WEF KSC Re-EmergenceEurope 2012

7/30/2019 WEF KSC Re-EmergenceEurope 2012

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The Re-emergence

of Europe

Professor Klaus Schwab

Founder and Executive Chairman

of the World Economic Forum


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2 The Re-emeRgence of euRope


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3The Re-emeRgence of euRope

TABLE OF CONTENTS

1.INTRODUCTION 52.A SHORT HISTORY OF EUROPE 93.DECLINE 173.1. The Debt Overhang 18

3.2. The Banking Crisis and Its Collateral Eects 23

3.3. The Competitiveness Decit 29

3.4. Institutional Failure 35

3.5. The Disintegration o Common Values 39

3.6. The Erosion o Global Credibility 43

4. RE-EMERGENCE 454.1. Exiting the Euro: A Bad Good Idea 46

4.2. Fiscal Discipline and Economic Growth 50

4.3. Rebalancing and Conditions or Sustained Growth 54

4.4. Restoring Europes Competitiveness 60

4.5. Strengthening European Institutions 66

4.6. Reintegrating Europes Youth 68

4.7. Nurturing an Ideal and Rebuilding a Global Brand 73

4.8. Progress? 77

5.CONCLUSION 83NOTES 87


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1.INTRODUCTION

Europe has reached a critical tipping point. It aces either disintegration andcollapse or a chance to achieve deeper integration and emerge much strongerrom the current crisis. For the moment, the European project o integration ishalted midstream: between the old collection o nation-states and ull Europe-an political union. In the years to come, a multitude o scenarios and variationsranging rom a disorderly collapse to a famboyant resurrection are possible,many o which, with hindsight, will surprise us possibly on the upside.

Even in the worst-case scenario, a Europe and institutions reerred to as the

European Union will remain. My own prudent prediction or Europe is that itwill manage through the turmoil, with the euro intact, even i one or even twocountries were to leave the eurozone. Based on the analysis laid out in thisbook, my rm and optimistic belie is that, once the crisis subsides, whichmay take up to a decade, Europe will regain its momentum, propelled by arenewed sense o mission among politicians and policy-makers to keep thisdecades-long project on track and moving orward.

Despite the current uncertainty, two things remain beyond doubt: (1) this prob-lem has no quick x or easy solution, and (2) as the worlds largest economy

by gross domestic product (GDP), whatever happens to the eurozone mattersenormously to the rest o the world. Thus the European crisis will, to a greateror lesser extent, dominate global issues or many years to come.1

Within Europe, opinion-shapers and policy-makers are deeply divided aboutthe uture o the continent, but outside Europe in the United States and Asiain particular the general consensus is that the euro will collapse and thatEurope will disintegrate, although what this means remains vague. Thosewho embrace these predictions are generally unaware o how the euro cameto be created and the reasons why the currency was devised. Among the

media in particular, there is a streak o pessimism that is based on a lack oinormation and appreciation o history, as well as a troubling xation with thesensational and the deepest downside o this unortunate situation.

I hope that this short book provides the necessary context to remedy this lacko understanding. The Re-emergence o Europe has two main objectives: (1)to explain in simple terms what is currently unolding in Europe and what is atstake, and (2) to review and assess certain policy options under considerationto resolve the crisis. Many o these policy options are based upon projects andinitiatives pursued at the World Economic Forum, o which I am the ounder


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and executive chairman. Most but certainly not all were discussed and de-bated in recent Forum gatherings.

To a large extent, this book also relies on private and public conversations Ihave had the privilege to enjoy over the years with key policy-makers and ex-perts, as well as with business and civil society leaders. Many o these thoughts

and ideas have contributed to shaping the Europe we know today and will playtheir part in raming the Europe o tomorrow.

This book takes a multiaceted and multidimensional approach, which runscounter to the currently ashionable siloed approach (looking only at economicswhile disregarding politics, or example). I adopt a holistic perspective combin-ing economics, sociology, international aairs and history, and even an ethicaldimension, or two reasons:

Since its onset in 2009, the eurozone crisis has undergone several muta-

tions. What started as a nancial crisis caused by sovereign indebtednessin Greece rapidly spread to other countries, accumulating multiple layers oadditional predicaments along the way. Now the entire European continentaces nancial, economic, banking, political, institutional, societal and moralcrises. Because they are so intertwined, these many dierent predicamentspose exceedingly complex challenges that simultaneously require strongpolitical leadership, original policy proposals and solutions, and a set oinstitutional changes. In light o all the above, it is hard to disagree withthe notion that the eurozone is unique in recent history, both in terms o itsdepth and complexity. It is also unique in terms o its size as a monetary

union, as it requires constant coordination on the part o the 17 disparateeurozone countries. More oten than not, the negotiations have to involveall 27 EU member states the more parties to the negotiations, the greaterthe complexity!

None o the plethora o ideas currently under discussion to resolve Europesproblem, in my opinion, can sensibly be considered i viewed in isolationrom the broader perspective o what is doable or not. This point is bestillustrated by some examples. Several opinion columns in the internationalmedia have suggested that Greece should sell some o its islands to certain

oreign buyers as a means to reduce its sovereign debt. Such a proposalmay make sense economically, but it does not rom a political and societalperspective: it would simply be a violation o Greek sovereignty. As such,it is o no use or the purposes o this book. Others have proposed thatthe EU should implement as rapidly as possibly a constitution modelledon that o the US with ull scal transers. Economically, it makes a lot osense. Politically and institutionally, that suggestion is a non-starter withina reasonable time rame. Inversely, some ideas are politically appealing buteconomically unrealistic. That private creditors, rather than the taxpayers increditor countries, should solely bear the risk o deault is one such proposal.


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It seduces politicians but worries economists and market participants be-cause o the mayhem that would ensue in the nancial sector and the disin-centive that it would create or uture lending. In this book, I review, analyseand put orward only measures and policies that are implementable rom apolicy-making as well as social perspective, even i the ideas are not easyto apply.

In terms o how policy-makers, regulators and business leaders deal with Eu-ropes predicament on a daily basis, it is critical to understand that they aredoing so against the background o a world in fux. Our world is changing veryast, ubiquitously and in a proound manner. In Europe and elsewhere thesedays, the words most requently heard are uncertainty, ragility, volatility,turbulence, unpredictability, and such. Four growing orces interdepen-dency, complexity, velocity and transparency are at play, creating a globallandscape that only a decade ago was the province o uturists. These ourorces constantly interact and mutually reinorce each other, making the world,

and o course Europe, much more susceptible to shocks and surprises thanjust a ew years ago.

The global environment now seems to be, as Thierry Malleret describes it in hisbookDisequilibrium: A World Out o Kilter, on the verge o constant instabil-ity, with random occurrences happening all the time. As the world becomesa conveyor belt or constant surprises, leaders have the impression they aredriving at very high speeds in the og, unable to nd the brakes, lurching romone crisis to the next.2 This is seemingly oten the case or European leaderswho, like most o their peers, nd themselves increasingly wrong-ooted as

they contend with situations that requently take them by surprise.

This state o aairs not only alters their understanding o the world but aectsthe way they exercise leadership, and it can even create eelings o burn-out. Inmy experience, it is air to say that to lead has never been so hard or challeng-ing. Although this may sound trite, it must be kept in mind when thinking aboutthe way European policy-makers are dealing with a very dicult situation.

I am well aware that addressing such a broad and sensitive topic at the verytime the crisis is unolding and policy proposals are being put orward is a her-

culean task. Hundreds o articles, editorials, discussion ora and conerencesare continually debating what ought to be done with respect to Europe and theeurozone. Every day, dozens and dozens o pundits and politicians argue overthe specics o implementing (or rejecting) particular policies and proposals.

My objective is dierent: I would like this book to serve as an easy reerence orall those who have an interest in the ate o Europe and in European aairs. Itrust the multidimensional approach adopted in this book will help them betterunderstand Europes intricacies and where they are likely to lead. The Re-emer-gence o Europe is short and simple (but not simplistic) and well inormed.


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Much o its content derives rom my deep interest in Europe. While the WorldEconomic Forum is today a truly global organization, integrating leaders romall walks o lie, its origin goes back to the act that I spent my childhood inGermany during and ater World War II. I belong to the rst generation o Euro-peans or whom Europe has not only an economic but also a deeply politicalmeaning. This book also draws rom situations in which the World Economic

Forum has played the role o honest broker or trusted adviser when dis-cussing and evaluating policy proposals and putting orward new ideas as parto the various initiatives it pursues and during its events, such as the AnnualMeeting in Davos-Klosters.

