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October 2012

Paper Series
Beyond the Euro Crisis: Implications for U.S. Strategy
by Aaron L. Friedberg

Summary: If the present crisis in the euro results in an economic implosion, Europe could drag others down with it, making it more difficult for the United States to generate the resources necessary to meet other pressing geopolitical challenges. Even if it avoids the worst, Europe as a whole seems unlikely for some time to come to have either the inclination or the energy to do more than just cope as best it can with its own problems. This paper identifies a range of plausible scenarios for the further unfolding of the euro crisis a stronger union, disintegration, and muddling through and considers their implications for U.S. strategy.

Introduction For 45 years after the end of World War II, U.S. strategists worried far more about Europes perceived political, economic, and military weakness than they did about its potential strength. Following the collapse of the Berlin Wall and the end of the Cold War, this pattern was briefly reversed. With the signing of the Treaty of Maastricht, the birth of a United States of Europe seemed finally to be at hand. Possessed of a vast market and nascent institutions of central governance, this new entity was widely seen as having the potential to become a major player on the world stage. While it had long supported the principle of European integration, these developments were met in Washington with a measure of ambivalence. Some observers feared that a more closely integrated Europe would use tariffs and subsidies to gain an unfair advantage in global economic competition. Others warned that it might start on an independent course in foreign and defense policy, diverting resources from traditional mechanisms for transatlantic cooperation, such as NATO, and putting itself at odds with the United States over how best to handle sensitive issues like

Middle East peace and nuclear nonproliferation. The last several years have seen a reversion to the post-war norm, but with one important modification. U.S. policymakers are concerned once again with Europes weakness but, in contrast to the Cold War, they no longer regard the continent as the primary focus of their strategic attention. Instead, over the last two decades, the center of gravity of U.S. strategy has migrated steadily eastward, from Europe to the Middle East and the Persian Gulf and now, with the Obama administrations self-proclaimed pivot, to East Asia. As seen from Washington, Europe is becoming a strategic sideshow and, what is more, it appears increasingly to be a hindrance in dealing with other challenges, rather than a help. If the present crisis results in an economic implosion, Europe could drag others down with it, making it more difficult for the United States to generate the resources necessary to meet other pressing geopolitical challenges. Even if it avoids the worst, Europe as a whole seems unlikely for some time to come to have either the inclination or the energy to do more than just cope as best it can with its own problems. While the more

1744 R Street NW Washington, DC 20009 T 1 202 683 2650 F 1 202 265 1662 E info@gmfus.org

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extreme predictions about Europes future may turn out to be too pessimistic, they are certainly within the realm of possibility. The purpose of this paper is to identify a range of plausible scenarios for the further unfolding of the euro crisis and to consider their implications for U.S. strategy. Having briefly reviewed the underlying causes and dynamics of the current crisis, I will identify three such scenarios. First, it is possible that a near-death experience could give Europe the jolt of political energy required to forge stronger central institutions and a closer union. At the other end of the spectrum of possibilities, it is conceivable that the fissures revealed by the euro crisis could widen to the point that they cause the European Union to split apart. Finally, between these two end points is a range of outcomes that can be grouped under the heading muddling through. Europe may continue to limp along in something resembling its current institutional form, avoiding the worst without truly resolving its underlying contradictions. After describing the pathway that could lead to each scenario I will consider the potential impact, and the implications for the United States, in four concentric geographical spheres: within Europe itself, in the broader Middle East (including the Persian Gulf, the eastern Mediterranean, and North Africa), in East Asia, and globally (at the level of international norms and institutions). Causes1 The euro crisis and the bursting of the U.S. real estate bubble are causally connected, but the two catastrophes also bear a striking resemblance to one another. In each case, the sources of danger were identified in advance by a handful of astute observers and appear obvious in retrospect, but they were either discounted or overlooked entirely by the majority of analysts and decision-makers. In the words of Martin Feldstein, one of those who anticipated Europes troubles over a decade before they began to unfold, recent events are not an accident or the result of bureaucratic mismanagement but rather the inevitable

consequence of imposing a single currency on a very heterogeneous group of countries.2 With the introduction of a common currency in 1999, the nations of the eurozone surrendered the ability to set their own monetary policy, but they retained the right to tax and spend as they saw fit. In deference to long-standing German fears of inflation, the European Central Bank that was set up to administer the new currency had price stability as its primary objective. Over the course of the subsequent decade, the ECB worked to keep inflation and interest rates low. This helped Germany to restrain wage growth, implement much-needed labor market reforms, and improve productivity, which, in turn, enabled increased competitiveness, leading to rising exports and growing current account surpluses. But low interest rates throughout the eurozone also made it easier for governments and households in other countries, especially those in the south to borrow, spend, and go more deeply into debt. Cheap money helped to sustain large public sectors, generous social welfare programs, and consumer spending. In several countries, as in the United States, low interest rates also fueled a rapid run-up in real estate prices. In contrast to Germany and some of the other northern economies, reforms were deferred, labor costs grew relatively rapidly, competitiveness declined, and current account deficits ballooned. In pre-euro Europe, such imbalances would have been corrected by some combination of rising interest rates and declining exchange rates. Under the new dispensation, however, national governments no longer had the ability to manipulate these instruments of policy. Provided that others were willing to buy their debt, they could, however, continue to borrow in order to fund their growing fiscal and current account deficits. Until the onset of the global financial crisis, investors made no distinction between bonds issued by Germany and those of Greece or Ireland or Spain; all were assumed to carry equal, minimal risk. This began to change in the wake of global financial crisis. As growth slowed across much of the advanced industrial world, tax revenues declined, government spending increased, debt deepened, and the ratio of debt to GDP rose. Countries in which this indicator was already relatively high saw an especially alarming deterioration.
2 Feldstein, The Failure of the Euro, p. 105. See also Feldstein, EMU and International Conflict, pp. 60-73.

