Hugo Dixon

Europe needs a growth strategy. In the short term, that means preventing an austerity spiral. In the long run, it means structural reform and a drive to create a genuine single market. The European Union summit this week is a chance to aim at both targets.

The euro zone crisis may be receding. Last week’s temporary fix of Greece’s problems with a 130 billion euro bailout is the most recent cause for optimism. But so long as the region cannot grow – and the European Commission has just forecast zero growth this year for the European Union as a whole and shrinkage for several countries including Italy and Spain – there is a risk of sliding back into crisis.

The European Central Bank’s provision of 500 billion euros of three-year money to the banks before Christmas – and the promise of a similar cash injection this week – has lifted spirits in financial markets. Some of that money will find its way into the real economy. But while monetary policy is lax, fiscal policy is tight. No fewer than 23 of the EU’s 27 countries are in what are known as “excess deficit procedures”, which require them to bring their annual borrowing down to less than 3 percent of GDP over the next year or so. Under the so-called “six pack” system of fiscal discipline, countries can be fined if they fail to stick to the required austerity.

Balancing budgets is a good idea. The problem is that, if overdone, austerity can drive economies deeper into recession. Taxes fall, meaning it is even harder for governments to balance their finances. If they then have to squeeze again, the economy just gets further squished. The rational approach would be to give governments such as Spain – which is especially vulnerable to this spiral – a little longer to cut their deficits provided they are genuinely dealing with their countries’ structural problems, for example by tackling excessively expensive pension systems and rigid labour markets.

There are some tentative signs that policymakers are coming round to such an approach. Mario Monti, Italy’s highly respected new prime minister, seems to have had some success in persuading Germany’s Angela Merkel that economic policy can’t be just about austerity. Meanwhile, the European Commission, which is responsible for policing the excess deficits, is equivocating about what to do with Spain.

That said, it’s not easy for Europe to get itself off the austerity spike on which it has impaled itself. When the single currency was launched, governments were supposed to keep their deficits below 3 percent of GDP. Within a few years, those rules were effectively thrown in the bin, helping fuel the current debt crisis. The idea behind the “six pack” – and the even more stringent new treaty on fiscal discipline which is in the works – is to re-impose those rules in a more binding form. If this straitjacket is abandoned at the first sign of trouble, bureaucratic credibility would be shot to bits.

Some way must be found of squaring the circle. The best approach would be for Europe’s leaders to agree that what matters is medium-term rather than short-term fiscal prudence. That would not just be beneficial for growth in the short run, helping ensure that the current slowdown is mild not steep. Policies such as raising retirement ages and getting more young people into work would also boost Europe’s long-term potential.

But even more needs to be done. The most important way of combating Europe’s sluggish growth prospects is to complete the region’s single market, which covers all 27 EU nations, not just the 17 which use the euro. Twenty years after the single market was created in 1992, it is still pretty fragmented. There are, for example, 4,600 regulated professions, while the cost of setting up a business is nearly four times that of doing so in the United States. Creating a real single market by sweeping away restrictive practices and simplifying regulations would boost the EU’s GDP by 800 billion euros or nearly 7 percent, according to the UK government.

In recent years, attempts to inject new life into the single market agenda have floundered. For example, an initiative known as the Lisbon Agenda in 2000 aimed to make the EU the “most competitive and dynamic knowledge-based economy in the world” by 2010. That failed. Vested interests conspired to neuter most suggested reforms.

There may, though, be a window of opportunity to relaunch this plan. The UK’s David Cameron is certainly pushing it at this week’s summit. This might not seem to count for much, given how the British prime minister has been isolated in recent months over how to fight the euro crisis. However, he is not on his own this time. Eleven other leaders have joined him in writing a letter advocating measures to boost growth.

Cameron’s most important ally is Monti. Italy’s prime minister cares passionately about the single market, having written a blueprint two years ago on how to revive it. He has given a lot of thought about how the winners and losers can be balanced so that there is something in the single market for pretty much everybody. His voice also carries increasing weight in Europe’s discussions. The key will be to win over the two biggest economies – Germany and France – which were not part of Cameron’s letter-writing exercise. The politics won’t be easy. But Europe’s biggest need in both the short-term and long-term is growth. Its leaders should step up to the challenge.

