How Europe Will Triumph Over the Debt Crisis

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Scenarios for Europe's doom are multiplying after last week's trillion-dollar emergency bailout of Greece and other over-indebted southern European countries by fellow European Union members and the International Monetary Fund. But viewed from 2020, this crisis could well have been the catalyst Europe needed to solve a number of problems—overspending governments, inflexible labor markets, and otherwise overregulated economies—its leaders deliberately ignored in rosier days, when attacking them might have cost them votes. "Real reform starts when government money stops," says Valdis Dombrovskis, prime minister of one of Europe's hardest-hit countries, Latvia. If there is a silver lining to the crisis, this is it.

Start with Greece and the other southern European countries like and bailed out last week. For decades, they have avoided reforms and lost standing against Germany, Europe's largest and most powerful economy. Greece, now one of the most uncompetitive economies in the developed world, attracts virtually no foreign investment, thanks in part to a byzantine web of regulations that stifles competition. Fundamental reforms have now become unavoidable if these countries are to repay their debts, restore growth, and regain the confidence of markets. By 2020, argues Charles Grant, director of the Centre for European Reform in London, the southern European tier could become Europe's most competitive and dynamic region—provided it finally moves ahead with reforms that limit government spending, cut inflated public payrolls, and open up overregulated labor, product, and service markets that have stifled growth, productivity, and competitiveness in these economies.

That process is already underway, thanks to the twin pressures of bond markets and fellow European governments, which have attached tough conditions to the bailout. Greece is cutting government spending, lowering pay and benefits in the bloated public sector, and deregulating tightly controlled professions (like accountants, lawyers, and architects). Many more such steps are needed for Greece to claw back its competitiveness. But before the crisis, politicians would never have been able to muscle through these changes. Now they have cover from their creditors to make hard choices and infuriate constituencies like unions and pensioners.

Multiply this all over Europe. This week, Italy was debating budget cuts worth $31 billion over the next two years, in a move to convince markets (and fellow Europeans) that it was serious about getting its government finances in order. Spain and Portugal—which have similarly lost competitiveness during their debt-inflated booms—are also beginning to balance budgets, limit public sector wages, and introduce pro-growth reforms.

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The main engine of this process is Germany, which is now moving to take control of European monetary and fiscal policy. Chancellor Angela Merkel and her finance minister, Wolfgang Schäuble, are pressing for a new EU-wide agreement to punish countries with excessive deficits by taking away their EU voting rights. They're also pushing other EU members to adopt versions of Germany's "Schuldenbremse" (debt brake), a constitutional amendment passed last year that limits the government budget deficit to just 0.35 percent of GDP from 2016 onward. Finally, Merkel and Schäuble are working to maneuver a German, Axel Weber, into the leadership post of the European Central Bank. They want to make sure that a tougher German line on debt, deficits, and inflation prevails—as a de facto condition for continued German backstopping of profligate countries' debt.

The consequences of a debt brake could be a reduction in the size of European governments. With state spending averaging 50.7 percent of GDP across the EU (compared with 38 percent in the U.S.), taxes are already so high that governments in Europe are running out of room to increase them without strangling what's left of their economies. Now the tide is turning the other way, as leaders look to limit the size of government, as Greece, Spain, and Portugal are beginning to do—and hunt for more efficient ways to provide public services with limited resources. If the niches vacated by downsizing governments are taken over by Europe's entrepreneurs, that would lay a powerful foundation for new growth, argue Bob McKee and David Roche, analysts at London-based Independent Strategy, in their just-published book, Sovereign Discredit.

For this dynamism to be unleashed in Europe, it obviously won't be enough to force reform in just a few Mediterranean countries. Europe's greatest potential for growth is to harness the power of its 500-million-consumer-strong economy by creating a truly single, EU-wide market for products, people, and services. For that, bigger members like France and Germany will also have to slash the countless restrictions that still block people and commerce at national borders. Energy and transport are still highly protected, as are all kinds of regulated professions, especially in services. Taking as a model the tens of thousands of jobs created by airline and telecom deregulation, Europe can open up new sources of growth and dynamism that will make it so much easier to come out from under its mountain of debt.

As terrible as this crisis could turn out to be if it's mishandled, Europe's history tells us that its leaders only begin to push for reforms when their backs are against the wall. Finland became one of the world's most competitive, tech-driven economies and built the world's best-ranked education system only when its economy went into a free fall after the collapse of the Soviet Union, its main trading partner at the time. Germany began to reform its calcified economy and labor markets a decade ago only after years of relentlessly rising mass unemployment led to widespread protests and national discontent. The newest poster child for crisis-driven reforms is tiny Latvia, whose 38-year-old prime minister says openly that the country's economic crisis (GDP plunged 18 percent in 2009) has, for all its terrible pain, made it possible to drive through necessary reforms that would be impossible under normal circumstances. These include deregulation and wage cuts that are deeply unpopular now, but will improve the country's competitiveness, create a more stable basis for future growth, and generate new jobs for many years to come.

None of this is sure to happen, and Europe's crisis could very likely worsen. But if there is a positive scenario, it's this: by 2020, Europe's governments will—out of simple necessity—have become more efficient and less intrusive, the EU will have turned itself into a borderless and dynamic single market, and the continent's least competitive economies will have been forced to reform and innovate. If, that is, Europe's leaders don't let this crisis go to waste.