I would like to thank Thierry Malleret, who was an essential partner in research-ing and writing this book. I drew substantially rom World Economic Forum re-search and internal documents and am grateul to Jennier Blanke, the Forumschie economist, particularly or her contribution related to Europes competi-tiveness. Special thanks also to Fabienne Stassen, who in record time edited

this book, as well as to Kamal Kimaoui, who as usual made sure that the con-tents are presented in the best graphical way. Thanks also to Melanie Rogersand Al Reyes and Adrian Monck as well as to my two assistants, Nancy Knowl-ton Man and Jeanine Meili, who had to carry out this additional work during atime when the Forum and I were involved in so many dierent activities, tryingto improve the state o the world.

This book is structured in two main blocks: Decline and Re-emergence. Thechapter on Decline details how Europe came to be in the mess it is in. Thechapter on Re-emergence discusses some o the options that will put Europe

on a much stronger path. The experience o watching economies emerge overthe past orty years gives me both condence and optimism that Europeseconomy can re-emerge stronger and more sustainable.

Needless to say, this volume deals with a very ast-moving and fuid situation.This explains its publication in the orm o an e-book, refecting the volatile andever-changing nature o the subject matter. Its contents will be continuouslyupdated based on the direction o the policy debate and what actually takesplace on the ground.


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2.A SHORT HISTORYOF EUROPE

Many conversations and propositions about Europe ail to convince becauseo their lack o historical perspective. Indeed, the present and uture cannot beunderstood without a modicum o history, which, in the words o the Frenchpoet and politician Alphonse de Lamartine, teaches us everything, includingthe uture.3 As is the case or most other continents, Europes history not onlyreveals the rich diversity o its past but, perhaps more importantly, the manydierent prisms through which the current situation and some o its possible

outcomes can be understood. It is thereore natural to start this book with apanoramic overview o European history, alongside a snapshot o how the Eu-ropean Union (EU) and the euro came into existence.

For all the claims that Europe has existed since antiquity and that it embeds thenotion o democracy, it is essential to remember that many European nationshave been united and democratic only in recent years. Italy unied in 1870,while Spain experienced a civil war less than a hundred years ago. Greece,Spain and Portugal were dictatorships well into the mid-1970s. For much o itshistory, rather than a neat collection o Westphalian sovereign states with clear

national borders that co-exist in peace, Europe has been a jumble o rival coun-tries, territories and enclaves linked by languages and culture but ragmentedby tribe and tribal allegiances.4

The idea o Europe is relatively modern, having emerged in a complex intellec-tual and political process spanning the 14th and 18th centuries. During thatperiod, the earlier concept o Christendom was gradually replaced; it wasonly ater the Treaty o Utrecht in 1713 that the awareness o a European ratherthan a Christian community began to prevail. The last reerence to the Res-publica Christiana a Christian Commonwealth dates back to this time. In

1751, the French writer and philosopher Voltaire described the Christian part oEurope, with Russia excepted, as a great republic divided into several states,some o which were monarchial, others mixed, some aristocratic, and otherspopular; but all corresponding with one another; all having the same basis oreligion, though divided into several sects, and acknowledging the same princi-ples o public and political equity, which were unknown to the other parts o theworld.5 In the eyes o many historians, the nal realization o the idea o Europecame at the end o the 18th century. In 1796, the Irish political philosopher Ed-mund Burke amously declared that, no citizen o Europe could be altogetheran exile in any part o it.6


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Throughout history, Europe experienced a sequence o cultural and politicalintegration. As Nobel Economics Prize laureate Amartya Sen has pointed out,7the rst public call or more European integration dates as ar back as the15th century when the idea o pan-European unity was originally mentioned. In1713, French priest Charles-Irne Castel, abb de Saint-Pierre, wrote a bookentitledA Project For A Perpetual Peace, in which he advocated a conedera-

tion o European powers destined to guarantee lasting peace on the continent.Other pleas ollowed rom many prominent names, including political guresrom abroad. In the 18th century, or example, George Washington is believedto have written in a letter to the Marquis de Laayette that a United States oEurope would one day be established, with the United States o America asthe model.

These bold ideas were insightul or their time, but it was only in the 20th cen-tury, with two World Wars and the incredible devastation they inficted on thecontinent, that the need or political unity was spurred.

To this day, the possibility o a war in Europe is eared by many o my gener-ation. Only in this context is it possible to understand the movement or theunication o Europe, which aimed or political unity. Neither a common curren-cy nor nancial union were objectives. The single most important driving orceo European integration by ar was the memory o war, powered by the ideathat such confict should never again happen. This is what prompted WinstonChurchill to declare in a amous speech in Zurich just ater the war: We mustbuild a kind o United States o Europe.8

Today, ew among the young generations realize that World War I caused 37 mil-lion casualties among the military and civilian populations o Europe (more than

16 million died and more than 20 million were wounded). World War II was even

worse. In Europe itsel, 55 million people died (20 million in the Soviet Union).

Europe was not built or economic or nancial reasons but, ater such prolonged

devastation, to bring peace between European countries. It was a political ambi-

tion, whose design was essentially a Franco-German compromise.9

In 1950, only six years ater German troops had let Paris and at a time omutual hatred and suspicion between France and Germany, Robert Schuman,

then French minister o oreign aairs, assisted by Jean Monnet, one his coun-sellors, announced a plan to create the European Coal and Steel Community(ECSC), with the aim o making war not merely unthinkable, but materiallyimpossible.10 Schumans core idea was to place French and German coal andsteel production under a single authority to prevent the two sides rom usingthe raw materials o war against each other (and also, o course, to power acommon industrial economy).

Today, a military confict in the EU is indeed hard to imagine, as unlikely as aclash between other democratic trading nations such as Canada and the Unit-


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ed States or Australia and New Zealand. This is a tribute not only to the variousEuropean institutions that led to urther integration but also to other organiza-tions such as the North Atlantic Treaty Organization (NATO) that played sucha crucial role in cementing peace on the European continent. Both NATO andthe European Community (EC) originated in post-World War II eorts to bringstability to Europe. NATO was created to ensure security or the United States

and its European allies to counter the Soviet Union.

The ECSC was in eect the institution that gave birth to todays EuropeanUnion. These undamental steps to establish long-lasting peace have beenrecognized with the awarding o the Nobel Peace Prize in 2012 to the EU.According to the Norwegian Nobel Committee, the work o the EU representsraternity between nations and amounts to a orm o the peace congressesto which Alred Nobel reerred as one o the criteria or the Peace Prize in his1895 will.11 The Committee explicitly praised the EU or helping turn Europerom a continent o war to a continent o peace.12

As the Hungarian-American nancier George Soros has written,13 Europeanintegration was driven by a group o visionary statesmen: not just Monnet andSchuman but Konrad Adenauer and Paul-Henri Spaak, among others. Al-though the ounding treaties spoke o an ever closer union, they understoodthat perection was unachievable. Thereore, they set themselves limited goalsand rigid schedules, then rallied the political will needed to achieve what couldbe done, ully understanding that, when that was achieved, it would eventuallybecome obvious that the status quo would be untenable and urther stepswould have to be taken. That is how the ECSC, ounded in 1951, was gradually

transormed into the European Union, attaining critical milestones such as theEuropean Economic Community (EEC) that eventually led to the creation o asingle European market.

Essentially, these leaders with a vision practised what philosopher Karl Poppercalled piecemeal social engineering:14 every step o European integration wasthe result o the development o common European policies in various elds, in-cluding agriculture, sheries, trade and eventually monetary aairs. There was,and still is, a caveat, though: the democratic politics o the European Unionhave always remained quintessentially national, leading to what is now com-

monly reerred to as the EU democratic decit. I shall return to this importantpoint later in the book.

From the very beginning, France and Germany led the eort towards Europeanintegration, although there were initially six states and subsequently three oth-ers involved. The six ounding nations (Belgium, France, West Germany, Italy,Luxembourg and the Netherlands) signed the Treaty o Paris that establishedthe Coal and Steel Community in April 1951. In 1957, they went urther andsigned the EEC Treaty in Rome, whose aim was to oster economic integration(including a common market). Three others Denmark, Ireland and the United


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Kingdom joined in 1972. All o them embraced the ideals o democracyand reedom, and subscribed to the rule o law. No country dominated. Eventhough the bureaucracy in Brussels was oten accused o nurturing a demo-cratic decit, all major steps had to be approved by elected parliaments.

