Why we must not break the European Union

After drawn-out negotiations, a deal between Greece and its creditors has been struck. This is good news – not just for Greece but also for currency area and for the European Union as a whole. If Greece had been forced to leave the euro, its banking system would have collapsed and the new drachma would have depreciated some 20% to 30%. While currency depreciation can sometimes boost economies, that wouldn’t have been the case for Greece: its export sector is too weak, its domestic market is over-regulated and it is highly dependent on imports. Instead, high inflation would have undermined consumer confidence. A “Grexit” would have almost certainly caused a very deep and prolonged economic crisis in Greece, potentially triggering civil unrest.

But while the deal is good news, Greece and Europe are not out of the woods yet. The next step to ensure Greece doesn’t crash out of the currency union is debt restructuring. Its public debt has to be reduced to make the process of structural adjustment credible. The IMF has given a clear indication of what it believes is needed and we should all support the Eurogroup in taking a long-term and bold view.

It’s also time to start thinking about what the Greek crisis means for the euro area and the European Union in the long run. Many politicians and economist believe the way forward is closer political cooperation in the euro area and stronger institutions that would allow decision-makers in Brussels to establish a common fiscal policy. They hold the US up as an example, where stronger fiscal policy makes stabilization policies more effective. According to this line of reasoning, we need fiscal federalism with increased taxes and expenditures and decision-making transferred away from national capitals to Brussels so the Eurogroup and the European Commission can manage the common economic policy efficiently.

I strongly disagree. The lessons I learned as Sweden’s minister of finance, as a member of Europe’s Economic and Financial Affairs Council and as president of the council in 2009 convince me that this is a dangerous route for Europe. In the short term, such a move will fuel right-wing populism. In the long term, it could lead to a weaker and more divided European Union.

The American dream

I’m far from convinced that US economic success is primarily down to a coordinated fiscal policy. Stronger growth, higher productivity and lower unemployment have more to do with the fact that the US is a more well functioning economy. Its business climate is better and the labour market is more flexible than in Europe.

To demonstrate that, let’s look at estimates for long-term unemployment rates in both regions. The difference is striking: between 4% and 6% in the US and between 8% and 10% for the euro area. That means the euro area’s long-term unemployment rate is almost double that of the US. Standard labour economics explain this difference: in the euro area, marginal tax rates for entering the labour market are much higher; hiring and firing regulation is substantially tighter; unemployment benefits are more generous and longer; early retirement is often an option; unionization rates are much higher; and the wage-setting process is much less flexible.

In the US, and indeed in the United Kingdom, unemployment levels are heading below 5%; in the euro area, it is stuck above 10%. Clearly, then, the main problem for Europe is not a short-term lack of demand – unemployment levels have been steadily growing for decades. Of course, the European Central Bank should do its best to boost demand, but the only way of bringing unemployment levels closer to those in the US over the long term is to make substantial structural reforms of the labour market.

A look at long-term GDP and productivity growth backs up the argument that the business climate in the US is more dynamic. In the past years, Europe has produced 13 “unicorns” – technology start-ups that have reached a value of at least $1 billion – compared to 22 for the US in the same period. Since 2000, the United Kingdom and Sweden have produced the most unicorns in Europe, leaving just a handful for the euro area, where these companies seem to be just as mythical as their fairytale namesake.

And there are reasons for the lacklustre performance of the euro area: the venture capital market is thinner; entrepreneurs are taxed more and face stricter restructuring and bankruptcy policies; the regulatory cost of starting a business is higher; and the barriers to competition are much more extensive. For all these reasons and more, the US finds it easier to attract researchers and entrepreneurs. This has very little to do with fiscal policy as a tool for stabilisation policy.

Follow the North Star

Fiscal policy is an important stabilization tool and should be used to manage demand when the business cycle is creating big swings in GDP and employment. But it is possible for Europe to achieve a high degree of coordination and to make fiscal policy more effective without delegating decision-making to Brussels. IMF research shows that the Nordic countries have been more successful than the US or the euro area in using fiscal policy to stabilize demand. The IMF-data, presented at the spring meeting, implies that the stabilisation effect of fiscal policy in the Nordic countries are almost double the impact in the USA and almost three times as in Germany.

I believe this is for three reasons.

