Hugo Dixon

Watch Athens more than Standard & Poor’s. The biggest source of immediate trouble for the euro zone could be the one country the ratings agency didn’t examine in a review that led to the downgrade of France and eight other states. Even if the short-term shoals can be navigated, the rest of the zone won’t find it easy to get by Greece.

The points S&P made when stripping France and Austria of their triple-A ratings and knocking two notches off the ratings of the likes of Italy and Spain were valid. It is true, for example, that policymakers can’t agree what to do to solve the euro crisis and that “fiscal austerity alone risks becoming self-defeating.” But these points, as well as the prospect of S&P downgrades, were already in the market.

Meanwhile, what Mario Draghi said last week about “tentative signs of stabilization” is true. The European Central Bank (ECB), over which Draghi presides, is itself partly responsible for that stabilization by virtue of providing 489 billion euros of three-year money to banks just before Christmas. Mario Monti’s promising beginning as Italy’s prime minister is the other main factor. The Super Mario Brothers have got off to a good start.

In Greece, though, matters go from bad to worse. The economy, which shrank about 6 percent last year, is now forecast to shrink an additional 4 percent or so by Credit Suisse and Goldman Sachs –- even worse than the International Monetary Fund forecast in November. What this means is that the numbers behind the latest bailout plan-cum-debt restructuring are probably out of date.

The immediate problem is corralling private-sector bondholders to swap 206 billion euros of bonds for new paper nominally worth half that value. There are actually two problems: persuading the negotiators for the bondholders to accept a deal and then getting virtually all the bondholders themselves to agree.

Despite the brinkmanship, which led the negotiators to leave the talks on Friday, it is likely there will be a solution — albeit a messy one. If the negotiators eventually agree, recalcitrant bondholders can be roped in by retroactively inserting collective action clauses in their contracts. If the negotiators don’t agree, there can be a formal default with losses imposed on everybody by diktat.

The snag is that restructuring the private-sector debt wouldn’t remotely close the Greek dossier as far as the rest of the euro zone is concerned. The question would then be whether to provide Athens with a bumper 90 billion euro tranche of bailout cash in March. The previous tranches have been much smaller: December’s, for example, was only 8 billion euros. But the debt restructuring means the next tranche has to be supersized: Up to 40 billion euros is required to recapitalize the country’s banks, whose balance sheets will be shot to bits because they are up to their gills in their own government’s bonds; a further 30 billion euros is needed as a sweetener to persuade the private bondholders to agree to the restructuring.

Politicians elsewhere will not find it easy to write the Greeks such a mega-check. There was much wrangling even before the previous smaller tranches, given that Athens’ finances were always worse than expected and that the country was never delivering on its promises. This time not only is serious money at stake but there will soon be an election that could bring in Antonis Samaras, the mercurial leader of the country’s conservative New Democracy party, as prime minister. He has been reluctant to embrace the austerity-cum-reform program that the euro zone and IMF want the country to follow.

Lending Greece such a huge sum when it’s not on track and is about to have an election would be risky. But the alternative would be for the whole program to fall to pieces. And despite the recent signs of stabilization that Draghi spoke of, other euro zone countries aren’t yet ready for an uncontrolled Greek default. So the best bet is that they will hold their noses, fudge things and hand over the money.

But that wouldn’t be the end of the trouble either. The continual bailouts mean that the public sector will soon have about 300 billion euros at stake in Greece. This is made up of loans by euro zone countries, loans from the IMF, purchases of Greek bonds by the ECB, loans by the ECB to Greek banks and permission given by the ECB to the Greek central bank to lend yet more money to its own banks.

The rest of the euro zone hasn’t been willing to see Greece default on its debts or leave the single currency because it has been worried about contagion. In future, the risk of contagion may be reduced. After all, if the current debt restructuring is successfully concluded, there will be less private-sector exposure to Greece, and so any second debt restructuring might cause less of an earthquake.

But even if the risk of contagion is smaller, the euro zone wouldn’t be able to wave good-bye to Greece. After all, the flip side of less private-sector exposure will be that vast 300 billion-euro public-sector exposure. Politicians -– such as Germany’s Angela Merkel, who faces an election in autumn 2013 –- won’t want to explain massive losses to their electorates.

In Greek mythology, Sisyphus was condemned to roll a boulder to the top of the hill, only to see it roll all the way down again. It looks as if the euro zone will be carrying its Sisyphean burden for a long time.

Semantics could help save the euro zone. There is a crying need to distinguish between fiscal austerity and structural reform.  The endless austerity programs adopted by the GIIPS — Greece, Ireland, Italy, Portugal and Spain — threaten to crush their economies so much that they are socially unbearable. By contrast, reforming pensions, labor markets and the like would be good for long-term growth. A policy mix that emphasizes the latter and draws some sort of line under the former is needed to stop the euro crisis spinning out of control.

Europeans have become grimly familiar with austerity spirals over the past two years. A government that needs to cut its fiscal deficit embarks on a program of tax hikes and spending cuts. The snag is that this fiscal squeeze, in turn, squeezes the economy — partly via the direct impact of cash being sucked out of the private sector and partly because the private sector loses confidence. The depressed economy means the government’s tax take doesn’t rise nearly as much as envisaged. So the deficit doesn’t decline much and, as a percentage of shrunken GDP, it falls even less. The governments’ creditors, led by Germany, then demand another round of austerity to get the program back on track. With each round, the howls of pain from the population increase, belief that there is light at the end of the tunnel declines and the government’s political capital shrinks.

The Greeks, Irish and Portuguese have been trying to run up this down escalator the longest. Italy and Spain are now embarking on the same regime. Yet more doses will be required over the coming year if the policy mix is unchanged. After all, last year’s budget deficits are expected to be about 10 percent for Greece and Ireland, 7-8 percent for Spain and Portugal (if a one-off pension transfer is ignored) and 4 percent for Italy.

Some austerity was needed given that expenditure had run out of control in the boom times and that, in some cases, there was a deliberate fiscal boost in the aftermath of Lehman Brothers’ bankruptcy in 2008. In Greece’s case, there was also a failure to implement the programs properly, meaning time and credibility were lost. But endless rounds of austerity are debilitating. The better approach would be to have one chunky program that is properly implemented and then rebuild.

