Could the European Union be among the big losers of the global financial crisis?

Despite signs that recession in Europe may be bottoming out, the 27-nation bloc risks emerging from the turmoil with its economic growth potential stunted, its public finances shackled by mountains of debt, and its international influence weakened.

That is the backdrop to Jose Manuel Barroso's campaign for a second term as president of the executive European Commission.  In a manifesto sent to EU lawmakers last week, he warns that unless Europeans shape up to the challenge together, "Europe will become irrelevant".

The conservative former Portuguese prime minister is  seeking a confirmation vote in the European Parliament this month, so a degree of dramatisation is to be expected. But there is no hiding the setback the crisis has dealt to European integration. Barroso has rightly put economic recovery at the top of his agenda, but he lacks powerful levers to achieve his goals at a time when the knee-jerk response in Europe has often been to revert to national economic solutions.

The recent crisis showed that there remains a strong short-term temptation to roll back the single market when times are hard, he acknowledges in the 41-page document.

Barroso is too much of a politician to name names, but he was clearly referring to the way Britain pressured state-rescued banks to lend at home and France and Germany sought to protect domestic jobs when aiding car manufacturers. Those governments deny their moves are protectionist and cite their duty to spend taxpayers' money in the national interest. But such measures pose a threat to the principles of free movement of capital and labour and fair competition.

Barroso vows to be "an implacable defender" of the EU's single market and its competition and state aid rules -- the foundation stone of European prosperity. But he does not say how he can force governments that have rescued stricken banks to restructure and dispose of them in ways that avoid distorting the level playing field for business.

Critics say the Commission president was too deferential to the major European powers in his first five-year term. Whether he will show more independence once he no longer needs their
support for his re-election remains to be seen.

His programme calls for greater economic policy coordination especially in the euro zone, and more surveillance of national budgets by Brussels, but he does not say how the Commission can persuade big member states to accept more EU supervision. He acknowledges that some new member states in central and eastern Europe have suffered a deeper recession and drifted away from economic convergence with western Europe. But he doesn't say how this can be fixed or offer a plan for those countries to join the euro zone in the near future.

Barroso rightly says that Europe will need to find new sources of growth with its post-crisis output potential crimped by stricter financial regulation, higher taxes, unemployment and demographic decline. The low-carbon "green economy", building new broadband and energy super-networks, and developing personal services for an ageing population all offer potential wellsprings of growth.

But while he advocates a "root and branch reform" of the EU budget to shift resources to these new priorities, Barroso does not say how he would stop farm subsidies gobbling up 40 percent
of community spending. The common budget is anyway likely to stay pegged at 1 percent of EU gross domestic product -- a fraction of national expenditure.

While the Europeans will struggle to redynamize a stagnant economy, they also face a challenge in shaping a new global order.

The EU prides itself on being a model of rules-based multinational governance, but its inability to agree on joint representation in international fora such as the G20 weakens its influence with emerging powers such as China and India, as well as with the United States. Barroso says the EU must speak with one voice at the world's economic top table, but he has no recipe for ending the current cacophony of eight European delegations in the G20.

As the Bruegel economic think-tank said in a perceptive memo to the next Commission president, the EU needs to reform its economic governance and centralise more policy in some
fields, but there is no appetite for such reforms in the crisis.

In his cautious Franglais central-bank speak, Jean-Claude Trichet has pointed to the strong possibility that the euro zone may face a double-dip or W-shaped recession.

Of course, that's not exactly what the European Central Bank president said. But how else are we to interpret his repeated references to a "bumpy road" ahead, and his comment that we are likely to see quarters with positive growth and other quarters with "less flattering" figures? All this was illustrated with a hand gesture that drew a W (or a corrugated iron washboard) rather than a V or a U.

True, he also said a significant contraction in economic activity has come to an end, and may be followed by a very gradual recovery. The ECB staff have lifted their economic forecasts for the 16-nation euro area after Germany and France surprised markets by exiting recession in Q2. The bank is now forecasting 2010 growth in a range from -0.5 to +0.9 percent, compared to its June prediction of -1.0 to +0.4 percent. But Trichet made clear there remains a high degree of uncertainty.

Furthermore, the ECB's only significant policy announcement -- that it will offer banks yet more 12-month liquidity at its basement 1.0 percent refi rate later this month -- was a strong indication that rates are on hold for the next year, coupled with another clear signal that ultra-loose monetary policy would not be withdrawn any time soon. "Today is no time to exit."

