Erdogan’s harsh actions against protestors and harsh words against investors could backfire economically. The country depends on foreign investors to fund its big current account deficit. If they turn tail in response to the mounting unrest, interest rates will indeed have to rise.

The protests which began two weeks ago over Tayyip Erdogan’s alleged authoritarianism, triggered by the prime minister’s insistence on bulldozing one of Istanbul’s few public parks, initially alarmed investors. The stock market plunged, the lira fell and government bond yields spiked. Then, after the central bank intervened in the foreign exchange market and Erdogan offered concessions last week, investors calmed down.

But the weekend’s use of riot police has stoked a conflict that seemed like it might be on the point of resolution.

The problem is not so much that speculators have an incentive to jack up interest rates. This would be perverse. Foreign investors own $140 billion of domestic bonds and equities, according to Standard Bank. They will lose money if interest rates rise.

The risk rather is that investors will pull out their money if they lose confidence. The U.S. Federal Reserve’s indication that it may slow down its massive bond-purchasing programme has exacerbated that risk, as some of the money it has been pumping into U.S. bonds has seeped into emerging markets such as Turkey.

What’s more, the Turkish miracle isn’t quite as good as it seems. The economy grew only 2.6 percent last year, down from 8.5 percent the previous year – after the central bank had to hike interest rates because the economy was overheating and inflation reached 8.9 percent last year.

Turkey’s biggest economic weakness is its current account deficit – a sign that consumption has been growing faster than is sustainable. The deficit did fall to 5.9 percent of GDP last year, after a 9.7 percent gap the previous year, as the economy slowed. But it is rising again this year. The April trade deficit was $10.3 billion, up from $6.6 billion last year.

Indeed, the selloff in Turkey’s financial markets began a week or so before the police crackdown on protestors in Istanbul’s Taksim Square on May 31. For example, two-year bond yields rose from 4.8 percent on May 17 to 6 percent at the end of the month; and the stock market fell 8 percent between May 22 and the end of the month.

Until now, international investors have been happy to fund the deficit. Not only were they attracted by the strong economic growth. They also liked Erdogan’s pro-market approach, the political stability they thought he had brought and the prospect that Turkey’s march towards a market democracy would be anchored by negotiations to join the European Union, says Timothy Ash, Standard Bank’s head of emerging markets research.

The “interest-rate lobby” also liked the fact that the government’s debt is only 35 percent of GDP and that banks have strong balance sheets, partly because they were seared by Turkey’s financial crisis at the start of the millennium. Meanwhile, both Moody’s and Fitch recently upgraded the country to investment grade.

The problem is that the unrest is casting doubt on some of these positive factors. For a start, Turkey no longer looks so stable politically. Then there’s the fact that Erdogan’s attack on speculators is sowing doubts about the depth of his commitment to markets. Furthermore, the crackdown on protestors may undermine Turkey’s chances of joining the EU after Germany last week suggested delaying the next round of negotiations. What’s more, the unrest could harm growth if tourists are deterred from visiting and domestic consumers become more cautious.

A particular weakness is that the current account deficit has been largely funded with hot money. The share accounted for by foreign direct investment – long-term money that can’t easily run away – has been falling, according to Morgan Stanley. Meanwhile, the share made up by debt has been on the rise.

One measure of Turkey’s vulnerability to a loss of confidence is that it has an “external financing requirement” of $205 billion – roughly a quarter of GDP – over the next year, according to Standard Bank. This financing requirement is the sum of its current account deficit and the maturing debt it needs to repay or roll over. A more extreme measure of vulnerability would add the $140 billion of foreign held bonds and shares. If this tries to flee, the lira could plunge.

Against this, the central bank has $130 billion of reserves, which it dipped into last week when it helped to stabilise the foreign exchange market. This war chest, though, is low compared to Turkey’s external financing needs. What’s more, the net reserves – after excluding foreign exchange deposited by the banking system – are only $46 billion, according to Standard Bank.

So the central bank couldn’t hold the line if the “interest-rate lobby” really did run for the exits. In that case, Turkey would have to raise interest rates, which would damage growth. And then the economic miracle, which Erdogan has presided over and which is one of the main sources of his popularity, might look like a conjuring trick. Instead of choking protestors, Turkey’s prime minister should try to make a genuine peace with them.

In recent years, the zone has started to address these problems on a piecemeal basis. But it is still haunted by zombie banks, which are not strong enough to support an economic recovery.

The European Central Bank now has a golden opportunity to press the reset button in advance of taking on the job of supervisor in mid-2014. It mustn’t flunk the cleanup.

Mario Draghi, the ECB president, is alive to the opportunity and the threat. His fear is that, even if the supervisor does its job properly, there won’t be a safety net for troubled banks that can’t recapitalise themselves. This is why he called on governments last week to make an explicit commitment to provide such a “backstop”.

Draghi highlighted the contrast between the U.S. stress test, in which Washington committed to plug any balance-sheet holes, and the last European stress test conducted by the European Banking Authority in 2011 which lacked such a commitment by governments. The U.S. test launched its economy on the road to recovery; the EBA one triggered a new phase in the crisis.

