Germany fiddles as the fuse burns low for Italy and Spain

German stubborness about Greek and other debt repayment is pushing Europe ever closer to danger.

On Friday, European Union leaders agreed to create a banking union, which they claim will avert a break-up of the single currency and help secure a global economic recovery. But in reality, the euro crisis remains the greatest threat to Europe and the rest of the world. As emerging markets in Asia and the Middle East power ahead, the old continent is falling further behind.

The purpose of the proposed banking union is to break the vicious circle between sovereign states and banks that has locked the euro area into a death spiral of debt and recession. In 2007 and 2008, billions in bad bank loans required government bailouts, which sent budget deficits soaring. Throughout the recession of 2009, banks abandoned risky private debt in favour of seemingly safe national debt. When Greece teetered on the brink of bankruptcy in early 2010, the banking crisis also became a sovereign debt crisis.

Friday's agreement addresses neither the banking nor the sovereign debt crisis. European leaders have designated the European Central Bank as the single supervisor with the power to intervene in any of the euro area's 6,000 banks - a key step towards a full banking union. But this was little more than a deferred decision from the previous EU summit in June, which had given rise to a period of unexpected stability.

German Chancellor Angela Merkel insists that bad assets held by insolvent Spanish and Irish banks will not be dealt with by the European Stability Mechanism - the euro zone's new €500 billion (Dh2.4 trillion) rescue fund.

But without recapitalising over-indebted banks using money from the ESM, Ireland will need ever-greater austerity to cut its budget deficit and public debt. The perverse result is to undermine both the banks and the government while inflicting even more unnecessary pain on the Irish people.

Dublin has incurred about €63 billion of national debt by bailing out its stricken banks. Now it stares into the abyss of debt, recession and default. That would represent ignominy for a nation of workers who produced an economic miracle in the past 30 years.

If Spain is also denied access to the ESM for direct bank recapitalisation, the government in Madrid will have to borrow at least €60 billion more to save its regional banks from insolvency. That will tip the country over the fiscal edge. A sovereign bailout is fast becoming a self-fulfilling prophecy. At that point the ECB could intervene and buy Spanish bonds to lower interest rates, but the damage to market confidence would be done.

Should contagion spread to both Spain and Italy, the euro area will be finished. Neither the ESM nor the ECB will be able to save the single currency then.

So Ms Merkel's refusal to sanction the recapitalisation of Irish and Spanish banks not only locks both countries into the iron cage of austerity and debt deflation, it also leaves the euro zone in a state of dysfunction, prolonging the recession instead of kick-starting a recovery. Little wonder that much of Europe resents her intransigence.

Germany's stance departs from its post-1945 commitment to democracy and reconciliation with its erstwhile European enemies. Reconciliation created peace and prosperity for which the EU won the 2012 Nobel Peace Prize.

Now the German diktat threatens to erode the foundations of European democracies and market economies. Greece's descent into depression is causing levels of social unrest that could topple the coalition government and bring to power extremists, from the right or the left. Spain faces the prospect of break-up, with the rich region of Catalonia trying to secede. Soaring unemployment and crippling austerity are fuelling the battle between the forces of centralism and regionalism.

Crucially, austerity fatigue in the periphery and bailout fatigue in the core are undermining European solidarity and reviving virulent nationalism. Even the International Monetary Fund now recognises that austerity alone is economically self-defeating because it diminishes overall demand, killing off growth and increasing debt.

While much of Europe is mired in recession, China's booming economy creates the GDP every three months that is the equivalent Greece's. Together the Bric nations - Brazil, Russia, India and China - create every year the equivalent of a new Italy, still the world's eighth biggest economy.

Jim O'Neill, the economist who coined the term "Bric countries", said last week that Germany already exports more to them than to France, insulating it from the crisis on the euro periphery. Thus the greatest threats to the euro and democracy in Europe are the growing imbalances between surplus and deficit countries.

What can be done? First, Europe needs to restructure debt by writing off some sovereign debt and converting much of the banking debt into equity. That would help turn short-term, self-serving shareholders into long-term, socially responsible stakeholders who lend to small and medium-sized enterprise and family-owned businesses.

Second, surplus countries such as Germany need to raise wages in line with productivity and channel their export-generated revenues into domestic consumption. Meanwhile, deficit countries like Greece and Spain must eschew borrowing to consume, in favour of saving to invest.

Third, Europe needs to invest its vast savings into research and development to generate innovation. Only growth will secure the prosperity and stability on which democracy depends.

Adrian Pabst is lecturer in politics at Britain's University of Kent and visiting professor at the Institut d'Etudes Politiques de Lille in France