Matthew Melchiorre

As the New Year approaches, many challenges loom for Europe. Here’s a quick list of the toughest hurdles for 2013:

1. Implementing the Single Supervisory Mechanism (SSM): Earlier this month, European leaders agreed to establish a supranational banking regulator for the member states of the European Union (EU). The European Central Bank (ECB) will directly supervise banks with assets greater than €30 billion or 20 percent of national GDP. National regulators, operating within the confines of the European regulatory framework, will oversee smaller banks within their respective countries. Although the SSM is scheduled to begin operation in March 2014, the actual regulations to be enforced are still unwritten. As political leaders hash out the specifics next year and attempt to harmonize national regulatory structures of EU member states into one single framework, tensions will run high. Calls for a common European deposit insurer or reinsurance scheme will likely be one of the political speed bumps, as Brussels insists and Germany resists. The drama this fall between EU leaders and the U.K., Sweden, and the Czech Republic (all opting out of the common regulator) was a taste of the future tension that implementing the European banking regulator will inevitably entail.

2. Bailouts:The European Stability Mechanism (ESM), Europe’s permanent bailout fund, began operation this fall. Essentially, the fund is a more fluid way for Europe to bailout its struggling members, as raising and disbursing bailout funding now relies on bureaucratic procedure instead of intergovernmental political wrangling. The ESM’s Board of Governors, made up of the member states contributing to the fund, decides whether to approve requests for rescue funding. Voting weights reflect the capital contribution of the members, so Germany, France, and Italy have the most influence. Additionally, the ECB buttresses the power of the ESM through its “unlimited” sovereign bond-buying Outright Monetary Transactions (OMT) program, as any member state that formally requests ESM funding and agrees to ESM conditions can also apply for OMT assistance. Neither ESM nor OMT assistance has yet been requested by the member states. The ESM is also incomplete. It cannot recapitalize banks directly until the SSM is in place — thereby raising the stakes for negotiations next year concerning the SSM’s implementation.

Although Spain received a bank recapitalizationof €37 billion earlier this month from the ESM (first going to Spain’s “bad bank,” because direct recapitalization is prohibited without the SSM), that funding was part of €100 billion credit line approved by Europe in June — the ESM was simply the vehicle used to deliver the pre-authorized cash. Madrid will almost certainly come back for more, as the bailed-out banks make private bondholder haircuts and trim back credit to repair their balance sheets – a painful but necessary measure that will temporarily increase the volume of non-performing loans and trigger a restructuring of more banks. Another European bailout risk is the recurring Greek debacle, as next year’s strong round of budget cuts threatens to inflame political tensions. Europe was on the edge of its seat this spring when it seemed that Greece’s far-left Syiza party would come to power and repudiate current and future reforms. Fortunately, this did not occur. June elections gave the conservative New Democracy party the most votes and a political mandate to pursue austerity and keep Greece within Europe. But this is a fragile equilibrium, as Syriza came in a close second and populist anger in Greece could resurface and destabilize New Democracy’s power when new budget cuts to pensions and public wages take place next year.

But a European bailout crisis in 2013 will not come from Spain or Greece. That hinges on whether larger economies and larger ESM contributors like France and Italy will be in need of rescue funding, as the cost of such potential bailouts would break the bank.

3. Estrangement of Non-Eurozone Members: As the currency bloc pursues greater integration, non-Euro members like the U.K. and the Czech Republic drift further away from Europe. They don’t want to cede more sovereignty to Brussels, and the U.K. is even pushing to repatriate some. The momentum in the U.K. for a referendum on EU membership has been gaining steam over the past several months, and although it will likely not occur until the 2015 general elections, its recurrence in European dialogue and in domestic politics is driving a wedge between Brussels and London.

4. Italy’s General Election: Now that technocrat Mario Monti’s government came to an end last week, Italy risks a return to the same political class whose failure to countenance reform made Monti’s appointment a necessity. Italy will hold a general election in February. The result will have major implications for Europe, as Italy is the third largest contributor to the ESM and the Eurozone’s third largest economy. In the EU Observer, I discuss the broken nature of Italian politics and why it is incapable of solving Italy’s economic dilemmas in its current state. Although Monti only made modest reforms in 2012, he at least had the courage to confront Italy’s stagnant politics, in which politicians are all rhetoric and no action. Now, it seems Monti will endorse a coalition of centrist parties that, if given a majority in parliament, will return him to government. But this is a tall proposition, as polls indicate that the center-left party is poised to reap the most votes in February and history shows that centrist parties have always been a marginal force in modern Italian politics. A return of the anti-politician Monti signals a continued commitment to reform and friendly Italian-European relations while a return of Italy’s political class means Italy’s backsliding on Monti’s hard-fought changes and a more adversarial attitude towards Europe and the liberal reforms it is pushing Italy to make.

5. U.S.-Europe Free Trade Deal: A White House-EU committee will release its report in the coming weeks on the feasibility of a U.S.-EU free trade deal. A Transatlantic Free Trade Area (TAFTA) could boost trade between America and Europe by $200 billion annually, according to a study carried out by Sweden’s National Board of Trade. A deal, my colleague Iain Murray writes in the Huffington Post, could also have great potential to increase labor mobility and business productivity between the U.S. and Europe if it liberalizes bilateral immigration to allow a freer movement of workers seeking opportunity but not necessarily citizenship. However, age-old trade stumbling blocs may obstruct agreement, not coming least from Europe’s unrelenting commitment to protect its agriculture through tariffs, regulations, and the biggest single item and subsidy on the EU budget: the Common Agricultural Policy.

Europe, having already chosen more integration at the fork in the road, has a long year ahead of it in 2013. Time will tell whether that will be a path to prosperity or a superhighway to perdition. But one thing is certain. The further that Euro-skeptic member states go down the path to less integration while their pro-integration counterparts continue down the path to more, the harder it will be to bridge the gap between them down the road.