When the Soviet empire disintegrated, German leaders understood that re-

unication would only be possible in the ramework o a more united Europe.They knew it would not be easy, echoing the oten quoted words o the writerThomas Mann, who proclaimed in 1953 that he wanted not a German Europebut a European Germany.15 When negotiating, the Germans were disposedto compromise, which made nding agreement easier. Indeed, the Germanpoliticians would state that Germany had no independent oreign policy, onlya European one. Hans-Dietrich Genscher, when he was West German oreignminister, amously said: The more European our oreign policy is, the morenational it is.16

This approach helped the process enormously, both in size and urther integra-tion. In terms o size, the rst steps taken were to overcome once and or allEuropes post-World War division by including most countries o Central andEastern Europe. Simultaneously, economic integration was urthered, culminat-ing with the signing o the Maastricht Treaty in 1992, the launch o the euro in1999 and the currencys circulation in 2002.

It is essential to remember that this process took place against the backgroundo constant currency instability, rom the introduction o foating rates in theearly 1970s to the euros creation. A number o endeavours to x one European

currency against another collapsed due to the dierent economic perormanc-es o the countries concerned. Such was the case, in particular, with the orcedwithdrawal o the pound sterling rom the Exchange Rate Mechanism (ERM)in 1992.

The EU today comprises 27 countries, o which 17 have committed to theeuro. There are ve candidate countries or accession: Croatia, Iceland, theFormer Yugoslav Republic o Macedonia, Serbia and Turkey. With the crisisnow engulng the entire European Union, particularly the eurozone, all under-stand that the Maastricht Treaty was imperect in its design. Also, critical com-

ponents, such as a common social policy, were missing.

The Treaty established a monetary union without the political union that con-stitutes a prerequisite or a common currency to unction properly. How couldthat be? The ounders o the euro and other people involved in its creationthemselves recognized that it was an imperect structure. There was a centralbank but no common treasury that could issue bonds that would be endorsedby all the member states. They all believed, however, that when the need arose,so too would the motivation necessary or a political union. That never hap-pened. As a result, the eurozone now rests on the shaky basis o a coned-


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eration o states that are committed both to a monetary union and to retainingtheir scal sovereignty, ormer German oreign minister Joschka Fischer wrotelast year. At a time o crisis, that cannot work.17

Unortunately, the euro had many other deects, o which neither the architectsnor the member states were ully aware. For several years, Germany and most

northern European countries adhered to scal discipline and maintained mod-erate levels o debt, while most southern economies went on a spending spree.Either public spending, like in Greece, or private spending, like in Spain and Ire-land, skyrocketed. The nancial crisis o 2007-08 revealed these excesses andthe imbalances that had built up within the eurozone, setting in motion a pro-cess o potential disintegration. Slightly more than 10 years ater its creation,the nancial markets began battering the euro. Many hedge unds bet that thesingle currency would not survive, thinking wrongly that the euro is nothingmore than a technical creation that could disappear without causing too muchtrouble. The euro is much more than that. Politically, it holds important symbolic

value throughout Europe. In Germany, the euro is perceived as the symbol andtool that commit the country to a united Europe.

Today, the European Union is in the throes o an existential crisis threateningits very survival. The turmoil in the eurozone crisis has resulted in a situationin which economic and political considerations are completely intertwined. Somuch so that they are now generating an adverse eedback loop: a bad eco-nomic situation makes politics divisive, which in turn exacerbates the economicand nancial problems.

Yet, amid the crisis, it is important to recall Europes impressive track record. Asdocumented by the Global Agenda Council on Europe o the World EconomicForum,18 a great deal has been achieved over the past ew decades. Generally,the integration o European countries has been a great success, leading tothe creation o a single market o 500 million consumers. The single market,launched in 1992, has been one o the greatest achievements o the Europeanintegration process, transorming the way in which citizens live, work, travel, dobusiness and even study. Most importantly, rom a trade perspective, Europeanenterprises can do what was previously inconceivable: sell their goods andservices across borders without incurring specic taxes or acing other obsta-

cles.

First and oremost, wars in Europe have become a thing o the past, with theexception o some countries in the Balkans that were not members o theEuropean Union. Economically, Europe is also a great success story, despitedramatic divergences in perormance that are analysed in depth in this book. In2011, according to the International Monetary Fund (IMF), the combined GDPin nominal terms o the 27 EU member states amounted to US$ 17.6 trillion,higher than that o the US (US$ 15.1 trillion) and China (US$ 7.3 trillion).


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With 20% o world trade, the EU is the worlds second largest exporter andimporter, ater China and the US, respectively. Europes labour productivity isone o the highest in the world.19 On average, Europeans are considered tohave the best quality o lie. Indeed, high levels o economic activity mesh withequity and social inclusion much better than in most other countries, promptingsome commentators to call Europe the liestyle superpower. The United Na-

tions Development Programme Human Development Index ranks 13 Europeancountries in its list o the top 20 perormers.

Put simply, the European Union has been an amazing success story, especiallywhen considering the ashes rom which it arose. A united Europe brought morecompetition and thereore more prosperity to the entire continent. Brusselsopened protected markets and broke up state monopolies in transport, tele-communications, energy and other sectors. Guy Sorman, a liberal economist,describes the European Commission, an institution that is so oten derided, asthe major ree-market agent we have in Europe.20

The euro, meanwhile, brought currency stability but most importantly it took thetool o devaluation away rom politicians who wanted an easy x and reused toimplement structural reorms. It orced each economy to be more fexible andmore productive because it was much easier to implement ree-market princi-ples than when decisions belonged to each nation. In addition, EU enlargementhas been the key actor in helping ensure the remarkably successul transitiono ormer communist countries to ull-fedged democracies and market econ-omies.

Even at the micro level, Europe has thrived. European multinationals are justone example. They have been very successul, investing abroad ar more andin more countries, particularly emerging markets, than their American and Jap-anese counterparts.21

Without anticipating what ollows in the coming chapters, it is important to notethat the crisis has already generated quick solutions to obvious shortcomings.Greeces political leaders will no longer be able to alsiy the budget as theydid or years. Italy and Spain have proposed tangible solutions to clean uptheir banking systems and reduce their debt and scal imbalances. The EU

authorities power to monitor and enorce budget ceilings has been signicantlystrengthened, making it unlikely that France and Germanys mistake o breach-ing the EU treatys limits on scal decit without consequence a decade ago(encouraging bad scal behaviour by others in the process) will be repeated.The EUs enorcement powers have strengthened suciently to prevent it.

In the years ahead, i and when a revitalized EU lessens regulatory, tax andother burdens on the private economy while maintaining a certain degree osocial protection, the stage will be set or the exploitation o great entrepre-neurial energy.


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It is also important to look at what has been avoided on the downside. Despiteall the negativity about Europe, one phenomenal success has already beenachieved in the midst o the crisis: the euro has acted as a powerul bulwarkagainst the temptation to engage in protectionism and competitive devalua-tions as prevailed during most o European history and globally in the 1930s.

KEY POINTS

The idea o Europe is relatively modern (end o the

18th century)

The memory o World War II constitutes the most

important driving orce o European integration

France and Germany led the process o integration

The Maastricht Treaty was awed and its European

architects knew it

Today, the eurozone crisis is generating an adverse

eedback loop between politics and economics

Overall the EU is an amazing success story


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3.DECLINE

From the outset o the idea o a common currency, such prominent econo-mists as Milton Friedman and Martin Feldstein proclaimed the end o the euro,warning that, since the eurozone was not an optimal currency area,22 thesingle currency could only ail. A number o actors were given, including labourmarket rigidities, the lack o redistribution mechanisms and the strong nationalidentities o the members. On the other side, Robert Mundell, one economistwho had argued strongly or the euros creation, believed that with the reemovement o capital and trade, closer political union would come and the eu-rozone could evolve into a natural optimal currency area.

Today, proponents o European integration recognize all the problems under-lined in the period leading up to the euro but argue that its creation was es-sentially a triumph o politics over economics. They claim that the economiclogic underestimated the political will that has driven European monetary unionsince its inception. Now that it is being shaken and mercilessly tested by thenancial markets, acts seem to vindicate the position o the early sceptics. ForFeldstein, ailure is inevitable and ar-reaching; the progressive disappearanceo the eurozone is the chronicle o a death oretold:

The euro should now be recognized as an experiment that ailed. Thisailure, which has come ater just over a dozen years since the euro was

introduced, in 1999, was not an accident or the result o bureaucratic

mismanagement but rather the inevitable consequence o imposing a

single currency on a very heterogeneous group o countries. The adverse

economic consequences o the euro include the sovereign debt crises

in several European countries, the ragile condition o major European

banks, high levels o unemployment across the eurozone, and the large

trade defcits that now plague most eurozone countries.