Even the ECB's most outspoken inflation hawk, Juergen Stark, is cautioning against any early withdrawal of the monetary stimulus.

The latest growth figures may indeed flatter to deceive. Germany probably only grew in Q2 because the government's cash-for-clunkers handout boosted the auto sector. That scheme ran out at the end of August.

Private consumption in France and Germany has been buoyant because of state-subsidised short-time work programmes that have kept people in jobs despite the collapse in orders. Those schemes expire late this year or early in 2010. In some cases, order books have filled and workers have gone back to full-time jobs. But unemployment is bound to rise over the next year to over 10 percent. That will likely depress consumer spending leaving the euro area's two biggest economies reliant on exports for growth.

Against this background, Trichet is right to keep monetary policy loose. With some voices in Germany's Sept 27 general election campaign calling for a premature return to fiscal orthodoxy, sage words from Frankfurt suggesting that recovery is not the bag, and that inflation is not currently the biggest worry, are welcome.

European Commission President Jose Manuel Barroso needs to set out a convincing agenda for the European Union to win the European Parliament's endorsement next month for a second five-year term. Here is the speech he should give but probably won't to avoid offending key member states and

interest groups. (In brackets, he says what he really means).

My fellow Europeans, the European Union is at a turning point which will determine how quickly and strongly we recoverfrom the financial crisis and how much influence we have in shaping a new world order.

The EU's economic structures -- the single market and the euro -- have weathered the storm and protected Europeans from the worst ravages. It was Europe that set the agenda for global action in the G20 to stabilise financial markets, give more resources to the International Monetary Fund and improve financial regulation.

But we cannot rest on our laurels (we're not doing as well as you think). Other economies, in Asia but also the United States, are showing signs of recovering faster than ours. Some of our member states (Germany, this means you) have yet to tackle decisively the biggest obstacle to recovery -- the

solvency of their banks. Our social welfare systems and fiscal stimulus programmes have cushioned the blow of recession and saved jobs, but at the cost of soaring budget deficits (the UK, Ireland, France) and debt burdens (Italy, Greece) that will weigh on our ageing societies for a long time.

We have seen some signs of nascent protectionism within Europe (I'm talking about you, Nicolas Sarkozy) and distortion of the single market through national subsidies. (UK banks have been told to lend at home, while French loans to carmakers are conditional on not closing any plants in France).

After a decade of gradual east-west economic convergence, we see a worrying trend towards divergence in some of the economies of new member states (just look at Hungary and the Baltic

states) that may delay their entry into the euro zone. There are also signs that the cross-border integration of our financial services market has gone into reverse. It will be crucial to resist pressure to close our markets to each other or to the world when unemployment predictably reaches a peak next year (and French unions are in the streets again).

Just as the EU came together at the height of the crisis to prevent a collapse of the financial system, we must act jointly now to build a sustainable recovery.

That means firstly coordinated action to fix our banks (as soon as the German election is out of the way). Of course, individual governments remain responsible for how they use their taxpayers' money (calm down, Gordon Brown).

But at the European level we can ensure that banks are subject to transparent stress tests, based on common criteria (which Germany has so far prevented), and that the solutions for recapitalising those worst affected do not distort the single market. The EU's competition rules are not an obstacle to saving troubled banks but a guarantee of durable solutions that do not discriminate against healthy institutions. It will be vital to uphold those rules (against pressure from London, Berlin and Paris) as many banks undergo restructuring in the next couple of years.

Second, we must swiftly enact the De Larosiere committee recommendations for a new European system of financial supervisors, headed by a systemic risk board to provide early warning of looming troubles and bubbles. We will pursue appropriate regulation of credit ratings agencies, hedge funds,

private equity and derivatives trading (which should assuage the French, Germans and the left).

Our publics rightly demand better protection against excessive risk-taking, including in remuneration systems. But we should avoid regulatory overkill (UK, this means I'm open to amendments) and aim for as much convergence as possible with the United States and other major financial centres. This is the best way to prevent regulatory arbitrage, and close loopholes and tax havens.

Thirdly, we need to harness our quest for new growth to our ambition to lead the world in fighting climate change. The Green Economy must be our new motor of growth, and that requires a

sensible degree of European industrial policy (that should please the Greens, Socialists and French).