The moral is obvious: without a safety net, making a clean breast of problems can provoke panic. The supervisor may as a result be tempted to continue sweeping problems under the carpet. The euro zone’s recovery would then be further delayed and the ECB’s credibility destroyed.

So far, governments have not responded to Draghi’s request for a backstop. In the meantime, the ECB and the EBA – which are working on different aspects of the cleanup – have many issues to clarify themselves.

First, who exactly will review the banks’ assets? The ECB does not yet have the manpower to do it. So it has to rely on national supervisors. The snag is that these national supervisors could have an incentive to hide problems in their banks so the cost of bailing them out is ultimately borne by the euro zone as a whole.

Draghi’s answer is to get supervisors to cross-check the balance sheets of banks in other countries – and to reinforce the audit’s independence by involving private-sector assessors. The latter suggestion originally provoked unhappiness in France. But at a recent dinner with central bank governors, Draghi pushed his solution through.

That still leaves the question of whether the ECB can conduct a sufficiently in-depth review given that it wants to finish the whole process by next spring. It needs to figure out how likely loans are to turn sour and whether banks have taken adequate provisions against that possibility. Around 140 of the euro zone’s top banks will be reviewed.

The ECB should also look into whether lenders have used appropriate “risk weights” for their assets. A risk weight determines the size of capital buffer a bank is required to hold. There is a widespread suspicion that many lenders are using artificially low weights to give the misleading impression that they are well capitalised.

After the ECB completes its review, the EBA will conduct a stress test to check whether banks can survive a shock. This raises many other questions including: how big a shock it will test; how much capital banks will need to have in this stressed scenario; and how long they will get to restock their capital if they fail the test. If the EBA is too soft, the test will be exposed to ridicule in financial markets.

Yet another issue is whether capital shortfalls will be expressed as an absolute number – such as 1 billion euros – or as a percentage of risk-weighted assets. The last EBA test plumped for the percentage method, with the disastrous consequence that many banks solved their capital problem by selling assets and stopping lending – so further crushing the economy. Ewald Nowotny, an ECB council member, suggested to Reuters last month that this error would not be repeated.

Once all this is dealt with, the question then becomes who will provide a backstop if the bank has a capital shortfall that it can’t fill itself and its government has too much debt to help out.

One option would be for the European Stability Mechanism (ESM), the zone’s bailout fund, to inject capital directly into banks. But Germany seems to have rejected this.

The main alternative is that the ESM should lend money to national governments, which could then pop it into their banks. That’s what happened last year when Spain’s lenders got into trouble.

The snag is that this would add to the government’s deficit and debt. A partial workaround could be for the European Commission to ignore any capital injections when it determines whether governments are doing enough to cut their deficits. Without such forbearance, they could be forced into another round of growth-pummelling austerity measures.

With so many issues to resolve, there is a risk that Europe’s mega bank cleanup will either be another damp squib or even create more damage. Having wasted five years failing to address the problem properly, the euro zone must make sure this does not happen.

The West’s three nuclear powers clearly don’t have much appetite for intervention in Syria. Nobody is pushing for an Iraqi or Afghan-style invasion. There is also precious little desire to impose a Libyan-style no-fly zone – not least because it would be impossible to get United Nations’ authority for such a policy given Russia’s steadfast support for the Assad regime.

The West is anyway struggling to clarify why it should get involved in this increasingly grisly sectarian war. Syria doesn’t have much oil or gas, unlike Libya and Iraq. Nor is Assad threatening the West with al Qaeda-style attacks. It could even be argued, on the basis of realpolitik, that it could be in the West’s interests if Sunni jihadists and the Iran-Assad-Hezbollah Shi’ite axis exhausted each other in an orgy of mutual destruction.

There are, though, two reasons why the West might not wish to stand by as the death toll, already over 80,000, climbs ever higher. First, civil wars have a tendency to drag on. The one in neighbouring Lebanon, where I spent last week, lasted 15 years and left over 120,000 dead. Given Syria is about five times Lebanon’s size, a similar rate of killing would result in more than 600,000 deaths. Although humanitarian considerations are rarely the driver of foreign policy, it would be good if Western intervention really could cut the killing of innocent people – admittedly a big “if”.

The second, more hard-headed reason for the West not washing its hands of Syria is concern for spillover effects. There are already signs of Lebanon being sucked into the conflict: Hezbollah-dominated areas have seen rocket attacks and skirmishes with Syrian rebels in recent days.

If an al Qaeda-style regime were to take control of Damascus, with its presumed huge stash of chemical weapons, who knows what havoc it would wreak? It might not be just Israel that would feel the heat on its border given that many Sunni jihadists see their mission as global.

Such thinking seems to be behind the emerging plan to arm the moderate rebels. This would be intervention on the cheap, since it would not involve the West committing its own soldiers or weapons to the fight. Britain and France last week succeeded in lifting a European Union embargo on weapons sales, despite strong opposition from other European nations which want to keep out of the conflict completely.

Before pressing the button, the UK, France and possibly America (whose position on arms supplies is not clear) want to give peace one last chance. They are trying, so far without much success, to get Assad and the moderates (principally the Syrian National Coalition) round the negotiating table.