1 For useful overviews of the underlying economic dynamics of the crisis see Erik Jones, The Euro and the Financial Crisis, Survival vol. 51., no. 2 (April-May 2009), pp. 41-54; Alexander Nicoll, Fiscal Union by Force, Survival vol. 53, no. 6 (December 2011-January 2012), pp. 17-36; Martin Feldstein, The Failure of the Euro Foreign Affairs vol 91, no. 1 January/February 2012, p. 1051-116.

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Fearful that some governments had now gone so deeply into debt that they might be unable to make good on their obligations, investors began to demand higher interest rates in order to compensate for the perceived increase in risk. Starting in early 2010, the yields on long-term bonds issued by various eurozone nations began to diverge, with those of Greece, Portugal, Ireland, and, to a lesser extent, Spain and Italy increasing the most dramatically. Albeit to varying degrees, all of these countries were soon seen to be in danger of slipping into a self-reinforcing downward spiral, in which higher borrowing costs would contribute to deeper government deficits, mounting debt, rising investor fears, further increases in interest rates and debt burdens, and ultimately, the possibility of default. National financial crises also threatened the solvency of commercial banks in the affected countries, many of which saw their large holdings of government bonds diminish in value at the same time as they were forced to write off bad private sector loans. As the crisis deepened, there were growing worries about contagion. Even in countries with comparatively healthy public finances, like France and Germany, banks holding substantial quantities of private and sovereign debt in troubled economies found themselves at risk. As always in such situations, psychological factors loomed large. Whatever the objective indicators might suggest at any given moment, investor anxieties about the future threatened to create self-fulfilling prophecies, as the demand for everhigher risk premiums pushed one country after another to the brink of default. Scenarios Since the start of 2010, a combination of actions by national governments and multinational institutions has been sufficient to stave off disaster, but even the most optimistic observers do not believe that these measures have put Europe on a clear path to stability and sustained growth. Across the continent, governments have sought to reduce fiscal deficits by slashing spending and raising taxes. In the most serious cases, austerity has been imposed as a precondition for loans intended to enable governments to continue to finance their debt at sustainable cost from regional and international financial institutions. Low cost lines of credit have also been made available to prevent bank failures and insure the continued functioning of the European financial system. In addition to their more

concrete effects, all of these emergency measures are intended to reassure investors, stabilize markets and restore the normal processes of economic growth. At this writing (late September 2012), the situation remains highly volatile and the array of alternative futures is exceptionally broad. Depending on how events play out, Europe, and the world, could look very different six months or a year from now than they do today. That said, and acknowledging the possibility of hitherto unforeseen black swans, there are three basic scenarios (or families of scenarios) that together incorporate a significant portion of what appear at this point to be plausible outcomes.

Depending on how events play out, Europe, and the world, could look very different six months or a year from now than they do today.
An Alexander Hamilton Moment3 The very gravity of the current crisis, and the deep flaws that it has revealed in the foundations of the European project, could provide the impetus for fundamental reforms. Faced with the prospect of collapse and even chaos, leaders and publics may be willing to accept measures that they have hitherto rejected. More specifically, national governments may consent to granting even greater control over economic policy to central European institutions. Some observers have drawn an analogy to the early years of U.S. history. The American founders tried at first to build a nation in which virtually all decisionmaking authority was dispersed among the 13 original states. Within a few years, they were forced by the evident weakness of their initial design to draft a new constitution that granted considerable authority to the federal government.4

3 This phrase is borrowed from David McCormick, Europe needs its own U.S. fiscal union moment, Financial Times (June 20, 2012). 4 In addition to McCormick, see Charles A. Kupchan, Centrifugal Europe, Survival vol. 54, no. 1 (February-March 2012), pp. 111-118.

