Europe’s new Iron Lady is even criticizing Trichet for doing some little covert easing on the side. Traditionally, central banks have been sacred to German governments. And yes, right-wing teutons would have us believe that the country is still traumatized by a bout of hyperinflation happening 85 years ago, so that monetary orthodoxy and financial rigor shall never be doubted, much less undermined. So Ms Merkel, while the country is sinking into a hole dragging the whole of Europe into unemployment and eurozone is falling into deflation (it wouldn’t if the ECB were doing some serious quantitative easing), is worrying about inflation and fiscal profligacy. Call it the Maastricht fixation. Hope the european and national elections punish here. If that weren’t the case, it’d be as if europeans had signed their own pink slip and rewarded Europe’s present élites for the mess they got us into and cannot get us out of.

By Stefan Wagstyl, February 25 2009

This should have been a year of celebration in central and eastern Europe. It is 20 years since the Berlin Wall fell, the 10th anniversary of Nato’s eastward expansion and five years after the European Union began its enlargement into the region: from the Baltic to the Black Sea, the countries that escaped from Soviet rule have much to commemorate.

But the global economic crisis has spoilt the party. Instead of building on the achievements of the past two decades, the region’s leaders are feeling the economic foundations shaking under their feet.

All of Europe is heading towards its worst economic crisis since the 1930s. But compared with the wealthy west, central and east European nations are in a weaker position to respond. The dangers are so great that European Union leaders meeting in Berlin last Sunday agreed to back a doubling of International Monetary Fund resources to $500bn (£348bn, €391bn) to support the CEE countries in what Angela Merkel, German chancellor, called an “extraordinary international crisis”.

At risk is not only the economic development of vulnerable countries but even their political stability. Nobody expects a repeat of 1930s evils. But mounting anger over recession, unemployment and debt could fuel populism with unpredictable consequences. As in western Europe, there could be social and ethnic tensions. Reformist governments, multinational companies and banks could all become the targets of public protest when livelihoods are threatened. “The economic crisis will impact … eastern Europe more than western Europe because the political and economic systems in eastern Europe are more vulnerable,” says Carl Bildt, Sweden’s foreign minister.

The EU itself, the region’s political and economic lodestone, is running into trouble amid signs of western leaders responding to the crisis by putting national interests before Union-wide solidarity, notably over state aid for finance and industry. Having worked hard to bring their countries into the globalised European mainstream, some central and east European leaders feel betrayed. Pavol Demes, a former Slovak foreign minister and head of the CEE office of the German Marshall Fund, a US think-tank, says: “People are questioning liberal democracy, the markets and the EU. They see countries like France going for national solutions when international solutions are needed. They feel excluded.”

He and others applaud the Czech Republic, holder of the EU’s rotating presidency, for challenging Nicolas Sarkozy, the French president, over suggestions that aid to France’s carmakers might be tied to preserving French jobs rather than those the marques provide in central Europe. Mirek Topolanek, Czech prime minister, spoke for many in the CEE region when he said the response of eurozone countries “has deformed the joint project of the euro more than any other imaginable event”.

For all the anti-government demonstrations in Bulgaria and Lithuania, violent protests in Latvia and a surge in anti-Roma rhetoric in Hungary, however, CEE is not a region about to collapse into disorder. Despite the worries about EU solidarity, the 27-nation bloc’s new members remain committed to enhancing their integration. Poland, for example, is accelerating plans to join the eurozone. “What we need is more Europe, not less Europe,” says Eugeniusz Smolar, head of Warsaw’s Centre for International Relations.

Whatever happens, different countries are likely to go through the crisis with widely differing results. At one extreme are nations under particularly severe financial pressures, headed by Hungary, Latvia and Ukraine, which have secured IMF rescue packages. At the other stand Poland, the Czech Republic and Slovakia, a base of relative economic stability in the central European heartland. Manfred Wimmer, chief financial officer of Erste Group, the Austrian bank with big CEE operations, warns: “What’s been lost in this crisis very often has been the ability of people to differentiate.”