I will hold a "clean transport summit" with governments, auto manufacturers and other stakeholders to discuss how we can target European and national support to help the European car industry power us towards a low-carbon future (that should help bring Angela Merkel on board).

We should also ensure that our common EU budget is directed more towards the priorities of clean energy and innovation in future (and less to farm subsidies for the French and others).

Fourth, I will propose practical ways to coordinate our "exit strategy" from the current phase of extraordinary monetary and fiscal policies, as the economy recovers. We need to ensure that member states synchronise measures to reduce deficits (so the Germans and the ECB don't tighten too soon or the French too late). This has to happen both on the revenue and spending sides to maximise the common gain and avoid steps that could distort the single market (we also need to give each other political cover for tax rises and spending cuts). The ECB should be fully involved in this dialogue without undermining its independence (nothing to fear, Jean-Claude). We will also review how the euro entry criteria are applied, to avoid penalising new member states (The Germans and the ECB won't let us change the treaty, but we should apply it more flexibly).

(Now I have to respond to socialist demands for another big spending programme, a European minimum wage and show that I'm not a heartless economic neo-liberal):

Fifth, I will initiate round-tables with the social partners -- employers, trade unions and other stakeholders -- on two issues crucial to the future of our European social model. One will cover the relationship between minimum wages, working hours, labour contracts and productivity; the other will cover weak spots in our labour markets -- employment of young people, women and older workers, including the possibility of part-time work for seniors.

These are not areas where the Union has legislative powers (so don't worry, UK). The aim is to learn from each other and encourage the spread of best practice. We cannot afford to stop economic and social reform if we are to keep Europe competitive in the post-crisis world.

(And now I have to concede something to that nice Guy Verhofstadt, floor leader of the liberal group, who wants my job):

Another aspect of our European model, and of our "soft power", is our commitment to human rights, both in our own societies and around the world. I will appoint for the first time a European Commissioner for Fundamental Rights to promote civil and minority rights both within the Union and abroad.

If the Irish people vote to ratify the Lisbon Treaty on Oct. 2 (let's hope they do what they're told this time) the enlarged EU will have a more coherent presence on the world stage. I will work with member states to ensure we speak with one voice in international financial institutions to maximise

Europe's influence, as we do in the World Trade Organisation. It looks ridiculous having eight European delegations at G20  meetings, each using as much speaking time as China or the

United States. But this will take time (so calm down France, Germany, UK, Italy, Spain, Netherlands)

(Finally a "je vous ai compris" moment for Eurosceptics):

The Lisbon Treaty's entry into force will close a long period of institutional reform for the foreseeable future. I have understood the message of voters (and non-voters) who are fed up with wrangling over institutions and want more practical responses to their everyday concerns. That will guide the next Commission's work.

The saga of German carmaker Opel goes east on Friday when Chancellor Angela Merkel travels to the Black Sea resort of Sochi to meet Russian President Dmitry Medvedev (the picture shows her last visit to Sochi in August 2008).

Both leaders back a bid by Canadian-Austrian car parts maker Magna, in partnership with Russia's Sberbank, to take over the main European arm of fallen U.S. auto giant General Motors. Merkel reiterated her preference for Magna in her first interview on returning to work this week, and vowed to get involved again if needed.

But GM has indicated a clear preference for Belgium-based financial investor RHJ, not least because it is worried that the Magna bid would hand GM's prize technology to persons unknown in Russia. The business dispute has assumed Cold War overtones, with hints that the Kremlin may be trying to get its hands on technology with military uses through the Opel deal.

Why is the conservative Merkel backing the Magna/Russia bid so vociferously, when it would require more German taxpayers' money than RHJ's plan? Is it to build an industrial partnership with Russia alongside the two country's close energy relations? Or is it simply because Opel's German workforce, regional barons and her junior Social Democratic coalition partners support Magna because they believe it will save more German jobs and production plants?

Opel's labour unions are baying for a decision on the company's future before the Sept. 27 German general election. Merkel has a 13-point lead over the Social Democrats, but she cannot afford to be seen to be stalling, or supporting a private equity company suspected of wanting to turn a quick profit by downsizing Opel and selling it back to GM.

But Merkel should consider Opel's longer-term interests. Russia is a murky business environment where foreign companies can find they suddenly lose control of joint ventures or come under tax or regulatory pressure.  GM's negotiator has hinted that Sberbank keeps changing its conditions and raising issues over control of the Russian operation that should be red flags for Opel.  It's not too late for business sense to prevail over politics.

