Can Europe Make it?

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WASHINGTON –  

“Mistah Kurtz, he dead”. (Joseph Conrad, Heart of Darkness).

This famous line, right after a question in the title as to whether Europe can “make it” may appear as unequivocal answer that it cannot. There is something quite definitive about death. Well, not quite so, assuming that death of bad stuff can lead to new beginnings. In Conrad’s story, the death of Kurtz is the death of a crazy dream. In the case of Europe (and not just Europe), the “crazy dream” to be laid to rest is the somewhat delirious idea that it is possible to spend forever more than what states can reasonably take in as revenue, borrowing the difference. If we do recognize that this is impossible, that, as someone said, “In the end what is not sustainable will not be sustained”, then we have a chance to get back to reality, building on the simple yet cardinal notion that prosperity is based not on unfunded hand outs but on real economic growth, itself sustained by innovation and high productivity. The final demise of this insane notion that borrowing mismatched from actual wealth creation is a viable strategy is the “death” that should be recognized and, indeed, welcomed.

The dream of a free lunch lingers

But we shall never get there until we abandon the dead wrong yet uncrtically embraced notion of welfare whereby people can and indeed should receive ample benefits regardless of the actual amount of real wealth produced by a given society. As strange as it may sound, this amazingly distorted notion about entitlements, current fiscal crisis notwithstanding, is still quite popular. In fact, because of the crisis, people, as they are hurting, expect to receive more, not less. So, “Kurtz is dead”; but this fact has yet to be ackowledged. However, if we do not get past this critical milestone, it is hard to conceive how people, (irrespective of any notion of what social justice should be), can accept new policies  based on the recognition that the limits on what one can expect as benefits are ultimately set by what society produces.  Any residual illusion that the old ideas of untouchable entitlements disconnected from actual economic conditions are still viable will only get us into deeper trouble. 

Big Crisis, Part Two

Be that as it may, the above reflections are prompted by the unfolding plot of “Big Economic Crisis, Part Two”, a plot quite unforseen a year ago, featuring Europe’s insolvency drama. We know “Part One”, featuring the USA, quite well. Starting in 2008, America had to deal with the devastating consequences of its very own brand of economic craziness, resting on the incredibly fantastic delusion of always appreciating assets against whose increasing value it should have been possible to borrow and borrow forever. And so it was. No point restating what happened when the real estate dream collapsed, with the serious risk of carrying almost everything along its ruinous fall.

Signs of life in America?

But now, in 2010, at least some pieces of America, notwithstanding the epic losses and the mountains of public debt created to shore up practically everything, (Fannie and Freddie, AIG, Citigroup, Bank of America, General Motors), while Lehman Brothers was allowed to sink, are showing new signs of life. The economy, from Intel to Caterpillar, is growing again and so is employment, albeit very slowly.

Corporations are investing, balance sheets are recovering and, most importantly, labor productivity is up, indicating an ability to react, to do more with less in order to regain markets and competitiveness. It is a mightily confusing, uneven picture of huge losses and some recovery, of astounding numbers of mortgage foreclosures with no real end in sight, and frightfully high long term unemployment, mixed however with areas in which we detect innovation and some optimism.

USA: a two tier economy with millions left out

The problem for America is not whether or not the country will recover. It will. The problem is that it is recovering and will recover in a very uneven manner, with millions of low skilled unemployed left behind, with scant opportunities to be brought back into the mainstream economy. How will they live? We have a serious risk that the America getting out of this recession will be like a patient coming out of a serious illnness: luckily alive; but permanently impaired.

On top of that, (and a huge factor contributing to permanent disability), public debt, if its size is not reversed seriously and soon, will act as a gigantic brake, slowing everything down and quite possibly creating the preconditions for US terminal decline. Good Bye to “America as Number One”. How long can the US fight two wars in Iraq and Afghanistan, keep troops in Japan and South Korea and finance the biggest defense budget in the world with 1 trillion plus federal budget deficits as far as the eye can see? And it is not just defense. It is government sponsored R&D. It is investment in basic science; it is the National Institutes of Health and NASA, And fresh spending is badly needed for critical infrastructure upgrades, from a new air traffic control system to ports and bridges literally falling into pieces.

And the US debt now has two components: one is arising from recent counter cyclical spending aimed at softening the blow of this current crisis; but the other is systemic, deriving from the growing cost of existing entitlement programs, mostly dedicated to the elderly. Public health care costs alone, if left on the existing upward spending trajectory, in a few years will bankrupt America.

