Europe at a crossroad: the main challenges after one year of war in Ukraine

There is an old Irish joke about someone who asks for directions, and is told: I would not start from here. Advising the EU on economic strategy feels very much the same: they committed so many unforced errors, like fiscal austerity, that I really would not want to start from here. But I must. 

Before we start, we have to be clear of the limits of our endeavour. We can no longer turn the EU, with the euro area at its heart, into the world’s leading economy. This was a reasonable ambition in the early phase of monetary union. I recall a private conversation with Tommaso Padoa-Schioppa, the late Italian finance minister, around that time. He was an economist by training, previously a member of the European Central Bank’s executive board, yet he described the euro not in economic terms but as a geopolitical tool. He saw it as an instrument to challenge the US dollar, and with it US economic supremacy. 

A sovereign debt crisis, a pandemic, a war and the return of high inflation have since intruded. The serial shocks of the last ten years left Europe’s economy exposed and weak. Italy has had almost no productivity growth since 2000. Others, even Germany, are now experiencing the same. Europe missed the digital revolution, the basis of modern-era wealth creation. And committed serial policy errors.

Those of us who fought for the idea of geopolitical euro have lost the debate. We have lowered our ambitions. But even in this situation, the world of second-best options is not to be scoffed at. I would prioritise three: improve the macroeconomic policy regime; complete the capital markets union; and invest into the digital transformation. I mean, really invest. 

Improving the macroeconomic regime is a big deal. The current system has created structural north-south imbalances that will be hard to correct. I see no chance that this can happen without a fiscal union. Defence procurement would be an ideal area where the EU could benefit from economies of scale through centralisation. Green investments and energy policy should also be run from the centre, difficult though this may appear politically. It would be massively more efficient. The small fiscal union would acquire tax raising and debt issuing powers. The ECB should be allowed to buy eurobonds issued by the fiscal union, at the expense of bonds issued by member states. I would also amend the treaties to allow for more policy co-ordination between the ECB and a future European finance minister. Fiscal-monetary co-ordination constitutes an essential prerequisite for a successful macroeconomic policy during time of crisis. This is something we can learn from the US. We don’t have to give up on central bank independence either.

My second priority is the capital markets union. It has been on the EU’s to-do-list forever, but it has not got anywhere because the EU always thinks it has something more important to do. Especially in combination with a small fiscal union, a capital markets union could be game changer for corporate finance and investment. Without it, our venture capital industries will never compete with their American counterparts. Nor will our bond markets. The euro will remain a distant second global currency. A monetary union, a fiscal union and a capital markets union belong together. Such a  project would also encompass the completion of the banking union. What we have now is a banking union in name only. The big banks are supervised by the ECB, but the EU lacks an efficient bank resolution regime and has no common deposit insurance. Banking today is more national than it was in 1999 when the euro was created.

And finally, if I had to prioritise one spending category, it would be digital modernisation. It is not the lack of hardware like optical fibre networks that is the main problem in Europe, but the lack of digital sophistication. Digitalisation is not about computers, it is about how we interact with the world. Europe’s business models are stuck in the analogue age. In Germany, industrial companies still interact with each other and their clients through trade fares, a distinctly 20th century structure. They sell through wholesalers and retailers, rather than online. They do not create communities of clients and potential clients. Modern era digitalisation is about interacting networks

My expectation is that the EU will do none of these things. The EU missed the moment to choose a first-best strategy in the early 2000s, when it focused all its policy efforts on structural reforms. It missed it in second decade of sovereign debt crisis firefighting. The last three years were dominated by the pandemic and the war. The EU lives in the here and now, always distracted by the latest fads. 

What the EU is doing now in response to the US Inflation reduction act is to protect existing industries; return to the stability pact with only some minor modifications; and reduce its global ambition to that of the world’s regulator. But how can you regulate digital industries if you don’t have any skin in the game? 

The rest is economic policy virtue signalling. The Green deal? Or the €300bn Juncker investment programme in 2014? Most of it has been hot air. I admit the recovery fund was made up of real money, but it was a one-off scheme. It will help Italy a little, but at €310bn over five to seven years the total programme is too small to make a lasting impact on economy the size of the euro area. I doubt it will have a big impact on Italian productivity growth either. The EU has patchwork programmes, but we lack a comprehensive strategy. Yet, we Europeans are surrounded by countries whose leaders think strategically.

The bitter irony of the situation is that at one point it really becomes rational to say: I would not start from here. Then, we will be talking about third-best options.