Of course, the creditors aren’t willing to give something for nothing. But this is where a semantic distinction between austerity and structural reform could be helpful. Both require political courage by a government and sacrifices by its people. But the former pushes an economy down, while the latter boosts it — albeit in the long term. A virtuous cycle is even possible with the economy reviving, tax income rising, the deficit falling and confidence returning.

Pushing up retirement ages is a case in point. This doesn’t just reduce government spending, especially in the long run as savings build up year after year;  it also increases the productive potential of an economy by expanding its work force. Or take labor reform. Making it easier to hire and fire people puts downward pressure on wages, improving an economy’s competitiveness and reducing unemployment — which, in turn, cuts government spending on social security.

Other desperately needed reforms — privatization, liberalization of product markets, and increasing the efficiency of the public sector and the judiciary — would also improve long-term growth. Privatization would have the added benefit of cutting government debts, as would crackdowns on tax evasion.

The GIIPS have all done something in the field of structural reform. Italy, Spain and Greece, for example, are pushing up retirement ages. But the reforms have been slow in coming and sometimes half-hearted. Greece is the worst example: little has happened on tax evasion or privatization. Meanwhile, the new governments in Rome and Madrid have yet to get to grips with labor reform, although they are indicating that they will do so soon.

If the GIIPS could convince their creditors that they were serious about such reforms, they would win brownie points. That would put them in a better position to avoid yet more rounds of austerity. After all, Germany’s Angela Merkel would still be able to argue to her people that the peripheral economies were serious about change. What’s more, the economies of Germany and other creditor nations would benefit. Austerity in their neighborhood combined with the threat that the whole euro zone could blow up is not good for business. But to start the process, policymakers and pundits need to stop talking about austerity and reform as if they are the same.

PHOTO: A one euro coin is held in an adjustable spanner in this picture illustration taken in Ljubljana, January 4, 2012. REUTERS/Srdjan Zivulovic

The views expressed are his own.

The most electrifying event of the year, for me, was the Egyptian revolution. I’d long had an interest in Gandhian-style struggles. Here was a nonviolent struggle unfolding in real-time against Hosni Mubarak’s repressive regime. Tens of millions of people were gaining their freedom.

The media coverage of the events in Tahrir Square focused on the Facebook revolution. But when I went to Cairo shortly after, I discovered that the use of social media was only part of the reason why the dictator had been toppled. Behind the protests was a cadre of activists who had been trained in the techniques of nonviolent struggle. This realization was a eureka moment. If it was possible to overthrow dictators with comparatively little bloodshed – less than a thousand died in Egypt’s revolution — many millions more elsewhere might be able to gain their freedom given proper planning and training.

2011 was a banner year for nonviolent struggle. Not only did it witness the successful Arab Spring revolutions against dictators in Egypt, Tunisia and Yemen; it also saw three Arab kings – in Morocco, Jordan and Kuwait — liberalize their political systems to head off similar protests. And the brave people of Syria went out on the streets again and again, despite being arrested, tortured and killed in their thousands.

Further afield, the Burmese regime started to reach an accommodation with pro-democracy activist, Aung San Suu Kyi, after two decades of nonviolent opposition; China experienced increasing stirrings of protest, for example when citizens posted nude photos of themselves on the internet after the authorities ruled that a photo of Ai Weiwei, the dissident artist, was pornographic; and even Vladimir Putin had to face demonstrations after seemingly widespread vote-rigging in Russia’s parliamentary elections.

The techniques of nonviolent struggle have also been used for purposes other than bringing down dictatorships. A man called Anna Hazare led a successful campaign against corruption in India. Meanwhile, the West had to contend with the Indignant anti-austerity movements in Spain, Greece and Italy as well as the anti-banker Occupy movements in the United States and Britain.

And don’t forget Leymah Gbowee, one of the winners of this year’s Nobel Peace Prize. She helped end Liberia’s civil war in 2003 by getting women from Christian and Muslim communities to go on a sex strike until their men stopped fighting. The technique has a long pedigree, at least in literature. Aristophanes’ Lysistrata, first performed in 411 BC, is a comedy about how women used sexual abstinence to force peace talks between Athens and Sparta in the long-running Peloponnesian War.

2011 was the most successful year for nonviolent struggle since 1989 when peaceful revolutions led by the likes of Poland’s Lech Walesa and Czechoslovakia’s Vaclav Havel, who died at the weekend, swept away the old communist regimes of Eastern Europe. But nonviolent struggle hasn’t mown down everything in its path this year. The Occupy movements haven’t achieved much apart from raising consciousness. The transition to democracy in Egypt is still uncertain. Pro-democracy protests in Bahrain were snuffed out with the help of Saudi tanks. Bashar Assad is still in power in Damascus. And Libya’s Colonel Muammar Gaddafi was brought down by a bloody civil war and foreign military intervention, not by unarmed protesters.

The Gandhi network

Over the past year, whenever I could tear myself away from the unfolding drama in the euro zone, I turned my attention to nonviolent struggle. How were these movements organized? Did they draw inspiration from common sources? And what were the ingredients of success?

The trail began in early January, several weeks before the Tahrir Square demonstrations. I was in Delhi meeting Kiran Bedi, a key member of Hazare’s anti-corruption campaign. I wanted to know whether Mohandas Gandhi, the leader of India’s independence struggle against the British in the first half of the 20^th Century, was still relevant today. Of course, she replied, explaining that they had chosen January 30, the anniversary of Gandhi’s assassination, to hold their anti-corruption demonstration.

It wasn’t until August, though, that the campaign gathered momentum. The decisive moment came when Hazare announced he would go on a public hunger strike, a classic Gandhian technique, until the government agreed to create a tough anti-corruption watchdog. This posed a dilemma for the authorities. Either they would let the 74-year-old man go on strike and they would look weak; or they wouldn’t and they would look brutal. The police chose the latter option, arresting Hazare and over a thousand of his supporters on the grounds that they were holding an illegal demonstration. Indians came out in their millions in protest. Some kids in an orphanage even staged a hunger strike in sympathy.