It's not often you get to lift the hood and watch a power struggle going on in the engine room of General Motors. But the vice-president of GM Europe, John Smith, has just provided tantilising details of the arguments over the rival bids for Opel/Vauxhall, the main European arm of the fallen U.S. auto giant. Smith is the chief negotiator on the sale of Opel.

In a blog apparently intended to reassure Opel staff, but accessible to the public, he insisted GM had not specified a preferred bidder. But he made clear his own preference for the bid from Belgian financial investor RHJ International, which is loosely related to U.S. private equity fund Ripplewood, over the offer by Canadian-Austrian car parts maker Magna and its Kremlin-backed Russian partner Sberbank.

Smith's post is entitled "Clearing the Air" and was ostensibly written to clarify GM's intentions and dispel erroneous reports ascribed to interested parties. But his account shows just how poisonous the atmosphere appears to be between GM and Magna, and GM and the German government, which backs Magna's bid. It also suggests that the air is not too clear within GM's top management either.

Specific to the Magna bid, which is clearly preferred by several politicians and the Labor Bench, the bid presented to GM varied from the negotiations we had in the previous weeks and contained elements around intellectual property and our Russian operations that simply could not be implemented...

The bid from RHJI is completed and would represent a much simpler structure and would be easier to implement. It would require less monetary participation by the government and would keep our global alignments solid, while still creating an independent Opel/Vauxhall organization in Germany. This remains a reasonable and viable option to be considered as the very difficult issues around the Magna negotiations continue to be worked.

The following day, (July 29) Smith felt the need to add an update denying that GM was seeking to buy back control of Opel at a later date, or that it had asked the U.S. Treasury for financial assistance to restructure Opel. The former is strange since several sources have said a buy-back option is a key feature of RHJ's offer and not of Magna's.

So what is going on here and why did the chief negotiator feel the need to explain himself in semi-public in this way? One can only speculate, but one plausible theory is that GM's top management is split. This would not be surprising since the U.S. government now holds a controlling stake in the shrunken GM that emerged from bankruptcy, and Washington is probably being lobbied heavily by Berlin to support the Magna bid. A senior aide to Chancellor Angela Merkel discussed Opel with the U.S. Treasury on Wednesday.

If GM were to choose RHJ in defiance of Berlin's clearly stated wishes, it would spark a crisis with political ramifications just as Germany is entering the final phase of campaigning for a Sept. 27 general election. Might the Obama administration not lean on GM's top management in Detroit to avoid being branded as a potential job-killer in Germany? If so, Smith's blog may be a doomed effort to make business arguments prevail over politics.

– Paul Taylor is a Reuters columnist. The opinions expressed are his own –

Pacta sunt servanda. For centuries international law has rested on the Latin principle that agreements must be kept.

Now Britain’s Conservative party, widely expected to win power in a general election next year, is vowing to go back on the country’s signature on European Union treaties. The Tories say voters were denied a promised referendum on the EU’s Lisbon reform treaty. Opponents of closer European integration — the Conservatives and the more radical UK Independence Party (UKIP) — won most of Britain’s seats in the European Parliament elections last month.

If implemented, the Tory policy would set a government under David Cameron on a collision course with its European partners that could harm Britain’s wider political and economic interests, which rely on EU cooperation and leverage.

The Conservatives have already taken a first step away from the centre-right mainstream by quitting the European People’s Party (EPP), the biggest group in the European legislature, and forming a caucus with nationalists and sceptics from Poland, the Czech Republic and other mostly east European countries.

Swedish Prime Minister Fredrik Reinfeldt, a fellow centre-right leader from a moderately Eurosceptic country, lamented that step and told The Guardian newspaper Cameron will need mainstream European partners to achieve his objectives, including on climate change. He is right.

The Tories have said that if they take office before all 27 EU states ratify the Lisbon treaty, they will call a referendum on withdrawing British ratification, which was completed by parliament last year. That would put the government in the unprecedented position of campaigning against a treaty which Britain had already signed and ratified.

It could take Britain back to the isolation of John Major’s last Conservative government. Major stopped cooperating with the EU in 1996 after British beef exports to the continent were banned over mad cow disease.

But there is a chance that disaster may be averted. Cameron must be secretly hoping that Irish voters approve the treaty in a second referendum in October and the Eurosceptic Polish and Czech presidents then sign it, averting an immediate crisis for a new Conservative administration.

