IT’S TOO SOON to pop the champagne corks. Europe, mired in gloom for years, still faces many high hurdles to resolve its crisis. Nonetheless, there are some auguries of prosperity that might invite a stockpiling of party hats and noisemakers. In December 2013, Ireland successfully emerged from its bailout, and Portugal followed this May. This verifiable progress represented a first for members of Europe’s struggling periphery. But this news should only lift spirits so high. If these financial gains make anything clear, it is the need now to go beyond budget control to more fundamental and structural economic reform. Ireland’s finance minister, Michael Noonan, summed up the situation well, characterizing his nation’s emergence from the bailout as a “milestone,” not the “end of the road.” To secure their economic and financial future, Ireland, Portugal, the rest of Europe’s periphery and France (which increasingly resembles the periphery) will have to reform long-standing labor, product and tax practices, and even industrial structures, to promote rather than impede organic growth. These nations must do nothing less than reshape the political-economic models under which they have operated for decades.

Such structural reform has huge significance. Success or failure on this front will effectively determine power relationships throughout the euro zone and the European Union. German dominance, even hegemony, will expand if France and the nations of Europe’s beleaguered periphery fail to enact fundamental economic reform. Without it, they will remain economically weak, financially fragile, dependent on Germany and subject to its lead. With effective reform, however, France and the periphery have a chance to regain economic vitality and shed the need for German support. These are the options. Ironically, all the initiative lies with the weaker countries. Germany is bound to the union. It will have to play the hand France and Europe’s periphery deal it. They will determine whether Berlin gains dominance or whether Europe can restore its former balance.

FOR ALL that remains to be done, Dublin, Lisbon and Brussels are entitled to some rejoicing. In 2009, Ireland and Portugal were insolvent. Each country’s ongoing budget deficit ran at more than 10 percent of its gross domestic product (GDP). They had to pay double-digit interest rates to borrow on global capital markets, an expense that intensified their financial strains. The official bailout lifeline, €85 billion for Ireland and €78 billion for Portugal, bought time for needed budget reform. It also enforced it. Unlike in the ad hoc arrangements made for Greece, Europe was much better organized when it moved on to Ireland and Portugal. Germany and other stronger nations pooled their resources in what they called the European Stability Mechanism, which then, in concert with the International Monetary Fund (IMF) and the European Central Bank (ECB), supported the bailouts. This troika, as it is called, offered subsidized financing in a series of tranches, each conditioned on certain budget and deficit milestones. And the process can claim success. Now, Ireland expects deficits at 4.7 percent of GDP in 2014 and Portugal at 4.0 percent. The improvement has allowed both governments to return to capital markets, where investors have shown considerable interest in their bonds, allowing them to borrow at significantly reduced interest rates.

Gratifying as this success is on one level, it has undeniably come at a terrible cost. The budget austerity demanded by the troika has driven both Ireland and Portugal into deep recessions, especially coming, as the bailout demands did, while these economies were still reeling from the 2008–2009 financial crisis. Unemployment in Portugal remains a heartbreaking 14.3 percent of the workforce. In Ireland, unemployment, having peaked at 15 percent of the workforce in 2012, has improved to about 11.6 percent, but more from mass emigration than economic gains. Worse, ongoing austerity threatens to keep these economies in recession or stagnation at best. Indeed, continued austerity runs the risk of creating a vicious cycle in which the budget restraint so depresses the economy that, despite the best efforts of the authorities, slow growth and additional demands for social services enlarge budget deficits, eliciting more austerity that causes more recession, more budget problems and so on in a downward spiral.

