The EU may be in a mess but ...

Events in Europe are moving so fast it's hard to follow developments, Hamish Rae offers 10 observations to help keep things in perspective about the state of the union.

1 Recognise that while the eurozone is about 15 per cent of world GDP, it is only 15 per cent of world GDP. The other 85 per cent matters more.

This explains the reasonably robust response on the equity markets to the mess in Europe.

Share prices have fallen in Europe and elsewhere in recent days but this is nothing like the collapse associated with the banking crisis two and a half years ago. The reason is that global business is still doing all right, notwithstanding the near certainty of recession on the Continent.

2 From Britain's point of view, it is overwhelmingly in its self-interest to rebalance its economy away from continental Europe.

One of the few encouraging bits of news in Britain yesterday was that Jaguar Land Rover (JLR) was hiring another 1000 workers in the West Midlands in response to increased demand.

JLR has been turned round by India's Tata Group, and its exports to India have steadily increased. The proportion of exports going to the emerging countries is still small; Britain exports more to the Irish Republic than all the Bric nations (Brazil, Russia, India, China).

But at least these are growth markets, whereas the plain reality is that Europe can't be a growth market.

3 While the present Greek rescue can't succeed, because the burden on the Greek people is too great, it could be just about possible to rescue Italy.

Italy will certainly need a rescue and to do so will stretch the limits of Germany's balance sheet for, one way or another, Germany would have to guarantee a portion of Italian debt.

France can't help, because it's likely to lose its AAA status and has no spare capacity to support anyone else. So it has to be Germany.

My own back-of-an-envelope calculations would suggest that Germany cannot safely do this without undermining its own credibility, but that may be too pessimistic.

4 Italy could do things to save itself, with a bit of help from the rest of Europe, the IMF, the Chinese, plus anyone else who might join in. The public debts are huge at 120 per cent of GDP but private debts are not. Italian families carry a much smaller debt burden than British or American families.

The country has great strength in engineering (its car industry led by Fiat has been turned round), in luxury goods and in tourism. It's only recently that its bond yields have started to move into the crisis zone - in fact only this week.

With good governance and somewhat lower borrowing costs, the country could gradually escape from its debt burden. I happen to think it won't and will eventually default in some form or other, largely because of its adverse demography. But I would like to be proved wrong.

5 Continental Europe has adverse demography. Britain is the only large European country where the population is forecast to rise significantly over the next 30 years.

France may rise a bit but Germany will decline: it already has a declining workforce. It's conceivable Britain will have the largest population in Europe some time after 2050.

So the euro, were it to continue, would be supported by a smaller population. Debts denominated in euros would be serviced by fewer working people.

So anyone lending to a eurozone country, any eurozone country, has to be aware of the risks involved. The change brought about by demography is gradual, but the change in the perception of risk can be very sudden, as we have seen.

6 So what will European nations do? They will go for austerity. Greece, of course, is tightening its policy; Italy's new Government will do so; France has just announced tighter measures.

I know some people feel this is likely to be self-defeating but people who believe that have no influence on policy. No one listens to them.

The question, then, is what austerity will do to European politics. It's difficult to call this one.

There seems to be support in France for a tightening of policy and in Britain the Coalition has held approval in general terms for deficit-reduction, though the specifics of the programme have been widely criticised. But policies that can retain democratic support for a while tend to hit a fatigue barrier. You have to ease up but you can't.

Over the next few years, even the present set of austerity measures will be tested and the north/south division within the eurozone will be under tremendous strain.

7 There is a divergence across Europe in economic performance. Before the recession, Germany was doing a little better than France, Italy and Spain in terms of industrial production, but not much. Since the recession, the gap has shot up. Italy has managed a bit of a recovery and France has done much the same, but Spain is still flat on its back. The weaker countries need a devaluation.

8 Will the eurozone split? Of course it is being discussed. Governments have to plan for disagreeable outcomes however unlikely they might think these are. The problem is it's very hard to think through the detail of such a split.

Would there be two euros, a financial euro and a trading one? Some years ago something on those lines was adopted in Belgium.

Or should there be capital controls within Europe, for example stopping Italians shifting money out of Italian banks and putting them in German banks? Or should one euro trade at a discount to the other euro - a soft and a hard euro? My own feeling is that none of this would be workable. But they may try.

So they try and fail. Here you have to stand back and ask what the EU might look like without the euro, or with a much smaller eurozone built round Germany. Maybe France would be in, maybe not. Would that be the end of the EU? Surely not.

The euro was an intermediate goal, a tool designed to pull the European economies together. It has pushed them apart. But it need not destroy the EU, which is surely a much bigger enterprise.

After all, the project is more than 50 years old, while the euro has been in action little more than a decade.

9 For the first 40 years, the EU managed fine without the euro.

10 That brings me to my final point. The EU was actually very lucky that Britain and other countries stayed out of the eurozone. The experience has demonstrated you can have an EU with countries retaining individual currencies. Had everyone gone in, the whole project might be in jeopardy. As it is, it's just in a mess.

- Independent