Hoping in a resurrection of Yankee ingenuity

But, all told, America, at least for now, has a fighting chance to engineer a come back, provided of course, that there will be a new consensus on what sustainable public spending should be. If that could be somehow taken care of, America’s real chances rest in large part on still valuable assets, such as first class super universities, R&D clusters and world class innovation hubs. All of these are laced with an intangible yet perhaps even more valuable asset: a reservoir of dynamism and entrepreneurship, a “can do spirit” that, while less vibrant than in the past, is still kicking. True, Apple and Google alone cannot sustain America. But the fact that the IT companies continue to invest and innovate means that something is still working. Other sectors may follow suit. So, innovation, combined with a new political consensus as to what is a fair but sustainable entitlement system, may create the foundations for a healthy fresh start.

In Europe the recession hit alreday weakened countries

Whereas in Europe the overall picture is worse, because the crisis hit countries already weak on account of lack of innovation and new enterprise. Many countries, especially in Southern Europe, were limping along on a course of economic mediocrity and burdened by huge public expenditures to pay generous benefits for workers and retirees. And these expenditures were unfortunately matched by only modest growth and comparatively little innovation. These trends, already quite apparent before the “Big Recession”, indicated thin margins and limited international competitiveness.

Lisbon Goals: dreams of High Tech were just delusions

 The pitfalls of loss of competitiveness were not totally ignored by the Europeans. Indeed, there was a moment in which the EU elites declared the desire to seriously catch up and become respectable players in the high tech games. But The 2000 Lisbon Goals aimed at quickly recovering lost ground in high tech industries amounted to a dream whose failure had already been brought home way before this recession hit.

So, the 2008- 2009 catastrophe worsened a picture that was far from inspiring to begin with. The growth of public spending aimed at diminishing the impact of the recession exposed a dreadful picture of ever increasing public debt whose real measure nobody wanted to take, up to the point of practically falsifying budgets or engaging in creating accounting with the objective of making things look better than they were.

Sailing towards insolvency

But today, thanks to the Greek appetizer, now very familiar to all, we know the truth. Indeed Greece is an exceptionally bad example. But many other European countries, while not currently insolvent, are sailing toward insolvency. The ongoing debt trend is caused  by the growing needs of very expensive welfare states that European countries in varying degrees are wedded to and is now reinforced by the additional imbalances caused by the recession. All these unfunded costs lumped together have caused unsustainable financial burdens.

Bad combination: high spending, weak economic base

And this alarming trend is worsened by relatively weak and not particularly dynamic economies not at all well poised to get off high debt any time soon through a stronger push towards growth. The now infamous “PIIGS” acronym (Portugal, Ireland, Italy, Greece and Spain) portrays societies that blended together expensive welfare systems, bloated public sectors and large inefficiencies, often laced with corruption. The pitfalls created by this toxic mix were wished away via a fatalistic idea that “somehow we shall find the money to pay for all this”.  If this is the picture within the Eurozone, the UK, although on its own regarding the currency, is doing worse. Indeed: “There is no money”.

After Greece: a big firewall to fend off future crises

As we know, Europe, after months of confused debate about Greece, in the end, with additional help from the IMF, decided to create a major rescue package for Athens. Almost immediately thereafter, though, fearing contagion that might affect other weak countries, such as Portugal, the Europeans decided to set up a really big financial firewall in the amount of almost 1 trillion US dollars, aimed at telling markets that the Old Continent will be ready for the next contingency, should there be serious concerns about the solvency of this or that Eurozone member.

Well, fine as far as it goes. Better to have something prepared ahead of time, rather than repeating the already tried script of reacting a little bit to the current stage of the ballooning crisis, never giving observers any confidence that key decision-makers are even a little bit ahead of events. But what about fixing the causes of the possible insolvency?

Two systemic weaknesses: politcs and economics 

This solvency crisis has exposed two real systemic weaknesses. The first one is a European monetary union without political union. The second one is the progressive erosion of Europe’s competitiveness within a global economy featuring now many dynamic Asian economies gobbling more and more market share. The two factors combined create a rather worrisome picture that spells decline as the only plausible outcome.

The Euro: in the beginning it worked 

For many years the Euro overall worked rather well. That is until now. And now it may not be able to work as intended, because the assumptions of shared frugal and responsible behavior on the part of all 16 Eurozone members have proved to be unrealistic. It was said at the very beginning of this monetary adventure (1992) that precisely this present scenario at some point would unfold. Indeed, it was said by the pessimists that there would be a crisis or a trend coupled with a crisis that would cause at least some members to break the rules, run huge deficits and risk bankruptcy, without the option, such as it is, of devaluing their currency. In a word, the stringent rules that bound everybody to a regime of fiscal prudence were not credible. And, in fact, they have proved to be unenforceable and thus not credible. When things got rough, everybody broke them. And some in a major way, as the facts tell us.

Budgeting is more than just accounting: it is about political choices

How do you fix this mess? Many Europeans are talking now, in the middle of the tempest, about harmonization of fiscal policies. And this is in principle a good idea. But the problem is that fiscal policies are not just accounting exercises.