First, fiscal policy is highly credible in the Nordic countries because it is underpinned by low debt. The Eurogroup has already strengthened the fiscal targets and started to make progress in reducing debt levels. A further reduction of the debt level down to the level in the Nordic is likely to be much more efficient than fiscal federalism.

The second reason is that all Nordic countries run very stringent and comprehensive budget processes with a top-down approach to budget negotiations. A strong position for the Ministry of Finance in the setting of policy is putting the common interest at the centre. This gives credibility to the expectations that budget deficits are likely to be temporary. Progress has been made thanks to the fiscal reforms of the past six to seven years, but further progress is clearly possible without moving decision-making to Brussels.

The third reason is that Nordic countries, like the US, have more growth-oriented and flexible economies than the rest of the European Union. This makes it easier for them to deal with economic shocks. Nordic countries tend to adjust faster and therefore also recover faster than those of the euro area. Competitiveness, then, has very little to do with moving decision-making from national governments to European institutions.

The democratic deficit

But economic reasons aside, the main argument against a stronger common fiscal policy in Europe is a political one: EU citizens do not support the idea of moving decision-making on taxes and expenditures to Brussels.

We can see this in the high levels of support for some right-wing populist parties in Europe. The key drivers behind this wave of populism have more to do with reactions to immigrants and problems related to their integration and social exclusion, along with deeper and darker forces like xenophobic reactions to refugees from the Middle East and North Africa. The combination of globalization, urbanization and digitalization is undermining real wages and job security, and marginalizes groups of men that historically have been able support themselves and their families through manual labour.

It is likely that a substantial transfer of power and decision-making to Brussels would further fuel right-wing populism. If countries like Germany, France, the Netherlands, Austria or Finland are going to tax their citizens and transfer the resources to subsidize uncompetitive economies like Greece, Italy and Portugal, this will strengthen political discontent. If this were to happen, even Germany might see populist parties gain support.

Further transfers of power would also undermine democratic accountability and strengthen populist arguments about anonymous bureaucrats in Brussels taking over political decision-making without being accountable to media and voters on the national level. There is no ongoing conversation on economic policy in the euro area that is well anchored among voters and no common spirit of citizenship and solidarity that would be able to carry the democratic burden of taxation in the euro area today.

Increased support for populist parties would likely make European countries more difficult to govern, and it would become more challenging to create strong majority governments. It would also make it more difficult to secure parliamentary support for much-needed long-term political reforms. Short-term political competition to win over dissatisfied marginal voters would undermine political willingness to implement structural reforms and deal with fiscal deficits. And if bitter men, stuck in rural areas with weak labour markets and worried over jobs lost to globalization become the crucial voters to fight over, this will shift the focus of the political debate in a problematic direction.

A high price to pay

A stronger and more political Eurogroup could lead to a weaker and more divided European Union. To my mind this is problematic because the broader union is more important than the euro area. For one thing, the wider European Union has an additional 165 million citizens to think about. It is also a substantially bigger economic market than the euro area. Given that the growth rates have been higher outside the euro area, this is likely to be more pronounced in the future, and the UK, Poland, the Nordic countries and Central Europe are likely to continue to outgrow the euro area.

A move towards an even closer political union in the euro area would also increase the risk that the UK will leave the EU. A “Brexit” would be a major setback for the European Union, particularly as population and economic growth will make the UK the strongest and most dynamic country in the union over the coming decades. Losing the strongest economy would be a high price to pay for unnecessary fiscal federalism in the Eurogroup.

That price could be even higher if we consider the context of a more aggressive Russia and regional instability. In terms of political clout, it is clearly the European Union, not the euro area, that leads on security issues and international relations. The European Union is a major power compared to the smaller euro area, largely down to the Franco-British axis, with Germany still not ready to take on the burden of leading in this field.

Now more than ever, we need a strong European Union. It would be a great mistake to let the Greek crisis weaken and divide Europe in a moment when the strength of the cooperation is more important then ever before.

Have you read?
What’s next after the latest Greek deal?
Is Greece addicted to aid?

Publication does not imply endorsement of views by the World Economic Forum.

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Author: Anders Borg is a Swedish economist and politician who served as Minister for Finance in the Swedish Government. He is the Chair of the World Economic Forum’s Global Financial System Initiative

Image: Flags of European Union member states fly in front of the European Parliament building in Strasbourg July 13, 2009, on the eve of the election of its new president. REUTERS/Vincent Kessler