Hugo Dixon

A year after David Cameron promised a referendum on EU membership, the British prime minister and his Conservative party are alienating potential allies across the Channel. He needs to pitch reforms that benefit the whole bloc, not just pander to eurosceptics. Otherwise an “Out” vote looks more likely.

Cameron promised to hold a referendum by the end of 2017, assuming he’s still in power. His original hope was to first renegotiate the terms of Britain’s EU membership sufficiently so that he could then sell the advantages of staying in to a sceptical electorate.

In such a scenario, the expectation was that much of Tory press would rally round – or at least mute their criticism. Meanwhile, business would campaign to stay in, alongside the Liberal Democrats, the junior partners in Cameron’s coalition, and the opposition Labour party.

Cameron’s strategy was partly based on the idea that the EU would need a new treaty to keep the euro zone together. This would give Britain leverage to extract concessions, say repatriating powers on social policy, as the other 27 EU members would need its approval to change the organisation’s treaties.

This scheme never looked terribly convincing, not least because many other EU countries are afraid they could never get a new treaty ratified by their people. They are also reluctant to open a negotiation that would give Britain the ability to dictate terms.

A weekend pact between Matteo Renzi and Silvio Berlusconi offers new hope to Italy. The constitutional reform deal between the leader of Italy’s largest party and the leader of the opposition addresses one of the country’s biggest problems: its ungovernability. Now Renzi, who runs the centre-left Democratic Party, needs to put his energy behind key economic reforms, especially jobs and public spending.

Italy, where I spent much of last week, has been plagued for years with unstable governments. In part this is because the voting system gives a lot of power to small parties and can lead to conflicting majorities in the two houses of parliament, which have equal power.

The Renzi-Berlusconi deal aims to reinforce the power of larger parties by changing the voting system. It also would demote the upper house so that governments will only need to secure a majority in the lower one. Meanwhile, the two leaders have agreed to cut the power of Italy’s regions – a move which should save money and lead to more stream-lined decision-making.

The hot phase of euro crisis may be over. But the zone will limp on for years with low growth and high unemployment unless further action is taken on three fronts: bank balance sheets must be cleaned up, monetary policy loosened and more free-market reforms adopted.

The latest news from the euro zone’s various battlefronts is fairly encouraging. GDP in all the problem countries, with the exception of tiny Cyprus, is expected to grow next year. Budget deficits, one symptom of the crisis, are being cut. Current account deficits, the other main symptom, are coming into balance.

Ireland, the poster child of the harsh recipe of fiscal austerity plus structural reform, has just exited its bailout programme. Portugal may do so next year. Even Greece is toying with the idea of issuing government bonds towards the end of 2014.

Italy seems continually condemned to disappoint. The economy has barely grown in 20 years. The younger generation is languishing without opportunity: youth unemployment stands at 41 percent. So many chances to reform the country have been wasted – and many by Silvio Berlusconi, who was finally expelled from the Senate last week after being convicted of tax fraud.

The country now has two chances to reform. The first is that Enrico Letta, the prime minister, will be emboldened to push through changes now that Berlusconi has been sent packing. If he still can’t, Matteo Renzi – who is expected to be chosen leader of the centre-left Democrats on Sunday – should force elections and show he is as radical in deed as he is in words.

Look first at Letta. He is an intelligent centrist from the Democratic party. But, since he became prime minister in April after an indecisive election result, he has not achieved much. This is largely because his government had to rely on Berlusconi’s centre-right party. The two groups found it virtually impossible to agree on anything.

Greece has been the markets’ whipping boy for most of the past four years. But in the last few months, sentiment has changed and international investors are bottom-fishing – in particular for banking assets.

This gives the country a double opportunity: lenders can use it to clean up their balance sheets by selling non-performing loans; and the state can privatise its stakes in the banks. Both should grab the chance while it lasts.

Greece’s banks have been in a terrible mess as a result of the crisis. Not only were they loaded up with government bonds, which got haircut; even the big four that survived are weighed down by about 65 billion euros of non-performing loans, equivalent to around a third of GDP.

Greece’s reform job is not even half finished. The government hasn’t done enough to root out the vested interests that strangle the economy. Nor has it cracked down fully on tax evasion or pushed hard enough to privatise state-owned properties.