The political goal o creating a harmonious Europe has also ailed.France and Germany have dictated painul austerity measures in Greece

and Italy as a condition o their fnancial help, and Paris and Berlin have

clashed over the role o the European Central Bank and over how the

burden o fnancial assistance will be shared.23

Many do not share such an extreme position. However, most agree that, or awhile, the existence o a single currency allowed the undamental economic im-balances within Europe to be hidden. Because o the crisis, this concealmenthas come to an end.


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3.1. The Debt Overhang

In the early years o the euro, interest rates ell across the board thanks to the

robust anti-infationary stance o the European Central Bank (ECB), including incountries such as Italy and Spain where expectations o high infation had pre-viously kept interest rates elevated. Blessed with such a situation, householdsand governments in these countries responded by increasing their borrowing;they went, in the words o the historian Timothy Garton Ash, on the mother oall binges.24 From 2000 to 2008, government expenditure as a proportion oreal GDP increased on average by 12 percentage points in Ireland and by 3.8points in Greece, Italy, Portugal and Spain. As the economist Allan Meltzer saidin an interview with Fortune magazine: It doesnt help when the government isused to borrowing at 12% and suddenly it can borrow at 3% or 4%.25

Households used their increasing debts to nance a surge in home construc-tion and a concomitant increase in housing prices. The governments usedthem to und larger welare programmes. This resulted in rapidly rising ratioso public and/or private debt to GDP in southern Europe and Ireland. In somecountries like Greece, the public debt skyrocketed, while in others like Spainand Ireland, it was private debt that exploded.

In normal conditions, the debt markets should have responded by raising inter-est rates on those countries; they did not because they made the assumption

a wrong one, it turned out with hindsight that a bond issued by any memberstate was as sae as that o any other European Union nation. They disregard-ed in the process the provision included in the Maastricht Treaty that prohibiteda nancial bailout o any member state by another. In consequence, the interestrates on Italian and Greek bonds diered rom the rate on German bonds byonly a ew basis points. Contrary to the situation that prevails when a monetaryunion does not exist (where scal decits lead to higher interest rates or lowerexchange rates, acting as a warning or countries to reduce their borrowing),countries continued to borrow excessively and banks continued to lend exces-sively to buyers o housing that was overpriced. Only at the end o 2009 did the

nancial markets recognize their mistake o considering all eurozone countriesas equally sae. Very soon aterwards, the interest rates on the sovereign debtso Greece, Italy and Spain started to diverge rom the others.

Market dynamics put into motion an adverse eedback loop: rising interestrates soon became unsustainable and led countries to the brink o insolvency.What was originally a liquidity problem rapidly became a solvency issue. Veryquickly, expectations o higher uture interest payments implied a doom loop,meaning that, as debt burdens grew aster than originally thought, they wouldin turn lead the nancial markets to require even higher interest rates to contin-


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ue nancing these countries, thereby increasing the uture stock o debt evenurther.

As shown in Figures 1 and 2, the government decit as a share o GDP is muchlower in the eurozone than in the US, the UK and Japan. The gross governmentdebt is roughly similar to that o the US and the UK, and much lower than in

Japan. Yet it is the eurozone that is currently in the line o re. Why? Becausethe eurozone is not one country. The reason the nancial markets anxiety iscurrently ocused on the eurozone is because when the picture is disaggregat-ed, it looks very dierent. It does not look as good as it appears in the chartswith, very roughly, a partition between the North, mainly composed o surpluscountries with reasonable scal positions, and the South, mainly composed odecit countries with shaky i not unsustainable scal positions. (Irelandis the exception.)

The current crisis has laid bare the divergent economic circumstances, pro-

ductivity and income levels dierentiating the north rom the south o Europe.With hindsight, the initial conversion rates to the euro were probably too highor the southern countries, enticing them to consume too much (as the highexchange rate conversion increased the purchasing power o private savings)and produce too little (as unit labour costs became too high, although this isonly part o the picture).

Figure 1: Government Defcit, 2012 and 2013 (% o GDP)

Source: Absolute Strategy Research: IMF, Thomson Reuters Datastream

-12

-10

-8

-6

-4

-2

0

US UK Japan Eurozone

2012 2013 (IMF forecast)

Fiscal balance (% of GDP)


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Figure 2: Gross Government Debt, 2012 and 2013 (% o GDP)

Source: Absolute Strategy Research: IMF, Thomson Reuters Datastream

Figure 3: Defcit and Debt by Eurozone Country (% o GDP)

Source: International Monetary Fund, World Economic Outlook Database

(October 2012 edition).

US UK Japan Eurozone


Gross government debt (% of GDP)

0

50

100

150

200

250

-10

-8

-6

-4

-2

0


Fiscal balance (% of GDP)

Germany Finland Italy France Portugal Spain Greece Ireland


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In a paper delivered at the amous Jackson Hole Economic Policy Symposiumin 2011, three economists rom the Bank o International Settlements (BIS),oten reerred to as the central bank o central banks, reported that they useda new dataset that includes not only government debt but also non-nancialcorporate and household debts to determine when good debt goes bad.26

Their conclusions: debt becomes a drag on growth when it exceeds levels oabout 85% o GDP or government debt, 90% o GDP or corporate debt and85% o GDP or household debt.

In the eurozone, but not in the UK, the debt overhang concerns mostly thepublic sector. As the two charts below demonstrate, both household and cor-porate debt remain below or just at the levels that should raise concern.


Gross government debt (% of GDP)

0

50

100

150

200

GermanyFinland ItalyFrance PortugalSpain GreeceIreland


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Figure 4: Household Debt, 1990-2014 (% o GDP)

Source: Accenture Capital Markets, Capital Markets Open House, October 2012, p. 13.

Figure 5: Corporate Debt, 1990-2014 (% o GDP)

Source: Accenture Capital Markets, Capital Markets Open House, October 2012, p. 13.

110

U.K.

United States

Eurozone

90

70

50

30

10

1990 1994 1998 2002 2006 2010 2014

Eurozone

United States

U.K.

1990 1994 1998 2002 2006 2010 2014

140

120

100

80

60

40


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3.2. The Banking Crisisand Its Collateral Effects

When the euro was introduced, all government bonds across the eurozonewere treated in a similar ashion: as essentially without risk. Accordingly, reg-ulators across the eurozone permitted banks to purchase any number o sov-ereign bonds. They did not require them to put aside any equity capital, whichmeant that the ECB made no distinction between the bonds o dierent mem-ber governments. Thereore, commercial banks ound it interesting to buy thebonds o the weakermember states because they could earn some extra basispoints on slightly higher interest rates.

Only at the end o 2009 did the nancial markets begin to realize that the

government bonds o weaker eurozone countries carried signicant risks andcould possibly even deault. This happened ater the newly elected Greek gov-ernment announced that the country decit exceeded 12% o GDP. Immedi-ately, risk premiums the extra yield that governments must oer to be able tosell their bonds on the markets rose dramatically.

This phenomenon created a banking problem over and above the debt issue,by rendering commercial banks potentially insolvent as their balance sheetswere loaded with these poor quality bonds. As Table 1 shows, a ew system-ically important banks have high exposure to toxic sovereign assets, most

notably in Italy and Spain. This matters to the system as a whole because thebanking system is highly interconnected. As such, it is hard to imagine how theailure o just one bank would not propagate stress through the entire system.


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Table 1: Exposure o Selected Banks to the Eurozone Crisis

Source: Accenture Capital Markets, October 2012.

This makes it very apparent that the banking and sovereign crises are com-

pletely intertwined, linked in a refexive eedback loop. In the words o GeorgeSoros, they are tied together like Siamese twins and cannot be solved sep-arately.27Not all eurozone crises are equal in nature, however. In Ireland andSpain, or example, the crisis results rom excess private-sector demand thatled to a real estate bubble and eventually to a banking crisis. This, not scalprofigacy as in the case o Greece, was the major cause o the crisis. Econom-ic and political pressures orced governments to bail out their banks, signi-cantly increasing public debt, which in turn led the sustainability o governmentnances to be questioned.

euros (billion)

Germany (mostly exposure to Italy)

Commerzbank 10.9

Deutsche Bank 6.6

DZ 6.6

Hypo 10.0

France (mostly exposure to Italy)

BNP 14.9

Crdit Agricole 4.5

Socit Gnrale 3.0

Italy (mostly domestic exposure)

Sienna 28.4

Banca popolare 11.4

Intesa SanPaolo 70.9

Unicredit 49.9

UBI Banca 17.5

UK (mostly exposure to Italy and Spain)

Barclays 6.3

HSBC 1.5

Lloyds 0.02

RBS 0.06

Spain (almost all domestic exposure)

BBVA 56.5

Santander 57.3

Barcelona 26.7

Banco Popular 15.6


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Despite the rollover o debt rom banks to public institutions, European banksare still substantially over-exposed compared to the US and Japan (as the g-ures rom 2010 show in Table 2). This also explains the pervasive nervousnesso the international investment community, as related to the European crisis.