What makes matters even worse is that there is little room for fiscal latitude. Even now, as these countries emerge from troika controls, Ireland and Portugal know that promoting growth and employment through expansive fiscal policies, as France has suggested on occasion, is out of the question. Though they have regained control over their ongoing budget situations, they cannot so easily shed the legacy of past profligacy. Because this legacy has created suspicion among investors and left capital markets with a huge overhang of their debt, the slightest hint of a turn away from austerity now would panic investors. The same constraint applies throughout Europe’s periphery, France included. Any attempts to use expansive policies would quickly cool investor interest, drive up these nations’ borrowing costs and prompt credit-rating agencies to downgrade their national bonds (as they have already done with France’s), raising borrowing costs still more. Finding it increasingly difficult to borrow at reasonable rates, these countries would have to return to austerity or they would quickly find themselves back in a fiscal-financial crisis of the sort from which they have just begun to emerge.

Confronted with such constraints, the countries of Europe’s periphery must either accept the unpalatable option of ongoing recession or find some other way to promote growth. This is where fundamental reform comes in. At other times in other nations, efforts to improve economic efficiency, flexibility, innovation and competitiveness have promoted growth and employment even under strict budget controls. The ability to return to well-grounded growth and financial health has both its own obvious appeal and the added attraction of freeing these nations from their present dependence on Germany. Still, such structural reform will face high political hurdles. Many powerful groups in these countries have vested interests in the old policies and practices and will inevitably resist the necessary changes. Established businesses, many of which receive subsidies or otherwise dominate the status quo, will fight any effort to promote competition or efficiency. Union officials will resist labor-market reform for fear that it would detract from their power and influence. Government bureaucracies will fight the need to change their presumptions and biases.

IF SUCH reform faces resistance, these nations certainly do not lack for guidance on what they need to do. In fact, Germany’s own experience offers one proven blueprint for economic revitalization. Just over ten years ago, Germany, too, had an unsustainable political-economic model. Its industry was inflexible, becoming less productive and competitive. Employment policy discouraged work. Unemployment, not surprisingly, had risen toward 12 percent of the workforce. The Economist fairly called Germany “the sick man of Europe” in 1999. In response, Peter Hartz, personnel director of the Volkswagen Group, offered a series of bold proposals in 2003. To his immense credit, then chancellor Gerhard Schröder embraced them and, against all the recidivist inclinations of his own party, launched a series of successful reforms that have come to be called the Hartz Reforms or, as Schröder preferred to call them, “Agenda 2010.”

These changes, first and foremost, aimed to encourage hiring by making it easier to fire excess or incompetent employees. Previously, the time and expense needed to terminate an employment contract had made German businesses reluctant to hire even promising employees. In a similar vein, Schröder’s reforms liberalized rules on part-time and temporary employment. To put labor resources at the disposal of a revitalizing economy, his policies sought to encourage work by cutting taxes and emphasizing the training of young workers and the retraining of displaced workers. He reduced the attractions of welfare and unemployment by consolidating the two benefits into a basic living standard, widening the range of jobs considered acceptable by the authorities and shortening the time people could collect unemployment from three years to one year, or eighteen months for those over fifty-five.

The reforms took time to have an effect. In the interim, Schröder lost the chancellorship to Angela Merkel in 2005. Now, with the Hartz Reforms widely acknowledged to have revitalized Germany’s economy, Merkel is enjoying the payoff. Today, Germany, unlike much of Europe, is growing. Even in the midst of this crisis, its economy expanded in real terms by 4.0 percent in 2010 and 3.3 percent in 2011. The weight of Europe’s crisis slowed growth to 0.7 percent in 2012 and 0.4 percent in 2013, but there is still widespread confidence in the fundamental strength of the German economy as a result of the reforms. German unemployment stands at 6.5 percent of the workforce, less than half Europe’s average and its lowest rate since reunification in 1990. Youth unemployment, a scourge throughout most of the rest of the Continent, stands at a twenty-year low in Germany. The difference is especially evident among older workers as well. Some 60 percent of Germans between fifty-five and sixty-four work today, well up from 40 percent in 2003. Meanwhile, Germany’s budget is balanced and its debt is falling, both absolutely and as a percentage of GDP.

