Hugo Dixon

The last Italian prime minister whose surname began with a “B” – Silvio Berlusconi – was a disaster. The country’s next leader’s name is also likely to start with a “B”.

Investors want Mario Monti, the technocrat who took over from Berlusconi last year, to stay as prime minister after the election, which will probably be in March. But they are more likely to get Pier Luigi Bersani, leader of the left-wing Democratic Party (PD). While there are risks, such an outcome may not be as bad as it looks – not least because Bersani has promised to continue with Monti’s policies and was one of the few reformers when Romano Prodi was prime minister in the last decade.

Trade union-backed Bersani will be the standard-bearer for the left in the coming elections after winning a decisive primary at the weekend against Matteo Renzi, the modernising mayor of Florence. His first comments were promising: he said the PD would have to tell Italians the “truth, not fairy-tales” about the country’s grave economic situation.

What happens next is the subject of feverish speculation and intrigue in Rome, where I spent part of last week. Will the PD and its allies, the radical-left SEL – who collectively have a firm lead in the opinion polls with 36 percent support, according to SWG – be able to secure an overall majority in the election? Or will parliament, which Berlusconi’s centre-right coalition still dominates, change the voting system to deny them that chance? The current electoral law guarantees the coalition with the largest number of votes at least 55 percent of the MPs but there are various schemes under discussion to cut the so-called winner’s premium.

Another topic of speculation is whether Monti will endorse a new movement set up by Luca Di Montezemolo, the Ferrari boss, whose avowed intent is to gather enough votes to secure the technocrat’s continuation as premier? And what about Berlusconi, who received an initial conviction for tax fraud in October? Will he re-enter the political fray by forming a new party?

Finally, how well will Beppe Grillo, the comedian who wants to default on Italy’s debts and pull it out of the euro, do? His Cinque Stelle movement, which defies categorisation on the standard left-right spectrum, is currently polling 20 percent.

Italian politics is always colourful. But what happens in the election is no joke. Despite the European Central Bank’s promise to do whatever it takes to save the euro, Italy still stands fairly close to the financial precipice. If it falls in, the rest of the euro zone will be dragged in too.

The country’s main problems are its recession and high debt. Italy is forecast to shrink by 2.3 percent this year and end the year with debt equal to 126 percent of GDP, according to the European Commission.

The government expects the economy will start growing again in the second half of next year. But consumer confidence is shot to bits, investment is being delayed by political uncertainty, previous rounds of austerity are depressing activity and interest rates are still uncomfortably high. If the economy fails to turn around, debt will rise above 130 percent of GDP. If, at the same time, Italy has a government that is not committed to reform, investors could suffer a new bout of jitters.

Predicting what will happen in Italian politics is tricky, given the large number of moving parts. That said, the right is in such disarray that it is unlikely to be a major force in the next election: Berlusconi’s old party, the PDL, is scoring 14 percent in the opinion polls; its former partner, the Northern League, is on only 6 percent. Meanwhile, even if Grillo does well in the election, he doesn’t want to get involved in any government.

The main question is whether the PD and SEL form a government on their own or whether they team up after the election with a group of centrist parties, including Montezemolo’s. That, in turn, depends not only on how well the PD does in the poll; but on whether Bersani wants a broader mandate for what could be a few tough years of government. It currently looks like he wants such a centre-left alliance – not least because it would help dilute the influence of his radical left partner, the SEL. 

The question then would be what the centre would get in return for its backing. Given that it is polling only about 10 percent, it doesn’t have much leverage. But Bersani would presumably make some centrists, as well as a few of Monti’s technocratic team, ministers. He could also back Monti for the important, albeit non-executive, role of president of the republic.

Such calculations could conceivably change if Monti endorsed Montezemolo’s party – and so boosted its showing in the election, in turn giving it the power to push for him to stay as premier. But although Monti is tempted by the scenario – not least because he wants to ensure his reforms continue – getting involved in party politics would be a high-risk strategy. It could damage one of his prime assets: a reputation for impartiality. What’s more, even if Monti did back Montezemolo, the centrists might still fail to make a break-through.

The most likely scenario then for a post-election Italy is a Bersani government with Monti-esque elements. While that is not as attractive as a full Monti government, it does not have to be a disaster.

The battle against Grexit – Greece’s exit from the euro – is far from won. Assume Athens is promised its next 44 billion euro tranche of bailout cash and some further debt relief when euro zone finance ministers reconvene on Nov. 26. Even then, the banks will still be hobbled, while another round of austerity is in the works and vested interests are rife.

It will be hard to restore confidence and, without that, there won’t be a return to growth. Meanwhile, without growth, Antonis Samaras’ fragile coalition government will fall. Alexis Tsipras’ radical left SYRIZA movement would then probably take over – plunging the country into a new hot phase of the crisis. What’s more, if investors and consumers fear such a scenario, they won’t start spending – making a continuation of the slump self-fulfilling.

