15 June 2015

Bringing Europe back from the abyss

By

Never mind renegotiation. If Europe wants Britain to stay on board, it needs to sort out its economy.

The challenges Europe faces are immense. In the Eurozone, unemployment stands at 11%, with youth unemployment more than double that at over 22%, whilst labour productivity growth is virtually zero and government debt is over 90% of GDP. When it comes to economic growth, last year’s Eurozone growth performance (at around 1%) would look limp for a normal year, not to mention one in which the economy still has the opportunity to make up for lost ground following a major recession. At the moment, Europe hardly looks to be in good health, and, quite simply, an unhealthy Europe is not an attractive Europe. Demand-side stimuli, such as the interventions of the ECB, even if helpful in the short term, will not tackle the deep underlying problems, whilst the focus on government debt has for too long diverted attention away from dealing with these bigger issues. Whether we are talking about the European Union or the Eurozone, if the continent is to stay united, it needs to sort out its economy. A poor economy is a divisive economy. It is time for European leaders to move beyond simply dealing with short-term problems. It is time for Europe to do more to encourage long-term growth and prosperity.

 

The usual advice: structural reform and fiscal union

The supposed magic bullet – and the solution that predates the trauma of the last eight years – is “structural reform”. We all know the story. However, since it may have been buried, let us refresh. If we can make European markets more competitive – if Europe can embrace free-market principles – productivity will be boosted, unleashing years of economic growth potential, and unemployment will fall. With full-employment, welfare bills will tumble, making the welfare system more affordable. With economic growth, debt will soon be on a downward trend relative to GDP. Furthermore, freer markets come with the promise of the natural adjustment properties required to withstand “shocks”, minimising the need for government intervention. Fiscal policy (and so future debt) will then be under less pressure and the one-size-fits-all monetary policy will be less of a problem.

In addition to free-market reforms, greater fiscal union has also been high on many economists’ lists. As one author has noted, the Eurozone has “no future…without fiscal union”. European politicians such as the German Vice-Chancellor, Sigmar Gabriel, and the French Economics Minister, Emmanuel Macron, have recently spoken out in favour of a “radical” move in this direction. Fiscal union would involve a system of more centrally determined tax and benefits, enabling the recycling of receipts between better and worse performing regions, evening out economic performance. Benefit harmonisation would put an end to so-called “benefit migrants” and tax harmonisation would mean that where companies chose to operate would be determined by fundamentals – by efficiency – and not by a process in which countries compete downwards on tax in a potentially hazardous zero-sum fashion. Such fiscal union would also help to eliminate the propensity of some Eurozone economies to spend beyond their means, amounting levels of debt that could serve to destabilise the region as a whole.

However, despite the straightforward economics, the simple fact is that Europe has spent many years giving lip service to “structural reform” whilst sharp political divides make achieving fiscal union within the Eurozone seem like nothing more than a fantasy.

 

Structural reform is not enough

Remember Dorothy’s painful journey along the yellow brick road to the Emerald City, in the hope of finding the Wizard of Oz? It was a journey that appeared to be the only way for her to achieve her goal of returning home and so, she thought, worth all of the pain along the way. And what did she find at the end? A small man pretending to be something he was not, stood behind a curtain and with absolutely no power. Disappointment. In her single-minded and hopeless pursuit she had missed the obvious and much less arduous solution to her problem.

This story of old has been used as a metaphor for the pursuit of the Gold Standard in the 1920s: lots of pain and zero gain. But, thinking about Europe, it still has something to tell us today. Like Dorothy’s journey, the road of structural reform is not an easy one to travel and, along the way, we can become tied up with all of the associated economic and political battles. The question is, are we, in the process, losing sight of a bigger picture and of other solutions?

Behind the structural reform agenda is a faith in free-market principles and a distrust of state intervention. Despite the financial crisis, the free market case is now being trumpeted loud and clear, including by the Centre for Policy Studies. Here in the UK, significant parts of the left have been politically demolished. By contrast, in some parts of Europe they remain stronger than ever, making reform ever more difficult. However, there is a way out of this stalemate: moving beyond the old-fashioned and out-dated politics of the past. As I have already argued, the traditional left versus right distinction should by now be extinct. The reality is that neither the state nor the market are perfect. At the moment, far too many on the left fail to recognise the virtues of the market. At the same time, many on the right neglect the significant contribution that the state can make to prosperity if it uses its powers wisely. If both sides think afresh, much common ground could be found, a new reform agenda achieved and, at long last, put into practice.

What we need is new thinking – new thinking that goes beyond structural reform and which challenges the traditional left verus right distinction. This would not only create a better recipe for long-term prosperity but it would also help to bridge the political divide that currently stands in the way of reform, turning growth potential into growth reality.

 

The elephant in the room for the Eurozone

Not only is Europe failing to overcome the division between left and right, which therefore continues stand in the way of reform, it is also doing the same when it comes to north versus south. Germany is cast as the good guy and particular southern countries as the persistent pests. The reality is something in between: Germany is not as squeaky clean as we like to think, whilst those supposed “pests” do not deserve to take all of the blame.

For too long, the European economy has faced a crippling “internal imbalance”. Rather than converging, economies have diverged. As with all fixed exchange rate systems (a single currency being the most extreme form), it is possible that situations can arise in which some members tend to have impressive export performance (with a sizeable trade surplus) and others lag behind (facing a trade deficit). Without the ability for nominal exchange rates to adjust, adjustment needs to instead through prices. Ideally, this adjustment needs to be shared between the deficit and surplus economies, with prices rising in the successful and booming (trade surplus) economies and prices falling in the laggard (trade deficit) economies. The resultant relative price adjustment would then help to correct the imbalance between the two in the longer term. However, when prices fail to rise sufficiently in the surplus economies, the deficit economies needs to doubly-deflate to achieve the required relative price adjustment and so overcome the imbalance. According to Barry Eichengreen, the world expert on monetary systems and a fellow Cambridge economic historian, this was precisely what happened in the 1920s under the Gold Standard fixed exchange rate system and the result was a “deflationary bias” – one which culminated in the Great Depression.

In recent years we have repeated the same mistake: the majority of the burden of adjustment within Europe has been placed on the trade deficit economies – many of which are in the south. The result has been, just as in the 1920s, that the trade imbalances have gone unaddressed, sticky-plastered over for a short time by capital flows into the deficit economies, which only served to create a veneer of stability and ultimately magnified problems once they eventually erupted. Instability, deflation, debt and recession have been the inevitable result.

If Europe is to avoid a repeat of recent problems, as much focus needs to be placed on reforms to limit the build up of unsustainable imbalances and to share the resultant burden of adjustment as is placed on the much better known set of “structural reforms”.

Europe stands at a momentous point in time. If it is to dig itself out of the mess, it is time to think big – to think about more than demand-side stimuli and about more than government debt. Structural reform needs to be back in the limelight, but we also need to open our eyes to the fact that it is not sufficient by itself. Reform needs to incorporate new thinking – and lessons from the past. Doing so could help to bridge both the political and the regional divides that currently exists and will place Europe in a more sustainable long-term position. A healthier faster growing Europe will in turn help to keep Britain (and others) on board.

 

Dr Victoria Bateman, Economic Historian and Fellow in Economics, Gonville & Caius College, Cambridge, and Fellow of the Legatum Institute, London.