If Lisbon is already in effect, the Tories say: “We would not let matters rest there.” This deliberately vague phrase gives Cameron some wiggle room. Conservative leaders have said they would demand a negotiation to return EU powers over social affairs, employment, fisheries and some aspects of justice and home affairs to national level.

That would cause a clash at Cameron’s first EU summit, since it is highly unlikely that any of Britain’s partners will agree to open talks on repatriating major competences from Brussels.

Cameron is deluding himself if he thinks Britain can expect Paris or Berlin to cooperate on financial regulation, policy towards Iran and the Middle East, carbon trading or free trade if it is at loggerheads with all its EU partners on the treaty. The United States has often made clear that Britain’s influence in Washington is directly proportionate to its influence in Europe. Britain’s neutral civil service has been conveying that message privately to the Conservatives.

The danger of a UK-EU confrontation comes at a time when London has a strong interest in shaping European regulation of financial markets to preserve the position of the City of London, which generated some 10 percent of Britain’s gross domestic product before the financial crisis. Britain does some 60 percent of its trade with the EU.

Cameron has modernised his party and shifted it towards the pragmatic centre on a swathe of policies from gay marriage to the environment and public services. But he has used Europe as one area on which he can throw red meat to the party faithful, and protect his right flank against inroads by UKIP. He promised to withdraw from the EPP when he ran for party leader in 2005.

Cameron is seeking to balance shadow Foreign Secretary William Hague, who lost a 2001 election on an anti-European platform, and pro-European cabinet veteran Kenneth Clarke, whom he brought back to the front bench for his economic competence.

Clarke said recently a Tory government would not reopen the Lisbon treaty if the Irish ratified it, and would seek instead a practical arrangement on repatriating employment rights. He was swiftly denounced by Eurosceptics in the party.

True, the governing Labour party has failed in 12 years in office to achieve Tony Blair’s objective of putting Britain at the heart of Europe, and reconciling the British with the EU.

Blair achieved some progress on EU defence cooperation and economic reform. But he never used his political capital to win public backing for taking Britain into the euro, despite his personal support for the objective. His successor, Gordon Brown, no fan of the euro, has warmed to the EU somewhat since the financial crisis struck.

Public opinion, as Blair acknowledged before he resigned, remains as Eurosceptic as ever. Grassroots Conservative members are even more hostile, as are some big Tory donors.

That constrains Cameron’s room for manoeuvre. But if he wants to maximise Britian’s international influence and avoid his first term being blighted by conflict with Europe, he should brush up his Latin and declare “pacta sunt servanda”.
(Editing by David Evans)

Lufthansa <LHAG.DE> is milking an antitrust standoff with the European competition regulators to extract maximum cost cuts from Austrian Airlines <AUAV.VI> as it seeks to cement its dominance of central Europe's skies.
The German flag carrier has held back key concessions to the European Commission needed to secure approval for the takeover of the ailing airline while it squeezes further concessions from Austrian's workforce and its biggest shareholder, the Austrian government. It won another 150 million euros in savings from job cuts agreed in a third round of AUA cost-cutting this week.
The EU regulator, which supports airline consolidation in principle, is right to insist that the creation of a central European mega-carrier should not be at the expense of consumer choice on key routes such as Vienna-Frankfurt.
Lufthansa, which has set its own deadline of July 31 to clinch the deal, has the Austrians in a tight spot because the cost to the Austrian taxpayer would be far higher if it walked away. The Austrian government holding company, OIAG, says this could cost about 1,400 jobs and imply total costs of 840 million euros. The state has promised to assume 500 million euros of AUA's 1 billion euros of debt as part of a Lufthansa deal.
The German giant needs to reduce the cost of acquisitions it launched last year before the financial crisis hit air travel.
It has already beaten down Sir Michael Bishop to lower the cost of his majority stake in British carrier BMI [BMI.UL] and has snapped up Brussels Airlines, the successor to bankrupt Belgian flag carrier Sabena.
In the latter case, Lufthansa made concessions to the Commission on routes and take-off and landing slots to avoid restricting competition. But it has balked so far at the most important remedies for the Austrian deal, which concern what would be a monopoly on nine daily flights between Vienna and Geneva, operated jointly with another subsidiary, Swiss, and above all on feeder flights to its Frankfurt Airport hub to connect with its more lucrative transatlantic routes.
If the Commission does not stand firm on these issues, it risks being overturned by the EU's Court of First Instance, to which rivals Air France-KLM <AIRF.PA> and former Formula 1 racing ace Niki Lauda's latest venture, Fly Niki, would undoubtedly appeal.
Of course, Lufthansa could let the Austrian deal founder on EU competition concerns in hopes of picking up the pieces of a shrunken or bankrupt AUA later. But it might face competition were the airline's assets to be sold out of bankruptcy. Both Air France and a consortium of Air Berlin and Fly Niki were interested last time.
So the betting must be that, as with the Belgian deal, it will yield to Brussels' demands to clinch the deal in the end.