Still, there is a sense of gathering gloom even in countries that have so far escaped the worst. In Croatia, record numbers of skiers have holiday­ed abroad this winter, property prices on the Adriatic coast remain high and the nightspots of Zagreb, the capital, are busy. But all is not well, says Davor Butkovic, a commentator at the daily Jutarnji List. Speaking in Zagreb’s fashionable Bulldog bar, he says: “We don’t have an economic crisis yet but there’s a feeling that something bad is coming. At Jutarnji List there is a 30 per cent drop in advertising this year.”

After nearly a decade of rapid growth, still at nearly 5 per cent last year, gross domestic  product in the region – including central and south-east Europe and Ukraine but excluding Russia – is set to fall in 2009 for the first time since the post-communist chaos of the early 1990s. Migrants are returning home from the faltering economies of western Europe and Russia. Foreign direct investment is being postponed, as with Fiat’s €1bn ($1.3bn, £890m) plan to modernise Serbia’s Zastava car plant.

Worse, some of the international banks that fuelled the recent economic growth are struggling to fund local subsidiaries, raising fears of collapses in credit. According to the Bank for International Settlements, the central banks’ grouping, at the end of September eastern Europe’s loans from foreign banks (local and foreign currency) were $1,656bn – three times more than in 2005 and mostly borrowed from west European banks.

This month’s market turmoil has highlighted the dangers. The European Bank for Reconstruction and Development, the region’s multilateral bank, estimates the banking sector needs $200bn in refinancing this year and $100bn-$150bn to recapitalise in order to cope with bad loans. The question is how much of the loan books turn sour as economies slow and currencies fall. Foreign exchange loans, ranging to 90 per cent of lending in Latvia, are a particular concern because of the extra burden on borrowers who make repayments out of local currency earnings.

If banks cover only 70 per cent of their subsidiaries’ needs, governments and multilateral institutions might face demands for about $100bn – a big sum but not overwhelming given the scale of west European and US bank bail-outs. Robert Zoellick, the World Bank president who has estimated a lower figure of $40bn-$45bn, is urging EU governments to support the IMF, the World Bank and the EBRD in raising funds, saying the issue is crucial to Europe’s future. He told a German newspaper this week: “I would consider it an immense tragedy if Europe were to break into two parts again.”

Not everybody is queuing at the IMF, however. Slovakia and Slovenia are safely inside the eurozone. Poland and the Czech Republic insist they need no support and say recent market upheavals are partly due to panicked investors mistakenly viewing the region as an undifferentiated disaster zone.

The social and political impact of the crisis will also vary. Latvia’s government collapsed last week over IMF-mandated austerity. In Ukraine, the economic turmoil has become the latest battleground between President Viktor Yushchenko and Yulia Tymoshenko, his prime minister. In Bulgaria the crisis has boosted support for Gerb, a populist anti-corruption grouping that hopes to win power in elections this summer. Elsewhere, however, the crisis has strengthened governments. Donald Tusk, Poland’s liberal prime minister, is more popular today than when he took power in 2007.

But these are short-term developments. A prolonged crisis could undermine support for market-oriented policies and generate conflict and confusion. Krisztian Szabados, head of the Political Capital Institute, a Budapest research group, worries about increased far-right activity, particularly in countries with significant gypsy minorities. “The right wing is on the rise,” he says, pointing to Jobbik, a far-right Hungarian party that won 8.5 per cent of the vote in a local election last month.

A bigger test for the likes of Jobbik will come in this summer’s European parliament elections. The issue for CEE leaders may not be the size of the extremist vote. After all, few rightwing parties in the region have done as well over time as France’s National Front. But managing shows of extremism will be hard. Public institutions are weaker than in the west and officials are sometimes unable or unwilling to impose their authority. Mr Szabados cites the example of the recession-hit Hungarian city of Miskolc where a police chief, removed for blaming gypsies for a crime wave, was reinstated after demonstrations in his support.