The so-called dilemma action was perfected by Gandhi in his salt march in 1930. At the time, salt-making was a British government monopoly. Gandhi declared he was going to march to the sea and make his own salt, daring the authorities either to arrest him or display their impotence. After weeks of dithering, the British arrested Gandhi — triggering a massive civil disobedience campaign which led to over 80,000 people being put behind bars and paved the way for the end of British rule. Today’s Indian authorities made the same mistake as their British predecessors.

But this is moving too fast. Long before Hazare’s victory, Zine El Abidine Ben Ali had fled Tunisia and Mubarak had resigned in Egypt. When I went to Cairo a month later, I met Saad Bahaar, a former engineer who had been training activists in the techniques of nonviolent struggle for six years. I was stunned. How had he learned what to do? He pointed, among other things, to the work of Gene Sharp, a frail 83-year-old Boston-based academic who has been studying and proselytizing this type of warfare for about 60 years.

I’d never heard of Sharp, who runs a small think-tank called the Albert Einstein Institution. But I sought him out and devoured a clutch of his books, including his classic treatise, The Politics of Nonviolent Action. Sharp had analyzed how the pillars on which dictators’ power rests could be undermined systematically by nonviolent struggle. He also listed 198 tactics that could be used. Sharp had taken the insights of Gandhi and others and developed them into a quasi-science.

One of Sharp’s concepts – political jujitsu – is particularly powerful. This is the idea that violence inflicted by a dictatorship on peaceful protesters could boomerang on the regime and destroy it. Bystanders would abandon their neutrality; the regime’s pillars of support would become shaky; if the activists had the courage to maintain their struggle, the tyrant would ultimately collapse. But – and this was a crucial “but” – the revolutionaries had to maintain their nonviolent discipline, according to Sharp. Otherwise, they would lose the active support of the masses and, in a trial of strength, the regime would overwhelm them.

Boston is one node in a loose network of activists involved in nonviolent struggle. Another is Belgrade, home of Srdja Popovic, a 38-year-old Serb who was a founder of the resistance movement which helped bring down Slobodan Milosevic in 2000. Popovic now runs Canvas, a group that trains activists around the world in nonviolent struggle. The tall angular Serb has simplified and popularized Sharp’s work, adding a huge dose of energy and humor as well as real-life experience.

Then there are academics who have helped refine the techniques of nonviolent warfare by studying past campaigns. For example, Erica Chenoweth and Maria Stephan studied 323 liberation struggles between 1900 and 2006 in their new book Why Civil Resistance Works. They discovered that 53 percent of the nonviolent campaigns succeeded in bringing about regime change, roughly double the 26 percent success rate for violent ones. The nonviolent struggles were also faster – taking on average three years to reach their goal rather than nine. And such campaigns had a good chance of ushering in democracies whereas regime changes brought about through violence tended to lead to new dictatorships.

Ingredients of success

The overall message of these activists and academics can be boiled down to several simple points. Success comes from having a clear and powerful goal, unity among the opposition, good strategic planning, tactical innovation and nonviolent discipline.

The first point can be illustrated by comparing Hazare’s anti-corruption campaign to the less successful Occupy movements. Hazare had a precise goal that resonated with a huge swathe of Indian society. The Occupy movements and their close relations, the Indignant movements, haven’t yet articulated clear goals nor have they yet achieved anything concrete.

The perils of abandoning nonviolent discipline are also shown by Italy’s Indignati and Greece’s Aganaktismenoi. In the former case, protests were hijacked by a group of anarchists called the Black Bloc; in the latter by demonstrators throwing Molotov cocktails. Almost all the media coverage focused on the fringe violent elements rather than the peaceful masses.

Colonel Gaddafi’s bloody overthrow is, of course, the supposed counter-example from 2011 to the merits of pursuing a nonviolent struggle. It seems to suggest that violence pays. As such, some members of the Syrian opposition are advocating it as a model they should follow – although the main umbrella body, the Syrian National Council, is still pushing the nonviolent approach.

But the lessons from the Libyan revolution aren’t clear-cut. For a start, it’s unknowable what would have happened if the people had pursued a nonviolent campaign: they might eventually have got their way with less bloodshed. Although estimates of the Libyan death toll vary widely, the Transitional National Council has used a number of 25,000. If the same proportion of Syria’s larger population was killed in a conflict, its death toll would be 89,000 – much higher than the 5,000 so far estimated by the United Nations.

The Libyan campaign also relied on France, Britain, America and other countries attacking Gaddafi’s forces from the air. That can’t easily be repeated in Syria. Foreign powers aren’t always willing to play the role of global policeman – and, when they are, they typically want something in return such as control of a country’s natural resources.

How the Syrian conflict plays out will determine many people’s perceptions of the value of nonviolent struggle. At the moment, it looks like there is a significant risk of it descending into civil war. But even if such a tragedy unfolds this won’t prove that Gandhian-style campaigns are worthless. 2011 has already shown the power of the technique in other countries. As more people learn the strategy and tactics of nonviolent struggle, it will become more powerful still.

The opinions expressed are his own.

The UK’s self-immolation beggars belief. The government’s clumsy attempt to extract concessions from euro zone countries in their time of need has set off a chain reaction which could undermine Britain’s interests and even drive it out of the European Union.

It’s not clear what David Cameron thought he was doing at the European summit in the early hours of Dec. 9 when he demanded vetoes on financial regulation in the EU. Was the prime minister asking for something he knew was unacceptable so that he could return to Britain and parade as a hero in front of the euroskeptics in his Conservative Party? Or did he just vastly overestimate his negotiating position, thinking that the euro zone countries were so desperate to save their single currency that he could bounce them into accepting the British demands by presenting them with a take-it-or-leave-it offer in the middle of the night? If it was the former, Cameron was cynically putting his personal interests above those of the nation; if the latter, he was just extraordinarily inept.

