Issue #18, Fall 2010

A More Perfect Union

Over the years, European leaders forgot how to justify integration to their citizens. It’s time they remember—and proceed with tough reforms.

Americans are writing Europe off–and apparently for good reason. The last several months have seen the European Union stagger from one crisis to another. After barely passing the Lisbon Treaty–which amended the EU’s fundamental texts in order to streamline its institutional structures–the EU soon found itself in the throes of its current crisis over the economic governance of the euro, while simultaneously confronting the failure of its ten-year effort to modernize the European economy.

American pundits seem almost to take pleasure in Europe’s problems. Richard Haass, the president of the Council on Foreign Relations, claims that the European project is “foundering” and that Europe’s days as a world power are over. Officials in the Obama Administration are less consumed by schadenfreude, but are nonetheless irritated with Europe’s navel gazing. They find the EU’s decision-making structures confusing and indecisive–no one knows whether the president of the European Council, the high representative on foreign affairs, or the country holding the Council presidency is supposed to be in charge of foreign policy. While U.S. officials publicly claim that the relationship with Europe is “the cornerstone for U.S. engagement with the world,” they privately do everything that they can to avoid entanglement with Europe’s byzantine policy apparatus. When the United States wanted to make sure that some decision would emerge from the Copenhagen talks on climate change, it deliberately cut the Europeans out of the final stages of the negotiations in favor of one-on-one discussions with China. As European Commissioner for Energy Günther Oettinger acknowledges, “If the Copenhagen summit showed us one thing, it is that even the European Union isn’t big enough for world authority when it comes to countries like China.”

That the European Union is going through a rough patch is indisputable. The Greek debt crisis and the reluctant bailout by members of the union have underscored the unsustainability of Europe’s economic arrangements. Even so, the United States cannot afford to lose patience with Europe. The U.S.-EU economic relationship is the largest and most important in the world. The EU and the United States together dominate international financial markets, accounting for 80 percent of the debt securities market and 65 percent of issued equity before the Great Recession. If, as Haass predicts, the EU falls into complete disarray, it will hurt the United States nearly as much as it hurts Europe. The collapse of the EU would cause massive turmoil in international financial markets, and very likely a new Great Recession, which would be far worse than anything recently experienced.

America has a strong interest in seeing the European Union come through the crisis. It also has a longer-term interest in the stability of Europe. Even when the United States wants to ignore Europe, it has much more in common with it than with most other parts of the world. Europe and North America are by far the most important examples of democratic stability in the modern world. The European Union has not only helped bring peace and stability, but has helped spread democracy in the wake of the fall of the Berlin Wall.

However, Europeans need to decide whether they are ready for real European politics, or whether they are content merely to senesce. The decisions that the EU takes about how to recreate its system of economic governance will have long-term consequences. If Europe decides simply to muddle through, it will run a high risk of failure, with little real prospect of breaking out of the trap that it finds itself in. If it chooses instead to remake itself as an exemplar of harsh economic austerity, it will destroy what legitimacy it still retains. Europe needs instead to rebuild its economic framework so as to make it more flexible in accommodating national differences.

A Crisis of Legitimacy

The politics of the continent are a tangle of contradictions that would have led to the current predicament with or without an economic crisis. Europe is paralyzed by three major intersecting problems. The first is a general crisis in European integration–the EU lacks the political legitimacy to undertake major institutional changes. The second involves the more specific deficiencies of Europe’s institutions for economic governance. These problems are inherent in the current system, but have been cruelly exposed by current harsh economic conditions. The third problem concerns the structural factors–an aging workforce, inefficient labor markets–that present long-term challenges to European economic growth. Raising European levels of productivity and innovation will be a struggle, as it has been for years.

The crisis of European integration is a byproduct of Europe’s past success. The European Union began in France and Germany’s desire to dissolve their historic enmities through economic cooperation. The EU’s institutional ancestor, the European Coal and Steel Community, was founded in 1952 in order to create unity “through practical achievements which will first of all create real solidarity, and through the establishment of common bases for economic development.”