Samaras, who became as prime minister in June, has been better than many feared. His strategy has been to do everything demanded of Greece by the “Troika” – the European Commission, the European Central Bank and the International Monetary Fund – with the aim of changing the perception that Athens cannot be trusted.

The prime minister had to make up a lot of lost ground: partly because of mistakes made by George Papandreou’s government; and partly because Samaras himself was unwilling to get behind the reform programme when he was in opposition and then brought Loukas Papademos’ technocratic administration to a premature end. The last year’s shenanigans – Papandreou’s aborted referendum followed by two destabilising elections – have savaged Greece’s credibility.

That said, Greece’s recent “good behaviour” looks like being rewarded by a cash injection and some debt relief. That will undoubtedly be good news – giving a new chance to the country, where I spent much of last week. But it probably won’t be big enough.

Most attention has focused on the fact that Athens’ debt will still be unsustainable because Angela Merkel is unwilling to countenance a writedown of loans to Greece before next year’s German elections – and that this will act as a drag on confidence and investment. But a failure to make the banking system sustainable is potentially an even bigger problem.

Most of the 44 billion euros in new cash will be used to recapitalise the banks. When that is added to bridge capital provided during the summer, the system will have received 48 billion euros in total. Although this amounts to a quarter of Greece’s GDP, it probably won’t be enough to handle two mega problems: the banks’ vast portfolio of Greek government bonds which have undergone a haircut and will have to be written down again; and an avalanche of non-performing loans to the private sector caused by the depression.

Since the 48 billion euro figure was calculated last year, admittedly with a buffer, the economic outlook has deteriorated. The European Commission, for example, expects GDP to be about 10 percent less at the end of 2013 than it did a year ago.

Nobody, though, seems to want to look at the possibility that the banks will be undercapitalised – presumably because they haven’t got a clue about how to raise the extra money. Nor does anybody seem to be looking to create a “bad bank” to take over the viable banks’ dud loans. Such a scheme – which is being used in Ireland and Spain – is a tried and tested mechanism to free banks from the past and so allow them to fund an economic recovery.

The financial system’s probable capital inadequacy isn’t its only problem. The banks are also still relying on the ECB and the Bank of Greece for about 135 billion euros in funding, after wholesale markets stopped financing them and many savers took out their deposits. Banks will have a strong incentive to repay these loans. So, all in all, they are unlikely to pump much liquidity into the economy.

The next tranche of bailout cash will also be used to repay the government’s unpaid bills – which stand at about 8 billion euros. But this will be swamped by the latest 13.5 billion euro fiscal squeeze.

Meanwhile, Greece still needs to restore its competitiveness. The good news is that labour costs are collapsing and the current account deficit is shrinking – partly because of labour reforms and partly because of the brute force of depression. The bad news is that prices haven’t yet dropped because the country’s vested interests are exploiting their positions to hang onto excess profits.

Given all this, the Greek economy – which has slumped 20 percent since the end of 2008 – will shrink again next year. The government should be able to survive that, even if rising social unrest buoys SYRIZA and the neo-fascist Golden Dawn party. The real problem will occur if the economy continues to contract into 2014.

To some extent, the outcome is outside Samaras’ control. But his best chance is to win brownie points with the Troika by a determined onslaught on corruption, cartels and tax evasion. Greece may then eventually be rewarded with a bigger debt writedown, more cash to recapitalise its banks and a more efficient economy. There will also be less risk that it will be forced into another round of austerity.

It is unclear whether Samaras has the courage to confront the country’s business lobbies, many of whom are supporters of his conservative New Democracy party. But doing so would give him a claim to a place in the history books.

Is Francois Hollande more like Mariano Rajoy or Mario Monti? In other words, is the French socialist president condemned to be always behind the curve with reform like Spain’s conservative prime minister? Or can he get ahead of it like Italy’s technocratic premier?

I put this question to my fellow guests at a dinner in Paris last week. France is not in imminent risk of blowing up, as wrongly implied by the Economist magazine, which used a cover picture of a lighted fuse on baguettes tied together like sticks of dynamite. France is much richer than Spain and its people are more willing to pay their taxes than the Italians. French 10-year borrowing cost is only 2.1 percent, compared to Italy’s 4.9 percent and Spain’s 5.9 percent.

That said, the country has three deep-seated problems which could ultimately cause a mega-crisis: public spending at 56 percent of GDP is way too high; industrial competitiveness has steadily eroded; and the population is in a state of denial. The last cannot be said of either Italians or Spaniards.