Cameron did little to win allies for his position, not even circulating his list of proposals in advance of the summit, according to Reuters. Even worse, he put Britain in the position of seemingly being prepared to blow up the single currency if he didn’t get his way. In fact, Cameron didn’t have the power to stop the 17 euro zone countries from agreeing to sign a new treaty committing themselves to fiscal discipline. They just sidestepped the existing EU treaty. What’s more, they got all nine of the other countries which are part of the EU but not the single currency to sign up too. So all Cameron achieved in the middle of the night was to irritate Britain’s partners massively and isolate the UK 26-1.

Where does London go from here? One approach would be for Cameron to carry out his next threat: to try to stop the euro zone countries from using the European Commission and the European Court of Justice to police their fiscal discipline on the grounds that these institutions belong to all 27 countries. It’s not clear whether this is a legally winnable position, but pushing it would certainly make Britain look petty and further antagonize other European countries.

Meanwhile, members of Cameron’s euroskeptic wing will find it hard to hide their desire to see the single currency wrecked — something that could further madden those whose livelihood depend on it.

Unnecessary battle

None of this was remotely necessary. The euro zone countries weren’t trying to impose fiscal discipline on Britain, only on themselves. In fact they weren’t trying to impose anything on the UK. True, France has often seemed like it wanted to undermine the City of London’s position as a financial center. But until now, it has had zero success because the UK has always managed to assemble enough allies to support its position. In future, though, that can no longer be guaranteed. France’s President Nicolas Sarkozy may find he has allies if he wants to push through regulations that disadvantage what he calls his “British friends.” The risk of an inner club acting as a caucus and imposing its wishes on the UK has increased significantly.

The danger extends beyond financial services. Britain has been the main campaigner for free markets within the EU in recent decades. Although it hasn’t achieved everything it wanted, there have been notable successes such as creation of the so-called single market. Germany which, in some ways, is closer to Britain than France in its economic thinking supported these initiatives. But Angela Merkel isn’t going to be so keen to do the UK favors after Cameron snubbed her. The same goes for Italy, whose new prime minister Mario Monti, was a natural ally for liberalization given his passionate advocacy of the single market.

The British PM, meanwhile, has been reduced to the pathetic position of saying that the Netherlands, a fine but rather small country, will protect its interests in the single market. But even the Dutch finance minister has said: “The situation for the UK is very serious…..If you don’t have a seat at the table, you don’t participate.”

The biggest worry is that a vicious cycle develops — in which the euro zone squeezes the UK off the top table because of its lack of cooperation, London behaves increasingly like a spoiled brat because it is frustrated by its lack of influence, and this further antagonizes the big continental powers. Life could ultimately become so uncomfortable that Britain leaves the EU.  It would then lose the automatic right of access to the world’s largest  market. Although the rest of Europe might still let British business and finance operate on its side of the English Channel, it would largely dictate the rules of engagement.

Such an outcome would be disastrous for the City, British industry and UK foreign policy. Why would the United States, China, the Middle East and India want to deal with London if it had no friends in Europe? It would also be harder to persuade foreign business to locate in the UK if it had only second-class access to the single market.

Not all lost

But it’s not too late to retrieve the situation. The business and financial community can and should put pressure on government to find some face-saving position that allows Britain to move on in harmony with the rest of Europe. Something along the following lines might work: the UK would reverse its opposition to the existing EU mechanisms being used to enforce fiscal discipline on the euro countries while also saying how much it wanted to support them in their time of need; the other countries would then say how what they were doing would in no way undermine the single market while also asserting that they had no intention of imposing any new taxes on the UK, including the so-called Tobin tax on financial transactions, unless London wanted them. The euro zone wouldn’t actually be giving anything away as the UK already has a veto on new taxes. But such a declaration would sound good.

Getting to such a position wouldn’t be easy given that Cameron would have to eat his words and France would have to be persuaded to let Britain back into the fold. But Sarkozy may no longer be France’s president in five months; and the UK government may not be totally impervious to argument.

One pressure point are the Liberal Democrats, the minority partners in the coalition. They think of themselves as pro-Europeans and are aghast at Britain’s far from splendid isolation. Their leader, Nick Clegg, who is also the deputy prime minister, foolishly backed Cameron’s negotiating strategy without thinking through how it was likely to play out. He has now performed a U-turn, saying he is “bitterly disappointed” at the outcome. That, of course, is not the same as leaving the coalition. The LibDems will be reluctant to go down that route because they are scared of being slaughtered if there is a new election. But the chances of a collapse of the government have definitely risen.

Another pressure point, paradoxically, may be Boris Johnson, the euroskeptic Mayor of London. Cameron may well have hardened his line on Europe because he didn’t want to be outflanked by Johnson, a hugely popular figure in the Conservative Party. But the summit’s outcome isn’t in the interest of the City and therefore isn’t in the interest of London. If bankers can bring this point home to Johnson, who is an old friend of mine and whom I informally advise from time to time, he may soften his line — allowing Cameron to take a more accommodating position too.

Salvaging the situation will be tricky. But Britain doesn’t have an interest in being at loggerheads with the rest of Europe or vice versa — especially when the region’s worst financial crisis in a lifetime is still raging.

PHOTO: Britain’s Prime Minister David Cameron (C) looks at Germany’s Chancellor Angela Merkel (L) at a European Union summit in Brussels December 9, 2011.  REUTERS/Yves Herman

The euro zone will probably get another short-term fix at its summit this week. Exactly how the fix will work isn’t clear. But both Germany and the European Central Bank have softened their positions so much that some sort of solution is in the works. The ECB will probably cut interest rates and spray more liquidity at the troubled banking system; it may also step up its purchases of government bonds; and some scheme for assembling enough money to bail out Italy and Spain — probably by getting national central banks to lend money to the International Monetary Fund, which could then pass it on to Rome and Madrid – may be unveiled.

All this would be cause for celebration. The problem is the price that Germany and seemingly the ECB are demanding for their help: fiscal discipline, embedded in a treaty. Merkel wants the European Commission in Brussels to have the power to overturn irresponsible national budgets and for the European Court of Justice to fine governments that step out of line.

