The European Union: The Broken Convergence Machine
BY NAHUEL FEFER
Europe is in the midst of a crisis. On January 13th Standard and Poor’s downgraded the debt rating of 9 countries within the Eurozone – including France, raising their borrowing costs. Greece has unofficially defaulted, as it has finally, after weeks of negotiations, struck a deal with private holders of Greek debt, who have accepted losses on approximately 70% of their debt.
Spain and Italy’s borrowing costs, meanwhile, have skyrocketed due to stagnant growth and high levels of debt. In a self-fulfilling prophecy of sorts, this has in turn weakened their economies even more.
The European Union has held a series of summits, often dragging deep into the night as countries try desperately to find a solution to the euro crisis. What they have come up with thus far are bailouts (primarily funded by Germany) for, in chronological order, Greece, Ireland, and Portugal.
Although the bailouts have likely prevented the complete implosion of the national economies they targeted, the European Union now faces two fundamental problems; stabilizing its economy and paving the way to long-term growth.
Thus far, driven by Germany’s vision for a stronger European Union, the EU has attempted to stabilize the European economy with last minute bailouts and pave the way for long-term growth with forced austerity (cuts to social services, wages of government employees, etc.) and increased enforcement of laws targeting fiscal irresponsibility.
Stabilizing the European Union: Structural Problems
According to the Bruegel Institute (A think tank funded by EU member states) two qualities built into the European Union’s foundation have prevented it from reacting effectively to this crisis; a central bank that rarely buys government bonds, and a lack of fiscal unity.
The first problem is a result of the Maastricht Treaty, which created the EU in 1992 and gave the European Central Bank (ECB) a very limited mandate which discourages it from buying government debt. Unlike the United States’ Federal Bank, the ECB is not tasked with crafting monetary policy to maintain financial stability.
Fortunately this issue is beginning to be addressed. Although the ECB abstained from buying government debt in the initial stages of the financial crisis, it eventually began doing so in response to extraordinary circumstances. According to some experts, this lack of decisive action perpetuated the crisis.
Now, however, under the leadership of new President Mario Draghi, the ECB has accepted this role as routine. This means that markets are now beginning to assume that the ECB will buy government debt instead of having to wait for a specific announcement. All of this allows countries to borrow at lower rates and stabilize their economies.
Draghi has gone one step further, and, in a move that has angered many within the EU, loaned hundreds of billions of dollars to European banks at extremely low interest rates. An unspoken agreement between the ECB and European banks dictates that the banks use the influx of money to buy up government debt at low rates.
Although his critics do not believe that this lies within the ECB’s mandate, the controversial move has been justified by the market’s response. The borrowing costs of Europe’s economies have fallen significantly across the board.
The second main impediment to an effective response has been a lack of fiscal unity. As it stands now, each country in the EU is responsible for its own debt; a fiscal union as it is envisioned today would involve the creation of “Eurobonds” which would make Europe as a single entity responsible for its debts. Investors buying Eurobonds would not be investing in a specific country, but instead in the EU as a whole. While the borrowing costs of the most stable economies like Germany would go up, those of countries such as Greece, Italy, Portugal, and Spain would go down, stabilizing their economies.
Although many economically unstable countries, and even others such as France have expressed interest in adopting Eurobonds, Germany is currently strongly opposed to them. Although there is no denying that Eurobonds would likely hurt the German economy in the short term, the dissolution of the Euro would hurt its economy far more. Germany’s current economic success is built on exports and a return to the mark would, given its extremely high valuation, make German goods more expensive abroad, and deal a potentially crippling blow to the German economy.
Thus, if the European crisis continues Germany will likely consider Eurobonds as a last ditch effort to maintain the integrity of the Eurozone. This would significantly change the dynamics of the European Union. Nations would be even more reliant on each other, as one’s failure would directly drive up borrowing costs for everyone. This in turn would likely lead to demands for a surrender of some national sovereignty in regards to economic issues.