Hollande certainly started off like Rajoy. During his election campaign, he did nothing to prepare the population for the sacrifices ahead. Instead, he made promises he couldn’t keep. The French president spent his first few months in office merrily attacking the wealthy, pushing up taxes and partly reversing his predecessor’s pension reform. This anti-enterprise message has knocked the trust of the business community – which is precisely the opposite of what France needs as it flirts with a renewed recession.

Hollande, like Rajoy, is a politician. He had to get elected, a process which almost invariably forces leaders to sugar-coat their messages. Monti, by contrast, didn’t have to face the ballot box and so hasn’t had to go back on any promises. He also had a clear idea of what problems Italy faced – unlike Hollande and Rajoy – and so didn’t need to waste time learning on the job.

Hollande and Rajoy have been forced into U-turns – in both cases, for example, putting up VAT – partly as a result of which their popularity has plummeted. Hollande’s approval rating has sunk to only 36 percent from 60 percent when he took office six months ago. Monti’s popularity, though, remains high.

That said, Hollande seems to be more adept at making U-turns than the Spanish PM. The increase in VAT will be used to compensate for part of the revenues lost caused by a 20 billion euro cut in taxes on employers. This is a classic “internal devaluation”, which will go some way towards restoring France’s competitiveness. The rest of the money for funding this tax cut will come from spending cuts – again a good move, even though the precise reductions haven’t been specified. Hollande also largely adopted the recommendations of a report on competitiveness he’d commissioned from Louis Gallois, the former EADS boss.

The French president also started softening up the population for the need for reform in a widely praised press conference last week. That’s important because it suggests that he, at least, is no longer in denial. What’s not clear is whether a leader who has lost the trust of parts of both the business community and the electorate can drive through further changes.

In the last 30 years, several attempts at reform in France have been abandoned in mid-course. Governments capitulated to street demonstrations and strikes protesting against even minor reductions of privileges. The Greeks and Spaniards look stoical in comparison.

The internal devaluation was a dry run for Hollande’s big test: reforming the sclerotic labour market. More flexibility is needed to keep labour costs down and encourage business to invest – both of which will be required to stop the unemployment rate rising too much from an already uncomfortable 10 percent.

Unfortunately, two big changes aren’t on the cards: an abandonment of France’s 35-hour week and a cut in the minimum wage. However, it will still be possible to make improvements to competitiveness if the package is sufficiently radical.

Hollande hasn’t yet spelt out what he wants. Instead, he has asked employers and unions to sit down and negotiate a new deal. That was one tactic employed by Monti that didn’t prove effective. Italy’s resulting labour reform is half-hearted.

That said, the Medef, the French employers’ association, has come out with a robust initial opening position in the negotiations. What’s more, a socialist is probably better placed to persuade the unions of the need to change than a conservative president. So the question really comes down to how much courage Hollande has.

My dinner companions and others I saw in Paris were divided on the topic. Some said he would only ever do the minimum at the last moment possible. One argued that, while he was good at navigating political shoals, he has no sense of direction. Others said he was a natural optimist who understands that change is necessary but underestimates its urgency. One, though, said he might surprise everybody by realising that reforming France was his historical opportunity and that he would then display audacity. We must all hope this is the correct assessment.

Investors have been obsessed with the notion of “Grexit” – Greece’s exit from the euro. But “Brexit” – Britain’s exit from the European Union – is as likely if not more so. The country has never been at ease with its EU membership. It refused to join its predecessor, the European Economic Community, in 1957; it was then blocked twice from becoming a member by France’s Charles De Gaulle in 1960s; and shortly after it finally entered in 1973, it had a referendum on whether to stay.

The euro crisis has put further pressure on this difficult relationship. David Cameron’s Conservative Party, the governing coalition’s dominant group, delights in pointing out the flaws in the single currency. The party’s eurosceptics feel vindicated because they have long believed that monetary union was only possible with political union.

But “I told you so” is never a good way of endearing oneself to others. What’s more, the idea that greater integration in the euro zone has “remorseless logic” – as Britain’s finance minister, George Osborne, puts it – directly undercuts the country’s national interest. The more the 17 countries in the single currency club together, the more the UK will be left out on the fringe.

If the Tories weren’t so keen to prove the point about how right they had been, they would be able to articulate an alternative way of keeping the euro together based on two key principles: more flexibility at the level of both nation states and the single market so economies can weather shocks; and the use of market discipline rather than bureaucratic rules to prevent banks and governments borrowing too much money and hence requiring taxpayer bailouts.

Such a vision would play to the UK’s national interest. London has long wanted a more open, market-orientated Europe. But, unfortunately, the government has been urging the euro zone in the direction of further integration – only to realise belatedly how bad this could be for Britain’s interests.
This is most apparent with the euro zone’s current push to create a single banking supervisor. It’s far from clear that this will actually help solve the current crisis. But it will certainly create problems for Britain as all 17 members of the zone will vote as a single bloc on future banking regulations.