On the other hand, Antonis Samaras’ coalition is so fragile that it could collapse if the troika – the European Commission, the European Central Bank and the International Monetary Fund – forces it to impose more austerity. That could lead to a new phase in the Greek crisis. The government’s best bet is to make a sharp distinction between structural reform and austerity – and persuade its lenders that it’s so serious about the former that more cuts and taxes aren’t required.

The atmosphere in Athens, which I visited last week, is tense. One reason is that two members of the ultra-right wing Golden Dawn party had just been murdered in a professional hit job. That followed the killing of a left-wing rapper by a member of Golden Dawn which, in turn, had triggered the arrest of the party’s leader. No one is quite sure whether this is the start of a cycle of violence which could destabilise the government, drive away tourists (the country’s main source of export revenues) and undermine business confidence.

The case for looser monetary policy should be clear when the European Central Bank governing council convenes in Frankfurt on Thursday. The question is what tools to use: lower interest rates, spraying the banks with more cheap long-term money or the ECB’s first dose of “quantitative easing”. The answer should be a mixture of all three.

Mind you, there are enough inflation hawks inside the governing council that it’s not certain it will even agree that more needs to be done. Some central bankers may argue monetary policy is already loose enough. After all, the ECB’s main interest rate is 0.5 percent and back in July the central bank said, in its first experiment with “forward guidance”, that it expected interest rates to “remain at present or lower levels for an extended period of time”.

What’s more, the euro zone is gradually recovering. In the second quarter, GDP rose 0.3 percent compared to the previous three months. As if this were not enough, Germany’s Bundesbank has started warning that property prices are getting overvalued in some German cities. Why stoke an emerging bubble with still cheaper money?

Finance has rightly been in the sin bin for the last six years. And the cleanup job isn’t finished. But Mark Carney, the new Bank of England governor, is correct to stress how a large and expanding City of London is good for Britain, Europe and the world – provided it is properly organised.

Carney’s comments, in a speech last week, will seem heretical to many – maybe even to his predecessor, Mervyn King, who showed a barely disguised disdain for financiers. Would it really be healthy, for example, for the balance sheets of British banks to reach nine times GDP, double the current ratio – as Carney projected they could by 2050?

British public will have some big questions about the potential resurgence of finance. Will taxpayers be asked to swoop in again to bail out bust banks? If a rescue is needed, would the government have the wherewithal to support a gigantic sector? Is it wise for the UK to put so many of its eggs in the finance basket?

Imagine the British people vote to quit the European Union in the referendum David Cameron has promised to hold by 2017. What happens next? What, if any, special relationship would the UK seek to retain with the EU? Would it be able to negotiate what it wanted? And how would the economic damage unleashed by years of uncertainty be kept to the minimum?

These questions aren’t just troubling British businesses, the vast majority of which want to stay in the EU so they can enjoy full access to its single market. They are also worrying some eurosceptics who are concerned that, even if it would be good for Britain to quit the EU, the process of getting from A to B could be messy.

Hence, the launch of a 100,000 euros prize by the Institute for Economic Affairs, a UK eurosceptic think-tank. It will announce later this month the shortlist for the best essay to answer the question of what measures are needed to ensure a free and prosperous economy after an “out” vote in a putative referendum.

Germany’s Bundesbank is not afraid of playing the role of bad fairy. Last year it opposed the European Central Bank’s scheme for buying potentially unlimited quantities of sovereign bonds – a promise which ended the hot phase of the euro crisis. Last week, it criticised rules that encourage euro zone banks to load up on their own governments’ debts.

Jens Weidmann, the Bundesbank president, is right to put this topic on the agenda. After all, the exposure of banks to governments is one half of what has been dubbed the “sovereign-bank doom loop.” When governments such as Greece got into trouble, they dragged their banks down as well. (The other half of the doom loop involves troubled banks dragging down their governments.)

The problem is how to break this loop without triggering a new crisis in vulnerable countries such as Italy and Spain. After all, if their banks were suddenly told to cut their holdings of Italian and Spanish bonds, Rome and Madrid would be hard-pressed to fund themselves.