Ivan Krastev, head of the Centre for Liberal Studies in Bulgaria, worries about a collapse in middle-class morale if people lose their jobs and are engulfed by their mortgages: “These people identified with the west and now feel betrayed. ‘We did our best,’ they say. ‘We followed the best practices and now we are told these were the worst practices.’ And no other models are available.”

He draws parallels with the 1998 Russian financial crisis, where middle-class people who lost their savings turned their backs on liberal democracy and came to support the authoritarian Vladimir Putin. “There could be a loss of faith in the west, as there was in Russia,” Mr Krastev says.

But this seems too apocalyptic a view for most of the CEE region. With the benefits of EU membership in full flow, from farm aid to political security, elites will fight hard against populist efforts to change course. Democratic and market-oriented institutions are far stronger than in 1990s Russia.

Also, even in recession, the region’s economies are this year forecast to perform better than those of western Europe. CEE’s advantage of low-cost, high-quality labour remains in place. As Erik Berglof, the EBRD’s chief economist, says: “Despite the crisis, the long-term integration of central and eastern Europe with western Europe will go on. The development model is the right one.”

AUSTRIAN BANKS:

Exposed Vienna tries to put a brave face on its neighbours’ misfortunes

The fall of communism in eastern Europe marked the beginning of a long bonanza for Austria, writes Eric Frey. From the late 1990s it recorded growth rates well above the eurozone average thanks to its massive engagement in the economies of its by then booming neighbours. As recently as January this year, the European Commission predicted that the country would be less affected by the global economic downturn than Germany or Italy.

Yet Austria’s luck may have finally run out. Of particular concern is the huge exposure of the three major banks, Bank Austria, Erste Bank and Raiffeisen, to central and eastern European economies now in the grip of a deepening financial crisis. Shares of Erste Bank and Raiffeisen International, once the heavyweights on the Vienna stock exchange, have tumbled over the past two weeks, losing about 90 per cent from its 1997 peaks before recovering slightly.

Austrian banks have lent a total of $300bn (€210bn, £235bn) to clients in the region, equivalent to 68 per cent of Austrian gross domestic product, according to the Bank for International Settlements (BIS). If Bank Austria, which is owned by Italy’s Unicredit, were included, the figure would rise to about 100 per cent, by far the highest of any west European country.

An economic collapse in the east would wipe out the capital of Austria’s banks and force the government to launch a hugely expensive bail-out. It would also hurt hundreds of industrial groups, retailers and other service companies that either invested in eastern Europe or rely on sales in the region.

Market jitters about the crisis in eastern Europe have driven up the spreads on Austrian state debt over German bunds since the beginning of the year. Last week they widened sharply amid talk that Austria might lose its triple-A credit rating.

These reactions may be overdone, according to some analysts. “Even a wave of defaults in the east similar to the Asian crisis would not affect Austria’s ability to service its debt,” says Dirk Schumacher, an economist at Goldman Sachs in Frankfurt.

Most Austrian bankers and economists argue that the country’s links with eastern Europe remain an asset for the economy, at least in the long run. Ewald Nowotny, the governor of the Austrian National Bank, points to the relatively solid economies of the Czech Republic and Slovakia, two of Austria’s main economic partners. “Austria is most exposed in those countries that are still expected to grow,” he says.

The two main trouble-spots are Ukraine, where Raiffeisen has a large exposure, and Romania, where Erste Bank has been the market leader since it acquired Banca Comerciala Romana in 2005. Both countries are suffering from high private debt burdens and are projected to see a surge in default rates.

But Andreas Treichl, Erste Bank’s chief executive, says: “Ninety-eight per cent of our clients make their interest payments on time. I don’t see that it is dangerous for Austrian banks to be in central and eastern Europe. We made huge investments in the region, but we invested in the real economy.” So far neither Erste Bank nor Raiffeisen have accepted capital injections offered by the government because they have not yet agreed on terms.

Yet there is plenty of anxiety in government and financial circles. The banks have lobbied the European Commission for a special aid programme for institutions exposed in central and eastern Europe, while Josef Pröll, Austria’s finance minister, this month toured the region in an attempt to mobilise support for a co-ordinated approach.