The prospect of supplying weapons is, in turn, being used as a carrot and stick to advance the peace talks. The moderates have an incentive to play ball because, otherwise, they won’t get weapons. Assad has an incentive to take part; otherwise his enemies will be better armed.

The snag is that nobody is holding out much hope for the peace talks. And the corollary of failure is that Western weapons supplies would then roll into Syria.

Advocates of such a policy argue that there is a triangular contest in Syria. In one corner is Assad, armed by Russia and Iran, and supported by foreign Shi’ite fighters – mainly from Iraq and Lebanon (in the form of Hezbollah). In another corner are the jihadists, financed by money from the Gulf, and supported by Sunni fighters from the Muslim world.

In the third corner are the moderates, who aren’t getting much help from anywhere. They are mainly Sunni too. And they are sometimes fighting alongside the jihadists against Assad. But because they are poorly resourced, they have failed to make much headway against Assad, while the jihadists have taken an increasingly important role in the revolution.

The idea is that, if the moderates are properly armed, they will not only start winning against Assad. They will also be able to edge aside the jihadists. There is also a parallel attempt by Saudi Arabia to channel money from the Gulf to moderates. Although staunchly Sunni, it saw how its original help for al Qaeda in Afghanistan boomeranged into an attempt to foment revolution at home.

Advocates of the pro-moderate policy don’t deny that some of the presumably fairly sophisticated weapons intended for moderates may end up in the hands of jihadists. Nor do they deny that Iran and Russia may react by stepping up their own arms supplies to Assad, with the result that the pace of killing will increase. Their argument, rather, is that conflict will end sooner and that whatever comes after Assad is more likely to be pro-Western.

While that is certainly possible, there are other scenarios. One is that the so-called moderates – who aren’t Western-style liberal democrats to start off with – may become radicalised as the conflict goes on. So a victory for them might not be so good for the West after all.

Another worry is that it may be too late to turn the tide in the moderates’ favour. If so, they may eventually decide to throw their lot in with the jihadists – taking their sophisticated weapons with them. Syria would then turn from a triangular contest into a bilateral one. The West, having unwittingly armed the jihadists, might ultimately conclude it would have been better off with Assad.

Yet another concern is that weaponry intended for Syria won’t stay there. It could be redeployed in other countries, creating yet more carnage – and possibly threatening the West’s interests more directly.

It is for these reasons that most European countries – and, until recently, even Britain, France and America – have been opposed to arming the rebels.

Two years ago the Syrian rebels were pursuing almost entirely nonviolent tactics to unseat Assad. He then cracked down so brutally that the revolution became militarised. Many of the nonviolent activists were killed; others resorted to violence themselves; yet others moved out of the struggle because there wasn’t room for them.

There are, though, still Syrians who would like to find a way of living together in peace. Now may not be the time for demonstrations and protests of the sort that are now racking Istanbul’s Taksim Square. But nonviolent activists can still play a role in building the institutions of a civil society. It is a shame that the West has spent so little effort identifying and supporting these people. They may be able to influence the conflict as it progresses – and they will be sorely needed if a peaceful Syria is ever to be rebuilt.

Draghi likes London. The Italian still has a flat in the city, kept from his time as a Goldman Sachs banker. He is a man with a natural affinity for the markets.

Last week Draghi was in London, the scene of his July 2012 promise to “do whatever it takes to preserve the euro”. The ECB President’s message this time was that Europe needs a more European UK as much as the United Kingdom needs a more British Europe.

He was careful not to wade directly into the British political swamp and say, for example, that the United Kingdom would be crazy to quit the European Union. He confined himself to listing the ways in which Britain’s economy, and the City in particular, are entwined with the euro zone. But it seems clear that he would prefer the United Kingdom to get stuck into Europe rather than stay on the sidelines (where it has been since Britain decided not to join the euro) – let alone quit entirely.

Draghi didn’t say what he meant by a more British Europe. But it is interesting to speculate what the euro zone would be like if the United Kingdom had decided to join the single currency. For a start, the zone’s monetary policy would probably have been less German-dominated – and, hence, less obsessed with fighting inflation to the exclusion of other economic objectives.

The ECB has, of course, still managed to innovate – in particular, with its bond-buying plan which has taken some of the sting out of the crisis. But it always has to watch its back, given criticism from Germany’s Bundesbank and challenges in the country’s constitutional court.

A more British Europe might also now find it easier to adopt a sensible “macroprudential” policy for managing the flow of credit around the financial system. One of the zone’s little noticed potential design flaws is a Germanic insistence on Chinese walls between bank supervision and the conduct of monetary policy, even though both will come under the ECB’s aegis.

While such separation makes sense insofar as the supervision of individual banks is concerned, it could be problematic for macroprudential supervision. Take the current situation. With inflation low, the ECB should be pushing interest rates into negative territory or buying government bonds. The snag is that, while such a monetary policy would be right for the euro zone on average, it would be too loose for Germany.

The sensible approach would be to counterbalance such one-size-fits-all monetary policy with tight credit policy focussed on Germany, implemented via extra high bank capital requirements there. Maybe the ECB will eventually get round to such a rational policy mix. But it would be easier if it could operate like the Bank of England, which doesn’t have Chinese walls.