This idea for a treaty is stirring up all sorts of problems. One is that Britain, which is not part of the euro zone but is a member of the European Union, wants a quid pro quo for signing a revised treaty – probably in the form of returning powers over social and judicial affairs to London or getting some veto over the regulation of financial services, the UK’s largest industry.

An even bigger problem is the objection of many people in the euro zone to Disziplin being imposed by Berlin. Even France’s Nicholas Sarkozy, who is backing Merkel’s plan, has had to swallow hard before embracing a policy which would involve a loss of sovereignty, and is still wrangling over the details. The opposition socialists, which look likely to defeat Sarkozy in May’s presidential elections, have been quick to dub the plan an “austerity treaty.”

Handing powers to Brussels at Germany’s insistence isn’t popular with France’s right-wing parties either. In fact, it is likely to be pretty unpopular right across the euro zone. Even the president of the European Parliament, a body which normally supports anything that increases the European Union’s power, has said treaty change could be “dangerous” because citizens were unlikely to warm to the idea.

This is not to say that Europe’s governments won’t sign up to the German plan. Fear over what would happen if the euro collapsed is now so high that they will probably fall into line if this is what is needed to unleash the ECB. But a marriage based on fear is not the most attractive or most sustainable one. It will breed resentment. This could be expressed in the growing popularity of right-wing nationalist parties. There is even a chance that the proposed treaty changes, which will require unanimity, would be voted down by at least one parliament or torpedoed in at least one national referendum.

Merkel says she wants “more Europe.” But she is offering a lot less than the fiscal union that many pundits outside Germany are clamoring for. They want the euro zone’s governments to guarantee each others’ debt, by issuing euro bonds. A fully functional fiscal union would also have a large central budget that would transfer resources from booming regions to struggling ones. Germany’s chancellor is against these ideas for the simple reason that her people are not remotely ready to bail out other parts of Europe on a permanent basis. Nor, for that matter, are the Dutch, the Finns and some other nations.

Merkel’s idea of discipline is not in itself a bad idea, mind you. Governments ought to run their finances responsibly. The problem is that she is trying to achieve this through rules.  An alternative would be to impose discipline through the market. If bond investors knew that profligate states might have to restructure their debts in future, they might rein governments in before their debts got out of hand in the first place.

It might be objected that the markets did a terrible job holding governments to account during the bubble years. This is true. But that’s partly because governments gave investors artificial incentives to buy their bonds. There’s now a golden opportunity to set a new baseline for market discipline by making clear that investors will have to share the pain if a euro zone country racks up excessive debts. To be fair, Germany has been pushing this idea, but France wants it abandoned. Even if Berlin gets its way on this, it won’t be giving ground on the need for rules.

The discipline of the bond markets may not be an appealing slogan. But it is less unpalatable than the discipline of remote bureaucrats dictated to by Berlin. Europe’s citizens can probably understand that, if you borrow too much money, you have to dance to your creditors’ tune. Unfortunately, this doesn’t seem to be the way the debate is going. The price for a short-term fix could be a long-term problem.

PHOTO: German Chancellor Angela Merkel makes a point during her speech at the German lower house of parliament Bundestag in Berlin December 2, 2011. REUTERS/Tobias Schwarz

It is fashionable for pundits outside Germany to lambast its government, the Bundesbank and the European Central Bank for being inflexible or stupid or both. Can’t they see that all that’s needed is for the ECB to fire its bazooka by printing unlimited money, and the euro crisis would be over?

After spending a couple of days in Frankfurt and Berlin last week, my impression is that these three institutions are neither stupid nor totally inflexible. That said, Germany is still determined to try its current plan for solving the euro crisis, though it has little chance of working. And by the time the trio get round to implementing a Plan B, the euro zone could be in deep recession or even have exploded.

The current plan has three elements. First, the governments of troubled countries such as Italy and Spain need to implement structural reforms and austerity. Second, the zone’s fire extinguisher, the European Financial Stability Facility, needs to be got in good working order in case the fires in Rome and Madrid become uncontrollable. Finally, governments need to agree a treaty committing them to long-term budgetary discipline.

A month ago, this plan might just have worked. But investor confidence has now deteriorated so sharply that even promising new prime ministers in Italy and Spain haven’t been able to stop their bond yields rising. Meanwhile, Belgium has become the latest country to get dragged close to the danger zone, with the yields on its 10-year bonds approaching 6 percent. Even Germany suffered a failed bond auction last week. The fire extinguisher also looks faulty: plans to leverage up the EFSF so that it is big enough to bail out Rome and Madrid have run into trouble.

Even the proposed treaty, which Germany’s Angela Merkel has been trumpeting with much ballyhoo, is unlikely to do much to restore confidence. While investors will like the idea that governments won’t rack up excessive debts in the future, they might not be so happy about the austerity needed to get every country’s debts below the promised level of 60 percent of GDP.

What’s more, there’s no guarantee that the current treaty can be changed given that it needs unanimous approval not just by the 17 euro zone countries but also by the 10 other members of the European Union, such as the UK. In some cases, there may also be referendums, whose results tend to be unpredictable. This explains why Germany and France are now casting around for alternative ways of getting the same result — say by having new treaties signed by a smaller group of countries.

Given all this, pressing ahead with Plan A might suggest that the decision makers in Frankfurt and Berlin are indeed stupid. That would be true if they were sure it would work. But they don’t seem to be. Indeed, the German finance minister called for extra resources for the International Monetary Fund on Friday in seeming recognition that the EFSF on its own won’t be enough to bail out big euro zone countries. Nevertheless, the policymakers in Frankfurt and Berlin still think that everything in Plan A is still necessary or at least desirable, even if it proves insufficient to solve the crisis. It is, for example, really important to keep the pressure on the new Italian and Spanish governments so that they deliver on their potential.

What’s more, coming up with a Plan B is problematic given that the ECB is forbidden from directly funding governments. This doesn’t mean that there’s no way saving the euro if Plan A fails. There are, after all, various gimmicks that could be used to get round the prohibition on directly funding governments. One is for the ECB to lend to the EFSF, making its fire extinguisher fully functional. Another is for the central bank to lend to the IMF and let it then lend to Italy and Spain.

