(FORTUNE Magazine) – ONLY LAST YEAR Europe seemed headed for an economic miracle. Gross domestic product (GDP) was sprinting ahead at more than 3% a year, the fastest rate in a decade. A surge in new jobs was finally easing the most intractable problem, high unemployment. Rolling with the smooth efficiency of a high-speed train, the European Community's 1992 campaign to create a single market spread a carnival of optimism from Manchester to Madrid. So potent was the revival that politicians like EC President Jacques Delors declared victory for Europe's policy of mixing deregulation with heavy doses of managed trade and workers' rights, claiming Europe's kinder capitalism would supplant the Reagan-Thatcher reliance on market forces as the leading economic model of the 1990s. Today such optimism has hit a slump, along with Europe's economy. Most forecasters think real GDP growth in the 12 EC countries will slow to just over 1% in 1991, far below the average of 3.2% from 1988 to 1990. That doesn't mean a return to the ''Eurosclerosis'' of the early 1980s. But the slowdown has come at the worst possible time. Over the next few months, the EC will make a series of crucial decisions that will set its course for 1992 and beyond. By raising unemployment and making life harder for Europe's weakest industries, the downturn strengthens the hands of the protectionists, mercantilists, and dirigistes who are fighting the Community's market-opening moves. Europe's major economies are basically sound. In a sea change, the countries are united in a remarkable resolve to fight inflation. Discipline comes from their commitment to the European Monetary System (EMS) -- and, down the road, to a single currency. Indeed, monetary austerity is one reason for the slowdown. A brace of unexpected shocks also contributed: last year's jump in oil prices and the recession in the U.S. WITH CHEAPER OIL and signs pointing to a U.S. economic recovery in the second half, Europe should escape recession. Financial & Economic Research International (FERI), a forecasting firm in Germany, for example, predicts that Europe will rebound next year with respectable growth of 2.8%. Even so, how the EC governments respond in the meantime will affect whether they complete the transition to a single market by the January 1, 1993, deadline or deal unity a setback. Unfortunately, policymakers don't exhibit the same discipline in liberalizing trade as in fighting inflation. The EC recognizes that the single market is the best guarantee of brisk growth in the 1990s. It has pledged to open public procurement and ventilate other protected markets. It also promises to lower prices for consumers and companies by attacking cartels. Europe's efficiency is hobbled by protected industries such as cars, airlines, agriculture, and computers that turn out inferior, overpriced products and services. Only by exposing the cartels to competition can Europe even approach its economic potential, estimated by the EC as average growth rates of about 3.5% from the middle of the decade on. The EC pushed through the easy reforms in the late 1980s with the help of a buoyant economy. Now the Community has to take on the toughest targets just as the slowdown is biting. The cartels are lobbying fiercely to protect their privileges. Governments that once leaned toward free trade are turning + protectionist. Stirring the backlash is one of Europe's most politically sensitive issues -- unemployment, which is rising for the first time since 1986. The European Commission, the administrative branch of the community, forecasts that the unemployment rate will increase from 8.2% in 1990 to 9.3% in 1992 before falling again in the mid-1990s. The issue is especially explosive in France, where new Prime Minister Edith Cresson promises to crusade against imported Japanese cars and computers to save French jobs. As the tide of growth ebbs from Europe as a whole, each EC member country must cope with its own mix of fiscal and monetary strains. At the same time, each must keep pursuing the transcendent goal of an open and unified European market. Says J. Paul Horne, an economist with Smith Barney Harris Upham in Paris: ''Euro-realism is replacing Euro-optimism.'' Here is how Europe's major economies are meeting the challenge in the near term. -- Germany bears the burdens of unity. Unified Germany has Europe's biggest economy, freest trading system, and most stable currency. But don't expect the powerhouse of the EC to generate a quick European rebound. Bonn wants Germany's economy to slow. Especially stalwart is monetary hardliner Helmut Schlesinger, newly appointed president of the Bundesbank, Germany's central bank. Germany's economic policymakers are on the right track. Short of triggering a German recession, restraint right now is the best prescription for restoring long-term, noninflationary growth to the rest of Europe. Since Chancellor Helmut Kohl's government extended the mighty deutsche mark to East Germany last July -- at the extraordinarily generous rate of one DM for each East German mark -- the German economy has had one foot in the furnace and one in the freezer. The flood of liquidity, including some 40 billion marks that the 17 million consumption-starved East Germans had hoarded in mattresses, swamped West German industry with new demand. Already straining against capacity from a strong seven-year economic