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Similarly, if they wish to preserve their Union, the individual European states may have no choice but to endow it with a great deal more power. In this view, as two highranking former officials put it, the only cure for what ails Europe is more Europe.5 The precise details of what this might entail are a topic of intense debate, but most observers agree that, if the euro (and perhaps the EU) are to survive, the states of the eurozone will have to harmonize their tax and spending policies, perhaps creating some kind of fiscal union with the power to do more than set notional targets for national governments.6 Some also urge enhancing the powers of Europes central banking institutions, giving them the resources and the authority necessary to insure deposits, buy the debt of troubled economies, and issue Eurobonds backed by the full faith and credit of the entire EU.7

darity, and faith in European institutions, that are now in very short supply. Assuming that an immediate catastrophe can be avoided, and these political obstacles overcome, Europe as a whole could be on a path to sustained stability and renewed growth. But the road to recovery will not be short and success is by no means assured. Reducing fiscal deficits and debt-to-GDP ratios will take time, and the process will tend to depress economic growth for years to come. As they struggle to put their finances in order, the nations at the center of the crisis will also have to undertake structural reforms that are going to be all the more painful for having been deferred for so long.8 In order to boost their competitiveness and increase exports, these countries are going to have to reduce costs, presumably through some combination of labor market reforms that will suppress the growth in wages, and the introduction of new technologies and management techniques to improve productivity.9 Nor is this a challenge faced only by Europes weaker economies. Over the last two decades, the gap in labor productivity between the EUs original 15 members and the United States, which narrowed considerably between the 1970s and the mid-1990s, had begun to widen once again. As a matter of simple arithmetic, the only way to sustain increases in national income, aside from population growth, is through improvements in productivity. The low birth rates prevailing across much of Europe mean that such increases in output per worker are essential to its future prosperity. As a recent analysis by McKinseys Global Institute concludes: given Europes stagnant population growth, it could be trapped in low GDP growth at or around 1.5 percent unless it can capture some new driver of accelerated productivity growth.10 Unfortunately, at this point, it is not clear whether, and if so where, such a driver can be found.

If they wish to preserve their Union, the individual European states may have no choice but to endow it with a great deal more power.
All such proposals face strong political opposition. States in poor financial condition worry that they will be subjected to harsh austerity measures for many years to come. Those in better shape fear that they will be forced to pay part of the price for their neighbors improvidence. Successful reform would appear to depend on the ability of political leaders to generate precisely the sense of European soli5 Kemal Dervis and Javier Solana, Could the euro destroy the EU? Europes World no. 21 (Summer 2012), pp. 8-15. 6 Some have suggested that the crisis has already begun this process of harmonization, in effect creating a fiscal union by force the force of financial markets. See Nicoll, Fiscal Union by Force, p. 18. 7 For a skeptical analysis of many of the proposals for reform, see Feldstein, The Failure of the Euro. For the details of one plan reportedly being discussed by top Euro-crats during the summer of 2012, see Konstantin von Hammerstein, Christoph Pauly, and Christoph Schult, Planning for the Future: A Sneak Peek at Tomorrows Europe, Speigel Online, June 11, 2012. http://www.speigel.de/international/europe/ europe=lloks-at-plans-for-political-union-and-budgetary-oversight-a-838142-druck.html.

8 On the need for labor market reforms, especially in the service sector, see Howard Davies, Sorting fact from fiction on Europes economic stagnation, Europes World no. 21 (Summer 2012), pp. 56-59. 9 Nemat Shafik, Deputy Managing Director, International Monetary Fund, Reviving Growth in Europe, Remarks at Brussels Economic Forum, May 31, 2012. http://www. imf.org/external/np/speeches/2012/053112.htm 10 Charles Roxburgh and Jan Mischke, European growth and renewal: The path from crisis to recovery, McKinsey Global Institute, July 2011, p. 13. http://www.mckinsey. com/insights/mgi/research/productivity_competitiveness_and_growth/european_ growth_and_renewal_path_to_recovery

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In sum, even if Europe has its Alexander Hamilton moment and emerges from the current crisis not only intact but more unified, it will still have its work cut out for it. Merely avoiding catastrophe will not be enough to preserve Europe from a future of slow growth and a dwindling share of world wealth and power. Meltdown At the opposite end of the spectrum of possibilities would be a series of developments leading to the unraveling of the eurozone and perhaps, although the first would not necessarily guarantee the second, the collapse of the European Union itself. This outcome would most likely be the result of some mix of policy errors and market panic. If one country abandons the euro (Greece being the most likely candidate at this point), defaults on its debts, and reverts to a national currency, it may trigger a cascade of events that would be difficult, and perhaps impossible, to control. International capital markets might respond to this decision in ways that would compel other governments to follow a similar path, regardless of their initial intentions. Martin Feldstein describes one variant of this scenario: If Greece leaves and devalues, global capital markets might assume that Italy will consider a similar strategy. The resulting rise in the interest rate on its debt might then drive Italy to in fact do so. And the competitive pressure might force France to leave the eurozone and devalue a new franc. At that point, Feldstein concludes, the European Monetary Union would collapse.11 The economic and political costs of such an eventuality are likely to be so large that, until very recently, few observers were prepared to consider it seriously. While it rated the probability of a breakup of the eurozone at close to zero, a September 2011 study by UBS sought to estimate the impact on individual nations of abandoning the euro. In the case of a weaker country, the near-term effects would include a sharp drop in the value of the restored national currency relative to the euro, a steep increase in the cost of capital as borrowers demanded high-risk premiums in the wake of sovereign and widespread corporate default, a decline in trade as other countries imposed tariffs to offset the effects of currency devaluation, and losses due to bank failures. Taking all these factors into account, the
11 Feldstein, The Failure of the Euro, p. 115. For another variant, which traces the contagion from Greece to Spain to the other big European economies, see Gerald ODriscoll, How the Euro Will End, Wall Street Journal, June 12, 2012.