Budgeting is about setting national priorities, and it is therefore an eminently political process. And we should believe that now, all in one swoop, because of this potential economic and fiscal catastrophe, the Europeans will become wise, that they will come together and submit their budgets to peer review and drastically cut here and there according to the wishes of the others? I doubt it. Wisdom is not abundant. This could happen if any agreement on fiscal policies would be based on an overarching, truly shared, political union plan. In other words, fiscal pain in the name of a common good, a truly shared value, is different from frugality on its on. But there is no such agreed upon overarching European Master Plan.

No fiscal union without overarching political accord

And so it is going to be very difficult to sell politically fiscal frugality on its own merit, with full awareness that any serious austerity plan will cause a wave of political protest, (witness riots in Greece), on the part of those who are accustomed to getting a lot, while paying very little.

The idea that the Europeans will all of a sudden discover fiscal rectitude and frugality in the name of a common European good that no one really defined or approved is really fantastic. Serious fiscal harmonization implies some degree of political unification. The idea that it is possible to have sovereign states surrendering new critical chunks of sovereignty without an overarching and deeply shared political plan is a truly remarkable delusion.

Is there a new European path to growth?

And, even if that could be done, (Greece after all, because of its incredibly bad conditions, had to accept what is in practice an ultimatum implying loss of sovereignty in exchange for a liquidity life line that, by the way, in the end may or may not do the trick), what about the Old Continent’s ability to produce new wealth? Not much light on this score. The European education systems, while good in many respects, and the general business “ecosystem” in the aggregate do not produce many innovators. Not too many European champions in new technologies. Labor costs are high, labor market flexibility is low, worker productivity is mediocre or low.

Can the welfare state model be reformed?

Welfare states designed to protect the needy and to give proportionately more to senior citizens cost too much, unless they can draw from extremely versatile and prosperous economies. But this is not the case in most European countries. On the contrary, the old paradigm whereby the currently employed population pays into the system the moneys handed over by the state to the retirees does not work anymore, because of lower fertility rates. Because of these demographic trends, nowadays there are fewer active people generating the revenue to be handed over to the retirees who are progressively becoming more numerous in absolute terms and as a percentage of the overall population. The old system is not working anymore. Yet, if cutting benefits is not an option, how does one generate the funds to pay for them? Until now more debt and more debt was the answer. Greece, Portugal, Spain, the UK and others warn that this is no longer an option. Then what?

Greece is the exception; but the others are not much better

In more extreme cases, such as Greece, if one combines these dynamics with a  stupendous level of corruption and tax evasion that apparently everybody, (before the crisis), knew was prevalent, one gets the real measure of a problem. The Greek problem, although confined to a small country, may very well be intractable, possibly causing Greece, massive rescue plan notwithstanding, to exit the common currency, declare national bankruptcy and try hopefully to start all over.

But, while excess Greek style may still be the exception, the general trend from Spain to Britain is about weak economies and levels of public spending unmatched by revenue. And the problem is that the political price for cutting drastically this level of spending is perceived to be so high that no one is willing to try or even talk about it. The new Conservative-Liberal Democratic coalition in Britain declared that it will try. But we shall see whether they actually get to it, bravely facing the political backlash that will inevitably follow any meaningful cuts to entitlement programs and any other form of public largesse. 

A reformulation of Europe? Rich in, poor at the margin?

In Europe, extremely high political and organizational hurdles, combined with relatively weak and uncompetitive economies, unfortunately created a very bad mix. It is quite possible for the most dynamic components of mostly Northern Europe to refashion a different type of Union in which more nimble members could reinforce each other. But, if this may ever happen, it may take years; including of course renegotiation of existing treaties and established practices. Possible but unlikely scenario.

Current mix unworkable

But if renegotiation of membership rules is out of the question, the current European Union, stretching from Sweden to Sicily, a Union that includes Germany and Bulgaria, Portugal and Finland makes it highly unlikely that this diverse group will forge a coherent way forward, institutionally and economically. And this is because this large group of countries lacks the internal political consensus and the shared vision to create an economic and fiscal road map that can and will be embraced by all and that will be practical for all. In the meantime, not much wealth left to do much of anything. As they used to say in Italy: “You cannot have a lavish wedding serving dried figs only”.  And that’s pretty much what’s in the pantry.

“There is no money”: wake up call or surrender?

Outgoing UK treasury chief secretary Liam Byme, in a now famous note addressed to his successor, David Laws of the new Conservative-Liberal Democrat coalition, wrote:

“I’m afraid there is no money left. Kind regards and good luck”. Or, (if you allow me an analogy with the quote at the top): “Mistah Kurtz, he dead”.

End of the dream 

Will this “no money” awareness prompt at least some Europeans to find ways to innovate and generate new wealth, or will they treat current penury as a permanent condition that indicates the end of any dream of long term prosperity, growth and international relevance for Europe?

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