When the Syrian revolution began, the activists employed almost entirely non-violent tactics. They also rejected the idea of foreign intervention. Nearly a year on, the revolution’s character has changed. There are still protests, boycotts, strikes and funeral marches. But the opposition’s main strategy for overthrowing Bashar al-Assad’s regime has become one of out-muscling it. To achieve that, it is calling for military help from abroad – a request that will be pressed when the Friends of Syria, a contact group of mainly Arab and Western countries, meet in Tunis later this week.

The switch in strategy is understandable, though regrettable. The endless killing and torture have taken their toll. Homs, Hama and several other cities are being bombarded by Assad’s forces in what look like medieval sieges and could have similar grisly outcomes. The people worry they will be massacred if they don’t take up arms to defend themselves. Meanwhile, they have seen how foreign military intervention in Libya tipped the balance there and got rid of Colonel Muammar Gaddafi.

The Assad regime probably likes the fact that the opposition has embraced armed struggle. This solidifies its support among its core constituency – the Alawites, who represent about 10 percent of the population – as well as other minorities such as Christians. The regime can argue it has to hit back hard, otherwise it will be massacred. What’s more, it has seen brutality work in the past. Assad’s father survived a rebellion in Hama 30 years ago after killing around 20,000 people.

Non-violent struggle has roughly twice the chance of bringing down dictators as armed struggle, according to a study of 20th and early 21st Century conflicts, Why Civil Resistance Works, by Erica Chenoweth and Maria Stephan. Among the many reasons for this, those close to the regime feel less threatened by non-violent tactics and so are more likely to shift their allegiance while it is easier to involve millions of people in Gandhian style civil disobedience than in military operations.

Out-muscling a dictator, of course, also works sometimes. Chenoweth and Stephan found that this was particularly so when foreign powers helped. The problem is that armed struggle results in more carnage than non-violent struggle and reduces the chances that what follows the dictator will be a peaceful democracy. Involving foreign powers, meanwhile, means the revolution has to dance to their agendas.

Such a script is playing itself out now in Syria. The conflict has increasingly descended into a sectarian civil war, pitting the majority Sunni population against the Alawites, who are an offshoot of Shi’ite Islam. A glance at the map shows how this could further destabilise a volatile region. Turkey and the Gulf Arab states are Sunni – and outraged by the atrocities committed against their co-religionists. Iran and, to a lesser extent, Iraq are Shi’ite and don’t want to see their man fall. The West, meanwhile, is worried about the knock-on effects on Israel and Iran as well as having some sympathy for a brave people being butchered. By contrast, Russia doesn’t like the idea of autocrats being toppled – as its regime is shaky too.

This is the context of the upcoming summit in Tunis. There are various ideas on the table, all fraught with problems. One, touted by the French, would create humanitarian corridors through which aid could be ferried to the trouble spots. The snag is that a large and sophisticated military force would be needed to blast open and protect such corridors.

Another scheme is to create a safe zone by the Turkish border, where refugees and defecting Syrian soldiers could congregate. This could then be a base from which to launch a counter-attack against Assad, in the same way that Benghazi was used against Gaddafi. Again, a foreign army would be needed to secure such a haven. Western powers, which have just disengaged from Iraq, don’t seem to have much appetite for that. There’s also the complication that Russia and China have made clear they will veto any resolution authorising military intervention in the United Nations Security Council.

The rich Gulf Arab countries, led by Qatar and Saudi Arabia, may not have such qualms. But they are not in a position to field an army to match Assad’s. Their main contribution is likely to be giving the Syrian opposition money to buy arms. If enough sophisticated weapons pour into the country, Assad may eventually be toppled. But the bloodshed will be horrendous and Syria could be left with radical Islamist gangs as Afghanistan was after the West decided to arm the mujahideen as a response to Soviet occupation in 1979.

The least bad option would be to revert to a non-violent struggle and support it from abroad with intensified economic sanctions in the hope that enough of Assad’s support would crumble and he could be eased out. The Syrian people would still be killed. But casualties might be kept lower if they emphasised tactics such as strikes and boycotts rather than demonstrations, where they are out in the open and sitting ducks. Defecting troops would also have to be given something to do other than attack the regime. One idea is to deploy them to persuade even more troops to defect.

Such an outcome doesn’t look terribly likely. Conflicts that turn violent rarely revert to non-violence. Probably the best known was the struggle against apartheid. But that change in strategy took decades. Still, the other options for Syria and the region look ghastly.