The zone’s banking system would also, arguably, be in a better shape if it was more British. This is not to deny the United Kingdom’s massive banking crisis. The point rather is that Britain has done a fairly good job of cleaning up the mess, while the zone has tended to sweep problems under the carpet – which has debilitated parts of the economy.

The ECB does have a chance to remedy this error. It has already insisted on a rigorous review of bank loan books and a stress test of their solvency before it takes responsibility for supervising them next year. It now needs to get governments to agree to wind down or recapitalise any banks that fail the test.

Another area where a more British Europe might have been beneficial would have been in shooting down the planned Financial Transactions Tax – which will gum up the markets, in the process disrupting the ECB’s monetary policy. Maybe the FTT will prove still-born anyway given lukewarm support from Germany. But this is not guaranteed.

The same goes for the management of the Cyprus crisis, where the somewhat anti-market European Commission insisted on imposing capital controls against the ECB’s advice. Again, it may not be too late to mitigate the damage. The controls could, and should, be lifted when the resolution of the country’s two big banks is finished. But it would have been better not to have imposed them in the first place.

To some extent, such speculations are academic. Britain hasn’t joined the euro and won’t for a long time, if ever. But there are still two main ways in which a more engaged Britain could advance not only its economic interests in Europe, but Europe’s too.

First, David Cameron’s push for more competitive markets – principally by extending the single market to services and by signing free trade agreements with the United States and Japan – could play a role in solving the euro crisis.

Second, the United Kingdom could campaign for an enhanced role for London’s capital markets in Europe. The EU’s “bankcentricity” – under which finance is mostly routed through a semi-broken banking system rather than the markets – will be a drag on growth.

Cameron and Draghi should make common cause on such an agenda. That’s a practical way to make the United Kingdom more European and Europe more British.

Britain has in recent years been playing a defensive game in response to the barrage of misguided financial rules from Brussels. It now needs to get on the front foot and sell the City as part of the solution to Europe’s problems. The opportunity is huge both for Britain and the rest of Europe.

The chance of getting the EU to swing behind a pro-City strategy may, on the face of it, seem pie in the sky. Many people blame financiers for the financial crisis. So how could they be part of the solution? What’s more, Continental Europeans have long tended to be suspicious of financial markets.

Hence, the plan by 11 EU countries (not including the UK) to apply a tax on all financial transactions. Hence, too, the recent decision to cap bankers’ bonuses thoughout the EU (against London’s objections) and a scheme, so far not agreed, to do the same for fund managers.

The oddity about these rules is that they do nothing to address the causes of the financial crisis. Trading in financial instruments wasn’t responsible for the crisis. Nor were fund managers. And while banker compensation does bear some of the blame, the so-called solution is cock-eyed. Banks will react to bonus limits by pushing up fixed salaries – something which will make their finances more vulnerable when the next crisis hits.

Meanwhile, the financial transactions tax could gum up markets so badly, pushing up the cost of capital and constricting growth, that even its supporters are having doubts. Britain is rightly trying to challenge the plan through the courts because of its extra-territorial implications. Any trading involving financial instruments issued by entities resident in the 11 countries would be caught by the tax even if the transactions took place entirely in London.

Despite the headwinds, Britain has a genuine opportunity to turn things around. To do so, it must challenge the conventional script, under which old-fashioned banking is seen as good and capital markets bad. The truth is that Europe has a banking crisis, not a capital markets one.

Banks have lent too much money to clients who can’t pay it back. Their balance sheets were too weak to start off. Now they are unable to lend to the real economy, throttling growth.

Banks are dangerous beasts. They are not well suited to provide long-term finance, as the Group of Thirty, an influential financial policy group, pointed out in a report earlier this year. Banks fund themselves with deposits and other short-term money. As a result, they either don’t lend long term; or, if they do, they expose themselves and taxpayers to huge risks if liquidity dries up.

The contrast between America and Europe is stark. In the U.S., banks provide only 19 percent of long-term financing, according to the McKinsey Global Institute. In big European countries, they provide between 59 percent and 71 percent.

America is a much heavier user of securitisation, where corporate loans and mortgages are bundled up and sold to investors in the capital markets. Nearly half of long-term financing is via securitisation. In France and Germany, it is only 2 and 3 percent respectively.

The corporate bond market is also in its infancy in Western Europe. Only 21 percent of the debt financing for non-financial companies comes from bonds. In America, it is 45 percent.

With the EU’s banking system haunted by zombies, its excessive reliance on banks to provide finance is dragging down the whole economy. It is telling that the European Central Bank thinks that the way to get loans flowing to small businesses in peripheral countries is to revive the securitisation market.

Overdependence on banks is not just a short-term problem. Even when the euro crisis is finally over, banks will be unable to do a good job of funding industry. They are rightly being required to hold bigger capital and liquidity buffers, which will push up their costs.

The euro zone’s half-hearted move towards banking union will lead to even tighter regulation. The ECB, which is to take over bank supervision next year, will first subject lenders to scrutiny to see if they are hiding bad debts. It understandably doesn’t want banks blowing up on its watch.

What’s more, if Germany eventually agrees to backstop banks in the rest of the zone, the quid pro quo could well be that these lenders are required to have fortress balance sheets. Berlin will want a virtually zero chance of that backstop ever being used.