Political and economic logic are set to collide in the byzantine decision-making over the future of German carmaker Opel, the main European arm of fallen U.S. auto giant General Motors.
If politics prevail, as seems likely, the cost to German taxpayers will be higher and the chances of commercial success lower.

The aim of the Berlin government and four federal states, which are sustaining Opel with bridging finance, is to save as many German jobs and production sites as possible. That makes political sense ahead of September's general election. But the business logic is that only a greatly slimmed-down Opel can survive in an industry with chronic overcapacity.
In theory, it is up to GM's board to choose among the three offers it expected to receive on Monday from Canadian-Austrian car parts maker Magna <MGa.TO>, Belgian financial investor RHJ <RJHI.BR>, and, less plausibly, Chinese state-owned auto maker BAIC. But there are several other powerful players with a say. They include the trustees responsible for the company since GM entered U.S. bankruptcy in June, the German federal and state governments, Opel's works council and, last but not least, the European Commission, which must approve the restructuring plan as a condition for authorising the state aid.

The German authorities and Opel's workforce prefer Magna's bid, which is backed by Russia's Sberbank <SBER03.MM> and automaker GAZ. The strategy is to seek growth in the dynamic but volatile Russian market. Magna requires the most state aid -- 4.5 billion euros -- but has pledged to keep all German production sites and cut 10,000 of the 50,000 workforce across Europe, of which just 2,500 would go in Germany. GM Europe also assembles Opels in Belgium, Spain and Poland, and in Britain under the Vauxhall marque.

GM management is thought to prefer RHJ because its offer includes a buy-back clause that could put Detroit back in the driver's seat after three years in which Opel would be shrunk. RHJ wants less state aid -- 3.8 billion euros -- and plans a similar number of job cuts. However, the make-up of those cuts would be unpalatable to the Germans: it plans to shrink the plant at Bochum and idle that in Eisenach until 2012.

However smart business this may be, it is lousy politics. Bochum, in the Ruhr industrial rust belt, is still smarting from the offshoring of a Nokia plant to Romania. And Eisenach was the first new car factory to open in ex-communist eastern Germany. Indeed if GM defies Berlin's wishes, the government has said it would reconsider the offer of state aid to any other bidder.

The key may ultimately lie in Brussels. Germany's economics minister says the EU competition watchdog will require any buyer to inject more of its own funds as a condition for allowing state aid. That could lead to a more rational business solution, but it could also drive Opel into a dead end by making the deal unattractive to investors seeking a cheap ride.

– Peter Thal Larsen and Paul Taylor are Reuters columnists. The views expressed are their own –

Sir Win Bischoff appears to relish a challenge. His brief spell as chairman of Citigroup was spent resisting regulators who wanted to break up the bank. If the veteran banker takes over as chairman of Lloyds Banking Group, his first fight will be with competition authorities in Brussels. This is one battle where it would be better if Sir Win did not live up to his name.

Neelie Kroes, Europe’s competition commissioner, says Lloyds and Royal Bank of Scotland could be forced to sell significant assets in order to win approval from Brussels for the vast amounts of government support they have received. Kroes has a track record in this area. Commerzbank and West LB have been forced to sell assets equivalent to about 40 percent of their balance sheets in return for EU approval of government recapitalisations.

The Commission has two objectives: to limit the duration of state aid, and minimise any competitive distortions that arise from public support. Typically, banks that receive state aid grow too big, too quickly, and have to shrink before they can stand on their own. The main question is how swiftly they should be forced to do so. Here, the Commission is prepared to be lenient. Commerzbank has apparently been given 2014 to sell its Eurohypo real estate division.