The problem is that either manoeuvre would be extremely controversial as well as possibly open to legal challenge. That’s not to say the ECB would never contemplate unusual measures if that was the only way of preventing the euro breaking apart. But it would seem that, even then, it would only do so if it had political cover.

Such cover is gradually coming. Following the scares of the past week, both Finland and the Netherlands — which, along with Germany, have been the strongest advocates of austerity — started to crack. The Finnish finance minister said that if there were no other alternatives, an increased role for the ECB had to be considered. Similarly, her Dutch counterpart said he’d prefer the EFSF to be strengthened but, if that didn’t work, other measures would have to be considered: “In a crisis, one should never exclude anything beforehand”.

Meanwhile, the ECB seems likely to offer some short-term palliatives. First, it is continuing with its programme of buying sovereign bonds in the secondary market as a way of preventing Italian and Spanish yields going through the roof — a programme that Berlin has studiously avoided criticising. Second, the central bank looks likely to offer longer-term money to banks as well as accepting more types of collateral in return for it — measures that should counteract to some extent a looming credit crunch.  Finally, it may cut interest rates again in December to reduce the deflationary potential of the coming recession.

Fingers crossed, such short-term palliatives will prevent an explosion until Germany implements Plan A and figures out that it isn’t working. But even in the best case, such an approach probably won’t be enough to prevent a nasty recession. Meanwhile, there’s the ever-present risk that a panic could trigger a chain reaction which even a Plan B would be unable to contain.

When confidence in a regime’s permanence is shaken, it can collapse rapidly. The fear or hope of change alters people’s behavior in ways which make that change more likely. This applies to both political regimes such as Hosni Mubarak’s Egypt and economic regimes such as the euro.

Fear that the single currency may break up now risks becoming a self-fulfilling prophecy. Banks and investors are beginning to act as if the single currency might fall apart. Politicians and the European Central Bank need to restore belief that the single currency is here to stay. Otherwise, it could unravel pretty fast.

Until a few weeks ago, the idea that the euro wouldn’t survive the current debt crisis was a fringe view. Since the euro summit on Oct. 26-27, it has become a mainstream scenario. So much so that last week risk premiums on the bonds of even triple-A rated countries such as France and Austria rose to record levels, while Spain became the latest country to be sucked into the danger zone.

The summit itself made two technical decisions which have had damaging, unintended consequences. First, banks underwent a stress test that marked their sovereign bond exposures to market whereas previously regulators maintained the fiction that these positions were risk-free. This meant that lenders suddenly had to start holding capital to back their sovereign debt investments. Not surprisingly, they have become more reluctant to buy bonds. This, in turn, has made it harder for governments to fund themselves.

Second, the summit decided to strong-arm the banks into agreeing to a “voluntary” debt restructuring for Greece. Because the deal is supposedly voluntary, credit default swaps (CDS) – a type of insurance policy that pays out if an entity goes bust – won’t be triggered. This arm-twisting has convinced lenders that CDSs are a useless way of hedging the risk of investing in euro zone government bonds. Without a hedge, many prefer not to hold the bonds at all – again making it harder for states to fund themselves.

After the summit, things went from bad to worse with Greece’s disastrous plan to call a referendum on its latest bailout plan. That idea was withdrawn – but not before Germany and France suggested that Athens might need to be kicked out of the euro unless it came to heel. The snag is that it would be very hard to isolate the Greeks. If one country could leave the single currency, why not two, three or all 17?

As investors thought about the possibility of a euro break-up, they started factoring in currency risk. Under such a scenario, the new Greek drachma would plummet in value; the new Italian lira and Spanish peseta would also take a tumble; even the new French franc would depreciate versus a vibrant new Deutsche Mark. That gave the market another reason to sell pretty much every non-German government bond – again making it harder for those states to fund themselves.

As if this wasn’t bad enough, banks are also suffering from a liquidity squeeze. It’s not just investors who are getting jittery about putting their money in banks; lenders are reluctant to lend to each other because they are not totally sure that their peers will survive.

Banks outside the euro zone are also cutting their lines of credit to those inside the zone. The big four UK banks cut interbank loans by around a quarter in the three months to end September, according to data compiled by the Financial Times. Meanwhile, the United States is about to embark on a new stress tests of its lenders. This will include contingency planning against further disruptions in Europe. It wouldn’t be surprising if this provoked American banks to cut their exposure to their euro counterparts, further exacerbating their funding problems.

These vicious spirals have drowned out the good news on the political front. Italy, Greece and now Spain have new prime ministers, all of whom seem intent on cutting debts and making their economies fitter. But they will struggle to reduce their borrowing costs unless investors can be convinced that the euro is here to stay.

The one thing that probably would restore confidence is if the ECB found some way of supporting governments that were pursuing sensible policies. But the central bank itself and Germany, the euro zone’s main paymaster, have so far resisted this. In part, this is because they think governments won’t have a strong incentive to reform if they are bailed out too easily.

The logic of making countries sweat so that they address problems they have shirked for years, and sometimes decades, is a good one. But the ECB and Germany should remember that carrots are useful incentives, as well as sticks – and, if they don’t provide the carrot soon, the euro may not survive.

The Super Mario Brothers need to work together to save Italy and the euro.

Even if Mario Monti can form a strong government in Italy, the euro zone is vulnerable to bank runs and a deflationary spiral. Stopping that is the role of Mario Draghi, the European Central Bank’s boss. The zone needs vigorous supply-side reform but looser monetary policy. With Silvo Berlusconi gone, the duo and Germany’s Angela Merkel should try to forge a new grand bargain based on this.

Last week witnessed both the Italians and the Greeks dragged to the brink, look into the abyss and dislike what they saw. The two countries have or are in the process of forming national unity governments led by technocrats. This is a step in the right direction. But dangers abound.

The biggest risk is of a visible bank run. There has already been massive deposit flight in Greece as savers fear that the country could get kicked out of the euro – a scenario which is still real despite Lucas Papademos’ appointment as prime minister. But so far there have been no queues outside branches as there were with the UK’s Northern Rock in 2007. If that were to happen, television pictures would be relayed across Europe in seconds potentially provoking copycat runs.