All this means that the only way of getting a healthy European financial system is to build up its capital markets. This is a huge opportunity for the City, as the bulk of the business would be routed through London. Cameron should start campaigning for this now. If he can push through such an agenda, it won’t just be good for Britain; it will be a powerful argument in any future referendum for staying in the EU.

The debate over Brexit has moved into high gear in the past 10 days, after the UK Independence Party – which wants Britain to pull out of the EU – performed well in English local elections. The Conservative party, which rules in coalition with the pro-European Liberal Democrats, has been thrown into turmoil because UKIP has been winning votes largely from the Tories.

What’s more, many Conservatives would like Britain to quit the EU too. Last week Nigel Lawson, one of Margaret Thatcher’s finance ministers, argued the case for Brexit. Boris Johnson, the mayor of London who is the Conservatives’ most popular politician, also shuffled a little further in a eurosceptic direction – although he stopped short of calling for an exit.

David Cameron himself has not shifted his position. He wants to hold a referendum in 2017 after he has had a chance to renegotiate Britain’s relationship with the EU in so far unspecified ways. But he may be tempted to tacitly support legislation to call a plebiscite in an attempt to embarrass the opposition Labour party which has so far refused to back such a vote.

Despite the increasingly anti-European tone of the debate, the overall likelihood of Britain quitting the EU hasn’t really changed since the local elections. True, the probability of the British people voting in favour of staying in the EU in a referendum has fallen. But the chance of such a plebiscite taking place has also probably dropped – because UKIP’s rise makes it less likely that Cameron will be reelected in 2015.

It is, of course, possible that the pro-European Labour party will match Cameron’s promise to hold a referendum. But that would probably be against its interests. A future Labour government would find it hard to win a referendum – as the Conservative party, unconstrained by government, as well as its allies in the media would mount a vociferous anti-European campaign. After such a defeat, Labour would be left reeling.

If Labour felt the only way to win the next election was to promise a referendum now, it might still take the risk. But its chances of winning have risen in the past 10 days. And any attempt by the Tories to embarrass Labour for not backing a plebiscite is more likely to backfire by further exposing the divisions in its own ranks.

Pro-Europeans, though, can’t just calculate the political probabilities. They need to make the case for staying in the EU.

Anti-Europeans often fudge the question of whether they would like Britain to quit the single market as well as the EU. They should be invited to clarify precisely what they mean.

Quitting the single market would be extremely bad for the economy, since about half of Britain’s trade is with the EU. This wouldn’t all vanish. But all sorts of barriers would make it much harder for companies to do business across frontiers, leading to a big rise in unemployment.

Britain has the world’s third-largest stock of foreign direct investment after the United States and China. But multinational companies, which have used Britain as a hub in part because it has access to the single market, would curtail their investment if that was no longer so. The City of London, the UK’s most successful industry, would also suffer if it was cut off from its European hinterland.

Not surprisingly, many eurosceptics don’t want to quit the single market. They think they can have unfettered access to this market without the rules and regulations that irritate them.

The idea that Britain can have its cake and eat it is naïve. The rest of the EU might well allow it access to the single market – and even then not on an unfettered basis – but only if the UK abided by its rules. What’s more, it wouldn’t then have a vote on those rules, putting its business at a disadvantage.

That’s the position Norway, which is not in the EU, finds itself in. It also has to pay almost as much on a per capita basis as Britain for the privilege of such second-class status.

The anti-Europeans are fond of lambasting Brussels bureaucracy. They also point to misguided policies such as the Common Fisheries Policy, which results in dead fish being thrown back into the sea, or the planned Tobin Tax, which will gum up financial markets.

These attacks are fair, even if they don’t snuff out the case for staying in. But Britain has a golden opportunity to help reform the EU. This is because the main solution to the euro zone’s crisis is to make it more competitive. It’s a misconception to suppose that the euro zone is charging towards political, fiscal and banking union – as Germany is just not willing to pay for it.

Instead, the single market needs to be properly extended to services. Free trade needs to be promoted with other blocs such as America. And capital markets should be boosted as a solution to Europe’s banking malaise.

Cameron needs to start pushing this agenda now. Achieving it would not just be good for Britain. It would increase the chance of persuading the electorate to vote yes in any referendum.

(Hugo Dixon is Editor-at-Large, Reuters News. The opinions expressed are his own.)

The UK Independence Party will not come close to winning Britain’s next general election. The populist anti-Europe, anti-immigration party may not even win a single seat, despite last week’s surge in English local elections where it won nearly a quarter of the vote – running a close third to Labour and the Conservatives. That’s how the maths of Britain’s first-past-the-post voting system works.

Nevertheless, the rise of UKIP could have profound consequences for British politics and business – in particular, for the UK’s relationship with the European Union. This is because UKIP is mainly taking votes away from David Cameron’s Conservatives. A calculation by Sky News suggested that, if the local election results were translated into a general election, Labour would win an overall majority. Even though UKIP might win no seats itself, its popularity would damage Cameron’s prospects for reelection in 2015.

