Narrow-minded leadership hurts Europe

By Wolfgang Münchau

Published: February 15 2009 19:27 | Last updated: February 15 2009 19:27

“It is justifiable if a factory of Renault is built in India so that Renault cars may be sold to the Indians. But it is not justifiable if a factory ... is built in the Czech Republic and its cars are sold in France” – Nicolas Sarkozy, president of France.

This is a troubling statement indeed. But instead of launching a tirade against Mr Sarkozy, I would like to make an observation that is perhaps not immediately evident: his statement is entirely consistent with the way the European Union has reacted to the financial crisis.

To see the link between crisis management and the rise in protectionism, look at the initial policy response to last September’s financial shockwaves. European leaders have woefully underestimated the crisis and possibly still do. The European economy is now heading towards a depression, with German gross domestic product falling at an annualised rate of almost 9 per cent. The early misjudgment of the crisis resulted in stimulus packages with two defects. They were initially too small but, more importantly, they were not co-ordinated. One important aspect of the economic meltdown is the presence of strong cross-country spillovers, both globally and inside the EU. The policy response failed to take account of these spillovers.

For the bank bail-out programmes, the EU managed to set a minimum level of competition rules, but these programmes, too, were national and not co-ordinated. So how does the combined effect of these two unco-ordinated responses lead to protectionism?

If stimulus money is dispersed at national level, governments naturally try to make sure that the money stays inside their countries. The prospect that consumers might spend the money on imported goods was one of the reasons why eurozone governments were reluctant to cut taxes. Because of EU competition rules, the same logic also applies to government purchases. Under those rules, governments had to open public projects to EU-wide tenders. If you play by the rules, keeping the cash in your country is not easy.

Governments have since relaxed those rules. In other words, if you want to make sure that these programmes function in their warped way, you have to dismantle the single market. The same logic applies to the bank rescue packages. If the European Commission tried to block each uncompetitive bank rescue, it would be blamed for causing a financial collapse. Governments have found a way to circumvent the EU, by breaking so many rules at once, that the Commission cannot even begin to react effectively.

Expect to see three effects with progressively destructive force. The first is that the stimulus is much less effective than it could otherwise have been. When everybody tries to gain a competitive advantage over each other, the effects usually cancel out.

Second, the stimulus and bank rescue packages harm the single European market directly. The French subsidies are more blatant, as is the protectionist rhetoric of its president. But everybody in Europe plays the same game. It is not as though the single market is the default position for European commerce. Much of the service sector is exempted. Europe lacks an effective pan-European retail infrastructure and retail banking system. Reversing this programme long before it is completed would be a mistake.

Third, and most destructive, the combined decision on stimulus and financial rescue packages poses an existential threat to monetary union. A blanket loan guarantee to every bank, as most governments have granted, in combination with indiscriminate capital injections and a reluctance to restructure, will mean the transformation of private into sovereign default risk – aggravated further by the economic downturn. Some insolvent banks are now owned by the state, while the bulk of damaged, not-yet-insolvent banks are lingering on, hoarding cash. This programme is a drain of resources with no resolution in sight.

I would now expect several eurozone countries with weak banking sectors to get into serious difficulties as the crisis continues. There is a risk of cascading sovereign defaults. If this was limited to countries of the size of Ireland or Greece, one could solve this problem through a bail-out. But solvency risk is not a problem confined to small countries. The banking sectors in Italy, Spain and Germany are increasingly vulnerable.

When European leaders meet for their anti-protectionism summit on March 1, they will produce warm words to reaffirm their commitment to the single market. I suspect they will continue to misdiagnose the crisis. Protectionism is not the root of the problem. The protectionism we are experiencing now is caused by co-ordination failure. It is neither sudden, nor surprising.

The right course would be to solve the underlying problem – to shift at least some of the stimulus spending to EU or eurozone level and, ideally, drop those toxic national schemes altogether and to adopt a joint strategy for the financial sector, at least for the 45 cross-border European banks. But this is not going to happen. It did not happen in October, and it is not going to happen now. As a result of the extraordinary narrow-mindedness of Europe’s political leadership, expect serious damage to the single market in general and the single market for financial services in particular. As for the eurozone, I always argued in the past that a break-up is in effect impossible. I am no longer so sure.