expansion, manufacturers pushed output into overdrive. Since mid-1990, West Germany's economy has expanded at a torrid 5% annual rate -- the fastest growth spurt since the miracle years of the late 1950s. The consumption boom set off a wave of new capital spending by West German companies. Gross business investment in the final quarter of 1990 jumped 9.5% from the year before; outlays for new construction, which had been slowing, rose at nearly a 10% annual rate. As they struggled to keep up with orders, employers added over 700,000 new workers, bringing West Germany's unemployment rate down to 5.8% -- the lowest in a decade. BUT WITH both costs and output priced in hard German marks, the old centrally planned eastern industries became hopelessly uncompetitive. Production plunged 60% in the past year. Though unemployment in the new eastern states officially stands at around 9%, another 1.3 million workers are on short hours and face imminent layoffs. They will be joined on the dole by some 500,000 former East German bureaucrats who are scheduled to lose their jobs in July. FERI estimates that the economy of the former East Germany could shrink by better than 15% this year before hitting bottom, and unemployment in the East could hit 30% by year's end. Because the economy of eastern Germany is less than a tenth of the West's, even this depression-level slump will knock only about one percentage point off united Germany's growth rate. That won't curb pent-up inflationary pressure in the German economy. The Bonn government shelled out $58 billion in the second half of last year for infrastructure investment, subsidies to East German industry, and unemployment and social security benefits to shoulder the costs of unification. The burden lifted government's total deficit more than threefold to $55 billion, or some 5% of total output. Moreover, as the western German labor market tightened, unions held out for -- and got -- huge pay hikes. Household disposable income rose 5% and private consumption rose 4.4%, the sharpest increases in 17 years. Though consumer prices remained steady, the Bundesbank's fear of future increases caused by further run-ups in wages and unit labor costs led it to push the discount rate to 6.5% in February, forcing rates higher throughout Europe. The Bundesbank may have room to ease. The Kohl government has announced a $25 billion package of tax increases through 1992, aimed at shrinking the budget deficit. As a result, says Robert Gay, chief international economist for the New York investment banking firm Morgan Stanley, the Bundesbank governors should be able to cut rates by year's end. -- France swallows its Gallic pride. Once a maverick and a spendthrift, France has emerged as one of Europe's most solid, prudently run economies. Since the mid-1980s it has tenaciously followed Germany's stiff anti-inflationary policies. French inflation is running at about 3% this year, compared with 3.7% in Germany. Since last year, long-term bond yields have dropped from 10.5% to 8.6%, wiping out the chronically wide interest-rate differential with Germany. Thanks to German unification, France for the first time in a decade is sending more goods across the Rhine than it is receiving. Peugeot's sales in Germany have risen 80% this year, to more than $800 million. Remarkably, Europe's slowdown is prodding France to rein in government spending instead of stimulating the economy. Pierre Beregovoy, the tightfisted Finance Minister, pledges to reduce the budget deficit by $2.5 billion, or 15%. His rigor is laying a foundation for steady growth at stable prices in the mid-1990s. According to FERI, France's GDP will increase at 2.6% next year, vs. 1.7% in 1991, with only a slight rise in inflation. Still, France's comeback has done little to dent its high unemployment. This year the jobless rate rose from 9% to 9.4%. Rigid labor laws make layoffs expensive and time-consuming. And French employers pay 58 cents in social charges for every $1 in wages. The Socialist government is in no mood to further alienate workers, but until France has the grit to cut social charges and reduce job protection, its 2.6 million unemployed won't reap the fruits of its strong revival. -- Still a sneeze left to the old British disease. Renowned as the Common Market's prickly loner, Britain has another distinction: It's the only EC country mired in recession. The slump is a hangover from the wildly expansionary policies of 1987 and 1988, which ignited a buying frenzy as consumers used easy credit to purchase homes and cars. Late in 1988, surging prices forced the government to throttle monetary growth. That pushed Britain into a downward spiral that will touch bottom this year with a 0.8% decline in GDP. Though GDP should rise 2.3% in 1992, Britain will be hard pressed to achieve brisk growth with inflation hanging at 6.3%, far above the levels in France and Germany. It's the old curse. Despite more than a decade of Thatcherism, Britain has been unable to tame wages. The economy is plagued by shortages of skilled labor and a notoriously immobile work force. That scenario boxes in Conservative Prime Minister John Major, who must call elections by mid-1992. -- Italy keeps shooting itself in the boot. It's truth or dare time for the Italian government, now in its 50th postwar incarnation. Since Italy pegged its currency to the narrow band of the European Exchange