Mario Monti’s ability to take a crisis and turn it into an opportunity may one day be taught as a case study in political economy. When Italy’s technocratic premier succeeded Silvio Berlusconi last November, the country’s 10-year bond yield was above the 7 percent level that had driven Greece, Ireland and Portugal to seek bailouts. Now it is 5.5 percent – still high but moving in the right direction.

Countries with high debt levels like Italy – its borrowing is 120 percent of GDP – are prone to self-fulfilling prophecies on both the upside and the downside. If investors think a government will go bust, borrowing costs rise which, in turn, makes bankruptcy more likely. But if markets think it is solvent, borrowing costs fall and that means it’s unlikely to fail.

In Italy, where I spent much of last week, there have been spirals within spirals. One has been via domestic politics. Monti has so much credibility that he has been able to reform the pension system, liberalise a raft of monopolistic industries and launch a high-profile crackdown on tax evasion. That has helped cut Italian bond yields, further boosting his credibility.

Another spiral has been via international politics. The prime minister’s credibility was an important factor in convincing the European Central Bank to let euro zone banks borrow 500 billion euros before Christmas. Italy was the biggest beneficiary. Its banks are no longer staring into the abyss, with the result that the credit crunch which threatened to suffocate Italian industry is going to be less severe. Moreover, some of the ECB money is finding its way into government bonds, lowering Rome’s borrowing costs.

Monti’s credibility has also helped persuade Germany’s Angela Merkel to ease up a bit on her austerity mantra. One consequence is that, if Italy misses its target of a balanced budget next year, it is unlikely to be forced to tighten fiscal policy again – something that would risk sucking Italy into a Greek-style austerity spiral. President Barack Obama even complimented Monti during an audience last week, saying he had restored faith in Italy and generated confidence in Europe.

The contrast with the end of the Berlusconi era is stark. The then prime minister had little credibility at home and so was unable to push through reforms. He was considered a naughty boy abroad and so was cut no slack. He was shunned by Obama, being left to hang around with the likes of Russia’s Vladimir Putin and Libya’s Muammar Gaddafi. And spiralling bond yields pushed the country and its banking system to the brink, while tipping the economy into its current recession.

But Monti cannot declare victory. Yields are still high. The economy is forecast by the International Monetary Fund to shrink 2.2 percent this year. And the debt hasn’t gone away. This makes the country vulnerable to shocks such as a blow-up in Greece.

While there’s little Monti can do about short-term growth, he can get yields down further with three more measures: labour reform; structural reforms in tax and spending; and privatisation. Such reforms won’t have an immediate impact on productivity. But they would further enhance credibility and so cut Italy’s borrowing costs, giving further rapid twists to the virtuous spiral.

Monti is well on the way to tackling the labour market, with measures to make it easier to hire and fire people. He should also find it surprisingly easy to push these through given that his trust rating with the electorate is at an extremely high 57 percent, according to the Italian pollsters SWG. Even the radical pension reform, which increased retirement ages and cut benefits, provoked only a three-hour strike.

The new government has been more circumspect about fiscal reform. Here what is required is to cut waste and recycle the savings into lower taxes on employment. Similarly, Monti hasn’t committed himself to privatisation. Given that the state has assets worth over 1 trillion euros, it should be possible to sell off large chunks in a multiyear programme to cut the country’s debt well below 100 percent of GDP.

But the most fundamental change Monti could help engineer is in Italy’s self-serving culture where rules are not observed and cheating is given a nod and a wink. Berlusconi made that worse by going soft on tax evasion (which is estimated to cost 120 billion euros or nearly 8 percent of GDP a year), by using parliament as a tool of his personal interests and through his long-running battles with the judiciary.

Monti, by contrast, has started to change the discourse of politics. He is sober, not flamboyant – and comes across as honest. His crackdown on tax cheats has also created a stir. But he has pledged to resign after next year’s general election, meaning he has precious little time to bring about cultural changes.

The good news is that the people are thoroughly fed up with the current crop of politicians, who have an extraordinarily low trust rating of 12 percent according to SWG. That means there is a chance that new politicians could come in to fill the vacuum. The bankrupt electoral system which allows party bosses rather than the electorate to pick the MPs may be reformed. But there’s no guarantee of a clean sweep. What’s more, it seems unlikely that Monti’s successor will be as good as him – and it would be hard for the prime minister to stand for election himself without going back on his word and so undermining what he stands for. Still, he’s made a remarkable start.

