Published on Let's Talk Development

Building A Stable Europe – It's About Time

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Six years after the collapse of Lehman Brothers, Europe’s economic recovery remains weak. Some believe that it is no longer a matter of whether Europe could experience stagnation a la Japan, but whether it can actually avoid doing so. 

A number of potential factors are commonly cited by critiques to explain how Europe has ended up with such gloomy prospects: fiscal indiscipline, external imbalances or loss of competitiveness are among those. One obvious aspect, however, is often overlooked: Europe is not a country, and it does not have a government. Could this simple fact have something to do with why European recovery has been lagging behind other advanced economies? It turns out that it could, as we found in a recent working paper.

A comparison between the EU and a federal system such as the United States is useful to elaborate on this point. The US is fiscally integrated. While individual states enjoy a certain degree of fiscal autonomy, a federal government represents the interests of the nation as a whole and guides investment in important areas, such as infrastructure. This is especially true when those investments could potentially benefit more than a single state. A good example of this coordinated investment is the interstate highway network, which improves the efficiency of transportation across state lines. The planning and construction of these highways reflect nationwide cost-benefit analysis rather than more local, state-centered interests.

The EU lacks this integration on several levels. In Europe, member states choose the type and degree of investments with their own interests in mind. This is true even if those investments could potentially have cross-border implications. For example, Germans do not build highways with the connectivity of Dutch travelers in mind. Same goes with national energy and railway policies. In the end, because governments perceive lower benefits from certain types of projects, they invest less in those as compared to what they would if decision making was centralized. As a result, for instance, trains carrying cars from Sweden to Italy are reported to change locomotives and crews four times, waste time in bottlenecks in Germany and Austria, and stop for switching the reflective panels at the rear with warning lights just before entering Italy.

Although the lack of centralized decision making for fiscal affairs may seem relatively benign in normal times, it may hobble the Union’s ability to extricate itself from the present prolonged slowdown. In times like these, the benefits of acting together increase; but, so does the cost of not acting together. Take, as an example, the financing of a boost in infrastructure investments. A centralized authority could raise more funds to invest in Union-wide projects than could all the individual members’ fundraising efforts. This is because the central authority considers the impact of investments on all members: an extra mile of railway in Germany could be worthwhile if it improves the access of Sweden to other markets. A central authority spends differently, seeing benefits that individual member states would not see. Investors like this. With debt repayment tied to the condition that the economy improves, investors would then be willing to lend more – more than the sum of member states- to a centralized authority.

This is not the end of the story though. An important strength of a centralized authority is the ability to limit the contagion of debt distress, as we show in the paper. In the absence of complete integration, an individual country’s inability or unwillingness to repay sovereign debt could be transferred to a seemingly healthy neighbor. The mechanism behind this is simple: when a country-specific shock decreases the output in the coming years, the government could find it more desirable to default on its debt and reduce public investments as net returns to these investments are lower now. This reduction, in turn, generates a second-round shock to other members who had no shock at the outset, which eventually could push them to default as well. 

Complete integration schemes are more resilient to such shocks and they contain debt distress more effectively. This is mainly because greater investments in such systems lead to deeper vested interests, which works like collaterals against debt obligations. As defaults become more costly with higher collaterals, relatively small shocks will not lead to default. Moreover, in a centralized system, the central authority performs a risk-sharing function: if a shock hits only one of the member states, the central authority could “transfer” resilience from other members. Avoiding a potential default and limiting the decrease in investments in turn diminishes the second round shocks to other members. Thus, the initial shock is contained. This is not to say that complete integration schemes are invincible to shocks. They are simply more resilient.

What do these tell about how Europe should move ahead? The most immediate implication is that more integration, not less, is needed. Although this has long been known; it was grounded in different reasons, and it has not led to decisive action yet. The idea that the same institutional design problem could be behind the weak recovery, however, is a game changer. Right now, the conditions are ripe for a more integrated Europe. From the finance ministers’ Italian summit in September to IMF’s recent call and Poland’s finance minister’s proposal, there is a recent momentum for boosting investments in a coordinated manner. 

The risk, however, lies in the fact that this momentum is mainly motivated by short-term demand considerations. It is not enough that investments are undertaken in many fronts in a synchronized manner; they should also be targeted at building a new and more resilient Europe beyond short-term national motivations.


Cem Karayalcin

Professor of economics, Florida International University

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