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Hurtling towards disaster: the eurozone crisis and the idea of ‘Small Europe’

Essay by Razeen Sally

Last year I left Europe for Asia. For eighteen years my day job was at the London School of Economics; and, for the last six years, I was deeply involved in a think tank in Brussels. I left hidebound Europe and returned to now-dynamic Asia, where I was born and where I grew up. My new base camp, Singapore, is thriving. From there I watch the Old Continent lurch from one crisis to the next.

 

At the heart of Europe’s crises is the existential crisis of the euro. This prompts the European Union’s policy elite to push for “harmonisation”. The euro must be defended at all costs. That means “more Europe”. A fiscal union – harmonisation of tax and expenditure policies – needs to be established. Now the talk is of a “banking union” as well, with harmonised financial regulation, a strong central regulator and a common bailout fund. Many argue for Eurobonds – a common debt pool. Others go further, arguing for, inter alia, harmonised labour markets and corporate governance. This is what a true economic union would look like – on the way to a political union.

 

Britain, of course, will have none of this, as its prime minister, David Cameron, has made clear. But he and his finance minister, George Osborne, urge the eurozone to move faster and deeper to economic union. This is the conventional wisdom, even among the “eurosceptic” British policy elite. The alternative is disaster: the collapse of the euro, the fragmentation of the Single Market (the EU’s free trade area), and possibly the break up of the EU itself.

 

Not one of Europe’s front-rank politicians has put forward an alternative — a Plan B.  But there is an alternative to ever-more centralisation – a radically different vision of “more Europe” that stresses decentralisation, diversity and competition. Plan A is all about a political-bureaucratic cartel with more discretionary powers; Plan B should be about greater limits to government intervention and the expansion of long-repressed economic freedom for ordinary Europeans.

 

I will come round to the fatal flaws of Plan A and what Plan B should look like. But first an excursion into the history of European ideas is in order. This is a story of “big Europe” versus “small Europe”. It frames the central policy choice before Europe today.

 

Big Europe and Small Europe

 

There was a heated debate on European integration back in the 1950s. The French elite and the founding fathers of European integration – Jean Monnet, Robert Schumann, Paul-Henri Spaak – wanted to integrate in a “small Europe” club – France, Germany, the Benelux countries and Italy. These were the signatories of the Treaty of Paris, which established the European Coal and Steel Community (ECSC), and the Treaty of Rome, which established the European Economic Community (EEC). “Federalists” in this camp wanted economic coordination to lead to eventual political union – a United States of Europe. All thought economic integration essential to healing the wounds of war and to ensure a permanent European Pax. And all had top-down economic integration in mind, imbued with the ideas of French post-war “indicative planning”. Dirigismewas the order of the day. This was at its most extreme in the ECSC: prices and production targets were set for coal and steel, inevitably accompanied by protection against imports from third countries. Finally, all in this camp favoured building supranational organisations with strong bureaucracies to administer centralised policies.

 

In essence, this was a command-economics, not a market-economics, approach to economic integration. And the club had to be kept small and exclusive in order to “plan”. As we know from Mises and Hayek, the larger the group the more difficult it is to ensure outcomes accord with a central plan.

 

There was an opposing camp, however – not of British eurosceptics; rather it was led by West German policy-makers and intellectuals. The leader-in-chief was Ludwig Erhard, the architect of West Germany’s post-war Wirtschaftswunder (“economic miracle”), its long-serving economics minister, and federal chancellor in the early-to-mid 1960s. Erhard surrounded himself with ardent market liberals. They included members of the Freiburg School, led by the economist Walter Eucken and the lawyer Franz Böhm, both of whom taught at Freiburg University.