Rate Mechanism in early 1990 -- guaranteeing that it would not fluctuate more than 2.25% plus or minus from the other currencies in the band -- the country's central bank has defended the lira by keeping interest rates high. But there has been no similar discipline in fiscal policy. Budget overruns have helped fuel inflation and added to a debt that doubled in the past decade. This year Italy's total indebtedness will exceed GDP. Italian business is caught between monetary discipline and budgetary chaos. High interest rates held capital spending on new plant and equipment to a 2.4% increase last year, about half the rate of 1989. The stronger lira hurt exporters as foreign sales slowed and held real GDP to a modest 2% gain for 1990. This year will likely be even tougher. Recently negotiated pay raises have increased unit labor costs for Italian manufacturers 7%, hobbling competitiveness and squeezing profits. Much of the blame can be pinned on the government. Public-sector pay jumped some 14% in 1990, creating what the Bank of Italy calls ''a dangerous benchmark for wage claims in the rest of the economy.'' The government of Prime Minister Giulio Andreotti has set an ambitious target of reducing the runaway deficit from 11% of GDP presently and stabilizing the debt by 1993. But with the economy slowing -- and given recent history -- it will likely miss that goal by a wide margin. IT WOULD BE a tragedy if Europe's disciplined efforts to build a base for growth were squandered by a protectionist backlash. By year's end, the EC will make the key decisions that point Europe toward or away from free trade and open markets in the 1990s. The tests are shaping up in four coddled industries that represent more than 20% of Europe's nongovernment GDP: agriculture, airlines, computers and telecommunications, and automobiles. Europe continues to fail the test in agriculture, with a decades-old policy that currently costs consumers $130 billion a year. Now the EC is putting forward a fresh proposal that would curb overproduction. But it will do little either to lower food prices or force Europe's tiny high-cost farms to become more efficient. In airlines the outlook for reform is uncertain at best. Europe's skies are dominated by bloated flag carriers whose productivity is one-third to one-half that of U.S. carriers. The EC set out last year to promote competition. But in February, to cushion the shock of the Gulf war, it relaxed antitrust enforcement to allow airlines to coordinate schedules and raise prices. While the slump in the U.S. brought customers bargains, the price of an Air France or British Airways flight from Paris to London rose from $348 to $510. The EC is poised to present the keystone of its airline deregulation package: guidelines for licensing new carriers. Even if newcomers get licenses, though, there's no guarantee that new, low-cost airlines can take off. Europe's airports are crowded, and the flag carriers seem to be winning their fight to keep control of scarce landing slots. Says Karel van Miert, the EC's transport commissioner, who is pressing for reform: ''Life will be very difficult for new airlines.'' For years governments have given their computer and semiconductor manufacturers generous subsidies and lavish orders. The EC helps with stiff tariffs on semiconductors and aggressive antidumping measures for computers. Perversely, those policies are handing Europe's thriving $156 billion information industry to U.S. and Japanese manufacturers that have honed their cost-cutting skills with intense competition in their home markets. Since 1980 the market share of European manufacturers has dropped from 24% to 12%. The EC's remedy? More of the same. It proposes giving European companies business by building Europe-wide, government-funded telecommunications networks. IN CARS the EC is proposing ''transitional'' measures that look more like permanent industrial policy. The Japanese have 12% of the overall European market but are limited to 3% in France and less than 1% in Italy. The EC has backtracked from its plan to eliminate all national quotas on cars by 1993. It now proposes to gradually allow Japan's market share to rise to 17% by 1998, when quotas would be eliminated. Incredibly, however, the limits would include Japanese cars produced in Europe. Since that's illegal under the Treaty of Rome, the EC is seeking a ''voluntary'' restraint agreement similar to the one the Japanese signed with the U.S. The Japanese are all too likely to agree to quotas, since they hold up prices and fatten margins. Nor are the quotas likely to disappear by the late 1990s. A safeguard clause gives the EC the right to extend them if the market deteriorates. And the Japanese will hardly want to give up their big profits. As growth and employment pick up in the next year or two, the EC may renew its attack on the cartels. If not, the protected industries will drag down Europe's immense potential. Stable currencies and low inflation are heroic accomplishments. They aren't enough to make companies competitive -- or consumers rich.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHARTS/SOURCE: FINANCIAL & ECONOMIC RESEARCH INTERNATIONAL GMBH CAPTION: GROWTH TAKES A VACATION FOR EUROPE'S BIG FOUR The battle against inflation and growing budget deficits will depress growth and cause that old bugaboo unemployment to rise for the first time since 1986.