Europe’s weaker nations face painful choices
to cure a credit-driven hangover.

LANDON
THOMAS JR. NEWS ANALYSIS


NEVER BEFORE HAS Europe’s monetary union seemed so fragile. Day by day, fears are growing that Greece or another weak country may default on its sovereign debt obligations, forcing the richer countries in Europe to ride to the rescue or risk having one or more of its most vulnerable members leave the 16-nation euro zone.

Many European economists discount such a fracture as a remote possibility. But that doesn’t mean Europe has safely emerged from crisis.

Instead, it faces a longer-term challenge to restore the fiscal credibility of at least half the countries that use the euro. The true test for the world’s largest common currency zone, analysts say, will be whether it can withstand the economic, political and social strains once the European Central Bank begins to raise interest rates in response to economic improvements in Germany, France and other Northern European countries.

At that point, the laggards on the union’s fringe - Portugal, Ireland, Italy, Greece and Spain (the so-called Piigs) - will face even tougher choices to cope with what looks like several more years of stagnant economies, high unemployment and gaping budget deficits.

“If inflation picks up in France and Germany, the smaller economies will be left behind in stagnation and deflation,” said Jordi Gali, a Spanish economist recognized for his work on business cycles who heads the Center for Research in International Economics in Barcelona. “Such an asymmetric recovery is pretty likely, and if the E.C.B. raises rates, it could get very ugly.”

Mr. Gali, like a number of other European experts, takes the view that the euro zone’s resilience has been underestimated.

Still, he says, there is no escaping this emerging growth divide, and he points out that the mandate of the European Central Bank is to ensure price stability in the union, not to look out for the interests of individual nations.

France and Germany have already emerged from the recession. Business confidence in Germany, Europe’s largest economy, hit a 17-month high in December. Yet on the periphery, the hangover from more than five years of a credit-infused boom shows little sign of diminishing.

Ireland has taken the most severe fiscal action, cutting public wages sharply. A new Greek government, punished by the rough treatment of bond investors no longer willing to countenance soft promises of reform, is just now promising steep spending cuts. But it is not clear whether the political system in Greece will accept them.

Spain seems to be putting off difficult fiscal questions in the hope that its economy will soon recover. But the European Council projects that Spain’s unemployment rate will reach 20 percent in 2010.

Critics of the euro zone contend that weak governments in the peripheral economies, facing high unemployment and restive voters, will not have the stomach to hold down wages, pensions and public expenditures.

“Are these people serious about reform, or are they just telling people what they want to hear?” asked Edward Hugh, a British-trained macroeconomist who lives in Barcelona and has been critical of Spain’s unwillingness to make difficult decisions.

The struggling two-tier Europe may represent the best chance for recovery if it leads to devaluation of the euro against the dollar, which many see as long overdue. In December, the euro lost more than 5 percent of its value against the dollar. Many economists predict that the currency will weaken more as the growth gap between the core and peripheral states creates further disharmony.

“If there are fears now that a breakup of the euro zone will lead to weakening of the euro, then that is good news,” said Paul De Grauwe, an economist based in Brussels who advises the president of the European Commission, Jose Manuel Barroso. “So we should congratulate Greece for getting us out of this anomaly of having a euro that is too overvalued.”

Any such recovery will not be rapid, however. In Ireland, where prices are falling by 5 percent, reordering the economy from its deep reliance on construction and property will take years. And an already unpopular Irish government, along with others on Europe’s periphery, will have a difficult time explaining to voters why they must accept the central bank’s decision to raise interest rates .

Yet the painful steps taken by Ireland offer a ray of hope, says Philip Lane, a professor of international macroeconomics at Trinity College Dublin who oversees the widely read Irish Economy blog. He points to signs of wage compression in the hard-hit service, property and government sectors as proof that there is a recognition that recovery, distant as it may seem, must occur inside the euro zone, not outside.

“It takes a crisis to learn a lesson,” Mr. Lane said. “Could it be that by getting countries to change their behavior you might get improved cooperation within the euro zone? “What does not kill you,” he added, “often makes you stronger.”

Struggling economies in the 16-nation euro zone may threaten its unity. People lined up before dawn at an employment office in Madrid. / ERIC THAYER FOR THE NEW YORK TIMES