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In Euro Zone, Signs of Progress and Fears of Complacency

M. Lorden | Taxi | Getty Images

This may be the year that Europe stops being the ticking time bomb of the global economy.

Ireland is on track to leave international bailout limbo by summer. Talk of Greece's departure from the euro is off the table. And financial speculators have generally stopped betting the euro zone will blow up.

But even as the sense of emergency fades, Europe is potentially facing a starker problem.

For three years, Chancellor Angela Merkel of Germany and a phalanx of policy makers have been working to shore up the euro's foundations to prevent the currency union from coming apart. As they gather with academics, executives and various experts this week at the World Economic Forum, which opens Wednesday in Davos, Switzerland, the biggest concern is that leaders might become less vigilant now that the heat is off, ushering in a spate of new troubles that could dog the euro for years to come.

(Read More: What Makes Angela Merkel Tick)

"The risk is that complacency takes hold because there is no more urgency in the crisis, and that everything that has been done up until now will be deemed sufficient," said Jacob Kirkegaard, a senior fellow at the Peterson Institute for International Economics in Washington. If that happens, he warned, "Europe will turn into the next Japan, and become a permanently depressed or stagnating economic area."

Ms. Merkel might be forgiven for feeling a sense of vindication. Her deliberate approach to crisis management and refusal to get too far ahead of German public opinion has often frustrated her euro zone peers and foreign allies. And yet, the strategy seems to have worked — so far, at least. Ms. Merkel, who is to speak in Davos on Thursday, and other European leaders have generally done just enough to contain the crisis without alienating taxpayers.

Much of the credit for the current calm in Europe goes to Mario Draghi, the president of the European Central Bank. He appeased financial markets with his promise last summer to do whatever it took to preserve the euro, including buying the government bonds of Spain if necessary to keep a lid on the country's borrowing costs.

The effect of Mr. Draghi's promise has been evident: financial markets have stopped driving the borrowing costs of Spain and Italy toward the danger levels that led Ireland, Greece and Portugal to reach for international financial lifelines. Today, few people fear that Europe's southern countries will break away from the euro union.

Other dire prospects, like Germany and other Northern European countries fleeing the euro union to avoid getting caught in a quagmire, have also dropped off the watch list. If anything, the focus of anxiety is the fiscal situation in the United States, where gridlock in Washington has become just as debilitating for the country's finances as the euro policy paralysis was for European politicians.

"Some European policy makers who visited the United States recently were delighted to see that because of the fiscal cliff, Europe wasn't on every channel," said Kenneth S. Rogoff, a professor of economics at Harvard. "There is an ecstasy over the fact that they won't blow apart tomorrow."

Still, Professor Rogoff added, Europe must revive economic growth to fully address its problems. "And even if they do, that's not a long-term solution," he said. "They need to integrate more fully, or they will fall apart."

Europe's political leaders have taken important steps to improve spending discipline among euro members, provide a financial backstop for troubled euro zone countries and consolidate supervision of banks. Despite many imperfections, the measures seem to have been enough to convince investors that officials are slowly building a more resilient currency union.

"European countries have shown their resolve in making the euro a success and reaffirmed the deep political commitment to work together toward a stronger union," Vtor Constncio, the vice president of the European Central Bank, told an audience in Beijing on Jan. 12.

But leaders have yet to address some serious flaws in the structure of the euro zone. For example, they have not solved the problem of how to wind down terminally ill banks without sticking taxpayers with the bill. And they are far away from a deposit insurance fund for Europe, which means the risk of bank runs remains.

"In order to define a turning point, you need a lot of factors besides the stabilization of financial markets," Mr. Draghi said this month.

But coming events could undermine confidence. Germany will hold national elections in September, which could make Ms. Merkel even more cautious than usual and stall euro zone decision-making. Already, her main rivals pulled off an upset in regional elections this weekend in Lower Saxony.

Italian elections are also looming. Mario Monti, the prime minister, who restored Italy's international credibility and is to speak at Davos on Wednesday, faces a public that is grumpy about a rollback of job protections and other policy overhauls. Silvio Berlusconi, a former Italian prime minister who presided over years of an economic standstill, is aiming for a populist comeback.

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In France, President Franois Hollande's pledge to bring the deficit down to 3 percent of gross domestic product this year to adhere to the rules governing euro membership may be challenged if France's military engagement in Mali and the surrounding region turns into a drawn-out affair.

Across the channel, Prime Minister David Cameron of Britain, who is scheduled to speak in Davos on Thursday morning, has sounded warnings that the country might leave the European Union if changes in its administration are not made. "The danger is that Europe will fail and that the British people will drift toward the exit," according to prepared text of a speech that Mr. Cameron postponed delivering last week because of developments in the hostage crisis in Algeria.

In the meantime, the severe effects of prolonged austerity in several European countries are leaving deep social scars. Tax increases and steep spending cuts have ground many European citizens deeper than ever into hardship, prompting millions to demonstrate in Greece, Italy, Portugal and Spain. Recessionary economies in those countries are expected to get worse before they improve.

In Greece, where austerity has hit the hardest, people are burning trash and wood this winter for lack of money to pay electricity bills, and the government's efforts to enact structural overhauls intended to turn the economy around and attract foreign investors continue to lag.

And then there is Germany, which itself is being tugged into a slowdown as its cash-poor southern neighbors continue to refrain from buying Audis and other high-price German goods.

Unemployment in the euro zone continues to climb: the jobless rate in the 17 countries of the bloc hit a record 11.8 percent in November. Youth unemployment has surpassed 50 percent in Spain and Greece, a stratosphere of despair. Thousands of bright young people continue to flee Greece, Ireland, Spain and other countries every month for the booming economies of Australia and Canada.

Portuguese workers are even going to Africa in search of a better future, as the middle class there grows along with improving economic conditions on the southern part of the African continent.

Yet painful adjustments are starting to bear some fruit. Labor costs have come down in countries including Spain and Portugal, helping make their work forces more competitive in the region. In Spain, for instance, where unit labor costs have fallen 4 percent since the onset of the financial crisis in 2008, the labor market is now so alluring that Ford, Renault and Volkswagen have announced plans to expand production there.

In addition, the alarming flight of deposits from banks in Spain has come to a stop.

The euro zone's problems have proved an opportunity for some countries to remove structural impediments to growth. In France, where Mr. Hollande has promised to make the economy more competitive, labor unions have agreed to a deal to overhaul swaths of the notoriously rigid labor market.

(Read More: Germany's Strong Man of Europe Image Threatened)

The deal would tame some of the French labor code's most confounding restrictions, including lengthy hiring and firing procedures and outsize business taxes, as the country tries to lift its competitiveness, curb unemployment and improve the budget.

"Is the worst over? Probably yes," analysts at Barclays Capital wrote in a recent note to clients.

That will be especially true if leaders and businesses persist in using the crisis as a chance to renew European competitiveness.

Some countries may have made enough economic overhauls to enjoy substantial growth, but once the crisis is past, said Nicolas Vron, a senior fellow at Bruegel, a research institute in Brussels, "there are a lot of nuts still to crack."

Contact Europe: Economy

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