In recent years, a new type of crisis has been dynamically emerging in Europe: a crisis of the European social and political model with profound consequences for fiscal and financial stability.
France’s problem
The big problem starts with exceeding the budget deficits in France and Italy, over 7% and over 5% for 2024 respectively. These numbers are a symptom, not a cause. Behind them lies the lack of economic development needed to maintain Europe’s social model.
Germany’s fiscal policy could not be more different from that of France or Italy, and yet Germany suffers from the exact same problem. The collapse of Nicolae Ceaucescu’s repressive but debt-free Communist regime in Romania should serve as a lesson that it is not the amount of debt that determines sustainability.
It is, in a broad sense, the ability of a state to provide prosperity and satisfaction while remaining solvent. Politics is the art of keeping these three balls permanently in the air.
The European model was fueled by oligopolistic industrial firms, which were largely supported by the state through regulations that tilted the playing field in their favor. The German car industry is a classic example, but everyone did this.
The service sector existed mainly in the service sector: state-owned banks that provide soft loans to industrial companies, repair shops for industrial products, such as car services. These industries enjoyed large profit margins due to the monopolistic or oligopolistic markets in which they operated, as well as high barriers to entry.
This system fed the entire structure of social policy – in the form of fiscal transfers and labor market policies to ensure that the spoils of the model flowed evenly. A notable feature of this system was its long-term nature.
The EU, governments, industry and universities organized research that fed into this model. After the end of the Cold War, two more factors sustained the model: a large reduction in defense spending, in some cases by several percentage points of GDP, and the rise of globalization.
The role of technology
What is killing this model now is a change in technology and geopolitical fragmentation. More and more functions in our lives that were previously the realm of purely mechanical processes have today been fully or partially digitized. The barriers to entry have collapsed.
China went from zero to the position of world leader in electric cars. European companies no longer generate sufficient profits to fuel the social model – and fund long-term research. The heavy bias in Europe’s survey towards incumbents affects its weight.
This is not about the public versus the private sector. Government intervention has played a huge role in the development of the digital industry. The selection of winners is still possible. Not surprisingly, Europe has very few tech companies.
In short, Europe’s old-tech oligopolistic model no longer works in a digital world. After all, there are not a few attempts by the EU to block technological developments through regulations. But this is a way of treating the symptoms and not the causes.
Technology gap
After the multiple global shocks of this decade, the consequences of Europe’s technological decline translate into lower potential growth rates.
Italy came first. Its productivity growth has been almost zero since it joined the euro. UK productivity growth fell after the global financial crisis and has never recovered since.
Germany’s productivity growth is unlikely to recover, even if the economic cycle does. The German Council of Economic Experts sees potential growth of around 0.5% by the end of the decade.
With productivity growth so low, Europe’s model has become economically unsustainable. It is not surprising that the political system is fragmented everywhere. We face a fiscal crisis, caused by a combination of falling productivity and political deadlock.
Technology is the main cause of decline. Geopolitics is what accelerated it. The solution is a common fiscal capacity, a capital markets union, common defense procurement to neutralize the increase in defense spending. If one of these parameters does not change, a financial crisis is a very plausible scenario.
Fiscal Disaster Zones
France and Italy are big disasters right now on the budget deficit rule. Neither Italy nor Greece should ever have been allowed into the EMU (European Monetary Union – Eurozone). Greece has a debt to GDP ratio of 170%. The target is 60%.
Looser rules both postpone and accelerate the crisis
On February 10, the EU agreed to looser fiscal rules to reduce debt and boost investment. The latest overhaul of rules, known as the Stability and Growth Pact, came after some EU countries racked up high public debt, as they increased spending to help their economies recover from the pandemic and as the bloc announced ambitious green, industrial and defense targets.
The revised rules allow over-indebted countries to reduce their debt by an average of 1% per year if it is above 90% of gross domestic product (GDP) and by an average of 0.5% per year if the debt is between 60% and 90% of GDP.
Countries with a deficit of more than 3% of GDP are required to halve it to 1.5% in periods of growth, creating a buffer for tough times. Defense spending will be taken into account when the Commission assesses a country’s high deficit, a consideration prompted by Russia’s invasion of Ukraine.
The new rules give countries seven years, up from four previously, to reduce debt and deficit starting in 2025. Note that the EU can modify enforcement, but not the main goals of the Stability and Growth Pact without unanimous agreement and a new condition.