Table 2: Size of the EU-27, US and Japanese banking sectors (2010)

Note: The Asian crisis fgure includes Indonesia, South Korea, the Philippines and Thailand.Source: Monthly Barometer. www.monthlybarometer.com

The end result is that banks in the eurozone badly need to strengthen theirbalance sheets, mainly by revisiting their portolios to take into account urthercapital needs that can cover risky sovereign debt. Much o the European bank-ing system, particularly in southern Europe, will have to go through a painulphase o consolidation and restructuring that goes beyond sovereign debt.

The Spanish banking system epitomizes this situation. Most o its banks haverecently posted sharp alls in prots ater having been orced into write-downsto cover heavy losses on their real estate assets and loan portolios.

In August 2011, Christine Lagarde, the managing director o the IMF, initiallywarned about the inadequate capital levels in European banks. She then re-erred to internal research showing that, i European banks were stress-testedor the sovereign deault risks implied by the nancial markets, they would beshort o capital by 200 to 300 billion euros.28 In aggregate, very little has beendone. Meanwhile, a slow-motion run on the banks in southern Europe, particu-

larly Greece and Spain, has beset the banking system or more than two years.Why are the depositors concerned? Simply because o the perception that oneeuro in a Greek bank no longer equals one euro in a German bank. (I Greecewere to exit the eurozone, it would immediately implement a reeze in depositsand euros would be converted into depreciated drachmas.)

This problem o capital outfows and o banks unhealthy balance sheets isparadoxically exacerbated by the policies being undertaken to support nationalbanks. Banks in every eurozone country mostly hold bonds issued by theirhost country. As concerns grow over the sustainability o public nances in

EU USA Japan

Total assets of banks ( trillion) 42.92 8.56 7.15

Bank assets, % of GDP 349% 78% 174%

Assets per bank of the top 10 banks

(6 for Japan) ( billion)

1,501 480 625

Top 10 banks assets (6 for Japan),

% of GDP

122% 44% 91%


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some countries such as Greece and Spain, the value o their sovereign bondsalls. This creates a hole in the assets o the banks holding their bonds. Asgovernments step in to ll these holes with public unding, their debt increasesand the sustainability o their nances deteriorates even urther. This, in turn,decreases the value o their bonds, eeding an adverse loop that creates newholes in banks assets.

Several prominent academics have emphasized the act that Europes nancialsystem relied to a large extent on moral hazard.29 Indeed, the no deaultspolicy put orward by the European authorities at the outset o the crisis has en-abled banks to attract the unding needed to roll over large amounts o short-term bank and sovereign debt.

The problem is that creditors lent money to banks and the sovereign under theassumption that they would all be ully supported during periods o trouble,which may not be the case anymore. Due to weak public nances, some sov-

ereigns may nd it impossible to bail out their banks at the same time the morerobust eurozone members display increasing hesitancy to bail them out. Thatis why the euro area is now switching rom a moral hazard regime to new ar-rangements under which all nations must end or themselves onlyin principle.In particular, politicians in creditor nations have called or private-sector bur-den sharing, leading investors to demand even higher interest rates or holdingthese debts, with the possible perverse eect o higher rates tipping banks andnations towards bankruptcy.

Also, in past months, national regulators have avoured domestic lending.

Meanwhile banks have shed assets outside o their country o origin. They didso hoping that a possible break-up or exit by one country could occur withouttriggering a complete meltdown o the nancial system. The words in princi-ple mentioned above are important because, although the nancial system inthe eurozone has been progressively reoriented along national lines, a break-up would leave creditor countries (primarily Germany) with claims against thecentral banks o the debtor countries that are substantial and also hard tocollect.

The reason or this has to be ound in the eurozone clearing system called TAR-

GET2, a settlement system or all payments involving the eurosystem, which isitsel the central banking system o the euro area.30 TARGET2, in contrast to theclearing system o the US central banking system, the Federal Reserve, whichis settled annually, accumulates the imbalances between the banks within theeurozone indenitely.

This should not be a problem when the interbank system unctions well: thebanks simply settle their respective imbalances through the interbank market.When the interbank market does not unction well (which has been the casesince the summer o 2011), an increase in capital fight occurs in the weaker


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countries. How does this work? I a Greek depositor makes a transer rom hisaccount in Greece to a German nancial institution, the German Bundesbankwill end up with a TARGET2 credit, which is oset by a TARGET2 claim againstthe Greek central bank. Since the onset o the crisis, claims within the TAR-GET2 system have grown exponentially. By the summer o 2012, the Bundes-bank had accumulated claims o more than 700 billion euros against the central

banks o southern European countries.

Germanys mounting net claims within the European central banking systemdo not necessarily mean that it would lose much i the eurozone were to allapart. The reason is that Germany, like other surplus countries, has accruednet claims not because o internal central bank reckoning but because it hasbuilt up a substantial current-account surplus, resulting rom the export ogoods and the import o nancial claims.

As a recent academic paper demonstrates, balances within TARGET2 are not

a good indicator o this new nancial risk because they have only risen dueto speculative nancial fows. These, by nature, do not aect net cross-bor-der claims.31 To put it in slightly simpler terms, TARGET2 losses would ac-cumulate on the books o the ECB. Thereore, Germany would only lose theamount corresponding to its equity share in the ECB. In addition, the value othe Bundesbanks liabilities (the monetary base) does not depend on the valueo its underlying assets. In a at monetary system (that is, a system in which acentral bank denes what constitutes legal tender, as opposed to a commod-ity money system, such as the gold standard), central banks need assets onlyor the purpose o monetary control. They can, i they wish, create money out

o nothing. But, in the end, the value o money depends only on its purchasingpower, or the amount o goods and services that can be purchased with a unito currency, which infation can erode.


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Figure 6: TARGET2 Claims and Liabilities in the Eurozone,2002-2012 (million euros)

Source: De Grauwe and Ji.32

What can be done in the ace o such a mammoth problem? Only one solutionexists: a banking union. It is an absolute prerequisite or a healthier eurozone

economy. A majority o independent analysts, economists and policy-makershave advocated the adoption o a ederal ramework or banking policy thatwould centralize the unctions o supervision, crisis resolution and deposit in-surance that are essential or the stability o the European banking system andthereore or the sustainability o the eurozone.33 I will review what this meansin section 4.3.

KEY POINTS

The sovereign and banking crises are completely

intertwined

Banks in the eurozone badly need to clean up their

balance sheets

Eurozone countries now favour domestic lending and

shedding assets abroad

Claims in TARGET2 are growing quickly

Only one solutions exists: a banking union


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3.3. TheCompetitivenessDefcit

Competitiveness matters considerably or national prosperity. For many years,

the EU has been concerned with the competitiveness perormance o its mem-ber states and has accordingly devised a number o strategies to improve it.In 2000, the EU launched the Lisbon Strategy, aimed at making Europe themost competitive and dynamic knowledge-based economy by 2010. It wasa vain attempt. The strategy was criticized in retrospect or being too broad,covering too many issues and lacking a compliance mechanism to give therecommendations teeth.

Having recognized that they had not met their goals, European leaders in2010 conceived a new competitiveness plan, the Europe 2020 Strategy, with

the purpose o encouraging national and regional policies that could providegrowth and jobs in the coming decade. It aimed to achieve innovation-driven,sustainable and inclusive growth. But much o the original good intent hassince been side-tracked by the short-term reghting o the nancial and sov-ereign debt crises, which has prevented policy-makers rom ocusing on andinvesting in the measures needed to boost European competitiveness.34

But what does competitiveness actually mean? The World Economic Forumhas been studying Europes competitiveness since 1979, when the preoccu-pation was with how the region was aring compared with the United States.

The Global Competitiveness Reports35

o the World Economic Forum denecompetitiveness as the set o institutions, policies and actors that determinethe level o productivity o a country. The level o productivity, in turn, deter-mines the level o prosperity that can be achieved by a particular country. Theproductivity level also determines the rates o return obtained by investments inan economy, which are the undamental drivers o its growth rates. Put simply,a more competitive economy is one that is likely to provide high and rising livingstandards over time.