Swedish, Finnish and Danish experiences should bolster confidence in the power of such structural change. Having followed Berlin’s lead, all these countries have shown better economic performance and stronger national finances than France and Europe’s periphery. Between 2009 and 2013, these three Scandinavian countries grew in real terms at annual rates of 3.0, 1.0 and 0.6 percent, respectively, hardly a powerful performance by longer-term historical standards but vastly better than the outright declines registered in Spain, Italy and France, for example. What’s more, the Scandinavian countries’ growth, by raising tax revenues and curtailing demands for social services, has put their public finances on a much firmer footing. They have reduced their budget deficits, in most cases to within the EU’s acceptable parameter of 3 percent of GDP, and so they have kept their outstanding debt burdens lower relative to GDP than elsewhere.

The Organisation for Economic Co-operation and Development (OECD) provides another authoritative source of reform guidance. Drawing on the experience of all its members, both inside Europe and outside it, the OECD has developed a thorough review of the structural reforms that, in its own words, have a proven ability to “enhance long-run productivity and growth performance.” The organization’s research, presented in a series of studies under the title Going for Growth, professes to tell nations not just “where to go” but also “how to get there.”

The wealth of analysis and recommendations in the OECD’s book-sized reports go beyond the scope of an article like this. In summary, it is fair to say that much of its work resembles the Hartz Reforms. On labor-market policies, for instance, the OECD would encourage hiring by making firing easier and less costly. Similarly, the OECD identifies great potential gains from efforts to reduce the cost of labor by cutting payroll taxes and by decentralizing wage bargaining, especially moving from national contracts to company-by-company negotiations. Less a part of Germany’s reform but identified by the OECD as significant are efforts to increase competition within domestic markets by, for instance, removing internal protections for inefficient, established firms and sweeping away regulations that impede entry by new competitors. Pointing to successful reforms made in Norway, the Czech Republic and the Netherlands, the OECD also recommends a simpler tax code that reduces statutory rates and makes up the revenue difference by sweeping away subsidies and applying taxes more broadly throughout each nation’s individual and business populations.

STILL ANOTHER reform blueprint emerges from the efforts of Italy’s former prime minister, Mario Monti. He was well aware that every nation in the OECD’s study that adopted such reforms grew faster and achieved lower rates of unemployment and a better fiscal balance than those that failed to reform. He was even more acutely aware of the need for an alternative way to promote growth while Europe’s periphery remained unable to give up budget austerity. Structural reforms, he made clear, were the only option for Italy and for Europe’s periphery in general. Though diplomacy no doubt prevented him from promoting such reforms explicitly as a way to shed dependence on Germany and so avoid German dominance, he surely must have thought about it.

Monti set out a reform agenda for Italy in 2011. Though he never drew the parallel explicitly, it looked remarkably like the Hartz Reforms. He began with an effort to liberalize Italian labor markets, making them more flexible by easing rules on hiring and firing, allowing wage negotiations to proceed company by company instead of on a national level and giving management more freedom to set work schedules. He also looked to alter unemployment compensation in order to encourage displaced workers to seek training and return to the workforce. Though such labor-reform efforts have failed in Italy’s past, Monti was able to use the exigencies of Europe’s crisis to move the government to action. The progress he made, though far from complete, was remarkable, especially given the powerful interests vested in those old labor rules. The last two times Italy tried to relax its restrictive labor laws, in 1999 and again in 2002, the Red Brigades paramilitary organization murdered the leading lights of reform. This time, not even all the unions opposed the changes.

Monti had to leave his efforts incomplete, however, because, for reasons unrelated to reform, his coalition collapsed and Italy had to call new elections in 2012. Monti, never a politician, could not prevail. Yet while he was making his biggest push in 2011 and early 2012, these sorts of reforms did gain adherents elsewhere in Europe’s beleaguered periphery. Spain, Portugal and even Greece pushed similar changes. Clearly, the fiscal-financial crisis served as a considerable lever with which to move entrenched opposition aside. The OECD analysts behind the Going for Growth series noted a marked uptick in interest during that time, especially from Spain and Portugal. But lately, enthusiasm about such progrowth reform has ebbed, no doubt because the intensity of the crisis has also ebbed, though no government to this point has substantively unwound its former reforms.