Over almost 60 years, the EU has accumulated many such practical achievements. It now has 27 member states with about 500 million citizens. Its GDP adjusted for purchasing power parity–a measure that calculates consumers’ actual buying power in different currencies–is $14.8 trillion, higher than that of the United States, and 21 percent of world GDP. In 2002, a new layer of economic governance was introduced to the EU with Economic and Monetary Union (EMU), which created the euro and sought to further break down economic barriers between member states. Today, 16 of the EU’s 27 member states participate in EMU, and all other member states, except the UK and Denmark, are theoretically obliged to join it when they meet its membership conditions. EMU members share a single currency and delegate all their monetary decision making to the European Central Bank.

However, in building an integrated European economy, the EU has lost its original rationale. It gets no political credit for maintaining peace between Europe’s major states, because Europeans now take peace for granted. This means that the EU needs a different source of legitimacy. It cannot look to economic success. A recent report commissioned by the European Union’s heads of government warns that Europe’s current state of “relative” economic decline may become “absolute” if serious measures are not taken. Nor can it look to international stature for legitimacy. The EU’s hope that its emphasis on peaceful diplomacy might increase its international clout looks increasingly forlorn. More militarily inclined powers such as the United States and China view it as a symptom of weakness rather than an alternative model of international relations.

To make matters worse, the old model of European integration has broken down. National politicians used to be able to negotiate changes to the treaties and expect that the public would accept them without necessarily understanding them. But over the last decade, European voters have stopped trusting their leaders. Voters have rejected treaty changes in France, Holland, and Ireland (twice) over the last several years. The EU’s Constitutional Treaty–which was supposed to be the culmination of the European integration process–failed ignominiously. Last year’s Lisbon Treaty limped into existence only after initial rejection by Irish voters, veto threats by the Polish government, and attempted sabotage by the Czech president (who is a noted Euroskeptic).

The situation poses a profound dilemma for EU leaders. For decades, Europe’s politicians did not have to justify European integration to voters. Now, when they have to justify it, they do not know how. EU integration had its origins in the political imperative of preventing future war. It then became a series of ever-more technocratic bargains. Now, with major institutional changes needed, European leaders need to make the idea of a European Union politically attractive again.

Such institutional changes are necessary to make the EU’s system of economic governance work. The place to start is EMU, which is still in the throes of a crisis that can be solved only through major changes to the EU’s treaties. EMU’s current rules are the worst of both worlds. They are sufficiently constraining to make it difficult to respond properly to crisis situations, while not constraining enough to prevent crises from happening in the first place.

When members first agreed to EMU in 1992, Germany insisted on an independent European Central Bank and a set of spending rules that were supposed to stop EMU members from running up big deficits. However, these rules were effectively abandoned in the mid-2000s when powerful member states (including Germany itself) found them politically inconvenient. The result was an EMU built on vague political expectations and informal commitments to back up member states that encountered difficulties. When Greece started to get into trouble earlier this year, these expectations and commitments got vaguer. Germans were especially unhappy at the prospect of a Greek bailout. Members of Germany’s government coalition spoke of the possibility that Greece might have to temporarily leave EMU; one prominent German newsmagazine ran a cover showing the Venus de Milo giving German taxpayers the finger. The German response led to a protracted crisis of confidence that was resolved only when Germany and other major member states reluctantly agreed to lend Greece hundreds of billions of dollars if necessary.

While everyone agrees that major institutional reforms are needed to stop such a crisis from happening again, there is rather less agreement on what the reforms should be. Austerity hawks, led by Angela Merkel, want strict new rules to ban EMU members from amassing deficits in the future. These hawks want a revamped set of international spending rules, combined with rigid domestic constraints on fiscal policy. They are opposed by politicians in France and elsewhere, who want a very different kind of European economic government. These countries are worried about the European Central Bank’s obsession with preventing inflation, and want to bring it to heel to promote employment and growth. Finally, Britain–which is not a member of EMU but still has substantial influence in internal debates–is opposed to any strong economic government but also fears having to bail out weaker member states that get into trouble.

