Northern lights, southern cross

A TWO-SPEED Europe has historically been a political spectre, but it has now become an economic reality. It is happening within the euro area, the heartland of European integration. On the fringes of the single-currency zone Greece, Ireland and Portugal have become ensnared in a sovereign-debt crisis. But in its northern core, driven by the German powerhouse, economies are reviving and public finances are solid. Now many fear that the economic divide could turn into a political chasm.

European finance ministers did their best to strike a pose of business-as-usual at a meeting on May 16th that Dominique Strauss-Kahn, then the head of the IMF, had been due to attend before his arrest in New York. They agreed to designate Mario Draghi, the governor of Italy's central bank, as the successor to Jean-Claude Trichet at the helm of the European Central Bank (ECB) later this year. But business-as-usual also meant giving the go-ahead to a third bail-out, for Portugal, adding €52 billion ($74 billion) to the €26 billion already pledged by the IMF. And there was mounting concern that the first bail-out, to Greece a year ago, is in deepening trouble. Euro-area finance ministers acknowledged that a “soft” restructuring of its colossal public debt may be on the way (see article).

The economic distress of southern Europe was manifest in recently published GDP figures for the first three months of this year (see chart). Portugal slipped back into recession. Although Greece announced a surprise increase, this still left its output 4.8% lower than in early 2010; and it followed a more woeful performance late last year than previously thought. The bigger Italian and Spanish economies managed to grow, but barely. Unemployment rates across most of southern Europe are desperately high. And Ireland, which has yet to report its output for early 2011 but suffered a sharp 1.6% contraction late last year, is sharing the southern gloom.

By contrast, the core of the euro area is basking in sunny economic revival. German output grew by a breathtaking 1.5% in the first three months of 2011 (6.1% on an annualised basis). The French economy, which had dawdled last year, got going too, expanding by 1% over the previous quarter. Since the pair make up almost half of euro-area GDP, this helped the single-currency zone put on a burst of speed in the first quarter, outpacing America and Britain, to grow by 0.8%. Output was 2.5% higher than in the same period in 2010.

Consistent with this healthy performance, the euro has been fairly strong, trading above $1.40. Renewed jitters about Greece have brought it down from a near-$1.50 peak in early May. But it is still higher than at the start of the year, helped by the fact that the ECB was the first big central bank among rich economies to start tightening, when it bumped up its main interest rate from 1% to 1.25% in April, with a further quarter-point increase likely this summer.

Explore our interactive guide to Europe's troubled economies

Growth in the euro area for the rest of this year is likely to be less exuberant, says Julian Callow, an economist at Barclays Capital. Output in the first quarter was flattered by the bounce back from poor weather in late 2010. There are already signs that the German economy may be coming off the boil. Manufacturing orders fell in March. An economic-sentiment index published this week by ZEW, a think-tank, was buoyant, but expectations for six months' time are sagging.

Still, Germany looks set to lead a robust expansion in the northern part of the euro area. As these countries grow they will import more, helping the beleaguered southern economies by boosting their exports within the single-currency zone. Germany, which itself struggled in the early euro years, can now spread its better fortunes more widely, argues Holger Schmieding, an economist at Berenberg Bank.

Yet despite that fillip, the weak economies may continue to flounder. Many of Germany's new imports come from central rather than southern Europe. A strong euro makes it harder for the southern countries to boost their exports to countries outside the currency union—and Germany's success in keeping its unit labour costs down means the less competitive southerners have to run just to stay still. On top of all this, the higher interest rates that may now be needed in Germany will inflict another blow on the most vulnerable economies. Mortgages in southern Europe and Ireland are typically variable-rate, whereas fixed-rate housing finance prevails in Germany and France.

More important, the predicament of Greece, where public debt is now forecast by the European Commission to reach 158% of GDP by the end of the year, looks ever more intractable. There is also growing concern over the rescues of Ireland and Portugal. Both countries' debt burden will vault above 100% of GDP by the end of this year, according to the commission.

The longer the economic divergence within the euro area persists, the more profound its political consequences. Northern electorates are growing restive over the apparently endless bail-outs. A recent poll in Germany showed that only 20% thought the rescue of Greece was right; 47% said it was wrong. But the fallout may eventually be even greater in southern Europe and Ireland. These countries are already struggling to deal with the onerous austerity packages that are the price of their rescues. If they come to believe that the promise of eventual convergence in living standards with rich Europe has been dashed, for how much longer will they be willing to swallow their nasty medicine?