A discussion is currently taking place on the European continent regarding the best way to economically salvage its future. However, these debates are being framed in the wrong way. The matter is as much political as it is economic. The discussions need to include – honestly and in a transparent way – the roots of the macroeconomic malaise that have befallen most European countries in order to understand the way to recovery.

The EU Can’t Defer Core Questions Any Longer

It has been clear that for the past decade that the EU has been unable or unwilling to discuss these hot topics, because then it would have had to make a mea culpa together with its member states. This would mean accepting that for almost a decade they have been at a crossroads: either destroy this Union and reform it to be more in line with what the founding fathers had envisioned, or part ways and return to the pre-WWII Europe. There can be no other way, mostly because all the member states have allowed the Union to fall into decay while pretending things were all right. Some have gotten richer as a result, while others have suffered.

COVID-19 is Forcing Key Issues to be Addressed

If there is one good thing the COVID-19 pandemic has done is bring everything out in the open. The political rivalries, deep divisions, opposite mentalities, bitter resentments that had been hidden for more than two decades, are now seeing the daylight, for everyone to see. Bureaucrats and national politicians have done their best, especially throughout the last few years, to present the image of a Union existing in harmony and cohesion, united and strong. The current emergency is proving this to be a farce. There are deep divisions between the northern European countries, which consider themselves richer and more responsible, and the southern Mediterranean ones that believe to have been mistreated and wronged.

The Reality of EU Divisions and Crises

The truth is that for most of the decade starting in the year 2000, countries like Spain, Italy or Greece increased their debt levels driven by unchecked government spending. Real estate bubbles, unsustainable deficits caused by obscene government expenditures and yes! the Euro caused the southern European countries to be hit hard by the global financial crisis and instigated the sovereign debt crisis. In this aspect, many countries in Northern Europe are right to voice their concerns about allowing these countries to access more debt, and going further by mutualizing it, because even after a decade they have not been able to recover. The management of the southern governments has been inefficient and deadly for their economies. Bad policies ensued even after the 2012 sovereign debt crisis, adding to the debt, but leaving productivity stagnated.

After the crisis, Spain made a remarkable recovery, gaining more than half of the jobs lost during the crisis, reduced its deficit by half and managed to reach 3% growth in the first quarter of 2018, proving that the supply side policies work. Government revenue actually increased due to the tax cuts implemented by the government of Mariano Rajoy. However, during the last couple of years of Rajoy and in the course of the current socialist government this amazing recovery is being threatened by a return to excessive spending, high taxes and more regulations. The same thing that has happened in Italy with unelected governments spending billions of euros in unproductive policies year after year.

The Northern Bloc Has Reasons to be Skeptical, but They’re Also Hypocritical

In this context, countries like Germany or the Netherlands are right to be sceptic of debt mutualisations. Why should a citizen in a country whose government has been sensible with respect to its policies share the risk for a country with bad management history? It is a valid question worth discussing. Why should some countries get a blank check from others?

However, the hypocrisy of the so-called Northern bloc rests in the fact that they and everyone else knew what countries like Italy, Spain and Greece were doing. Yet, they did nothing. It would be naivety to believe Brussels had no knowledge regarding how bad the situation was; still it did not raise any issues with the national management of these states. It is much worse than that. All these richer countries enabled it. They financed the debt and frenetic spending with their investments. When the music stopped, so did the capital.

Under the guise of austerity, they controlled Greece and as the former Italian Prime Minister Massimo D’Alema explained a few years ago, took its money straight to the German Banks. Now, the Union’s better-shaped countries are trying to use Italy’s past and present bad governance and policies as an example that Italy is unable to manage its own money, pushing it towards a similar scenario as Greece. Something similar was tried before when Silvio Berlusconi was Prime Minister, before his ouster not by his citizens through an election, but by European Elites.

More Challenges to Consider

Not all the woes of these Mediterranean nations come from bad governments. We should not forget that barely a month ago, Christine Lagarde’s reckless declaration about the ECB and the spread caused the sharpest ever decline in Italian stock market. Moreover, the concern is that accessing European funds and mechanisms will come with strings attached will actually dampen growth, instead of encouraging it.

