Analysis - Europe's state of disunion hinges on sovereignty
PARIS (Reuters) - When European Commission President Jose Manuel Barroso began his annual State of the Union address by declaring that "we are facing the greatest challenge in the history of our union," it was an understatement rather than hyperbole.
The sovereign debt crisis shaking the euro zone puts at risk the survival of the single currency and ultimately the wider 27-nation European Union with its single market, open borders and free movement of capital, goods and people.
"If we do not go for further integration, we risk fragmentation," Barroso told the European Parliament. "We need to complete our monetary union with an economic union."
Confidence and trust in governments and in Europe is at a low ebb. The financial turmoil if Greece defaulted, as many economists expect within months, would be unlikely to leave Europe's rules-based market unscathed in the long term.
Resurgent nationalism and populism could tear Europe apart, Barroso warned.
The crisis requires a united front. Yet the EU is politically more disunited than for decades.
Public opinion in the wealthier northern states Germany, Finland and the Netherlands is increasingly hostile to further integration just when the main proposals to preserve the euro area would entail a major new sharing of sovereignty and risk.
On the other side, resistance to harsher austerity is rising in Greece, epicentre of the debt crisis, where an unending recession and entrenched tax evasion make it ever harder to achieve EU/IMF-imposed deficit reduction targets.
As a result, euro zone governments are struggling to convince financial markets that they stand unwaveringly behind their common currency.
As EU leaders found at last week's International Monetary Fund, G20 and United Nations sessions, when Europe appears divided and irresolute in its financial crisis management, the world is less inclined to heed its views on trade, regulation, climate change or conflict resolution.
In Germany, the economic powerhouse of the 17-member euro zone, Chancellor Angela Merkel is battling to keep her centre-right coalition's majority in support of bailout measures.
"Roughly 80 percent of German voters are against an extension of the euro zone's rescue mechanism, while 80 percent of politicians are for it," Josef Schlarmann, who represents "Mittelstand" small businesses in Merkel's Christian Democratic party, told Reuters.
"The political establishment and the electorate are on a collision course."
UNANIMITY UNDER FIRE
All the key proposals for overcoming the crisis involve closer fiscal integration, joint debt issuance or guarantees, and more intrusive supervision of national budgets and economic policies that will erode national sovereignty.
Barroso cited proposals for more integrated economic governance, a financial transaction tax, joint euro zone "Stability Bonds" and regulation of credit ratings agencies.
In the short run, the European Central Bank -- the only federal institution holding the euro zone together in the crisis -- may have to intervene on a larger scale to support weak member states and banks by buying their bonds.
This has already caused a damaging split in the ECB, with the resignation of two German central bankers, Axel Weber and Juergen Stark, and continuing opposition in Germany to a bigger firefighting role for the central bank.
That could make it harder for Mario Draghi, the Italian who takes over as ECB president from Jean-Claude Trichet on November 1, to persuade his colleagues to back bigger risk-taking that could be needed in part to protect his home country.
Barroso said euro area governments would have to abandon the unanimity rule on key decisions to avoid moving at the speed of the slowest member while financial markets race ahead.
For example, the latest efforts to rescue Greece have been held up by Finnish demands for collateral on loans, and arguments within Slovakia's five-party ruling coalition.
ECB executive board member Lorenzo Bini Smaghi says it is an anomaly that EU countries which accept taking decisions at the IMF by weighted majority voting insist on maintaining a national veto over such policies in the euro zone.
But agreeing to be outvoted on decisions that commit taxpayers' money or liability seems a step too far for Germany and other big European nations.
Germany's constitutional court, when it upheld the existing temporary rescue mechanism for troubled euro zone states, set clear limits on further integration by ruling that parliament may not transfer fiscal sovereignty permanently to Europe.
In essence, the court said European integration had hit the bedrock of national democratic rule -- parliamentary control over the spending of public money -- and could go no further without changes to the German constitution.
RELATIVE FISCAL SOVEREIGNTY
The ad hoc system that has evolved in the debt crisis could be called a doctrine of relative fiscal sovereignty -- the healthier your national accounts, the greater your autonomy.
Countries like Greece, Ireland and Portugal that required bailouts have had to negotiate spending cuts, revenue targets and structural reforms quarterly with EU and IMF inspectors, although Dublin has preserved its ultra-low corporate tax rate despite pressure led by France.
The big EU states are determined to avoid such intrusive surveillance being enforced on themselves.
France led resistance to any automatic fines on countries that breach EU budget rules, and Merkel says Germany will never allow sanctions on running an excessive trade surplus -- Berlin's main contribution to economic imbalances.
The fiscally conservative Dutch are proposing the creation of a budget tsar with power to enforce EU fiscal rules, punish "sinners" and ultimately recommend that states leave the euro.
Such ideas highlight the gulf between those who see the solution as harsher discipline on individual wrongdoers, and those who see greater fiscal federalism as the only answer.
The traditional EU approach would be to strike a compromise between the two views -- first between Germany and France and then among the others -- with a little more enforcement balanced by another step forward in economic integration.
The risk is that Europe may not have either the time or the political will to forge such a deal and could be overwhelmed by events.
European leaders, in the words of U.S. political scientist Charles Lindblom, an authority on incremental policymaking, are "still muddling, not yet through."
(Writing by Paul Taylor; editing by Janet McBride)
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