Even without visible deposit runs, euro zone banks are debilitated. Many have already suffered runs in the wholesale markets: U.S. money market funds have sharply cut supplies of short-term cash; and hardly any bank has been able to issue unsecured bonds since the summer. The banks are able to get money from the ECB but only for up to a year. Their funding problems now look set to suffocate industry via a renewed credit crunch.

Meanwhile, the banks’ difficulties are exacerbating governments’ funding problems. France’s BNP revealed this month that it had cut its holdings of Italian debt by over 40 percent in the previous four months. Other banks could follow suit, thinking it is better to take smallish losses now rather than get caught in a Greek-style debt restructuring later. This means that, even if Monti gets a mandate to push through structural reforms–which need to be more radical than those planned by Berlusconi–Rome could struggle to finance itself on decent terms. Ten-year bond yields, which ended last week at 6.5 percent after shooting up to 7.6 percent, need to come down to 5 percent for the country’s debt to be sustainable.

The euro zone may already be in a double-dip recession. A renewed credit crunch plus extra austerity demanded of governments – France was the latest to tighten its belt last week – could push it into a fairly deep one. The snag is that the more governments raise taxes, the faster economies shrink, which in turn makes it harder for them to balance their books and so piles further pain on the economies.

Many European nations lived beyond their means for years. They enjoyed excessively generous welfare states and didn’t allow the free market to operate properly. So big changes are needed. But the current policy mix isn’t working. A new treatment is required that puts more emphasis on the long-term reforms — such as pushing up pension ages, making it easier to hire and fire, reforming bloated civil services and privatization – and less on short-term pain.

Such a new policy mix would require action not just by governments but by the ECB. The central bank is now the only realistic source of mega funding after many non-euro countries made clear at the G20 summit in Cannes this month that they thought the zone should solve its own problems. China, meanwhile, indicated that it would only help in return for unpalatable quid pro quos such as extra power at the International Monetary Fund.

Draghi and his colleagues at the orthodox central bank need to make three radical changes. Germany, the euro zone’s conservative main paymaster, would need to back the changes to give them political cover.

First, the ECB should offer banks longer-term cash to prevent an imminent credit crunch. Governments should simultaneously require their banks to hold more capital so that they have adequate cushions to withstand the hard times ahead. The 106 billion euros of capital injections agreed at last month’s euro summit should be doubled in line with what the IMF recommended. That might then reassure the ECB that it wasn’t lending to potentially insolvent banks.

Second, the central bank should be prepared to act as a lender of last resort to governments which are following responsible policies. The Lisbon Treaty prevents it from lending directly to states, but that shouldn’t stop it leveraging up the European Financial Stability Facility, the euro zone’s bailout fund. The EFSF would then have the firepower to help Italy and Spain if needed. So long as Berlusconi was presiding over a dysfunctional government, it was sensible to avoid bailing it out. But provided Monti can deliver, that would no longer be relevant.

Finally, the ECB should prepare to launch “quantitative easing.” At the moment, inflation in euro land in 3 percent. But it is soon likely to head below the 2 percent level that the ECB defines as price stability. Given that official interest rates are now 1.25 percent, there’s not much scope for further rate cuts. But the ECB could print money to buy government bonds and other assets, in the same way that the U.S. Federal Reserve and the Bank of England are doing.

The ECB does have a government bond buying operation already. But this is a long way from quantitative easing. First, it is small: 0.8 percent of GDP; the U.S. and UK programs are 16 percent and 18 percent of GDP respectively. Second, the ECB mops up all the money it creates when it buys bonds whereas the Fed and the Bank of England inject extra cash into the economy. The main benefit of a similar operation would be to help restore the competitiveness of struggling economies by weakening the euro which, despite the crisis, is astonishingly strong at $1.38.

Such a grand bargain might sound rational. But is it possible to orchestrate a deal between 17 different countries and a fiercely independent central bank? Not yet. But just as pressure from the markets and Italy’s euro partners has pushed Rome into doing things it wouldn’t have contemplated even weeks ago, pressure from the markets and the rest of the world may soon push the euro zone to be more creative too. The Super Mario Brothers need to get cracking.

PHOTO: Newly appointed Prime Minister Mario Monti looks on following a talk with Italian President Giorgio Napolitano at the Quirinale palace in Rome November 13, 2011. REUTERS/Stefano Rellandini

Chaos, drama and crisis are all Greek words. So is catharsis. Europe is perched between chaos and catharsis, as the political dramas in Athens and Rome reach crisis point. One path leads to destruction; the other rebirth. Though there are signs of hope, a few more missteps will lead down into the chasm.

The dramas in the two cradles of European civilization are similar and, in bizarre ways, linked. Last week’s decision by George Papandreou to call a referendum on whether the Greeks were in favor of the country’s latest bailout program set off a chain reaction that is bringing down not only his government but probably that of Silvio Berlusconi too.

The mad referendum plan, which has now been rescinded, shocked Germany’s Angela Merkel and France’s Nicolas Sarkozy so much that they threatened to cut off funding to Greece unless it got its act together — a move that would drive it out of the euro. But this is probably an empty threat, at least in the short term, because of the way that Athens is roped to Rome. If Greece is pushed over the edge, Italy could be dragged over too and then the whole single currency would collapse. So, ironically, Athens is being saved from the immediate consequences of its delinquency by the fear of a much bigger disaster across the Ionian Sea.

Italian bond yields, which were already uncomfortably high, shot up after the Greek referendum fiasco. Berlusconi was forced to pacify Merkel and Sarkozy at the G20 meeting in Cannes by agreeing to a parliamentary confidence vote on his government’s lackluster reform program as well as to monitoring by the International Monetary Fund. The humiliation in Cannes, where Berlusconi’s finance minister pointedly failed to back him, could be the final nail in the PM’s coffin.

The end of the Berlusconi and Papandreou eras should, in theory, be a cause for celebration. Although the Italian PM’s behavior has been scandalous, whereas the Greek PM’s has not been, they have both led their countries deeper into debt. They are also both members of political castes that have enfeebled their nations for many years. Getting rid of them could be the start of a renewal process.