 

The Freiburg School was a blend of law and economics in the classical-liberal tradition. They favoured a free market economy – not a “mixed” economy. This would be guaranteed by alimited state that would fulfil its core functions of establishing and maintaining a free-market order, but would refrain from becoming a “player” in day-to-day market activities. Eucken’s main concept of economic policy was Ordnungspolitik (roughly translated as “policy of economic order”). This came to be associated with competitive markets and a hard-money policy administered by an independent Bundesbank.

 

Prominent in Erhard’s circle was Wilhelm Röpke, an outspoken economist who fled the Nazis into Turkish exile in the 1930s and ended up in Geneva. Röpke was an homme de lettres whose interests ranged widely in European history, sociology and literature. He was also a clerc, a European intellectual in the thick of public debate in the early post-war years. It was Röpke, with his literary style and sharp pen, who best articulated an alternative liberal vision to that of “small Europe”.

 

Röpke argued passionately for a “big Europe”. Economic integration should be market-led “from below”, not planned “from above”. Policy competence should remain at the national level; and it was incumbent on governments to pursue liberal economic policies at home and free trade abroad. Yes, intergovernmental cooperation (among the democracies of Western Europe) would be needed for a European free-trade area – a “common market” – and governments would have to cooperate in the General Agreement on Tariffs and Trade (GATT) to bring about freer international trade. But Röpke was highly sceptical of establishing supranational organisations in Europe, for he feared they would create bureaucratic sprawl, and increase interventions and distortions in the market economy.

 

Hence Röpke’s Big Europe was one of policy decentralisation, competition, open markets and institution-light intergovernmental cooperation. And it had to be “big” geographically, bringing in as much of Europe west of the Iron Curtain as possible. This was more the model of the European Free Trade Area (EFTA) than that of the ECSC or the EEC. Beyond economics and politics, Röpke’s cultural vision of Europe was one of organic unity through diversity – facilitated, not least, by open markets. Switzerland, his adopted home, not centralised, homogenised France, was his ideal Europe en miniature.

 

This antinomy – Big Europe versus Small Europe – is set in the early post-war years. But it can be traced back to the divide between the Scottish Enlightenment and the French Enlightenment – between Edinburgh and Paris in the second half of the eighteenth century. Adam Smith and David Hume are the forefathers of Erhard and Röpke. They believed in organic, decentralised processes that, by means of an Invisible Hand (as it were), integrate markets and peoples. They also believed, like Hayek later on, that governments lack the knowledge – let alone the competence and honesty – to engineer desirable social outcomes. Voltaire, Diderot and Rousseau are the forefathers of Small Europe votaries. It is typical of the French intellectual, then and now, to believe that political, economic, social and cultural order can be planned by a collectivity of superior, rational minds, with all relevant information at their fingertips, and outcomes engineered accordingly.

 

The EEC was a French-German compromise: Small Europe and Big Europe ideas flowed into the Treaty of Rome and the resultant Common Market. The most visible outcome of Small Europe thinking was the Common Agricultural Policy. A combination of price-fixing, subsidies, production targets and protection against imports ripped off European consumers and taxpayers, and kept out cheaper imports from developing countries.

 

But the Treaty of Rome also contained German-style Ordnungspolitik, notably in Articles 85 and 86. The latter referred explicitly to a competition-based economic order, upholding individuals’ property rights and contracts, and underpinned by rules that were to be enforced by the European Court of Justice and national courts. Then, in the early 1990s, came the implementation of the Single Market with its “four freedoms” – the freedom of movement of goods, services, capital and people. The aim was to go beyond tariff elimination in the Common Market to abolish a panoply of more complex, entrenched non-tariff barriers.

 

The Single Market was a signal victory for the Big Europe. So was progressive enlargement of the Union – from the original six in the 1950s and ‘60s to twenty seven today. The British view, in harmony with Erhard’s and Röpke’s vision, was that enlargement, particularly to take in newly-liberated Eastern Europe, would weaken the dirigiste southern Club Med coalition led by the French, strengthen market liberals in Northern and Eastern Europe, and generally promote pro-market reforms. In the last decade, just before the global financial crisis, there were plans to complete the Single Market through further supply-side reforms. In all, as of five years ago, it seemed that Big Europe was in the ascendant.