authors concluded that withdrawal would result in a loss of between 40 percent and 50 percent of GDP in the first year alone, with continuing costs of roughly one-third that amount in subsequent years. By contrast, a relatively strong country like Germany would suffer severe but somewhat less drastic consequences; on the order of 20 to 25 percent of GDP in the first year and perhaps half that much for an indefinite period thereafter.12 The UBS study did not attempt to calculate the costs for Europe as a whole of the unraveling of the eurozone, but it did suggest that these could be even higher than merely the sum total of the losses incurred by each individual nation. Because continent-wide economic turmoil could result in civil unrest and possibly even interstate conflict with unforeseeable long-term effects, the costs of a breakdown are too great to quantify in bald cash terms.13 Without delving into such dark possibilities, Andrew Moravcsik concludes simply that if the euro fails, Europe will face a long-term economic catastrophe that could drain its wealth and power for the rest of the decade and beyond.14

Because continent-wide economic turmoil could result in civil unrest and possibly even interstate conflict with unforeseeable long-term effects, the costs of a breakdown are too great to quantify in bald cash terms.

12 Stephane Deo, Paul Donovan, Larry Hatheway, Euro break-up the consequences, UBS Investment Research, Global Economic Perspectives, September 6, 2011. 13 Ibid. 14 Andrew Moravcsik, Europe After the Crisis: How to Sustain a Common Currency, Foreign Affairs vol. 91, no. 3 (May/June 2012), pp. 54-68.

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Muddling Through Despite drastic warnings and calls for dramatic action, it is possible that the current crisis could end not with a bang but with a whimper. If ways can be found to limit the danger of contagion, one or two of the weaker countries might be able to revert to their national currencies without causing the entire eurozone to collapse. Alternatively, European governments and institutions may be able to stitch together a package of emergency programs sufficient to stabilize the situation in the most troubled economies and to achieve a degree of policy coordination adequate to prevent an immediate recurrence of crisis conditions, without necessarily creating new and more powerful mechanisms for centralized economic management. While the consequences of a diminished single currency area are less obvious and would presumably depend on which countries remained, the preservation of the eurozone through a series of half measures is unlikely to lead to marked improvements in economic performance. To the contrary, almost by definition, muddling through would leave underlying problems unresolved and prone to reemerge. Daniel Mockli of the Center for Security Studies in Zurich describes the manifestations of this scenario (which he regards as the most plausible): There will be more of the same in terms of austerity, adjustments, EU late-night summit meetings, and rescue packages. For crisis-hit countries at Europes periphery, this will mean long periods of hardship, with ever growing social costs. But the eurozone and the EU proper face difficult years ahead too. The bottom line of all this is that the EU will likely remain bogged down in crisis management for years to come.15 Implications Europe In his 1997 essay, Feldstein warned that the creation of a monetary union could paradoxically end up increasing the risks of war among its members. Over time, efforts to hold the union together would inevitably lead to conflicts over economic policies and interference with national sovereignty which, in turn, would tend to reinforce longstanding animosities based on history, nationality, and religion. The fact that the founding documents of the EU and
15 Daniel Mockli, The strategic weakening of debt-ridden Europe, Strategic Trends 2012 (Zurich: Center for Security Studies, 2012), p. 42.

the European Monetary Union contained no mechanisms for withdrawal made matters worse. As Feldstein warned: The American experience with secession of the South may contain some lessons about the danger of a treaty or a constitution that has no exits.16 Whatever their differences over economic policy, it is thankfully extremely difficult to imagine a scenario in which the members of the eurozone as presently constituted would have either the capability or the desire to wage war on one another. Greeks may be angry at the German government for imposing austerity on them, but Greece simply does not have the means with which to project military power against Germany. Germans may resent Greece for what they see as its fiscal irresponsibility, but they would probably be happier to see it go than to fight to keep it in the eurozone. The one caveat to these rather obvious points is that the further playing out of the current crisis could lead to radical shifts in the domestic politics of at least some of the countries involved. Nations in which unemployment has reached unprecedented heights and social safety nets are fast unraveling could be subject to severe civil unrest, dramatically increased support for fringe political parties of the left and right, and perhaps even shifts in the character of their domestic political institutions away from democracy and toward some form of authoritarianism.17 Seeking to rally support and deflect popular resentment of poor economic conditions, extreme nationalist governments might adopt belligerent attitudes towards other countries

The further playing out of the current crisis could lead to radical shifts in the domestic politics of at least some of the countries involved.
16 Martin Feldstein, The EMU and International Conflict, Foreign Affairs vol. 76, no. 6 (November/December 1997), pp. 60-73. Quote from p. 72. 17 As the UBS study notes, past instances of the unraveling of monetary unions have sometimes resulted in the collapse or overthrow of democratic governments and the rise of authoritarian regimes. Euro break-up: the consequences, p. 15.