What are the key drivers o productivity and competitiveness? The main vehicle

used by the World Economic Forum to measure competitiveness is the GlobalCompetitiveness Index (GCI). The GCI is made up o 12 pillars o competitive-ness. These range rom the basic to the more complex and include political in-stitutions and governance, inrastructure, macroeconomic stability, health andprimary education, higher education and training, goods market eciency, la-bour market eciency, nancial market development, technological readiness,market size, business sophistication and innovation. Variables measuring eacho these concepts are combined to come up with an aggregate score on ascale o 1 to 7, with 7 being the best possible outcome. The latest GlobalCompetitiveness Reportcovered 144 economies.


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On average, Europe trails other advanced economies in the creation o a smart,highly productive economy. This has had consequences on the regions pros-perity level. Indeed, as Figure 7 shows, the gap in terms o income per capitahas widened between the EU27 economies and the highly innovative and pro-ductive United States over the past two decades. And while the 27 countrieson average were signicantly wealthier than the Republic o Korea in 1992, they

have been overtaken by it since the beginning o this decade as South Koreahas seen a signicant improvement in its productivity and competitiveness.

Figure 7: GDP Per Capita (PPP Int. $), EU27, United States andthe Republic o Korea



In large part, the widening income gap between Europe and some o the morecompetitive economies can be explained by a competitiveness decit. As Fig-

ure 8 shows, when compared with the United States across several o thesepillars, although the EU ares somewhat better on average in terms o its mac-roeconomic environment, it trails behind the United States in many other areas,most notably in the eciency o its labour markets and its capacity to innovate.

0

10'000

20'000

30'000

40'000

50'000

60'000

1992

1993

19

94

1995

1996

1997

1998

1999

2000

2001

2002

2003

20

04

2005

2006

2007

2008

2009

2010

2011

2012

EU27 United States Korea


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Figure 8: Europes Global Competitiveness Gapwith the United States

The Global Competitiveness Index, Pillar Scores (1-7 scale) Source: World Economic Fo-

rum, The Global Competitiveness Report 2012-2013 and authors calculations.

A major issue or the eurozone is that a signicant gap also exists among EUmember states: some countries perorm very well across the dierent pillars

that determine competitiveness, while others do not. The Global Competitive-ness Report 2012-2013 shows convincingly that countries with relatively highlevels o economic prosperity but that lag in building a knowledge-based, high-ly-productive economy are those that have suered the highest losses in termso employment, salaries or both. In other words, high levels o prosperity inEurope cannot be sustained over time without high levels o competitiveness.

This competiveness gap within Europe can be seen through the heatmapshown in Figure 9, with the most competitive economies indicated in warmestred and the hues becoming increasingly cooler, ending with the least compet-

itive countries in dark blue. As the map shows, signicant disparities in termso perormances exist across the continent. They range rom the very strongperormances o countries such as Finland, Germany, the Netherlands andSweden, ranked at the top, to the poor and declining perormance o Greece,ranked a low 96th out o 144 economies. More generally, the northern Euro-pean countries are the most competitive and southern, central and easternEuropean countries the least competitive.

Institutions

Infrastructure

Macroeconomic

environment

Health and primary

education

Higher education and

training

Goods market efficiencyLabor market efficiency

Financial market

development

Technological readiness

Business sophistication

Innovation

1

2

3

45

6

7


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Figure 9: The Competitiveness Divide in Europe

Source: World Economic Forum, The Global Competitiveness Report 2012-2013.36

To understand the areas driving this diverging perormance, Figure 10 com-pares the perormance across the competitiveness pillars between the north-ern and southern European economies.

Figure 10: The Competitiveness Gap: Northern vs Southern Europe

Institutions

Infrastructure

Macroeconomic

environment

Health and primar

education

Higher education an

training

Goods market efficiency

Labor market efficiency

Financial market

development

Technological readiness

Business sophistication

Innovation

Market size 12

3

4

5

6

7

5.39 Best

5.00 5.39

4.60 5.00

4.20 4.60

3.86 4.20


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The Global Competitiveness Index, Pillar Scores (1-7 scale)

Notes:*Northern Europe: Denmark, Finland, Germany, Netherlands, Sweden

Southern Europe: Greece, Italy, Portugal, Spain

Source: World Economic Forum, The Global Competitiveness Report 2012-2013

and authors calculations.

As Figure 10 shows, the divide between northern and southern Europe is sig-nicant across almost all areas. As well as macroeconomic stability, northernEurope receives a much stronger assessment or the quality o its institutionalenvironment, the eciency o markets, its propensity or technological adop-tion and innovation, among others. These signicant dierences, o course,constitute a serious problem when countries are bound by a common curren-cy. Nations will ollow divergent growth paths in the uture, creating tensionsamong economies. At some stage, competitiveness and economic growth willhave to converge between northern and southern Europe i the monetary ar-rangement is to survive.

A question remains as to the uture path o France, a country with a less-than-stellar competitiveness prole as shown in the heatmap above. Ranked21st, France trails the most competitive economies o northern Europe by asignicant margin, despite a number o clear strengths, particularly related tothe countrys excellent human capital base and propensity or technologicaladoption. Yet businesses in the country are saddled with an extremely rigidlabour market and an oten dicult regulatory environment. Amid discussionsnow taking place about the countrys economic uture, one wonders whetherFrance will become more northern or more Mediterranean, even as the

Mediterranean eurozone countries to its south strive to address these issues.

Amid the current eurozone diculties, inevitably the question also arises as to

how the single currency relates to competitiveness. Could some countries have

done better in terms o competitiveness by being outside rather than inside the

eurozone? This is doubtul. Sharing a common currency prevents the external

adjustment that a country can achieve by devaluing its currency, but this ex-

port-led recovery idea corresponds to a very narrow and mechanical denition o

competitiveness, one that equates competitiveness with an improvement in the

current-account position, which does not necessarily lead to longer-term growth.

Many industries in Europe rely to a signicant extent on inputs rom other coun-tries, so the rising price o imports will undermine their competitive positioningon international markets. Moreover, the depreciation o a currency makes thecitizens o the country poorer because it leads to an increase in prices o im-ports and thereore a decrease in real incomes, similar to a collective nationalpay cut when viewed rom an international perspective.

As has already been seen among EU countries, divergent income levels andgrowth rates are to a very signicant extent the result o dierences in compet-


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itiveness and productivity, the underlying actors o which are much broader.Indeed, some countries, such as Germany and the Netherlands, respondedwell to the incentives and discipline imposed by a single currency and suc-ceeded in improving their economic perormance. Others that took advantageo low interest rates to increase debt to nance unproductive investments didnot do so well.

Would Greece, Italy, Portugal or Spain have ared signicantly better outsidethe eurozone? Probably not, because without ar-reaching structural reorms,they would have ailed to prosper, no matter what.

These results in terms o divergence point to the complexity and dicultieso bridging the competitiveness divides in Europe and raise questions aboutthe sustainability o the income convergence that many European economieshave experienced in recent decades. The recent declines in income in previ-ously converging economies, such as Greece, Portugal and Spain, where an

important competitiveness divide persists, suggest that stable economic con-vergence may only be possible i decisive action to address the weaknesses inthe competitiveness o these countries is taken.

Only by improving the competitiveness o the countries that are trailing andnarrowing the competitiveness gap will Europe nd a sustainable exit to thesovereign debt crisis and place the eurozone and the EU more generally on apath to more sustainable growth and employment.

KEY POINTS Competitiveness is a robust predictor of prosperity

and the potential for growth

On average, Europe trails other advanced economies

in terms of competitiveness

Considerable divergence exists within the eurozone

in terms of competitiveness

NorthernEuropeissignicantlymorecompetitive

than southern and eastern Europe Europe will be unable to address its current economic

andnancialdifcultiesifitdoesnotcloseits

competitiveness gap


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3.4. Institutional Failure

When the European Coal and Steel Community was ounded in 1951, there

were six participating states. Today, the European Union has 27 members. Thisdramatic increase brought with it the enlargement o European institutions andregulatory bodies to such an extent that complexity and maintaining legitima-cy have become signicant challenges. The reality o institutional ailure boilsdown to this: Europe is perceived as a aceless entity. The crisis has shownthat the governance o the EUs political economy is too weak. The executiveauthority is dispersed among too many dierent and airly obscure institutionsand players, and democratic accountability is thin.

The three main institutions that compose the EU the European Commission,

the European Council (representing the national governments), and the Euro-pean Parliament are at best misunderstood and at worst disliked by a major-ity o the European population. The European Commission is a case in point. Itis perceived and resented as a reuge or technocrats and civil servants while itis in reality a successul institution with a reputation or competence.