Given the importance of the UK’s financial services industry, such a prospect is extremely unappealing. But London hasn’t made any progress in persuading its partners to change the voting system to preserve its influence. This, in turn, is partly because the government has made a habit of burning rather than building bridges.

Cameron’s biggest error was to veto last year the so-called “fiscal compact”, which binds euro zone countries to budgetary responsibility. The proposal wasn’t even going to affect the UK. Moreover, the rest of the EU got its own way anyway by signing a new treaty that didn’t involve Britain.

The current battle over the EU’s budget could lose London further friends. Britain’s position that now is not the time to increase Brussels’ budget – given the strains on public finances – is reasonable enough. But its threat to exercise its veto again makes it look like a spoiler.

Matters have been made even worse by the way the Labour opposition has behaved. Last month, it backed a motion from dissident Conservative MPs calling for a cut in the budget. This unholy alliance makes Labour also look like an unreliable partner in continental European capitals.

The risk is that Britain gets into a series of ding-dong battles with the rest of the EU – in the process of which London feels marginalised and, in response, gets increasingly shrill in its demands. A fractious relationship would then be the backdrop to the next election in 2015.

Cameron is under pressure from large sections of his party to pull out of the EU – not least because UKIP, a staunchly eurosceptic party, is eating into its electoral support. The PM is attempting a compromise position: he wants to renegotiate Britain’s relationship with the EU by repatriating certain powers to London; he would probably then put the resulting deal to the people for approval.

The problem is that the UK is unlikely to secure big changes in its relationship with the EU. So the path Cameron is treading could easily lead to a vote on whether to stay in the EU at all.

Meanwhile, Labour is anxious that the Conservatives could score points in the next election if it doesn’t also promise a referendum on Britain’s relationship with the EU. Ed Miliband, its leader, seems to think he could win such a vote. But it would be an uphill battle: 49 percent of the electorate would vote to pull out of the EU compared to 28 percent who want to stay in, according to a poll last week by YouGov.

This wouldn’t matter if the UK had a rosy future outside the EU. But the country’s economy is closely entwined with the EU, which accounted for 47 percent of its trade last year. It is naïve to think that Britain would get full and fair access to the single market if it wasn’t a member. What’s more, it would still have to play by Europe’s rules to trade in its market.

Britain’s business community doesn’t seem to have woken up to the threat. If it waits too long, it may find the momentum for a Brexit is too strong to resist.

Last week I gave a speech on “healthy capitalism” at Oxford University. Before doing so, I tried the idea out on an academic friend of mine. He scoffed at it. For him, “healthy capitalism” was an oxymoron. Five years after the start of the world’s worst financial crisis in decades, it is easy to mock capitalism. The system ran amok – leading to debt, unemployment and shrinking economies.

But that’s precisely why the world needs healthy capitalism. Health involves vigour, well-being and resilience. Capitalism – with its basis in free enterprise and private property – can have all those qualities provided warped incentives are corrected and the culture of greed is tempered. State socialism certainly cannot. The practical alternative is to reform capitalism not throw it away.

But how should it be reformed? After the tribulations of recent years, the conventional wisdom is that the problem has been too much freedom. That, though, is a misdiagnosis. Most of the diseases that have become apparent during the crisis have been caused by a distortion of free enterprise rather than too much freedom.

Sickness number one was Alan Greenspan’s habit of lowering interest rates at the first sign of trouble during the pre-crunch era. Investors dubbed this the “Greenspan put”. The theory was that, since the U.S. Federal Reserve would always ride to the rescue, it made sense to take high risks. Fear was numbed and greed left untrammelled. The natural balance of a healthy organism was distorted.

Central bankers do have a role in mitigating the extremes of the economic cycle. But it is vital that, in doing so, they don’t just stoke up more trouble. They need to have the expertise to recognise bubbles and the courage to prick them – an idea which has, thankfully, gained currency in the post-Greenspan era.

The second malady was caused by an excessive willingness to bail out bankrupt banks. In a well-functioning free market, investors would bear the consequences of poor decisions. If a bank teetered on the brink, shareholders would be wiped out and bondholders would suffer. But, with the exception of Lehman Brothers and a few much smaller cases, bondholders were bailed out instead of being bailed in.

This was understandable given the fear of knock-on effects. But a healthy body sees old cells dying and new ones being born. A well-functioning financial system also has to allow for death and renewal. Propping up zombie banks debilitates the whole economy. Meanwhile, the message that foolish risk-taking won’t be punished encourages more folly. This is why reforms in the pipeline to allow banks to be wound down without causing the entire system to collapse are so important.