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or perhaps towards unpopular domestic groups. With the possible exception of conflicts involving immediate neighbors, most states would still lack the capacity to use force in a meaningful or effective way against their imagined foreign enemies, but this does not mean they could not do considerable damage in trying. Instead of conquering the world, or even one another, todays European nations are, in the words of Francois Heisbourg more likely to hurt themselves, along the lines of the wars of Yugoslav succession in the 1990s. In contrast to the immediate post-Cold War era, however, there might be few mechanisms available with which to restore order and keep the peace. If the EU unravels due to disputes among core member states, NATO, too, could be badly weakened, and without this traditional platform to support and legitimize its actions, the United States would be far less likely to intervene. Given its shifting assessment of its own interests, Washington might have little inclination to do so in any event. As Heisbourg suggests, in the aftermath of a meltdown scenario the U.S. may well turn its back on [a] newly Balkanised post-EU Europe.18 Putting aside such nightmarish possibilities, the playing out of the crisis within the eurozone seems certain to result in heightened tensions among its members. A protracted period of muddling through will likely yield further frayed nerves and deepening resentments, especially between Germany and the states of southern Europe, and perhaps between Germany and France as well. Even if the present crisis leads eventually to a strengthening of central institutions and a greater harmonization of national economic policies, it will be as the result of a bruising process of negotiation and compromise that will leave no one entirely happy or satisfied. A forced, shotgun wedding is more likely to be followed by an extended period of cautious reconciliation and halting efforts to reestablish trust than by a blissful honeymoon. To one degree or another then, the current crisis is going to reinforce pre-existing tendencies towards introversion, if not solipsism. For some time to come, the great bulk of the political energy in European capitals is going to be directed at consequence management, restoring growth, ensuring
18 Francois Heisbourg, The defence of Europe: Towards a new transatlantic division of responsibilities, in Francois Heisbourg, Wolfgang Ischinger, George Robertson, Kori Schake, and Tomas Valasek, All Alone? What U.S. retrenchment means for Europe and NATO (London: Centre for European Reform, 2012), p. 36.

If the EU unravels due to disputes among core member states, NATO, too, could be badly weakened, and without this traditional platform to support and legitimize its actions, the United States would be far less likely to intervene.
social stability, preserving domestic support, and managing relations with other governments, and within the institutions of the EU, whatever their eventual form. In the worst-case scenario of intra-European conflict, U.S. policymakers would face decisions about whether and to what extent to commit scarce resources to help keep the peace and restore stability. While there might be some inclination to turn away and leave the Old Continent to its own devices, in the end, the United States would probably end up intervening to help contain the economic, humanitarian, and geopolitical costs of a total European meltdown. If Europe somehow emerges from the current crisis with its central institutions strengthened, Washington will need to learn how to work with them effectively, perhaps taking the opportunity to finally shift its focus away from NATO and towards truly independent and capable EU security institutions. On the other hand, if Europe muddles through, the United States will likely seek to keep traditional transatlantic security mechanisms afloat, even as it pursues deeper strategic cooperation with a handful of key countries that retain some capacity for independent action. Of these, France and Britain have already shown an inclination to work more closely with each other, and with the United States. The biggest questions surround the future disposition of Germany, which is likely to emerge from the crisis with its influence enhanced, but which still has a strong aversion to employing the instruments of hard power.

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The Near Abroad Even under the most optimistic assumptions about the course of the current crisis, Europe faces a period of sustained, deep cuts in military budgets. Here again, the trends are not new. Compared with the period 1985-1989, by 2010, NATOs European members had collectively reduced military expenditures from an average of 3.1 percent to only 1.7 percent of GDP.19 Since the onset of the crisis, in an effort to narrow budget deficits and bring debt under control, virtually every European government has made further reductions in planned spending, with the larger and more capable states like Germany and the U.K. cutting close to 8 percent, the medium-sized powers 10-15 percent, and the smaller, poorer countries like Lithuania and Bulgaria as much as 30 percent.20 Coming on top of two decades of steady shrinkage, these dramatic reductions are resulting in serious losses of capability. Systems necessary for projecting power have been especially hard hit. Germany is retiring existing submarines, transport aircraft, and fighter-bombers and scaling back plans for procuring new ones. France is closing many of its remaining overseas bases and military installations, especially in Africa, and delaying acquisition of aerial refueling and transport aircraft. The decommissioning of the aircraft carrier Ark Royal has sharply diminished the Royal Navys ability to project military power and has been described by one observer as having essentially ended the era of Great Britain as a world power.21 Further cuts may be in the offing. This is especially likely to be the case if Europe continues to muddle through, but even if the crisis results eventually in the strengthening of European institutions, it will leave a fiscal mess that could take years to clean up. At the start of 2011, the European Commission estimated that the EU states as a group would have to devote 1 percent of their collective GDP to loan repayments over the next 20 years, a figure equivalent to half the total defense spending of NATOs European members.22 While the situation will vary by country, the
19 Jorge Benitez, U.S. and European Defense Cuts: A Race to the Bottom, Atlantic Council, August 31, 2011. Http://www.acus.org 20 Claudia Major, Christian Molling, and Tomas Valasek, Smart but too cautious: How NATO can improve its fight against austerity, (London: Centre for European Reform, 2012), p. 2. 21 Patrick Keller, Challenges for European Defense Budgets after the Economic Crisis, (Washington: American Enterprise Institute, July 2011), p. 4. 22 Smart but too cautious.

longer the crisis drags on, the higher debt levels are likely to rise and the greater the downward pressure on defense will become. With times tough at home, and external threats abstract, at best, it is to be expected that European publics and their elected representatives will continue to show a strong preference for cutting military expenditures while struggling to preserve social welfare programs.

