far too many suspects. The strange death of the European Union may prove to be a rather similar case.

So used are we to hearing the process of European integration likened to an unstoppable train that we discount the idea it could ever stop in its tracks. Yet the reality is that Europe has been quietly disintegrating for some time.

Outwardly, it's true, Europe's leaders still appear to be inching toward their long-cherished goal of "ever closer union." Last month they agreed to set up a new European Stability Mechanism to deal with future financial crises. It's still a long way from being the United States of Europe, but most Americans assume that's the ultimate destination: a truly federal system like their own. Think again. Not only has the economic crisis blown holes in the finances of nearly all EU states, it has also revealed a deep reluctance on the part of those least affected to bail out the hardest hit.

Americans bemoaning their own economy's sluggish recovery should look on the bright side: it's worse in Europe. The International Monetary Fund projects growth of 3 percent for the United States this year but just half that for the euro zone. Even more striking is the extent of economic divergence within the euro area. While the German economy is currently growing at an annualized rate of around 6 percent, Greek growth in the fourth quarter of last year was minus 6 percent. So much for the convergence monetary union was meant to bring.

The underlying problem is the euro's failure to create a truly integrated market for labor. In the decade after the euro's creation in 1999, German unit labor costs rose by less than 40 percent; the equivalent figure for Spain was 80 percent. Workers in the periphery took monetary union to mean they should be paid as well as workers in the German core. But their productivity didn't rise to German levels. At the same time, people in countries like Ireland took the post-1999 reduction in interest rates—one of the most obvious benefits to the periphery of euro membership—as a signal to go on a borrowing binge. The result: Ireland and Spain behaved a lot like Florida and Nevada. House prices bubbled, then burst.

In the wake of the American crisis, some banks failed—most spectacularly Lehman Brothers—but most were bailed out, and the federal deficit soared. Dollars were transferred by the U.S. Treasury from Texan taxpayers to welfare recipients in New Mexico. In Europe the story was different. There was no big bank failure; all "too big to fail" institutions were rescued. National deficits soared. But when some countries ran into fiscal trouble—when financial markets started to demand sharply higher interest rates—things got ugly, because there is no mechanism to transfer euros between countries other than in tiny amounts.

The crisis has driven not just one but two divisive wedges into the European economy. First there is the fundamental political rift between the 17 EU members who joined the monetary union and the 10 who didn't. Then, within the euro zone, there is the widening economic rift between the German-dominated core and the ailing periphery—the countries cursed with the unflattering acronym PIGS (Portugal, Ireland, Greece, and Spain).

In this whodunit, the prime suspect is not the real culprit. At first sight, the fingerprints on the murder weapon belong to feckless finance ministers of the PIGS. It's true that those countries had been heading for fiscal trouble even before the onset of the financial crisis. The Bank for International Settlements was forecasting that by 2040 they would all have public debts equal to at least 300 percent of gross domestic product.

In the cases of Greece and Ireland, the financial markets decided some months ago that they were likely to default; hence the surge in their borrowing costs as investors sought compensation for this risk in the form of higher rates; hence the need for bailouts from the other EU members.

But why exactly is Ireland's deficit so huge? Step forward suspect No. 2: Europe's banks. For it was by bailing out the country's bloated banking sector—the total assets of which now exceed Irish GDP by a factor of 10—that the last Irish government created the present fiscal crisis. In much the same way, worries about Spain have much more to do with the still-uncertain losses of the country's cajas (savings banks) than with the government's own fiscal health.

Nor is it only the banks of Euroland's periphery who are suspects. Equally culpable are the banks of the core. German banks, for example, have close to €500 billion of exposure to the PIGS. The dirty little secret of euro-zone finance is that if one of the periphery countries were to default, German banks—in particular the state-owned Landesbanken—would be among the biggest losers. And that, of course, is why it makes sense for the core to bail out the periphery: in truth, they are all in this banking crisis together.

It is the political difficulty of selling this proposition to German voters that is set to derail the EU train. A euro-barometer poll last year revealed that only 34 percent of Germans thought the euro had mitigated the effects of the financial crisis. Germans are overwhelmingly for fiscal austerity—88 percent favor a policy of deficit reduction, much higher than for the EU as a whole. That is why the German government keeps insisting that the recipients of bailout money impose painful austerity measures on themselves.

The mood of the German voter can be summed up as follows: No More Herr Nice Guy. So the tax-dodging Greeks, the feckless Irish, and the bone-idle Portuguese expect the thrifty German worker to write them yet another check? For five decades after World War II, a penitent Germany paid up. The Federal Republic was the single biggest net contributor to the process of European integration. But the era of war guilt is now over—witness the humiliating electoral defeat inflicted on Germany's governing parties in Baden-Württemberg at the end of last month. No matter how tough Chancellor Angela Merkel seems to the hard-pressed Greeks, to her own people she seems way too soft.

For years the train of European integration ran on German subsidies. No longer. So as the process of disintegration accelerates this year—as the economies of the periphery languish and their governments topple—don't blame the victim. It's the German voter who dun it.