By Eurasia Group's Europe practice

It hasn't been an easy year for Europe, and 2011 doesn't look much better. Hopes that a rescue package for Ireland would halt the debt crisis contagion have been dashed -- Portugal, Spain, Italy, and Belgium already face market pressure, and if the situation deteriorates, the European Union and IMF are likely to push for some form of structured assistance to Portugal. It may not end there. Italy and Belgium could be the next to face bond market problems, and non-eurozone countries like Hungary and Romania could face growing scrutiny about their finances. Eurozone watchers are already questioning the ability and willingness of core eurozone countries (particularly Germany) to spend additional bailout money beyond the current European Financial Stability Facility (EFSF) commitments that would be required. Such concerns raise both existential and tactical questions about the longer-term viability of the euro.

If countries abandon the euro, everybody loses. That scenario isn't a significant risk at this point, but some countries face the real prospect of restructuring and/or default, and they'll be much poorer following internal devaluation and/or a bout of domestic deflation. The next few years will be particularly tough for Greece, Ireland, Portugal, Spain, and Italy. In broader terms, there's a clear North-South divide emerging. Southern countries, in both Western and Eastern Europe, face a variety of challenges ranging from fiscal policy to macroeconomic rebalancing and competitiveness that will be extremely difficult to overcome in the short term. We've already seen social unrest in several countries as a result, and we'll see more in 2011.

In the broadest sense, the process of EU convergence has been thrown into reverse. For capital markets, this means that yields on bonds issued by non-core members are no longer converging to the lower rates that markets give core members. The widening spreads are obvious not only in peripheral eurozone countries like Greece, Ireland, Portugal, and Spain, but are also showing up among non-eurozone EU member states like Hungary, Romania, and Bulgaria. This divergence comes from two sources: a decline in the belief that the European Union will provide universal bailouts within the eurozone, and doubts among market players about the strength of political enthusiasm in Eastern Europe (where bond spreads have stabilized for now) for adopting the euro.

In 2011, the idea of an ever-closer union will provoke deeper skepticism than we've seen in years, but the European Union has an opportunity to use this crisis to build support for the sorts of reform that only crisis can make possible. Policymakers are working along three tracks. First, they want to establish a permanent crisis resolution mechanism -- an extension of the EFSF that includes some form of burden sharing with private investors. The second element would consist of fiscal reforms that actually enforce growth and stability pact targets that have been ignored in several capitals for many years. The third part would involve macroeconomic rebalancing, with a focus on labor market and judicial reforms to improve economic competitiveness. But during the European Council summit in mid-December, leaders made only limited commitments to take these issues head on, and more talks will be necessary in coming months. They did agree, however, on a permanent mechanism to help eurozone nations crippled by debts. Market players need a lot more detail on how the crisis mechanism will work, but it's a step in the right direction. Monitoring and enforcing fiscal targets will be more straightforward, with some enhanced penalties and European Commission oversight rules.

Then there's the need to make several European economies much more competitive. Belief in the ability of the European Union to force true macroeconomic rebalancing requires faith in the political will of both Brussels and core eurozone countries to push through systemic changes that will generate lots of pain. Selling those changes, and persuading crisis-weary publics to accept that the pain will last well beyond 2011, will prove the biggest challenge of all.

This post was written by analysts in Eurasia Group's Europe practice.