It is to be expected that European publics and their elected representatives will continue to show a strong preference for cutting military expenditures while struggling to preserve social welfare programs.
Numerous analysts have suggested that the fiscal crisis could present a powerful inducement, indeed an imperative, for closer European defense cooperation. While this is possible, and would certainly be desirable, there are reasons to be skeptical of how much can actually be accomplished. In an era of declining budgets, dwindling force structures, and general economic malaise, governments will be under considerable pressure to protect indigenous capabilities, jobs, and industrial capacity. In addition to economic factors, there are serious political and strategic obstacles to a genuine pooling and sharing of military resources. As differences over the recent intervention in Libya suggest, European countries may at times disagree over when it is appropriate to use force, and the decision of one government to opt out of a mission could cripple a truly joint operation. This would be especially problematic if the states of Europe were to try to rationalize their collective capabilities through a division of labor scheme in which different national forces were given responsibility for particular tasks, such as reconnaissance and lift.23 Even a Hamilto23 See the discussion in Heisbuorg, The defence of Europe, p. 34.

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nian scenario that produced more closely coordinated economic policies seems unlikely to dispel such concerns. The impact of a eurozone meltdown on national military capabilities is difficult to predict. On one hand, the devastating economic effects of such a disaster would impose even tighter constraints on resources. At the same time, the unraveling of Europe could produce mistrust, resentment, and a more threatening security environment. In its aftermath, some states might feel the need to bolster their military capabilities in order to defend their borders, deal with internal unrest, and prepare for a highly uncertain future. Depending on the extent of the damage caused to institutions like the EU and NATO, a financial meltdown could result in the substantial renationalization of defense as well as economic policies all across Europe.

torships do not become hostile Islamist states or dissolve into chaos. Unfortunately, non-military means have already proven to be insufficient to prevent a bloody civil war in Syria and they seem unlikely to be adequate to dissuade Iran from moving further towards acquiring nuclear weapons. If it decides to intervene in Syria, or is compelled to take action against Iran, the United States will undoubtedly turn to its European allies for help. Even if some of them have the will, as budget cuts proceed, even the most capable among them may lack the wherewithal to do much more than provide a multilateral cloak for what would for all practical purposes be unilateral U.S. action. Asia Well before the announcement of the Obama administrations pivot, the United States had already begun to shift its strategic focus from Europe towards Asia. The process of what has since come to be referred to as rebalancing started to get underway at the turn of the century but was delayed for almost a decade by the terrorist attacks of September 11, 2001 and the subsequent wars in Afghanistan and Iraq. With the winding down of those conflicts, U.S. strategists have begun to lift their eyes from the Middle East and Southwest Asia and to concentrate more intently on East Asia and the Indian Ocean. For the time being, however, their ability to take action to counterbalance what is widely perceived as Chinas growing power and increasing assertiveness has been limited by the onset of the United States own financial crisis. In part because of the constraints under which they now feel themselves to be operating, U.S. policymakers have been especially eager to engage others in a collective effort to balance Chinese power. While attention has naturally been concentrated primarily on the United States regional friends and allies, in the last several years there has also been increasing discussion on both sides of the Atlantic of Europes stakes in Asia. In addition to substantial economic ties, European governments have begun to consider whether their countries have broader strategic interests in the region and, if so, how these can best be served. At a minimum there is growing recognition, first, that conflict in Asia would have a direct and harmful impact on the functioning of the global economy and, second, that Chinese behavior could itself be a source of instability.

A financial meltdown could result in the substantial renationalization of defense as well as economic policies all across Europe.
In sum, the playing out of the current crisis seems likely to result in a further diminution in Europes collective military capabilities as well as its appetite for using them. Although some may eventually emerge with bigger budgets and stronger forces, even the nations that have traditionally had the capacity to project power to other regions are going to experience cutbacks. To the extent that U.S. strategists hope to engage Europe as a whole in new overseas military ventures, or even to rely on it to police its own backyard, they are likely to be disappointed for the foreseeable future. Faced with these realities, U.S. policymakers may prefer for the time being to focus on developing a common, transatlantic soft power approach to dealing with the aftershocks of the Arab Spring. While their ability to influence events will be limited, Americans and Europeans share a strategic interest in seeing that the nations of North Africa and the Middle East that have cast off long-standing secular dicta-