 

The euro crisis: Small Europe triumphant

 

The rootstock of the eurozone crisis is a failed political project – the euro itself. It was pushed through for political reasons – to further “ever closer integration”. And it was a top-down political design grafted onto European skin – a product of Small Europe thinking.

 

The eurozone’s fatal economic flaw was that it was never an “optimum currency area”, given its diverse economies and fragmented fiscal policies. However, there was the naïve expectation that a hugely expanded D-Mark zone, governed by a Bundesbank-style central bank, would ensure monetary stability, induce domestic structural reforms and boost European competitiveness. Quite the opposite happened: there was no structural adjustment in most of the EU; rather governments flouted common fiscal rules and went on a borrowing spree at artificially low interest rates. So did banks and individuals. The global financial crisis exposed these flaws. The result is a triple crisis – of sovereign debt, banks and the common currency.

 

A signal feature of Europe’s third-rate political and bureaucratic elites is that they cannot admit to catastrophic mistakes. They are purblind to the root causes of the crisis and wider eurosclerosis – the euro, unsustainable tax-and-spend policies, and repressed markets. That is testament to the parochialism of their milieu, not least in the inbred, ideas-deficient village that is Brussels. Hence the resort to half-baked solutions since Greece erupted in 2010 – a drip-feed of EU bailouts in return for reform promises (so far unfulfilled in Greece), and buying of government debt by the European Central Bank (ECB). Only very belatedly was there the reluctant admission that the EU periphery suffered from a sovereign-debt crisis rather than a liquidity problem, and that this compromised the solvency of highly indebted European banks.

 

The conventional wisdom, inside and outside the EU, is that monetary union needs the foundation of fiscal union. That means harmonising fiscal policies among eurozone members through “automatic” rules, centralised monitoring and enforcement, and tough sanctions on those who break the rules. This will have to be backed by bigger EU “firepower”: much more liquidity for severely indebted governments and distressed banks through the ECB, the European Financial Stability Fund (EFSF) and the European Stability Mechanism (ESM). There is also talk of new “Eurobonds” and a “banking union”. This is the logic of the “fiscal compact” negotiated by eurozone members plus all other EU members except the UK and the Czech Republic.

 

Once again, Small Europe provides the conceptual frame for these measures. They entail planning “from above”; centralised policies are to be administered by beefed-up Brussels organisations invested with vast new discretionary powers. But will this recipe save the euro?

 

I doubt it – for three reasons. First, “firepower” will have to be in the additional euro-trillions, not hundreds of billions, to be credible. The ECB, having waded into “quantitative easing” through purchases of sovereign debt, is already neck-deep in the junk debt of the EU periphery. Its actions have destroyed the sound-money Ordnungspolitik so painstakingly built up over four decades by the pre-euro Bundesbank. Hundreds of billion euros committed in EU bailout funds compound the problem.

 

It is highly unlikely that the Germans will accede to the vast additional transfers that vulnerable Eurozone countries clamour for. If they do, the resources of the virtuous will flood into the pockets of the profligate with the promise of future reforms; but wide-open moral hazard will diminish incentives to deliver on those reforms. The Germans will have committed themselves to an open-ended “transfer union”, and compromised their own virtue and future into the bargain. Hence they will veer towards halfway-house solutions to save the euro, but that is unlikely to convince the markets.

 

Second, the new fiscal compact, though dressed up in Ordnungspolitik language, will never have “automatic” rules. Inevitably, they will be bargained over and watered down to a low political common denominator, and broken by countries that are unable or unwilling to stick to the rules. That is true of Greece, of course, but it will also be true of others in the eurozone, extending all the way to Spain, Italy, France and Belgium. Already, President Hollande of France has led the charge to have more “growth” and less “austerity” – code for more, not less, public spending. This will make significant reduction of escalating public debt in the EU even more elusive.