The Lloyds case is more complicated. The bank was created last September when the British government waived competition rules in an effort to prevent the collapse of HBOS, the troubled mortgage lender. Even though the government had to recapitalise the banking sector anyway, the Lloyds-HBOS deal still went ahead. The result is the worst of both worlds: a state-supported superbank, which has a third of Britain’s mortgage and current account markets.

The problem here is that forcing Lloyds to shrink dramatically would make it less, not more, viable. Reducing its balance sheet by 40 percent would not just involve selling peripheral assets, like its Clerical Medical pensions division or its Insight fund management arm. It could require Lloyds to offload core operations, possibly including part of its retail banking business and branch network or its corporate banking division.

Were it required to break up the core business, this would restrict Lloyds’s market power and limit the billions of pounds of cost savings the bank expects to generate from the deal. The government, which owns 43.5 percent of Lloyds and wants to sell at a profit, would presumably resist. Kroes would no doubt be accused of using state aid rules to meddle with a merger that was originally beyond the Commission’s remit.

Nevertheless, she should persist. Reining in Lloyds might not please the bank’s shareholders, but it would be better for customers for whom the reduction in competition would most likely result in higher prices for banking services.

(Edited by David Evans)

-- Paul Taylor is a Reuters columnist. The opinions expressed are his own --

Higher taxes? Lower public spending? Devaluation? Inflation? Investment in green growth?

European governments are pointing in very different directions as they debate an exit strategy from the global financial crisis. Despite European Union efforts to coordinate economic policy, there are clear signs that the main European economies will charge off in disarray towards separate exits.

Germany is stressing an early return to fiscal discipline despite economists' warnings against a premature withdrawal of fiscal stimulus. Berlin has just amended its constitution to anchor a timetable for a balanced budget, and is holding down labour costs to promote an export-led recovery.

"This means that the German constitution now forces a very harsh austerity stance on Germany for the coming years," economist Sebastian Dullien wrote on the Eurozone Watch blog.

"For the rest of (the euro area) this means that after the crisis, Germany will consolidate its budget much earlier and much quicker than the rest of Europe," he said, arguing it would weaken domestic demand and hurt growth.

German and EU officials say the amendment merely enshrines existing European budget rules and note that a get-out clause allows parliament by a simple majority to set aside the target.

By contrast, French President Nicolas Sarkozy outlined plans last week to raise a big public loan to finance investment in "tomorrow's growth", despite warnings from the European Central Bank and the Bank of France against any increase in debt.

France's deficit is set to remain higher than Germany's. But with an eye to re-election in 2012, Sarkozy explicitly ruled out austerity or tax increases to pay off mounting public debt, although he talked of cutting wasteful spending, controlling health costs and possibly raising the legal retirement age.

In Britain meanwhile, the opposition Conservatives, scenting victory in a general election due within a year, are preparing to roll back public spending to curb a runaway deficit incurred partly to rescue wayward banks and combat the recession.

Conservative finance spokesman George Osborne has been quoted as telling business leaders: "After three months in power we will be the most unpopular government since the war."

The Europeans face a common challenge -- adapting to lower trend growth while coping with mass unemployment, an aging population and overstretched public finances after the deepest recession since the 1930s.

Different national economic cultures, as well as election timetables, explain the wide diversity of policy responses.

Britain has let the pound slide on foreign exchanges to help restore competitiveness after its banks were hard hit by the credit crunch. The British are more sanguine about the prospect of higher inflation after the crisis to work down public debt.

Influential French officials, such as Sarkozy's political adviser Henri Guaino, see higher inflation as inevitable, and not necessarily unwelcome, and worry about too strong a euro.

Germany is allergic to inflation out of bitter historical experience in the 1920s and wants a strong currency.

Its Bundesbank president, Axel Weber, has said the ECB will not be influenced by politics in withdrawing liquidity once recovery is under way.

ECB President Jean-Claude Trichet has made clear that his institution, which defines its mandate of maintaining price stability as keeping inflation below but close to 2 percent, will not allow prices to surge.

Despite these deep-seated differences, there is one key area on which the Europeans ought to be able to agree.

The EU has taken global leadership in the last decade in moving towards a low-carbon economy based on cuts in greenhouse gas emissions and promoting renewable energy. Under President Barack Obama, the United States is also pushing for the green economy as a source of growth and jobs.

If European leaders joined together in a continent-wide investment and tax incentive programme to promote clean energy, energy efficiency and low-carbon innovation, they could boost the growth potential on which sound public finances depend.

(editing by David Evans)