The snag is that it’s not certain that what comes next will be better. In both countries, where I have spent much of the last fortnight, the best outcome would be national unity governments committed to rooting out corruption and cutting back overgenerous welfare states. This could happen either before or after snap elections. Unfortunately, the old political castes die hard. They could continue bickering over who suffers the most pain and who gets the top jobs until they are staring into the abyss — or even fall in.

Many in the rest of Europe, meanwhile, would probably love to push them over the edge if they were themselves strong enough to take the strain. But Merkel, Sarkozy et al have been criminal in their lack of preparation. The so-called comprehensive plan agreed to at the euro summit of Oct. 26 was another case of too little, too late. Not only was the plan for recapitalizing Europe’s banks only about half as big as it should have been as well as foolishly delayed until next June; the scheme for leveraging up the region’s safety net, the European Financial Stability Facility, is full of holes. This became clear at Cannes, where Merkel had to admit that few other G20 countries wanted to invest in it.

The whole of Europe is now in a race against time. The Greeks have to get their act together before the rest of Europe is ready to cut them loose. The Italians have to restore credibility before they get sucked into a vortex from which they can’t escape. And the rest need to put in place really strong contingency plans in case Athens and Rome continue to let them down. If everybody runs very fast, the last week could be the beginning of the catharsis. If not, chaos beckons.

The euro zone’s future hangs on Italy – and Italy’s future hangs on its politics. The best way forward would be a grand coalition replacing Silvio Berlusconi’s discredited government. But after the prime minister’s Houdini act last week, that doesn’t seem likely and other scenarios aren’t as attractive.

Until recently, investors didn’t pay too much attention to the multi-dimensional chess game that is Italian politics. The state may have nearly 2 trillion euros of debt, equal to 120 percent of GDP,  but the country is rich: Net household wealth was 8.6 trillion euros in 2009, according to the Bank of Italy. The deal-making and back-stabbing in Rome – or for that matter, Berlusconi’s bunga-bunga sex parties – didn’t seem to matter. True, the country has virtually stopped growing in recent years. But there was even a view that Italy benefited from having politicians that were so concerned with their elaborate games that they couldn’t interfere with the business of business.

All that changed in early July. As the euro crisis gathered pace, scandals and wrangling in Rome unsettled markets. The 10-year bond yield, which had been a relatively comfortable 4.8 percent, shot up to 6 percent in two weeks. Berlusconi and Giulio Tremonti, his previously respected finance minister, fell out. The center-right government, which survives on a wafer-thin majority, was able to pass austerity measures to cut the deficit. But the actions were seen as too little, too late. Investors became hyper-sensitive to Italian politics and were no longer willing to take things on trust.

The rot was only stopped by the European Central Bank wading into the market in August and buying Italian bonds. But even this bought only temporary respite. Despite two European summits last week designed to provide a comprehensive solution to the euro crisis, Italian yields ended the week back at 6 percent. The country is on the edge of a debt spiral as investors’ concerns about the country become self-fulfilling. If borrowing costs rise further, the country’s debts won’t seem sustainable, meaning yields could shoot still higher.

The best way of breaking the vicious spiral would be to have a positive political shock – to counter the negative one delivered over the summer.  And the best way of achieving that would be to have a temporary grand coalition led by a technocrat such as Mario Monti, the former European Commissioner. Its mission would be to take harsh actions needed to solve Italy’s two big problems: debt and low growth. Labor markets would be liberalized; the bloated public sector would be cut down to size; and the over-generous pension system would be reformed. It might even be possible to reduce debt to below the psychologically important 100 percent mark by privatizing assets and instituting a one-off property tax.

Such an outcome doesn’t look likely. Although Berlusconi’s government has come close to collapsing several times in recent months, he has so far managed to pull it back from the brink. The latest crisis was caused by pressure last week from Germany and France to produce a stronger reform program. The Northern League, Berlusconi’s main coalition partner, balked at this. In the end, a compromise was struck which was just enough to satisfy the European allies but not too strong to bring the government down.

This was a pity. If the government had collapsed President Giorgio Napolitano would have been free to call on Monti or somebody else to form a technocratic government. As it is, Berlusconi will now limp on with a lackluster reform program which will struggle to secure the support of the market.

Even worse, the government may not be able to implement its program. The decisive vote in parliament probably won’t occur until January by which time another three months will have been wasted. What’s more, if the government falls at that point, the consensus in Rome — where I spent a few days last week — is that it will be hard for Napolitano to call on a technocrat to take charge and will instead be under pressure to agree to new elections. This is partly because Italy traditionally votes in the spring time and partly because the next elections have to be held anyway by mid-2013, meaning that a new technocratic government wouldn’t have much time to achieve anything.

New elections in, say, March might not be so bad if they delivered a decisive outcome. But Italy’s Byzantine politics make this far from certain. There are three blocs: the right, the left and the center. Current opinion polls show that the left would be the leading bloc but that it might not be able to form a majority without the support of the center. The center, though, is ideologically closer to the right – although it would be loath to join them in a coalition if Berlusconi was still around. Further complicating the picture is that fact that each of the blocks is made up of several parties each with its own agenda.

What all this means is that new elections could easily produce a messy outcome. Even a clear victory by the left wouldn’t necessarily be good. Pier Luigi Bersani, leader of Italy’s Democratic Party, the main left-wing group, hasn’t yet set out a clear agenda. Given that the party relies on support from unions, it might not be able to embrace the free-market reforms Italy needs.

There are, of course, other scenarios: Berlusconi may get his diluted program through parliament; his government may collapse before the end of the year, allowing a grand coalition to take over; even if it collapses in January, Napolitano may find a way of bringing in a technocratic government. Meanwhile, the euro zone last week agreed ways to leverage the European Financial Stability Facility, its bailout fund. This means it should soon have a much bigger war-chest with which to support Italy if its bond yields climb higher. But the EFSF’s resources are not limitless. If Italian politics remains dysfunctional, Europe could soon be back in crisis mode.