A key question will be how the Conservatives respond to this challenge. The party’s right-wing is already advocating a shift to the right to prevent more defections to UKIP. David Davis, who lost out to Cameron in the battle to lead to Conservatives in 2005, advocated an early referendum on whether Britain should quit the EU. Cameron has promised such a plebiscite but only after the next election – and implicitly only if he wins that election.

Other Conservatives will be arguing that it will be folly to tack to the right and leave the centre completely open to Labour. Holding a referendum on Europe before the election is not even practical politics, as the Conservatives are in coalition with the pro-European LibDems who oppose such a vote.

British business, which has a vital interest in how this debate progresses, should make clear that it wants the government to stick to the centre. It will not help the economy if there is a hard shift to the right on either immigration or Europe.

Look first at immigration. The economy benefits from having a moderately open approach to foreign workers – both in high-skilled and low-skilled sectors. Finance, information technology and, yes, plumbing are among the industries where Britain gains from imported skills. Immigration helps industry thrive and keeps costs down.

Within the EU, there is freedom of movement of labour – with the exception of Romania and Bulgaria, where the last controls will be lifted at the end of the year. This is a benefit too to British, who are free to work anywhere across the 27-member union. Immigration from the rest of the world is much more controlled.

There are worries, fanned by UKIP, about foreigners coming to Britain to enjoy free education, health care and benefits. But these are exaggerated. Immigrants tend to be younger, better educated and more economically active than natives. For example, a typical immigrant from Eastern Europe is 59 percent less likely to be on benefits than a British citizen, according to a study by the Institute of Fiscal Studies.

Immigration is therefore in most cases a good deal for Britain. And where this is not so, the answer is to make it harder for recently-arrived immigrants to get access to benefits rather than to stop immigrants who genuinely want to work.

Now look at Britain’s relationship with the EU. The economy benefits hugely from being part of the single market, which accounts for nearly half its trade. The City of London also gains from having a hinterland for its financial services. None of this is to suggest that Britain doesn’t also need to trade with the rest of the world. But Europe is a large, rich market on its doorstep.

That said, the EU is far from perfect. The economic model has been based too much on protecting people and companies from competition and not enough on boosting enterprise – as parts of the euro zone, in particular, have discovered with a vengeance in recent years. This isn’t just bad for the euro zone; it’s bad for Britain too.

The UK, therefore, needs to put its weight behind a campaign to make Europe more competitive. Although most of the work needs to be done at a national level, there are three supranational priorities.

First, the single market needs to be completed, especially in services, where Britain has a comparative advantage. Second, there needs to be a big push to cut free trade deals between the EU and other blocs, especially the United States. Third, there should be a drive to create vibrant capital markets, based in London, to take the strain off Europe’s dysfunctional banking system.

To be fair, Cameron started preaching some of this agenda in his European speech in January. But he also gave the impression that he wants to opt out of some European policies – a strategy that would reduce his chances of negotiating reform with other national leaders, even if it appealed to his right wing. He also implied that not much would happen before the general election. But the sooner reform starts, the better.

Part of the problem with acting sooner is getting the LibDems on board. But there might be a way of doing that. Why not focus on competitiveness now – something the LibDems ought to be able to sign up to – and leave any discussions on opt-outs until after 2015? Such an approach should certainly appeal to most of business more than tacking to the right in an attempt to negate the challenge from UKIP.

The last few weeks have witnessed a sea-change in the debate over fiscal austerity. A seminal academic paper by Carmen Reinhart and Kenneth Rogoff, which purported to show that economic growth was impaired if government debt levels exceeded 90 percent of GDP, has been discredited.

Meanwhile, the European Commission has softened its line on the merits of further deep budget cuts in peripheral economies. Spain, for example, looks like it will get until 2016 to bring its deficit down below the European Union’s magic number of 3 percent of GDP. Portugal, Greece, Italy and France are also being shown greater leniency by Brussels. One of the first things Enrico Letta, Italy’s new prime minister, said last week was that country needed to focus on growth not austerity.

The change in attitude didn’t all happen in the past few weeks. The International Monetary Fund, which in the old days used to be considered the high priest of austerity, has been advocating looser policies for a good year. And, as more countries have got sucked into the austerity spiral – slamming on the brakes, which crushes the economy, making it harder to hit budget targets – the folly of continuing with the same policies has been hard to ignore.

It is astonishing to think that it was only in December 2011 that virtually the entire EU, including most countries outside the euro zone, signed up to the German-inspired “fiscal compact” – a misguided treaty which hardwires austerity into governments’ constitutions. It will be interesting to see whether this has any residual role or, like the euro zone’s original growth and stability pact, is viewed as a piece of waste paper.

But there are dangers in the new consensus too. The so-called austerians do have a point that excessive debt acts as a brake on an economy, even if there is no discontinuity at 90 percent of GDP. There is also the small matter of how rising debt – Italy’s is heading to 130 percent of GDP and Spain’s to over 100 percent – is going to be funded.

At the moment, the markets don’t seem worried. The ECB’s pledge to do whatever it takes to preserve the euro is keeping governments’ borrowing costs down. One of the most dramatic examples of this is Portugal, whose 10-year bonds now yield 5.9 percent down from 11.4 percent before the ECB’s jawboning.