The third illness is caused by the heads-I-win-tails-you-lose bets that financiers and traders were able to enjoy during the upswing. If everything went well, they made a fortune; if everything collapsed, taxpayers picked up the pieces. Not surprisingly, they spun the roulette wheel.

Such privatisation of gains and socialisation of losses is not healthy capitalism. It is a caricature of the free market. Again, various attempts are being made to ensure that people bear the responsibility for their actions even if the consequences aren’t apparent for several years. Doing so won’t just mean the right people pay when things blow up; it should reduce the chance of things blowing up in the first place.

The fourth disease is caused by distortions in the tax system. The most egregious is the ability of companies in most of the world to deduct interest costs before calculating the profit on which they have to pay tax. Payments to shareholders, by contrast, are typically not tax-deductible. This skewed playing field incentivises companies to leverage themselves up to the gills. That happened during the bubble particularly with banks, private equity groups and real estate businesses – all of which then got into trouble.

Healthy systems are balanced. The tax-deductibility of interest unbalances the economy. There are various ways of curing the disease – for example, by closing the tax loophole and making compensating cuts in corporate tax rates so that business overall doesn’t pay more. Sadly, only a few countries have started to address this problem.

Most definitions of health talk about mental as well as physical well-being. One can make a similar point for capitalism: values matters as well as structure. The past 30 years have seen the rise of the “greed is good” culture, as epitomised by Gordon Gekko in the film Wall Street.

Greed is a natural emotion which has some healthy aspects. It cannot and should not be removed from economic body. But it does need to be balanced by other motivations. The most important of these is the concept of service. Businesses need to be asking the whole time: how are we adding value to our customers and society at large?

Most successful companies do this. But many financial institutions failed to think through whether their products were socially valuable. Merely relying on the theory that the market’s invisible hand will reconcile private greed with the greater good isn’t enough, when we know how often capitalism is rigged.

Business people and financiers should never forget that capitalism rests on the consent of the people. As years of economic gloom gnaw away at that support, the challenge is to show that capitalism can be healthy. That requires changes in both structures and mindset.

European leaders nudged forward plans for a fiscal union with discipline as its leitmotif at last week’s summit. But such a “Disziplin union” is neither desirable nor necessary. It may not even be politically feasible.

The consensus among the euro zone political elite is that fiscal union is needed to complete the crisis-ridden monetary union. There are two rival views of what this should consist of: a panoply of rules to prevent and punish irresponsible behaviour; or financial payments to help weaker economies. The former view, espoused by Germany, is in the ascendant. It involves lots of sticks but not many carrots.

The summiteers’ main achievement was to give further impetus to the idea that the European Central Bank should act as the zone’s central banking supervisor from the start of next year after Berlin dropped its insistence that its own savings banks should be excluded from the regime. That was an important political concession. It’s also conceivable that the new supervisor will be better able to clean the cesspits in parts of the euro zone than the current often-conflicted national supervisors.

However, banking supervision is only part of what the experts call “banking union” which, in turn, is only part of a planned fiscal and political union. Just looking at banking union, what has been agreed is the stick. Back in June, when the plan was first agreed, there was also supposed to be a carrot: the euro zone would inject capital directly into struggling banks in countries such as Spain. But Angela Merkel, Germany’s Chancellor, made clear after the summit that this would not happen retroactively.

Full banking union would also include a common deposit guarantee scheme. But there was no mention of this carrot in the summit’s communiqué. There were, though, more sticks to ensure budgetary discipline and economic reform.

First, the summiteers called for the “two-pack” to be implemented by the end of the year. Even aficionados of euro-speak find it hard to stay up-to-date with the whirlwind of rules designed to keep countries on the fiscal straight and narrow. The original “stability and growth pact” was augmented by first the “six-pack”, then the “fiscal compact” and now, if everything goes to plan, the “two-pack”. The basic idea is that there will be coordination of countries’ budgets and enhanced surveillance of those experiencing financial difficulties.

Mind you, this is not sufficiently tough for Wolfgang Schaeuble, Germany’s finance minister. He wants a new European Commissioner to be have the power to veto a national budget if he or she feels the deficit is too large. While that’s not yet a euro-wide consensus, the summit did give some support for the idea that individual countries should be required to enter contracts with the centre spelling out what reforms they would commit to undertake.

Counterbalancing these potential new sticks, one new carrot was dangled: what the eurocrats call an “fiscal capacity”. This is code for a centralised budget which could be used to help countries adjust to economic shocks or even as an inducement to persuade them to move ahead with unpopular reforms. This may turn out to be an important idea. But, as yet, there is no detail on how big such a central budget would be, where the money would come from or what exactly it would be used for.

Plans for yet more bureaucratically-mandated discipline are not desirable. They would hard-wire austerity into the circuitry, potentially deepening the recession in parts of the euro zone. They would also involve a further transfer of sovereignty to the centre, even from those countries that are not in trouble. That is a mistake. It is one thing to turn Greece or even Spain into a quasi-protectorate for a temporary period; it is quite another to centralise partial control of all countries’ budgets permanently.