 

Third, fiscal union is disastrous political hubris. EU elites are forging ahead with this as they did with monetary union and previous chapters of European integration. It is a product of elite negotiations behind closed doors, in the expectation that European publics will meekly follow. But this latest march of top-down integration is probably a bridge too far. It goes deep into national fabrics of taxation and expenditure. Europeans are a long way from being like Americans. Overwhelmingly, their identities are local and national, and only after that “European” – if at all. Forced, supercharged integration goes against the grain of European reality. My sense is that it will spark a popular backlash in the heart of the eurozone – not just in Greece and other parts of the periphery, but even in Germany.

 

That leads me to think that the eurozone will break up sooner or later. It might be replaced by a relatively strong D-Mark zone around Germany, with a significantly revalued currency, and one or more devalued currencies in the rest of the Eurozone. But any breakup will be very messy. It will reverberate around the world through financial markets. And, by tipping Europe further into recession, it will affect the rest of the world through trade and foreign investment. Most worryingly, an anti-EU backlash in the member-states would ratchet up internal protectionist pressures and threaten the future of the Single Market. That would spill over into EU protectionism against the outside world.

 

Plan B in the frame of Big Europe

 

One of the dreadful errors of the EU elite is not to have a Plan B.  Rather their tunnel vision leads them to conflate the future of the euro with that of the Single Market and the EU itself.  That is mad; it risks becoming a self-fulfilling prophesy. A sensible Plan B would attempt to contain the fallout from a euro breakup. It would smooth the transition to post-euro currency arrangements, protect the real gains of the Single Market, proceed with long-delayed structural reforms, and keep the EU open to the outside world.

 

First, on the macroeconomic front, the ECB should get back to core monetary policy in the spirit of the old Bundesbank. It should retreat swiftly from fiscal policy, i.e. stop buying sovereign debt with artificially created money. There should be a hard “no bailout” clause for future currency arrangements. That would force national governments to put their fiscal houses in order – or leave the common currency.

 

Second, there is huge unfinished business on structural reforms. The Single Market applies to industrial goods. But services, which make up 70 per cent of EU GDP, are fragmented twenty-seven ways: each member-state retains all sorts of restrictions. Energy is the other major area in which there is no single market – the main cause of over-reliance on energy supplies from the Kremlin. The EU’s climate-change and assorted environmental policies are the costliest in the world, and a source of backdoor protection against imports from developing countries in particular. Finally, the EU is becoming less open to foreign workers at a time when its ageing societies need them more than ever.

 

Third, the EU should decentralise existing policy competences. There are already too many “harmonised” policies, e.g. on labour markets, education and assorted “social” policies. These should be dealt with at national and sub-national levels. The EU should stick to its core business of upholding and extending the Single Market – no more, no less.

 

In sum, Plan B has Big Europe, not Small Europe, in mind. It would eschew further top-down integration with its centralised, one-size-fits-all bureaucratic nostrums that emerge from Byzantine political decisions taken far away from the ordinary citizen – and distort and repress markets to boot. Rather, power in the EU should be limited and decentralised to unfetter markets, give individuals more economic freedom, and make politics and policies less cartellised and more competitive. That would give life to the EU’s “subsidiarity” principle, which seeks to devolve as much policy competence as possible to national and sub-national authorities. So far, this has been honoured in the breach.

 

But will the EU’s elite change course? Or will they continue to drag the EU in a profoundly illiberal direction – in the name of saving a congenitally dysfunctional currency union? If they do not change course, the price of staying in the EU might become too high. The time may be coming for Britain and other countries to think seriously of other options. If they do, Switzerland should be their model.

 

 

The author is Visiting Associate Professor at the Lee Kuan Yew School of Public Policy and the Institute of South Asian Studies, both at the National University of Singapore​