France would seem to be an exception. Though the intensity of the crisis has dissipated there, too, Paris faces an alternative source of pressure. All three major credit-rating agencies have downgraded France’s standing. Since the agencies have encouraged structural change as a remedy for France’s troubles, Paris, unlike the others, has felt obliged at the very least to increase its conversation on the subject. Paris began to talk up reform last spring and even implemented rule changes at the time that at least gestured at the available reform models. In 2014, President François Hollande has again talked of reform in what he called a probusiness agenda. Acknowledging that Paris cannot redistribute if there is no wealth, he vowed to remove the burdens on business. As per much of the reform advice, he promised in particular to slash payroll taxes and wasteful government spending.

So far, however, French efforts have been more apparent than real. Admittedly, Paris has made it marginally easier to hire and fire and has made unemployment compensation less attractive, but it has done little to help displaced workers gain additional skills for new jobs. It talks about reducing the cost of labor, but, last spring, rather than lighten overall employment tax burdens, Paris merely shifted them from direct payroll taxes to the value-added tax. And Paris has only offered selective tax relief. More recent statements promised more earnest efforts to cut taxes and pay for the lost revenue with spending cuts, but those statements notably lacked specifics. Nor has Paris done much to promote competition. Instead of encouraging efficiency by easing barriers to entry into French industry, Paris so far has left all its old regulations, subsidies and special accommodations in place. Its substitute is a scheme of subsidized financing for firms in what it calls the “sectors of the future.” Hardly the “competition” the OECD and the rating agencies have recommended, this is an extension of government control and government subsidies for its favorites. Meanwhile, the present government has raised individual taxes and reversed many of the small reforms of its predecessor.

THE WAY it looks right now, France and Europe’s periphery will fail to embrace structural reform sufficiently. Unless they accelerate their efforts, they, stuck as they are with their budget constraints, will face ongoing recession or at best economic stagnation. They will consequently remain dependent on Germany and so increasingly be subject to Berlin’s influence. Perhaps if the euro zone were really a single coherent whole, as its elite so earnestly claims, weakness in the periphery would not lead so directly to rising German power. In such a world, financial and economic burdens would be more diffused and ambiguous, making it easier to argue that the burdens, wherever they fell, served the union’s general needs. But as it is, Europe is not yet such a coherent whole. Burdens and requests for help are associated with nations. And the citizens of those nations doing the lifting will naturally demand compensation in one way or another for bearing those burdens. Such demands will manifest themselves in claims for greater control and leadership.

This crucial difference between elite dreams and reality became painfully clear in an otherwise insignificant incident late last year. A group of smaller German banks, called Sparkassen, complained to the ECB about its monetary policy. The decision to hold interest rates low, the banks argued, helps Europe’s periphery at the expense of German savers. What they said is true, of course. The deeply indebted periphery benefits from low rates, as Germany’s earnest savers suffer low returns on their assets. German media picked up the story and, knowing the popularity of the message, broadcast it widely. What most highlighted the contradictions in Europe’s reality was the way the ECB’s president, Mario Draghi, responded. Instead of dealing with the Sparkassen’s argument, he chided them for their “nationalistic undertone,” insisting that the members of the ECB Governing Council are “not German, neither French nor Spaniards nor Italian” but instead “are Europeans,” and the ECB is “acting for the euro zone as a whole.” By clumsily pretending that these burdens and benefits did not fall along national lines, Draghi only managed to emphasize how few “Europeans” there really are, at least as he uses the term, and how many Germans and Spaniards remain, one to carry the burden to help the other.