That said, the euro crisis was not caused by austerity but rather stemmed from the fact that many economies became flabby and uncompetitive. Welfare states were too generous, labour had excessive privileges, civil services were bloated, swathes of industry were riddled with uncompetitive practices, judicial systems were sometimes dysfunctional, while tax evasion and corruption were often rife. What’s more, in many countries, there has been an unhealthy nexus between banks and politics.

These problems have been tackled, but only partly. Until they are more fully dealt with, the euro zone will not be able to return to sustained growth; unemployment, especially among the young, will stay unacceptably high; and the debt crisis will remain at risk of returning.

Look at Italy. Mario Monti, the outgoing prime minister, did reform pensions. But he botched his shake-up of the labour market, making it harder for young people to get jobs. He also failed to do much to liberalise services markets and did nothing to clean up politics. The best that can be hoped of Letta, who shouldn’t count on holding power for more than a few months, is that he will reform the electoral system. 

Things are a bit better in Spain, where labour liberalisation seems to be working. But Madrid is still being too vague on what will be in its next batch of reforms.

Meanwhile, Greece has been drinking bitter medicine for three years but has still to crack its problem of rampant tax evasion. Nor is it clear that Antonis Samaras, the Conservative prime minister, really wants to tackle vested interests in the business community.

Last but not least, France under Francois Hollande has only taken baby steps to restore its competitiveness. Public spending and taxes are too high, sucking vitality out of the private sector. Labour practices are too rigid.

More generally, right across the euro zone, banks have resisted coming clean on their bad loans. National and European policymakers have often connived in this denial, partly because the banks are well-connected and partly because doing so might require taxpayer-funded bailouts. But this is another drag on the economy.

Europe is over-dependent on a broken bank system. It should be emulating the United States which relies much more on capital markets to fund industry and households. But Brussels is deeply suspicious of markets. Indeed, its misconceived financial transactions tax will gum up financial markets, which is exactly the opposite of what is needed.

Austerity and structural reform are not the same. But they are often confused, because they both cause pain. With reform, the pain is mainly felt by well-entrenched vested interests. If the euro zone is going to have a healthy future, it must now tackle these with vigour – even as it goes easy on austerity.

Although the economy will have a terrible 2013, next year should be better. But the outlook is fragile: political crisis could yet rear its ugly head, tax evasion is rife and there’s the risk of external shocks.

Look first at the good news. Antonis Samaras’ coalition government has held together surprisingly well since it came to power last June following a period of political chaos, despite pushing through extremely unpopular measures. Samaras’ centre-right New Democracy party is neck and neck in the opinion polls with the radical left Syriza, the main opposition party. Samaras hasn’t suffered the plunging support of Spain’s Mariano Rajoy or France’s Francois Hollande.

Largely as a result of Samaras’ effective government, the troika – the European Commission, the International Monetary Fund and the European Central Bank – last week gave Greece a thumbs-up in its latest progress report. More bailout funds, which so far total around 200 billion euros, will be disbursed.

Last year’s trauma, when it looked like Greece might quit the euro, and the ongoing austerity will cause the economy to shrink by another 5 percent or so this year, taking the cumulative decline to around 25 percent. Unemployment will probably rise to about 30 percent.

These are grim figures. But Athens now seems on course to achieve “primary balance” this year. In other words, it won’t have a budget deficit before interest payments. That means it probably won’t have to implement another round of austerity next year, so the economy won’t be struggling against that headwind.

Meanwhile, up to 50 billion euros of bailout cash is being used to recapitalise viable banks and shut down non-viable ones. The money is meant to fill a hole left by the steep losses on their government debt holdings and the avalanche of bad private-sector loans. It is tragic that this operation wasn’t completed at the start of the crisis, as the zombie banking system has exacerbated the slump. Still, better late than never.

The banks’ dependence on expensive emergency liquidity assistance (ELA) from the Greek central bank has also been slashed. It is now 22 billion euros, down from a peak of around 120 billion euros. Banks’ funding costs have fallen, theoretically allowing them to pass the benefit to clients.

Another 8.2 billion euros of bailout cash is being used to pay the government’s bills. Again, it is terrible this wasn’t done earlier. Athens’ failure to pay its bills has crushed many businesses. But again, if the money is disbursed rapidly, the private sector will get a breather.

The drive to improve competitiveness, mainly through much lower wage costs, is finally bearing fruit too. This is most visible in tourism, which accounts for 17 percent of GDP. Revenues are expected to jump 9 to 10 percent this year, according to the industry.

If Athens can hold the course, there’s also a good chance that the euro zone will agree to further lighten its debt load, which amounts to about 160 percent of GDP, by cutting the interest rate and lengthening the maturities of official loans. This was explicitly mentioned in the latest troika report. Debt relief would allow Athens to avoid further fiscal tightening.

However, the outlook isn’t all rosy. For a start, the political situation remains fragile. Even if the coalition hangs together, elections will probably be called by early 2015 at the latest. This is because Greece needs to choose a new president then and the constitution specifies that if a super-majority of MPs can’t agree on a candidate – which seems likely – a general election has to be called.

Many observers think Samaras could be tempted to call an even earlier election, especially if he thinks he can win. But such a gamble could backfire. Meanwhile, a Syriza-led government could lead to renewed friction with the troika and a decline in business confidence.