This may sound speculative, but to an extent it has already begun, current laws preventing budget deficits larger than 3% are for the first time being enforced harshly. Although total surrender of budgetary sovereignty is a long way off, Eurobonds, if adopted will shift some economic powers from national capitals to Brussels.
Long term growth in the European Union: Restarting the Convergence Machine
If the European Union manages to stabilize its economy, it must develop a plan for long term of growth. Unfortunately the current emphasis on austerity and fiscal responsibility is misplaced. Although some countries such as Greece and Ireland have fiscal imbalances to blame for exasperating their current woes, others such as Spain and Italy could, before the recession, boast of debt to GDP ratios similar to those of France, the United Kingdom and even Germany.
The Euro Crisis began as a sovereign debt crisis, and the EU continues to treat it as such by prescribing balanced budgets and austerity. The real problem, however, is more profound and less palatable than simple irresponsibility—it is a lack of competitiveness.
The World Bank describes the European Union as a “Convergence Machine”: a unique economic system that takes poor economies and converts them into wealthy ones. The evidence is in the quality of life – income and consumption spiked in southern European countries such as Italy and Spain after being incorporated into EU. The same happened in the 90s and 2000s in central and eastern European countries. Meanwhile northern European economies continued growing at more modest rates.
The European growth model has two unique qualities. The first is the highest levels of regional integration in the world. The European Union’s single market has facilitated both trade and finance between members and encouraged the movement of private capital from richer to poorer countries via extremely high levels of Foreign Direct Investment (FDI). All of this has fueled high levels of growth in poorer countries and maintained steady growth in economies like France, Germany, and the Netherlands.
The Convergence Machine’s second distinctive feature is that European governments take on the responsibilities of encouraging research and making higher education accessible. The impact on research is moderate, government funding of research in Europe comprises of an average of 35% of total research funding, as compared to roughly 27% in the United States, but the impact on European education is dramatic: almost all European countries offer education that is either free, or costs less than €1000 per year. Both of these trends have large positive spillovers, both into the economy – encouraging innovation and creating an educated workforce – and into the high European quality of life.
The convergence model for European growth predicts that the most recent additions and poorest members of the EU will experience the greatest economic growth. Recently, however, this hasn’t been the case.
Labor productivity, a figure produced by dividing a country’s GDP by the size of its workforce, provides a good estimate of a country’s competitiveness and is the long-term driver of economic growth.
Between 2002 and 2008 the labor productivity of northern European economies slowly but steadily increased 1.5%, while that of recent, eastern and central European inductees to the EU skyrocketed slightly more than 6%. In that same time frame however, the labor productivity of Italy, Spain, Greece, and Portugal not only failed to increase at a faster rate than that of northern Europe, it fell almost 1%.
This counter-intuitive trend can be attributed to the structure of the Southern European economies, which rely heavily on micro businesses consisting of fewer than 10 people, and local family businesses. As the World Bank notes these businesses tend to be unattractive or inaccessible investments for foreign banks and have fewer resources to invest in innovation. The entrance of Eastern European economies into the EU both redirected FDI away from Southern European economies, slowing growth, and supplied cheap European labor that led to a shift of low technology manufacturing industry from Southern to Eastern Europe.
In order to become competitive in the long run, Southern European economies must, like their northern counterparts, increase government expenditure targeted at stimulating innovation. Of equal importance is an intensive reform of their domestic regulatory system. Their inefficiency, corruption, and intrusive enforcement have made these countries poor places to do business.
Ultimately, Europeans must ask themselves how far they want to take regional integration. Some, like the English consider European solidarity, as put memorably by The Economist, “spending someone else’s money”, and have always kept their distance from the experiment that is the Convergence Machine. Others, like Germany have a lot to gain from solidarity, but fear that if the southern economies fail to make the necessary reforms to keep their economies competitive, increased interdependence will require that Germany repeatedly foot the bill to keep these economies stable. The poorest economies on the other hand have a lot to gain economically from increased integration, but may lose their sovereignty in the process.