As shown in Figure 11, trust in the European Union at large has declined since au-

tumn 2011 and is currently at its lowest ever (31%, -3 percentage points). At the

same time, levels o trust in national governments and parliaments have recov-

ered slightly (28%, +4 and 28%, +1 respectively), such that the gap between trust

in national political institutions and in the European Union is currently very narrow.

Figure 11: Trust in National Governments,Parliaments and in the European Union, 2006-2012

50%44% 45% 45%

46%

57%

48% 50% 47% 47% 47% 48%

42% 43% 41%

34%31%

38% 38%

43%

35% 35% 34% 34%36%

32% 31% 31%33%33%

32%27%

28%28%29%29%32%32%

34%34% 35%

31%31%

41%

30%

36%34%

24%

30%

35%

The (NATIONALIITY) government The (NATIONALIITY) Parliament

The European Union

QA13 I would like to ask you a question about how much trust you have invertain Institutions. For each of the following institutions, please tell me if you

tend to trust it or tend not to trust it

Answer : Tend to trust


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Source: European Commission, Public opinion in the European Union, Standard

Eurobarometer 77, Spring 2012. http://ec.europa.eu/public_opinion/archives/eb/eb77/

eb77_rst_en.pd, p. 13.

Essentially, the much talked-about democratic decit stems rom this institu-tional ailure. The lack o trust in European institutions derives rom their lack o

legitimacy when compared to the elected governments o nation states. It hasseveral dierent aspects:

The European Council, a key player in Europes collective executive deci-sion-making, lacks the ramework to ensure collective accountability. Itsmembers, heads o state or government, are exclusively accountable totheir respective national citizens, but the Council as a whole is account-able to no one. The same shortcoming hampers the summit meetingso the eurozone, as well as other intergovernmental ormations such asthe Economic and Financial Aairs Council (ECOFIN) and Eurogroup (the

eurozone nance ministers). The European Commission has strongeraccountability to the European Parliament, but in the past ve years it hasoten been sidelined (with important exceptions, such as on competitionpolicy placed directly under its authority).

When electorates in individual member states are consulted on suc-cessive treaty revisions by reerendum, negative responses should beanswered by a change o orientation. This has not been the case. TheFrench and Dutch rejections o the 2004 constitutional treaty were ol-lowed by the reintroduction o nearly identical text as the Lisbon Treaty in

2007. Similarly, the Irish were asked to vote again on the Lisbon Treaty in2009 ater rst rejecting it in 2008. Nothing crystallizes better this senseo institutional fop than the ailure o the Lisbon Treaty. Signed in 2007beore entering into orce in December 2009, it was destined, accordingto its preamble, to enhance the eciency and democratic legitimacy othe Union and to improve the coherence o its action. However, a largemajority o EU citizens perceived it as so complex as to be incomprehen-sible. The problem o the three presidencies highlights this. One is therotating presidency: the president o the Council o the EU that rotatesamong member states every six months. Another is the permanent presi-

dent o the European Council (also known as the president o the EU sum-mits o heads o state and government), Herman Van Rompuy o Belgium.The third is the president o the European Commission, Jos ManuelBarroso, oten portrayed as yet another EU president. This arrangementis rather conusing or anybody not amiliar with the subtleties o EUdecision-making!

European citizens lack equal representation in the European Parliament.In June 2009, this critical shortcoming was cited by Germanys ederalconstitutional court as a key reason not to surrender national scal power
http://ec.europa.eu/public_opinion/archives/eb/eb77/eb77_first_en.pdfhttp://ec.europa.eu/public_opinion/archives/eb/eb77/eb77_first_en.pdfhttp://ec.europa.eu/public_opinion/archives/eb/eb77/eb77_first_en.pdfhttp://ec.europa.eu/public_opinion/archives/eb/eb77/eb77_first_en.pdf


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to Brussels. In addition, the European Parliament does not control nan-cial and other important executive decisions.

The democratic shortall o European institutions has been widely cited as aactor in the rise o populist anti-European parties in recent elections in severalmember states. It extends to some o todays most critical decisions. Certain

commentators such as Gideon Rachman, the chie oreign aairs correspon-dent at the Financial Times, have argued that the ECBs decision in Septem-ber 2012 to engage in unlimited bond purchases is immune to democraticcontrols,37 highlighting the act that European voters are subject to crucialdecisions about national economic policy that can no longer be challenged atthe ballot box. Rachman points in particular to Germany, where the realizationis growing, he believes, that the ECB is an unelected body independent romgovernment that has just made a decision with proound implications or Ger-man taxpayers but one that they can neither challenge nor change.

This institutional ailure can lead to policy paralysis in situations o stress. One othe reasons why the crisis became so acute is the inability o European leadersto make decisions when they are needed. This curse o ineective governmentjust when a tough situation most requires ast, eective and decisive action hasplagued the European decision-making process rom the onset o the crisis.

With the notable exception o the European Central Bank, European leadersand institutions have generally projected an image o collective indecision rath-er than decisiveness, well captured by the criticism that they are merely kick-ing the can down the road. It is air to say that, alongside a democratic decit,

Europe also suers rom an executive decit the true core o the Europeancrisis, according to the researcher Nicolas Vron, who has argued that Euro-pean institutions suer rom the absence o a mechanism to allocate losses akey eature o executive power.38 This is a major reason why Europe has beenunable so ar to resolve its banking crisis.

It is air to say that Europes political leaders must act within national, Europe-an and even international systems and constraints, rendering decision-makingslow and sometimes chaotic. In addition, the natural tendency in any complexsituation, where decisions may have unintended consequences, is to wait until

the last moment in hopes o gaining greater clarity.

To make the EU capable o decisive action, several things must be stream-lined and simplied, most notably: (1) the decision-making processes, (2) thedistribution o power between EU institutions and the nation states, and (3) theinteraction between the multiple EU institutions. I shall return to each later inthis book.


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KEY POINTS

The complexity and legitimacy o European institutions

has caused a democratic defcit

The curse o ineective government has exacerbated

the crisis


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3.5. The Disintegrationof Common Values

For many years prior to the 1990s, the process o European integration wasembraced and supported, albeit oten passively, by a large majority o Eu-ropeans. In Western Europe, the project was regarded as an eective bu-er against the Barbarians at the gate, a.k.a. the Soviets. In Eastern Europe(the kidnapped West as writer Milan Kundera called it), the idea o Europeanunication and the sense o common democratic values with the West wereclosely associated with the struggle or reedom, admittedly alongside the lureo Western prosperity.

These powerul drivers that led to a sense o common European values came

to an end with the all o the Berlin Wall in 1989. In September 1992, France the heartland o the unication project with Germany adopted the MaastrichtTreaty by reerendum with only a tiny majority. In Germany, where the constitu-tion did not demand a reerendum, Chancellor Helmut Kohl simply stated thatcitizens would have to abandon their cherished deutsche mark against theirwill. This proved a dramatic turning point, ater which the project o Europeanintegration became increasingly perceived as driven by the elites or the elitesand devoid o common values.

To a certain extent, this eeling that ar-reaching European decisions are taken

in an opaque ashion, without explicit reerence to a set o common values,coincided with the disintegration o the democratic principle embedded in theEuropean ideal. The ounders o Europe wanted a united democratic Europethat gives each person a vote and, most importantly, also a voice. Today, thedemocratic principle embedded in elections is rmly instituted in the constitu-tions o all European countries. However, the commitment to public discussion(as in Switzerland) in preparation or large policy decisions is oten let wanting.

I democracy, as the British political analyst Walter Bagehot dened it, is agovernment by discussion,39 then the democratic ideal has been pervert-

ed. Indeed, most o the decisions that will determine what Europe will be liketomorrow are made by experts and technocrats without much (i any!) publicdiscussion. The unilateral judgements o central bankers and nancial experts,and the pronouncements o rating agencies reign supreme, without properpublic debate. The disdain or the public could hardly have been more trans-parent in many o the chosen ways o European policy-making, Amartya Senwrote in an essay in The New Republic.40

In this respect, an analogy that is deeply misleading is oten invoked in themedia, based upon the idea o an imaginary set o common values. Many


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commentators and pundits have portrayed the current predicament in thesouth o Europe and German sacrices to achieve unication between its Eastand West as similar. This analogy is a alse comparison because what drovethe process o German unication was precisely a shared sense o values andidentity. Clearly, the sense o national unity that spurred the German eort doesnot exist to the same extent between southern Europe and the rest o the

continent.