Another issue that arises concerns the weight each country in the EU should have in discussions. Why should a country that contributes less have the same vote weight as another that contributes much more? Why the Netherlands’ opinion should matter more policy wise compared to Italy, when Italy’s contribution is many times higher? It is further evidence that the Union does not work in a fair way.

Missing: Smart Economic and Fiscal Policies

Overall, it is now indisputable that after a decade of low growth and high unemployment, national governments and Brussels have been unable to implement the right economic policies. Moreover, the Union is faced with the impossibility of a common fiscal policy.  It relies today, as it has over the past decade, on monetary policy. Yet, even that reliable institution seems to be losing its effectiveness with the departure of Mario Draghi and the simple fact that more liquidity from a stronger quantitative easing will not be enough.

Maybe the Italians are right and the centuries’ old divisions, prejudices and rivalries are the reason why the EU abandoned the Apennine country in its hour of need.

However, leaving bad policies and old resentments aside, Italy is right to require at least the money it has contributed over the years. Nevertheless, the problems Italy or Spain face will not disappear with the sums Brussels may give them, with or without strings attached, because it will depend on how the money is used.

What Needs to be Done Next?

What Europe – through its various member countries needs – is to produce. Its productivity falls considerably behind its international competitors due to rigid labor markets, high taxes, regulations and bureaucracy. For technological innovation as well, it falls behind the US and China. If Europe continues down the path it is on, it will soon be a zombified continent. Merely spending money from the government is not only inefficient, but also problematic. If the supply curve is not pushed up, the unproductive policies will lead the new lower demand to create its own lower supply. That is why European countries have had a long deteriorating recovery.

In the US, the Obama administration left the economy growing at 1% using the same policies as Europe. The supply side reforms aimed at increasing productivity pushed the GDP to close to 3%, by lowering taxes and removing regulations that were killing the small and middle enterprises. Greece is trying to focus on the supply side with the economic reforms introduced by the new center right government. Spain tried it during the past decade successfully and should return to the path it started in 2011 and abruptly stopped in 2016.

Companies in the EU are not incentivized to produce. Labor markets in countries like France and Italy are highly inflexible. Bureaucracy is choking the private sector. France and Italy were already in contraction during the fourth quarter of the last year. The pandemic made all the existent economic hardships more evident.

Italy’s Next Economic Steps

The Italian government and all the others that find themselves in a similar situation should prepare an economic program with considerable tax cuts (even considering a flat tax), reductions in government spending, structural reforms, cutbacks in inefficient government programs and subsidies, focus on small and middle enterprises and drops in regulations and bureaucratic procedures. These will allow the economy and its engine, the private sector, room to breathe. The discussion should not be solely framed around the positive or negative aspects of corona bonds or the European Stability Mechanism. Italy and other national governments should discuss how to use these funds.

The money coming from the European Union should be focused on the backbone of the economy, which are the small and middle enterprises, so they are encouraged to hire more and invest in their businesses. It can be through corona bonds, the funds already made accessible by the EU or even debt in the market at record low rates with other friendly international actors. It is acceptable to increase the debt and deficit when it will be used to finance the resurrection of productivity, because that higher productivity will lead to a decline in debt in the medium and long run. The problem in Europe has been using debt to finance universal income, welfare plans, bad subsidies or government programs that contribute nothing to the economy, leaving aside the ways and means that encourage employment.

The EU’s Incompetence is No Longer in Question

It has been proven especially throughout the past decade that this EU cannot lead. It has driven a once great continent towards economic catastrophe, political incompetence and social divisions. Now, it can step aside and allow national governments to implement sensible and efficient policies capable of saving their economies.

This is the path to go forward and prove Germany, the Netherlands and all the skeptics that through sensible, productive policies the economy can be reawakened, debt can be sustained and even reduced in the middle run. Afterwards, Italy can open the discussion on the future of the EU, if so wishes, but from a position of strength.

I am quite aware that to do this, Italy will need to head towards early elections first. However, if it waits until the next elections then it will be too late. Until the moment comes that the center right can win the elections and implement the supply side policies it has promised, public pressure must increase so that this government is forced to undertake the necessary reforms.  Spain, and every other country, should follow this example as well.

It's a tough moment