An alternative perspective

11 March 2015

Europe's Economic Prospects

It is not hard to take a pessimistic view of Europe’s prospects. Greece cannot honour its debts. Italy seems incapable of reform. France is paralysed by the politics of feeble gestures. The euro remains on an ECB life support system. The far right threatens the very idea of a unified and integrated EU. Growth is anaemic and deflation looms.

A decade ago, it had all looked rosy. The collapse of the Berlin Wall created a hubristic euphoria that the western model had triumphed over the Soviet planners. The great economic boom of the late twentieth century, with the technological revolution of the internet at its core, brought some growth and much consumer spending. Chinese competition reduced the inflationary threat and allowed interest rates to be kept low.

Reunification of Germany was the proximate cause of the euro, with the French trying to bind a more powerful Germany into the European project and subvert the mighty deutschmark. François Mitterrand was right to see the post-war Franco-German partnership at risk, but both he and Helmut Kohl were quite wrong to think that the euro would be a route to full monetary, fiscal and political integration – the United States of Europe that Jean Monnet and other founders of the European project had had in mind.

Europe’s Social Model Required Economic Growth

The structural issues did not go away. The euro simply exposed them. Europe’s social model could no longer stand the fierce fire of international competition. Concentrating on distribution rather than economic efficiency, protecting workers’ rights, promising ever greater pensions and more generous social security, providing free healthcare and education, worked only whilst the costs could be passed on to customers and taxpayers, and that in turn required economic growth to keep boosting incomes.

In hindsight, way back in the 1970s the model stopped being self-sustaining (and indeed France has never balanced its budget since then). The great post-war period of economic growth – 1945-1970 – yielded full employment, economic growth and rising incomes, and therefore ever higher tax revenues. The state expanded from around 20-25 per cent of economies to around 40 per cent, most of the increase being social transfers.

The beginning of the end of this social model began in the 1980s, with Margaret Thatcher and Ronald Reagan advancing a much more capitalistic model, and with it a challenge to the ideas of big government and an ever expanding share of the economy in the hands of governments. Reform took a major step forward when economic liberalism triumphed over socialism in Eastern Europe. Much later, Germany undertook a limited amount of labour market reform under Gerhard Schröder. France, meanwhile, stuck with its social model and Italy continued to struggle to make its state function at all.

Reforms Need to Go Much Further

In order for the future to be very different, the reforms required are obvious, and obviously painful. Some have begun, and it is thanks to the euro and broader economic crises that they have happened at all. Most European countries have had to address their unsustainable pensions, and for the most exposed cases of Greece, Ireland, Spain and Portugal, the changes have had to be on a massive scale. The state has been ruthlessly cut back.

But whilst these changes improve the competitiveness of the European model, they are still in their infancy. Labour markets, by international standards, remain fossilised. Employing people in Europe is a taxing business and firing them a legal hazard. Incentives are blunted by taxes that have become more rather than less progressive. The solutions France came up with included a 75 per cent tax rate. Top rates remain above 50 per cent across most of Europe. Social security remains internationally extremely generous, and yet the very poverty it is supposed to address remains stubbornly persistent. The sheer inefficiency of many of Europe’s welfare states is reflected in a heavy price for the poor who do not receive what the spending could easily achieve if so much was not wasted.

Europeans have yet to come to terms with what needs to be done. And while they prevaricate, the debt keeps on marching upwards. Deficit spending ratchets up the scale of the problem, whilst inflation refuses to yield the easy way to default. Many countries in Europe are approaching the toxic 90 per cent debt to GDP level, and several are well beyond it.

The implications are obvious: Europeans are enjoying a standard of living which is beyond their means, and therefore a return to a growing, competitive economy means that wages and consumption need to fall, to make way for savings and investment. Rather than relying on the convenient and seductive Keynesian idea that all that is needed is to stimulate demand, and that through the magic of the ‘multiplier’ demand will create its own supply, Europe needs to price itself back into contention.

It is not as if Europe has no strong cards to play. In a world in which technical progress is accelerating, in which knowledge and ideas take the centre stage, the open, transparent, democratic and open societies ought to be the winners. The US shows the way with its science base, its brilliant universities and its open markets, backed by legal protection of property.

There it is working well as it recovers from its banking crisis, builds new industries and now has its energy revolution as well. The great new companies are Microsoft, Google and Apple – with no European rivals in sight. Contrary to so many obituaries, the US is not gripped in some inevitable decline – and neither is Europe.

What has gone wrong in Europe is that it has ceased to be an open, dynamic, liberalised economic system, with the market being the key bit of the social market economy. To be fair, it did try in the 1980s with the bold measures to complete the Single Market, but this petered out before delivering what it promised. As the euro took centre stage, the plot was lost. Indeed, own goals mounted up. The driving up of its energy costs, whilst increasing its carbon consumption, is but one painful example.

A Focus on Technology is One Way Forward

Over the next decade, it is perfectly possible to turn this around. On the positive side, a major drive could put technology at the core of the European project. The future lies with material like graphene, 3D printing, robotics, artificial intelligence, driverless and electric cars, next-generation solar, and much else besides. That is where the new European Googles, Apples and Microsofts can come from. By contrast, trying to lead the world in social security will not work.

Will this happen? The darkest hour is usually before the dawn. That darkest hour may be upon us:

François Hollande’s inability to deliver economic reform in France, Angela Merkel’s tepid steps in Germany, and Italy’s lack of reform successes are all depressing examples of how the mainstream political parties are trying to prop up the existing social and labour market models.

Darker still is the soft option of default. Around Europe a number of countries could not realistically ever honour their debt, even at the current low interest rates. The debts are not sustainable – and hence they will not be sustained. Greece is an outlier. But there are others, and the growth of populist political parties across Europe points to the prospect of default, disintegration and nationalism. In France, a quarter of the voters prefer Marine Le Pen; in Hungary, truly ugly right wing parties are turning against immigrants and embracing a crude nationalism. In the UK, a significant minority wants to leave Europe altogether, and many in Scotland still want to leave the UK.

Mario Draghi’s latest stab at ‘whatever it takes’ is just one more way of defaulting – a modern version of the ancient tradition of debasing the currency. Devaluing the euro, getting inflation going and keeping interest rates negative are the quantitative easing mechanisms. Luck may ease the pain of the transitions which have yet to get seriously going. The halving of oil prices is the equivalent of a massive economic stimulus – a bit like quantitative easing on steroids. As US interest rates begin to rise in 2015, the euro may continue to fall and hence devaluation may add to the stimulus from falling oil prices. The result of all this luck may be modest growth and modest recovery.

All Is Not Lost

Short-term recovery, based upon shortterm luck, would however put back the day of reckoning when Europe has to address its fundamental challenges – to live within its means and concentrate more on investment and production, and less on social spending and consumption. But since the current model is not sustainable, that day will have to come. Europe cannot be written off, decline is not inevitable. The US ‘decline’ and Chinese ‘dominance’ turn out to be false prophecies and Europe may yet have a bright future as a beacon of prosperity. A much brighter dawn is perfectly possible after the darkest hour. Who after all would have put money on the UK emerging from hyperinflation, the IMF bailout, and the ‘Winter of Discontent’ in the 1970s?

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