This is just the latest illustration of how this fiscal-financial crisis has forced Europe’s national reality repeatedly to break through the illusions of elite opinion. Before the crisis, it was easy to pretend that Brussels or the ECB spoke for a coherent whole of “Europeans.” But as the crisis developed and burdens and needs clearly fell along national lines, it became increasingly obvious that the EU never directly served the people of Europe. It has always only worked through the separate member nations. The best it has ever been able to do is to ask the governments of its stronger members to accept disadvantages for the sake of the union, which they do only to the extent that it suits their longer-term national interests. In this crisis, that has effectively meant German support for the weaker nations of Europe’s periphery. As the burdens of the crisis have intensified, those asked to do the carrying, the Germans, have increasingly pushed their national government to demand something in return for their cooperation and sacrifice. As long as France and the periphery continue to need German help, those demands will continue to grow.

IT MIGHT seem that Germany could relieve the strain simply by walking away from the union. But it has stayed—and will stay—despite the burdens, less out of loyalty to Europe (though doubtless there is some of that) and more because Berlin sees more cost in leaving than in staying. Both the political leadership in Berlin and financial leadership in Frankfurt know how severely a dissolution of the union or the common currency would impinge upon Germany. Given the amount of the periphery’s debt held by German banks, such an event could actually threaten the country’s entire financial system. According to recent reports, German banks hold €300 billion in Spanish, Greek, Portuguese, Italian and Irish obligations. A loss of half this magnitude would so curtail liquidity and credit in the German economy that it would drive it into a deep recession, causing much more harm than even a much larger burden of rescues and bailouts. Clearly, it is cheaper for Germany to support the periphery than it would be to support itself were the periphery to fail.

Germany’s leaders can also see how the country gains economically from the common currency. If Germany were alone, its relative success would by now have pushed the price of its deutsche mark up to levels that would make it difficult for its industry to compete globally. Tied to the euro, however, with its weaker members, the currency in which German producers trade is hardly likely to rise as far as an independent deutsche mark would, sparing them those competitive disadvantages. Further, the euro offers German industry special advantages within the euro zone. Because Germany joined the euro when the deutsche mark was cheap relative to German economic fundamentals, the common currency has effectively enshrined a competitive pricing edge for German producers across the entire zone, especially compared to producers in Europe’s periphery nations, which joined the euro when their respective currencies were stronger. OECD data show that these currency differences initially gave German producers a 6 percent pricing advantage over their Greek, Spanish and Irish competitors, an edge that has actually expanded during the hard times of the crisis to between 15 and 25 percent. On this basis, Germany might well owe the periphery support.

But if national interests will hold Germany in the union, Berlin will still demand compensation for the support it provides. It is already making such demands. Chancellor Angela Merkel has proceeded diplomatically and respectfully, but nevertheless Berlin increasingly has taken control. A recent check to Merkel’s proposal for more centralized control of the euro zone’s economic policies was noteworthy mostly because such resistance to German prescriptions has become so rare. Otherwise, Berlin has dictated the rules for the use of the zone’s stabilization fund. It has insisted on German-style bank supervision before it will allow European (meaning German) funds to help troubled financial institutions in Spain and elsewhere in Europe’s periphery. It has blocked the issue of pan-European bonds, insisting, before even considering them, on ways to guard German wealth. One Brussels bureaucrat summarized the situation for the Economist by saying that when the Germans change their position, “the kaleidoscope shifts as other countries line up behind them.” Now, elements in Germany are trying to influence ECB policy. Merkel has had to make many of these demands on behalf of her constituents even while playing the good European. She will have to continue in this way as she pursues further European diplomacy. It is the only way she can get Germany to cooperate, though it is an open question whether she will try to influence the ECB.

In theory, the whole union could come unwrapped. But it’s an implausible outcome. The European Union may not be back yet as a healthy economic player. But it’s also not going away. If real reforms are implemented—always a big if—then before too long it may be time to take the champagne and party hats out of storage.

Milton Ezrati is senior economist and market strategist for Lord, Abbett & Co. He is the author of Thirty Tomorrows: The Next Three Decades of Globalization, Demographics, and How We Will Live (Thomas Dunne Books, 2014).

Image: Flickr/Eoghann OLionnainn. CC BY-SA 2.0.