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Europes contributions to the Asian balance of power were never going to be primarily direct and military, a fact that is merely underscored by recent and planned reductions in defense budgets. Despite this obvious limitation, individual European capitals, and Europes collective institutions, have other instruments at their disposal. When the EU joins with the United States to declare its commitment to finding peaceful, diplomatic, and cooperative solutions to disputes over territory and resources in the South China Sea, it sends a signal to Beijing that unduly aggressive behavior will have a harmful impact on relations with Europe.24 Similarly, when individual European governments resist Chinese efforts to silence their criticism of its human rights record (as many did when, over Beijings protests, they sent representatives to Oslo for the awarding of the Nobel Peace Prize to jailed dissident Liu Xiaobo), they demonstrate their continued commitment to universal principles, despite the potential risk to their economic interests. Through their policies on exports, investment, and technology transfer, European governments can also act in ways that will indirectly influence the balance of hard power in Asia. If the EU were to abandon its postTiananmen embargo on arms sales to China, the pace of Peoples Liberation Army modernization would increase, though by how much and in what areas is open to debate. The stringency with which governments monitor and regulate Chinese investment in firms involved in sensitive dual use technologies will also have an impact on the ability of the United States and its advanced industrial allies to maintain a qualitative edge in key areas of military capability. On the other side of the balance sheet, European firms could become quite active in helping other Asian states to strengthen their armed forces, either by selling them finished products or by collaborating in the development and manufacture of weapons and other military systems. The inclination of individual European governments, and of Europe as a whole, to take steps that would constrain or counter Chinas growing power has been undercut by the onset of the current crisis. As a recent study by Francois Godemont and Jonas Parello-Plesner points out, just as the EU was beginning to develop a more coordinated and tougher strategy towards China across a range of issues,
24 U.S.-EU Statement on the Asia-Pacific Region, Phnom Penh, Cambodia, July 12, 2012. http://www.state.gov/r/pa/prs/ps/2012/07/194896.htm

The inclination of individual European governments, and of Europe as a whole, to take steps that would constrain or counter Chinas growing power has been undercut by the onset of the current crisis.
the effects of the economic crisis are now fracturing Europes embryonic unity and making it much harder to implement this new approach.25 European governments eager for China to buy their debt and invest in their weakened economies are likely to be even more cautious than usual about antagonizing it with unwelcome pronouncements or policies, including those designed to restrict access to sensitive technologies or to improve the military capabilities of Asian states other than China. The divisive effects of the crisis have also made it harder for Europe to present a united front and easier for Beijing to cultivate ties with key countries and to discourage the formulation and implementation of common policies that would run counter to its interests. Persistent weakness of the sort envisioned in a muddling through scenario will exacerbate these tendencies, lessening Europes ability to work with the United States in defining and pursuing common strategic goals in Asia. The fragmentation of European political institutions that could accompany a financial meltdown would leave even the largest states at a disadvantage in one-on-one negotiations with Beijing. Under these circumstances, China would find it easier to extract concessions on access to sensitive technologies, including weapons systems, and to bend individual European countries to its will on a range of economic and diplomatic issues. By contrast, a stronger, more unified Europe would be better positioned to stand up to China and, assuming that its members chose to do
25 Francois Godemont and Jonas Parello-Plesner with Alice Richard, The Scramble for Europe, European Council on Foreign Relations (July 2011), p. 1.

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so, it could make significant contributions to bolstering strategic stability in Asia. While its ability to achieve them will vary depending on what happens in Europe, Washingtons objectives are likely to remain constant across these scenarios. At a minimum, it will seek to dissuade European governments from doing anything that could accelerate unfavorable trends in the Asian balance of power. To the contrary, where possible, it will encourage policies that have the opposite effect, whether by slowing the growth of Chinese military capabilities or enhancing those of other Asian nations. Outside the realm of hard power, the United States will attempt to maximize its leverage, presenting China with a united front on economic and diplomatic issues by appealing to the interests and values it shares with Europe. Global Regardless of the outcome of the eurozone crisis, the coming decades will be marked by the continuation of a phenomenon sometimes described as the rise of the rest, the ongoing diffusion of wealth and power from west to east and from north to south that first became evident in the 1970s and 1980s with the emergence of Japan and the other Asian tigers, and has been intensified since the 1990s by the rapid growth of China, India, and Brazil, among others. As has already been suggested, how the current crisis plays out could accelerate or slow Europes relative decline but, barring catastrophe in other parts of the world, it is not going to reverse it. That said, over the next several decades, the slope of Europes trajectory could have a major impact on the structure and functioning of the international system. Taken together, the nations of Europe have vast resources at their disposal. Working in combination with the United