It may not even be feasible to push through such a Disziplin union. While Germany and other northern countries want rules, the southerners are much keener on a “transfer union” involving ideas such as joint guarantees for their debts. Such mutualisation of debt didn’t get mentioned in the summit’s communiqué, because the southern countries’ bargaining position vis-a-vis Germany is weak. But even if their leaders are eventually browbeat into signing up to a Disziplin union, there must be some doubt over whether the people – who may be asked to vote in referendums sanctioning loss of sovereignty – will agree to it.

A fiscal union is, in fact, not even necessary. There clearly has to be some discipline in order to prevent countries running up excessive debts. But that can be better achieved by making clear that insolvent governments can go bust. The Greek debt restructuring earlier this year was a step in the right direction. But it should have been deeper and occurred earlier. If bondholders know they will suffer a haircut when debts spiral out of control, they will have a stronger incentive to hold countries to account in the first place.

There also has to be some sort of support system for countries in trouble. And the quid pro quo should be a loss of sovereignty for the period of the rescue operation. Deficits have to be cut and economies reformed. But that is quite different from either permanent rules for everybody or permanent mutualisation of debt. The euro zone needs neither a Disziplin union nor a transfer union.

The art of politics is about squaring circles. In the euro crisis, this means pushing ahead with painful but necessary reforms while hanging onto power.

In Spain, where I spent part of last week, these circles are getting harder to square. Mariano Rajoy isn’t at any immediate risk of losing power. His 10-month old government has also taken important steps to reform the economy – cleaning up banks, liberalising the labour market and reining in government spending.

But the recession is deepening, the prime minister is a poor communicator and his political capital has plummeted. Madrid will also find it harder than thought to access help from its euro zone partners.

GDP will shrink by 1.5 percent this year and another 1.8 percent next year, according to Funcas, the Spanish savings bank association. That is a result of both a severe fiscal squeeze and private-sector deleveraging. An austerity spiral is in operation. As the International Monetary Fund argued last week, so-called fiscal multipliers across the world are bigger than forecasters had previously estimated.

The severity of the downturn means the government seems destined to miss its deficit reduction targets again. This year, Madrid economists think it will end up with a deficit of around 7 percent of gross domestic product, against a revised target of 6.3 percent. Next year, the deficit could be in the 5-6 percent range rather than the new, 4.5 percent target.

It might seem that these slippages matter less now that the IMF and even some euro zone policymakers are softening their demands for austerity. Foreign governments are less likely to demand Madrid tighten its belt further if a failure to hit targets is not its fault.

However, Spain will have to sell 207 billion euros of bonds, equivalent to 20 percent of GDP, next year – to fund the deficit and rollover maturing debt. That’s even more than the 186 billion scheduled for this year – an amount Madrid has only been able to shift because the European Central Bank lent 230 billion euros of cheap long-term money to Spanish banks, much of it recycled into buying government bonds.

Spain should be able to sell the remainder of this year’s bonds because investors have been lulled by the ECB’s promise to purchase unlimited amounts of sovereign paper. For example, they brushed aside last week’s two-notch downgrade of the country’s credit rating by Standard and Poor’s. But as next year approaches, the mood could turn ugly – especially if Madrid hasn’t by that time taken advantage of the central bank’s security blanket and its credit-rating is junked.

Investors could start worrying about the fact that the state’s debt could well reach 100 percent of GDP in 2015 after including the cost of injecting capital into the banking system. They may also focus on the fact that the ECB’s bond-buying plan is partly a confidence trick because it is limited to the secondary market and short-term bonds – and would end if Madrid couldn’t sell bonds in the primary market. A loss of confidence could be self-fulfilling.

Why doesn’t the government just get on with it and ask for ECB help? That would lower the risk of a renewed “Spanic” attack and cut both the government’s and the private-sector’s borrowing costs – taking the edge off the recession.

Before I went to Madrid, I thought Rajoy’s misplaced pride was the main reason he was not asking for help. This, and the desire to wait until after regional elections in Galicia later this month, may be minor factors. But the two more important reasons for delay are lack of clarity over what the ECB will do and concern that Germany will block the bailout.

Does the ECB just want to cap Spanish 10-year bond yields at around the current level of 5.7 percent? Or does it want to drive them down to, say, 4.5 percent – the level that might be justified if there weren’t residual fears about a break-up of the euro? Rajoy hasn’t asked Mario Draghi, the ECB’s president. Even if he did, he wouldn’t get a straight answer. But it should still be possible to get some rough sense of what the ECB wants.