There was a whiff of the lynch mob in the UK last week. Stephen Hester, the current Royal Bank of Scotland boss, was bludgeoned by politicians and the media into foregoing his bonus even though he was brought in to clean up the largely state-owned bank. Two days later his predecessor, Fred Goodwin, was stripped of his knighthood. While Goodwin bore much of the responsibility for RBS’s near-bankruptcy, removing his title flouted normal procedures. Not only is such a dressing down traditionally reserved for criminals; the prime minister, David Cameron, prejudged the verdict of the committee which reviewed the knighthood. The week was capped off by the leader of the opposition, Ed Miliband, calling for a tax on bankers’ bonuses.

While the UK is currently the epicentre of the backlash against financiers, the phenomenon is widespread across the Western world. Francois Hollande, who is likely to be France’s next president, has said that his main adversary isn’t Nicolas Sarkozy but a faceless, nameless, opponent – the world of finance. And across the Atlantic, the only serious setback in Mitt Romney’s presidential campaign so far came when he revealed that in 2010 he had paid only 13.9 percent tax on his $21.7 million of income, most of which came from his time as a private equity baron.

There is certainly something ugly about the way politicians – who themselves bear some responsibility for the economic mess – have turned bankers into a scapegoats. But the public isn’t in the mood to show sympathy to bankers these days. The issue is not so much the amounts they are paid. In the same week that the banker backlash was gathering force in the UK, Facebook announced its initial public offering. Nobody batted an eyelid at the prospect of Mark Zuckerberg, the founder, being worth over $20 billion. The difference is that people think Zuckerberg deserves his billions but the bankers don’t deserve their millions.

The belief that bankers’ compensation is unfair operates at several levels. At its most basic there is the argument that, since bankers were the ones who got the world into its current mess, they shouldn’t still be coining it. This is simplistic. The mistakes made by banks were only one factor that fuelled the crisis – and many individual bankers were innocent of the mistakes.

There is, though, a more sophisticated critique: that the whole system has been rigged in financiers’ favour, allowing them to earn more than they merit. Few people complain when entrepreneurs make millions. They are seen to have come up with brilliant ideas, taken big risks or worked extremely hard. That’s how capitalism is supposed to work. But bankers have benefited from one-way bets that make a mockery of capitalism.

The system has been skewed in bankers’ favour in two main ways. First, individual traders were paid on short-term performance. That encouraged them to spin the roulette wheel. If their bets paid off, they did well; if not, their employers picked up the tab. Second, banks in general were highly leveraged. This magnified earnings and bonus pools during the good times; but when the crisis hit, many banks were bailed out.

Over the past four years, regulators have been trying to remove these one-way bets. Much has changed in the way individual bankers are paid. A bigger slice of their bonuses is paid in equity which they cannot sell for several years, tying compensation to institutions’ long-term performance. In some cases, bonuses can be clawed back. What’s more, banks have been required to cut their leverage. This, combined with the dire economic environment, has reduced earnings and so squeezed bonus pools.

But compensation hasn’t come down as rapidly as it should have. Just look at bonuses in the City of London as measured by the Centre for Economics and Business Research. These actually rose slightly in 2007/2008 to 11.6 billion pounds after the first shocks of the crisis. Although they fell to 5.3 billion pounds after Lehman Brothers went bust, they rose again the following year to 7.3 billion pounds as the benefits of the bailout started kicking in.

For the year just ended, City bonuses are forecast to be 4.2 billion pounds. Even so, compensation is still too high. One way of seeing this is to compare how well bankers do to how well their own shareholders fare. Last year, for example, Goldman Sachs cut its pay 21 percent. But earnings applicable to shareholders tumbled 67 percent and the bank’s return on equity was a measly 3.7 percent.

The public’s concern, however, should be for taxpayers rather than shareholders. Although steps have been taken to make the system safer, the changes are far from complete. Banks are being given several years to build up fatter capital buffers so that they are better able to withstand losses. Plans to enable regulators to pack banks off to the knackers’ yard rather than bail them out when they get into trouble are still on the drawing board. Meanwhile, the industry enjoys special treatment. Just think about the 500 billion euros that the European Central Bank lent to the industry in December at a measly interest rate of 1 percent. Entrepreneurs would die to be able to borrow money at such a rate.

The sad fact is that most banks are still too big to fail. Until that changes, the system will remain rigged in bankers’ favour – and they will be vulnerable to the kind of lynching suffered by Hester and Goodwin last week.