States and the other advanced industrial democracies, they can use these to help defend and spread the values that, whatever their differences, all share in common: a belief in the virtues of liberal democracy, the rule of law, the protection of individual rights and freedoms, market-oriented economics, and the peaceful resolution of international disputes. A Europe that is economically weak and politically divided will inevitably punch below its weight, exerting less influence than it could, given the raw capabilities of its constituent parts. Unfortunately, absent a turn around that is not yet in view, it seems increasingly likely that this will be the case. While they may overstate its influence before the crisis, many observers note that recent events have damaged Europes soft power, and, in particular, the attractiveness of its model for domestic development and regional integration. According to Rob de Wijk of the Hague Centre for Strategic Studies, Europes declining appeal means it can no longer set an example for regional development elsewhere, thus further undermining its power to shape the international agenda.26 Austerity and slow growth will also mean that fewer funds are available for development assistance and other programs that have served as instruments of European influence in Africa, the Middle East, and other regions. In what may appear to Americans as a somewhat belated discovery of the continuing importance of hard power, some analysts have also pointed out that the shrinkage of defense budgets will diminish Europes ability to shape events, and not only through active intervention. Nick Witney, Chief Executive of the European Defence Agency, argues that a key function of hard power, as ever, is to work on the perceptions of other competitors whether by persuading the Chinese leadership that Europeans are not so decadent that they will not at some point be prepared to stand up for their own interests; or in emboldening a people, as in Libya, to revolt against their dictator. As Witney notes: in the not-as-yet-post-modern world, nothing conveys resolve so clearly as a willingness to make the sacrifices involved in maintaining armed forces and, from time to time, employing them. If it continues to cut capabilities, Europe risks being marginalized in a world
26 Rob de Wijk, The geopolitical consequences of the -crisis, Europes World no. 21 (Summer 2012), p. 21. On Europes loss of soft power, see also Walter Russell Mead, The Euros Global Security Fallout, Wall Street Journal (June 19, 2012).

How the current crisis plays out could accelerate or slow Europes relative decline but, barring catastrophe in other parts of the world, it is not going to reverse it.
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where newer and more hard-nosed powers make the rules and assert their interests and values while Europe retreats into retirement.27 Such a development would obviously be contrary to U.S. interests. As it works to bolster and reinvigorate the order that it did so much to create, the United States is going to need all the help it can get. While its role can only be indirect, and while it will remain preoccupied with its own problems for some time to come, Washington needs to do what it can to encourage Europe to dig its way out of its economic difficulties, avoid the disintegration of its political institutions, and slow, if not reverse, the accelerating trend toward demilitarization. It may be possible, and at times even preferable, for the United States to address some problems in collaboration with a handful of allies. When it comes to global issues, however, there is no substitute for a unified Europe. Although it has yet to fulfill its potential, the EU could be a powerful force for good in the wider world, especially if it chose to align and coordinate its policies and programs with those of the United States, Japan, and the other advanced industrial democracies. Conclusions From a U.S. perspective, it is tempting, and in a sense reassuring, to see the eurozone crisis as marking little more than an acceleration in long-standing tendencies toward introversion, demilitarization, a diminished share of global wealth, and a dwindling voice in world affairs. For a number of reasons, however, this view is overly sanguine. Even if Europe is destined to decline, the pace at which it does so could be consequential. Coinciding as they do with the United States fiscal crisis and post-war fatigue, Europes troubles could lead to a dangerous diminution of overall Western engagement at a critical moment in various hot spots. Along with problems that may metastasize in the relatively near term (including Syria, Iran, and Afghanistan) there are also emerging long-term challenges to U.S. and European interests that will be far more difficult to manage without a coordinated, collective response. In addition to Chinas rise and the potential destabilization of large parts of the Middle East and North Africa in the aftermath of the Arab Spring, there is the likelihood that an Iranian
27 Nick Witney, How to Stop the Demilitarisation of Europe, European Council on Foreign Relations (November 2011), pp. 6-7.

bomb could trigger a new wave of nuclear proliferation. Finally, it is conceivable that events could unfold in new and highly disruptive ways, perhaps triggering a worldwide depression or the reemergence of armed conflict within Europe itself. The United States has every reason to hope that Europe will emerge from the current crisis stronger, more unified, and more capable of acting as a full partner in dealing with the strategic challenges of the 21st century. At this point, however, it must be said that such an outcome does not appear likely. The avoidance of disaster, and a continuation of previously existing trends, may be the best that can reasonably be expected. This is not good news, to be sure, but it reinforces an important conclusion: regardless of how the current crisis unfolds, but especially if it goes poorly, reinvigorated transatlantic dialogue, and enhanced cooperation, will be essential to the security of both the United States and its European partners.

About the Author

Aaron Friedberg is a Non-Resident Senior Fellow with GMFs Asia program and a professor of politics and international affairs at Princeton University.

About The EuroFuture Project

The German Marshall Fund of the United States understands the twin crisis in Europe and the United States to be a defining moment that will shape the transatlantic partnership and its interactions with the wider world for the long term. GMFs EuroFuture Project therefore aims to understand and explore the economic, governance and geostrategic dimensions of the EuroCrisis from a transatlantic perspective. The Project addresses the impact, implications, and ripple effects of the crisis in Europe, for the United States and the world. GMF does this through a combination of initiatives on both sides of the Atlantic, including large and small convening, regional seminars, study tours, paper series, polling, briefings, and media interviews. The Project also integrates its work on the EuroCrisis into several of GMFs existing programs. The Project is led by Thomas KleineBrockhoff, Senior Transatlantic Fellow and Senior Director for Strategy. The group of GMF experts involved in the project consists of several Transatlantic Fellows as well as program staff on both sides of the Atlantic.

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