The bigger issue is Berlin. The ECB’s bond-buying scheme is contingent on a parallel programme being agreed between Madrid and the other euro zone governments. Unfortunately, Germany has been saying that it doesn’t think Spain needs help. That, in turn, seems to be mainly because Angela Merkel, the chancellor, doesn’t want to have to push another bailout programme through the Bundestag only three months after it got parliamentarians to agree to a mega-loan for Spain’s banks. Sentiment in Germany towards bailouts in general and the ECB’s bond-buying plan in particular is negative.

Madrid has seen how Berlin is seeming to renege on an earlier plan that would have allowed it to transfer the cost of bailing out its banks to the euro zone rather than just receive a loan. It now doesn’t want to ask for help only to be turned down.

If there is another panic, Merkel will presumably decide to get parliamentary approval for Spanish aid. It is also possible that she will push a package deal through the Bundestag next month covering not just Spain but also Greece and Cyprus. But it would be far preferable to act before then. Sadly, that isn’t the way Europe, despite its new Nobel Peace Prize, normally works.

The credit crisis burst into the open five years ago. The euro crisis has been rumbling for over two years. The term “crisis” isn’t just on everybody’s lips in finance. Wherever one turns – politics, business, medicine, ecology, psychology, in fact virtually every field of human activity – people talk about crises. But what are they, how do they develop and what can people do to change their course?

The first thing to say is that a crisis is not just a bad situation. When the word is used that way, it is devalued. The etymology is from the ancient Greek: krisis, or judgment. The Greek Orthodox Church uses the term when it talks about the Final Judgment – when sinners go to hell but the virtuous end up in heaven. The Chinese have a similar concept: the characters for crisis represent danger and opportunity.

A crisis is a point when people have to make rapid choices under extreme pressure, normally after something unhealthy has been exposed in a system. To use two other Greek words, one path can lead to chaos; another to catharsis or purification.

A crisis is certainly a test of character. It can be scary. Think of wars; environmental disasters that destroy civilisations of the sort charted in Jared Diamond’s book Collapse; mass unemployment; or individual depression that triggers suicide.

But the outcome can also be beneficial. This applies whether one is managing the aftermath of Lehman Brothers’ bankruptcy, the current euro crisis, the blow-up of an oil rig in the Gulf of Mexico or an individual’s mid-life crisis. Much depends on how the protagonists act.

Students of crises are fond of dividing them into phases. For example, Charles Kindleberger’s Manias, Panics, and Crashes identifies five phases of a financial crisis: an exogenous, normally positive, shock to the system; a bubble when people exaggerate the benefits of that shock; distress when some financiers realise that the game cannot last; the crash; and finally a depression.

While there is much to commend in Kindleberger’s system, it is too rigid to account for all crises in all fields. It also downplays the possibility that decision-makers can change the course of a crisis. A more flexible scheme that leaves space for human agency to affect how events turn out has two just phases: the bubble and the crash.

The bubble is typically characterised by mania and denial. Things are going well – or, at least, appear to be. Feedback loops end up magnifying confidence. In corporations or politics, bosses surround themselves with lackeys who tell them how brilliant they are. In finance, leverage plays a big part.

This is not healthy. Manic individuals don’t know their limitations and end up taking excessive risks – whether on a personal level or in managing an organisation or an entire economy. As the ancient Greeks said, hubris comes before nemesis.

But before that, there is denial. People do not wish to recognise that there is a fundamental sickness in a system, especially when they are doing so well. For example, back in 2007 at the World Economic Forum in Davos, the greed was palpable. Market participants had such a strong interest in keeping the game going that they turned a blind eye to the unsustainable buildup of leverage.

The ethical imperative in this phase is to burst the bubble before it gets too big. That, in turn, means both being able to spot a bubble and having the courage to stop the party before it gets out of hand. Neither is easy. It’s hard to recognise a sickness given that there is usually some ideology which explains away the mania as a new normal. The few naysayers can be ridiculed by those who benefit from the continuation of the status quo.

What’s more, politicians, business leaders and investors rarely have long-term horizons. So even if they have an inkling that things aren’t sustainable, they may still have an incentive to prolong the bubble.

The crash, by contrast, is characterised by panic and scapegoating. People fear that the system could collapse. Negative feedback loops are in operation: the loss of confidence breeds further losses in confidence. This is apparent on an individual level as much as a macro one.

Events move extremely fast and decisions have to be taken rapidly. Witness the succession of weekend crisis meetings after Lehman went bust – or the endless euro crisis summits. The key challenge is to take effective decisions that avoid vicious spirals while not embracing short-term fixes that fail to address the fundamental issues. With the euro crisis:, for example, it is important to improve competitiveness with structural reforms not just rely on liquidity injections from the European Central Bank.