As illustrated in Figure 12, a deep and increasing sense o disillusionment per-vades the European ideal. It is in this sense that the disintegration o commonvalues is intertwined with the notion o democratic decit discussed in the pre-ceding section. The crisis has created a crisis o aith in the ideal o democracyitsel. More worryingly, it has also created a phenomenon o distrust in politi-cians and political institutions.

This is especially true in the hardest-hit countries o southern Europe. In Spain,

a recent survey showed that trust in political parties is at 9%, an all-time low.Some 27% o Spaniards have aith in trade unions, the local councils and theSupreme Court, while 23% express condence in the current government, andjust 16% trust the parliament. In Italy, only 7% trust political parties. The num-bers do not look much better in other southern European countries.41

The greatest risk that has arisen rom all this is the rise in populism and thehidden danger o radicalization. In Greece, or example, parties rom the ar-letand the extreme-right, which both reuse to implement the conditions imposedby the bailout and call or an exit and a deault, achieved their best results ever

in the June 2012 general election. In Ireland, the mainstream Sinn Fein partyhas attracted unprecedented levels o public support by attacking the countrysbailout by the Troika o the IMF, the ECB and the European Union. In Portugal,the Communist Party and the Let Bloc have surged in opinion polls.

In Italy, meanwhile, the recently created Five Star Movement o Beppe Grillo,who rejects the euro, austerity and the political establishment, won about 10%o votes in participating provincial capitals in local elections in 2012 (twice asmany as in the regional elections held in 2010), and received more than 18% ovotes in Sicilys regional elections in October 2012. During the 2012 presiden-

tial elections in France, Marine Le Pen, the leader o the extreme-right NationalFront, who advocates an immediate exit rom the euro, achieved 18% o votes,including a high level o support among the young. Jean-Luc Mlenchon romthe Let Front, who has a similar position on Europe, won more than 11% othe overall vote. And so on. It is no surprise that in such conditions the imageo the EU has deteriorated steadily since the beginning o the crisis, as shownin Figure 12.


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Figure 12: The EUs Image, 2006-2012

Source: European Commission, Public opinion in the European Union, Standard Euroba-

rometer 77, Spring 2012, p. 14.

Recent polls and elections show that the rise in extremism should not be con-sidered a oregone conclusion ar rom it. In what was widely perceived as aEuropean test case, the general elections that took place in the Netherlandsin September 2012 handed victory to the most pro-European political partiesand (relative) deeat to the anti-European platorm put orward by the Party orFreedom o Geert Wilders.

So where are Europes common values to be ound today? Not in a sense obelonging. Contrary to the situation that prevailed when the EU institutions

were rst ormed, todays European citizens identiy rst and oremost with theircountry o origin, not with Europe. A survey conducted by the World EconomicForum in 2012 o its Young Global Leaders and Global Shapers reveals thatamong the 75% o respondents who have a European passport, only 23.2%would identiy themselves as European. Respondents instead describe theirprimary identity as global (46.4%) or national (24.6%). These results do revealthat the next generation will increasingly look at Europe rom a global perspec-tive. This may become a driver or European unication, as the next genera-tion recognizes that Europe can only prosper in the international context i it isunited.

52%

49% 48% 48%

45% 45%43%

42%40% 40%

41%

39%

31%31%38%38%37%

35%34%34%

32%

50%

15% 15% 15% 15%

16%

17%20% 20%

26%

28%

2%2%2%2%2%2%2%2%2%2%2%3%3%3%

14%

17% 17% 17%

31%

35%36%36%

38%

46%

QA13 In general, does the EU conjure up for you a very positive, fairly positive, neu-tral, fairly negative or very negative image?

Neutral Total negative Dont knowTotal Positive


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At the moment, the ear nonetheless exists that Europes common values areast vanishing into the mire o diverging national, and sometimes regional, in-terests so prevalent in times o great stress. Many national media are awashwith ethnic stereotyping, lambasting the lazy Italians, the lying Greeks or theimperial Germans.

What is to be made o this situation and o the many dierent speeds in the EU?Some countries, like Germany, are willing and able to integrate quickly, whileothers, like the UK, are applying the brakes. Why do Northerners the Bel-gians, Finns, Germans and others escape to the South in the summer? Sim-ply or the sun, or are these temporary migrations destined to break the ethoso prudence and discipline in search o the delightul ineciency and sensualityo the Mediterranean culture? Are they in search o a dierent set o values?

The Germans have a word or this: the Volksgeist, which can best be translat-ed as national spirit. Will a common set o European values that transcends

the Volksgeist emerge in the oreseeable uture? This can only happen i poli-cy-makers and opinion-shapers succeed in instilling a shared vision or Europe.Section 4.7 looks at how best this might be done.

KEY POINTS

European common values disappeared in the 1990s

They have been replaced by distrust in politicians and

political institutions

In situations o crisis, the absence o common values

leads to populism and radicalism


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3.6. The Erosion of GlobalCredibility

The year 2005 was probably the apogee o the European idea. Until aroundthat time, the European project o integration was perceived globally as themost ar-reaching, ambitious and constructive attempt yet to unite a continentthat had been war-torn throughout history. This high-minded endeavour is nowin tatters. Today, the eurozone is kept together by ear. It is only the spectre ocollapse and the devastating economic and social consequences that a disin-tegration o the euro would entail that are keeping it alive.

This is not conducive to an outward-looking Europe, proud o its identity,dynamic and enjoying the active support o its citizens. I it is not to decline

urther in terms o its relevance and ecacy, Europe must nd a new drivingorce and ully mobilize its population or the eort.

I shall return to this later on in the book and ocus or the moment on Europeslack o credibility internationally. This stems rom the image o division andhopelessness that the continent oten projects abroad. Despite the recentcreation o a European External Action Service (EEAS), Europe never had asingle or unied voice in world aairs. The mixed and sometimes contradicto-ry reactions o dierent EU governments to the Arab Spring have highlightedthe embarrassing lack o common oreign policy. Most importantly, they have

shown that no one is in charge to dene Europes role in a ast-changing world.

The EEAS is small, with only 1,500 diplomats and an annual budget o lessthan hal a billion euros. By contrast, Europes combined national missionsemploy 55,000 diplomats and cost 7.4 billion euros a year. In 2011, a reportrom the Brookings Institution concluded: It is clear that the EUs oreign policyhas evolved as a patchwork, an ugly amalgam o dierent issue areas that werethrown together with little thought to overall strategy.42

Javier Solana, ormer Spanish oreign minister and European Union oreign

policy chie rom 1999 to 2009, put the issue this way: The choice is simple:either we Europeans act in unity to conront the tremendous challenges pre-sented by the tumultuous changes now underway in the world order, or wedoom ourselves to act as spectators in a world in which we have little or no say.Our prosperity and the viability o our socioeconomic model are at stake. Thatshould convince us that Europes states are too small to act globally on theirown, and that European integration is the only viable path.43

Should a country decide to leave the eurozone or simply withdraw rom someEU institutions, the blow to the project o integration and European prestige


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would be considerable. It is still a distant risk, but nonetheless conceivable.Today, the United Kingdom is at a crossroads regarding its EU membership,and so are its most important EU counterparts, particularly Germany. For therst time since the 1970s, when maintaining the UK in the European projectwas paramount, France, Germany and other European countries worry moreabout saeguarding the euro and EUs existing institutions than keeping the UK

within the EU. In the words o a British commentator, British pull is now beingreinorced by continental push.44

The necessity to put into place structural and institutional reorms to save theeuro may ultimately lead to a multi-speed Europe, with core countries continu-ously strengthening the EUs economic and political union and peripheral coun-tries being tied to the core through more fexible, looser arrangements. Sincethe core would certainly comprise most o the continental European countriesand the original ounding member states o the EU, such a solution is certainlymuch less desirable than a unied Europe o at least 27 countries. But it is still

preerable to possible disintegration.

KEY POINTS

The image o Europe has sharply declined, both in terms

o relevance and efcacy

Europe has no common oreign policy

Should a country leave the eurozone or the EU, the blow

to the project o integration would be considerable

A multi-speed Europe is preerable to disintegration


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4. RE-EMERGENCE

Disagreements abound among policy-makers and experts on how Europeshould move orward. The overarching consensus, however, is that a consid-erable eort o transormation and adjustment lies ahead. Sacrices alreadyincurred by most eurozone states and citizens are bound to get worse. Nomatter how one looks at it, there is no easy, straightorward or painless wayto resolve the eurozone crisis successully. Time, eort, stamina and resiliencewill be needed.

Many c

WEF KSC Re-EmergenceEurope 2012

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