Samaras should also not be complacent about the country’s finances. While Athens is hitting its deficit targets, this is because spending is below target. Revenues are also below target, a consequence of the continued failure to crack down adequately on tax evasion. Doing so is vital, not least so that taxes on honest citizens don’t have to be raised further.

More generally, Samaras doesn’t seem to be doing enough to combat oligopolistic practices – perhaps because his party is closely associated with some of the country’s oligarchs. The troika should make clear that freeing up markets is essential for Greece’s competitiveness and progress on this front will be a key factor in determining whether to provide further debt relief.

Finally, there is the risk of external shocks. Athens has so far largely dodged the bullet from Cyprus, after Cypriot banks’ branches in Greece were ring-fenced from the deposit haircuts in Nicosia. Even so, trade with Cyprus will plummet and the confidence of Greek depositors has been somewhat shaken.

The real danger would be if the Cyprus crisis deteriorates to such an extent that Nicosia quit the euro. Contagion to Greece would then be harder to avoid.

That said, the outlook for Greece looks far better than it has for years. The country will probably make it.

The fall in 10-year bond yields, which were 4.3 percent on Friday compared to 4.4 percent just before the election, is attributable to two factors. First, nobody wants to bet against the European Central Bank which has promised to do whatever it takes to preserve the euro. Second, the Japanese central bank’s pledge to buy gigantic quantities of bonds at home has buoyed asset prices elsewhere, including in Italy.

The backdrop to the current political crisis is starkly different to that in November 2011, when a sharp increase in bond yields created a panic which led to Silvio Berlusconi being forced out of office. Now none of the three main political blocs – Berlusconi’s centre-right group, the centre-left Democrats and Beppe Grillo’s 5-Star Movement – can govern on its own. But seven weeks have been wasted without a coalition being formed.

Action has now turned to selecting a new president to replace Giorgio Napolitano. An electoral college made up of parliamentarians and representatives from Italy’s regions will on April 18 start the process. The machinations are highly complex, as I discovered in Italy last week, and could yet unblock the situation. But there are many potential pitfalls.

The role of Italian president used to be a largely ceremonial one. But its power has grown under Napolitano who showed how the president could steer the country in a political crisis, for example by replacing Berlusconi with the unelected Mario Monti.

The Democrats have virtually enough votes to appoint their own candidate, somebody such as former Premier Romano Prodi, as president. But they know that this would produce a violent reaction from Berlusconi, leading to new elections. And while there is something to be said for returning to the ballot box, the Democrats’ current leader Pier Luigi Bersani, who performed badly in the last campaign, would not stand in such an election. So he has an incentive to hang onto power by cobbling together some sort of deal.

Bersani’s first hope was to form an alliance with Grillo or some of his supporters, the so-called Grillini. But Grillo has refused to do any deals and the Grillini have refused to be divided too. Meanwhile, Berlusconi is prepared to form a grand coalition with Bersani, but the latter fears this would split his party, many of whom detest the former.

Hence, the manoeuvring over the president. The idea is that if the Democrats agree to a candidate that Berlusconi doesn’t actively object to – somebody like Giuliano Amato, another former prime minister – it might be possible to form some sort of government that isn’t quite a grand coalition.

One option is a minority government led by the Democrats, who are the largest party, which Berlusconi would tacitly support. Another is a so-called president’s government, where the new president would pick his or her own candidate and try to persuade the Democrats and Berlusconi to fall into line.

If the new president had been jointly chosen by the two blocs, the hope is that this might work. In one variation on the theme, Napolitano himself – who is respected across the political spectrum – might be persuaded to continue as president. But the 87-year-old is resisting the idea on the grounds that he is too old.

Even if some government can be stitched together, there’s no guarantee that it can last long or achieve much. Berlusconi would be free to pull the plug whenever he wished.

The only thing that might stop this is the fear of new elections. This might seem odd given that opinion polls now show Berlusconi ahead of the centre-left, albeit not far enough to win an outright majority. SWG has the centre-right 3 points more than the centre-left; Ispo has it 0.3 percentage points ahead.

But Berlusconi’s slim lead could easily melt away given that the Democrats would probably replace Bersani as their candidate with Matteo Renzi, the popular centrist mayor of Florence, in any new election. Renzi, who is a sort of Italian Tony Blair, could probably win votes from Berlusconi, Grillo and Monti’s centrist movement.

Indeed, this is why new elections might be just what Italy needs. Renzi is a fresh face who is promising to reform politics and the economy.

But there are also potential pitfalls with this scenario. For a start, Renzi is reviled by some on the left of his party. If he’s chosen as their candidate, the Democrats could split, robbing him of a majority. Then there’s the fact that he has never run anything substantial. It’s one thing to make good speeches; another to govern in a recession when virtually every decision will be unpopular.

Finally, the whole process of choosing new leaders, calling elections and forming a new government could take another six months. Meanwhile, the economy is shrinking. Government debt is officially forecast to hit 130 percent of GDP. There is a risk that it could rise further, especially if taxpayers have to pump capital into the banking system and the recession continues.

One almost wishes that bond yields would rise to prod politicians to get a move on.