In this phase, there is no denial that there is a problem. But there is often no agreement over what has gone wrong. Protagonists are reluctant to accept their share of responsibility but, instead, seek to blame others. Such scapegoating, though, prevents people from reforming a system fundamentally so that similar crises don’t recur.

Crises will always be a feature of life. The best that humanity can do is to make sure it doesn’t repeat the same ones. And the main way to evolve – both during a bubble and after a crash – is to strive to be honest about what is sick in a system. That way, crises won’t go to waste.

Solving the euro crisis is a race against time. Can peripheral economies reform before the people buckle under the pressure of austerity and pull the rug from their politicians? After two months of optimism triggered by the European Central Bank’s plans to buy government bonds, investors got a touch of jitters last week.

The best current fear gauge is the Spanish 10-year government bond yield. After peaking at 7.64 percent in late July, it fell to 5.65 percent in early September. It then poked its head above 6 percent in the middle of last week because there were large demonstrations against austerity; because Mariano Rajoy’s government was dragging its heels over asking for help from the ECB; and because the prime minister of Catalonia, one of Spain’s largest and richest regions, said he would call a referendum on independence.

But by the end of the week, the yield was just below 6 percent again. That’s mainly because Rajoy came up with a new budget which contains further doses of austerity. The move prepares the way for Madrid to ask for the ECB to buy its bonds and so drive down its borrowing costs.

Rajoy didn’t want to be seen to be told to do anything by his euro partners. Hence, this elaborate dance – where he has now done what he knew he would have been told to do but can claim it was his choice. It’s hard to believe that anybody is fooled by this subterfuge; indeed, from investors’ perspective, it looks childish. But, at least the show is on the road again: the government has had the guts to press ahead with reform despite the immense unpopularity of the measures.

The question is whether Madrid and other governments in Lisbon, Dublin, Rome and Athens can keep up the reforms long enough to restore their economies to health. That, in turn, depends on three factors: how much farther they have to travel; how unruly their people are going to get; and how much help they will receive from their partners.

Economic health requires both that fiscal deficits are eliminated and that competitiveness is restored. The peripheral economies have made some progress on both fronts. But shrinking economies makes it hard to balance their budgets while fiscal squeezes undermine growth. The austerity vicious spiral is still whirring away.

That’s why Spain is unlikely to hit its target of cutting its deficit to 4.5 percent of GDP next year. It can get there only on the optimistic assumption that the economy will shrink by just 0.5 percent in 2013. The same could be said of France, not yet a full member of the periphery, whose budget unveiled last Friday calls for a deficit of 3 percent of GDP next year. Paris is assuming 0.8 percent growth. The French prime minister describes the projection as “realistic and ambitious”. Just ambitious would have been a more accurate description.

Meanwhile, restoring competitiveness is painful because it involves cutting people’s pay. Ireland and Spain have made good progress, covering respectively 80 percent and 50 percent of what they needed to achieve by the end of last year, according to a report last week by Open Europe, a British think-tank. Portugal and Greece have done less well.

Current account deficits paint a similar picture. Spain’s had shrunk to 3.5 percent of GDP last year while Ireland actually had a small surplus. Portugal, though, had a deficit of 6.4 percent of GDP and Greece was struggling with one of 9.8 percent.

Big falls in pay are forecast for the deficit countries over the next two years by Eurostat. It sees unit labour costs dropping 4.7 percent in Spain between end-2011 and end-2013; 3.8 percent in Portugal; and 9.5 percent in Greece. If that happens, competitiveness could be restored. Citigroup forecasts that Spain and Portugal will have current account surpluses next year while Greece’s deficit will have shrunk to 2.8 percent.

The snag is that such pay cuts – especially when combined with higher taxes and rising unemployment – provoke howls of outrage from the population. Short of leaving the single currency and devaluing, the only other medicine for improving competitiveness is so-called fiscal devaluation. This involves cutting the social security contributions paid by employers and, in return, putting up other taxes.

Germany succeeded in pushing through such a fiscal devaluation in 2007. But that just made it more competitive vis-a-vis the weaker euro zone economies. More recently, Spain did a mini fiscal devaluation. But the most ambitious attempt, by Portugal, provoked such a massive backlash earlier this month that the government backed down.

Help from abroad is the main way of easing the pain of adjustment. The ECB’s promised bond-buying plan is the most dramatic example. But solidarity has its limits. There has been a backlash in the German media over the central bank’s plan. Meanwhile, Berlin has been trying to persuade Madrid not to ask for help. The German finance minister also clubbed together with his Dutch and Finnish counterparts last week, proposing rules that will make it harder for Spain to shift the cost of bailing out its banks onto the euro zone.

The consequences of a breakup of the euro zone would be so ghastly for both the periphery and the core that they will probably pull through what looks like it is going to be at least another year of hell. But the risks have certainly not vanished.