These choices present Europe with some fundamental trade-offs. It could try to solve its economic problems through monetary rigor and harsh institutional controls on member-state spending. It could create a new economic governance system that would force the European Central Bank to be more relaxed about deficits and inflation. Or it could try to muddle through.

None of these options goes nearly far enough. Harsh controls on member-state fiscal policy will not avert future crises–problem states such as Ireland and Spain did not appear to be in fiscal difficulty before the crisis, since their troubles were concentrated in the private sector. While looser monetary policy might make it easier for Europe to respond to future crises, it would do little to address asymmetric shocks, where some member states need one monetary policy, and other member states need another. As Paul Krugman describes it, the EU now has a “one size fits one” policy, which suits Germany very nicely, but prevents Spain from easing its economic crisis by devaluing its currency. And muddling through is simply not a sustainable strategy. Without credible guarantees and funding mechanisms to back up these guarantees, the eurozone will collapse under a welter of speculative attacks by market actors shorting the government debt of weaker members.

No matter which path is taken, Europe faces long-term challenges to its productivity and economic growth. Economic growth has been consistently lower than growth in the United States, let alone in the developing world. Europe’s population is aging rapidly, creating increased strain on welfare states. And fewer working-age Europeans are employed than in other advanced industrialized countries. The so-called “Lisbon Agenda”–which was intended to make Europe the most dynamic economy in the world by 2010–was an inglorious failure. Its replacement, the “Europe 2020” program, is likely to fare just as badly. Like the Lisbon Agenda, it relies on soft measures of policy coordination and peer review among member states, rather than serious, targeted programs.

U.S.-based commentators such as Thomas Friedman often claim that these difficulties demonstrate the unsustainability of the mainland European model of big welfare states and labor market protections. This belies the fact that there is no European model. Some countries, such as Denmark and Holland, combine large welfare states with highly efficient markets to produce strong and sustainable economic growth. Others, such as Greece and Italy, have limited welfare states, but very inefficient labor markets (these countries have high pensions but low overall welfare spending compared to Northern European countries). It is enormously difficult to get the weaker European states to adopt the policy innovations that have worked in the stronger ones. Their existing arrangements are supported by powerful interest groups of state employees and other privileged insiders, who are distinctly unlikely to be persuaded by policy white papers and processes of peer review.

A Reform Agenda for Europe

Simply put, Europe needs a new institutional framework to deal with its problems. The new arrangement would seek to do three things: ensure that European states adhere to sustainable fiscal policies over the medium term; facilitate fiscal transfers to cushion asymmetric shocks; and promote domestic reforms within institutionally underdeveloped economies.

The fiscal element would begin from the premise of sensible Keynesianism. As IMF Chief Economist Olivier Blanchard and his colleagues have pointed out, fiscal Keynesianism is possible in hard times only if there is “fiscal space” to carry it out. Countries with high levels of accumulated debt or pro-cyclical fiscal policy pushed by booms in consumer spending will be in a poor position to enact stimulus policies when crisis hits. Hence, there is a strong economic case for policies aimed at gradually lowering the debt-to-GDP ratio in states where it is dangerously high, and for external monitoring to draw attention to risky scenarios, like the property-market booms that led to economic disaster in Ireland and Spain.

This would require a radical loosening of EMU rules that prevent states from running significant deficits. Short-term hikes in deficit spending are not a problem for an economic and monetary union. Nor is moderate deficit spending to finance activities that have long-term benefits for growth, like spending on human capital or infrastructure. The fundamental problem is spending that is unsustainable over the long term, either because it creates debts so great that they will overwhelm economic growth, or because it is fueled by bubbles.

Issue #18, Fall 2010

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