Europe Must Again Confront the Forces of Illiberalism

Op-ed in the Financial Times

August 2, 2005

It is economic performance-not the European Union budget or any proposed constitution-that will determine the fate of the "European Project." After all, Hitler came to power in 1933 due to "ordinary economic voting behavior" when the mainstream parties' economic agendas were unconvincing, not because a majority of German voters then embraced Nazi ideology. Similar feelings of frustration about economic change without evident benefits are rife in Western Europe today.

Echoing the 1920s and 1930s, competitive pressures on lower-skilled workers and the once-protected petit bourgeoisie are blamed on international capital and on inequitable global treaties. Declining birth rates, especially compared with poorer neighbors, are deemed to threaten European stability, just as they were in the interwar period. Liberalization and economic integration are under attack once again as self-defeating if not immoral. Resistance to economic reform is fertile ground for antiliberal politics. In Europe, then and now, the ability of interest groups to exploit economic discontent outstrips the influence of reasoned debate. Identification of liberalization with subversion of national (and self) interest is forcing continental mainstream parties to choose between sticking to reform efforts and losing seats to more radical alternatives, or going backwards on economics to avoid being outflanked.

It is intellectually sound to argue that only structural reform will raise the growth rate sustainably, but it misses the point. Labor reforms and fiscal consolidations, even when necessary, are contractionary in the short term. Responding to populist discontent by simply telling the dissatisfied to be patient would reinforce the image of an out-of-touch European elite and open the door to worse outcomes (figure 1).

What is needed now is an economic strategy that will forestall such radicalization until cyclical recovery comes and existing reforms yield benefits. Europe needs to buy time and buy off dissent. The way to do so is to channel the harmful pressures on economic policy into more rewarding directions and thereby drain support for the radicals (figure 2).

For example, the European Central Bank (ECB) is under increasing attack from eurozone politicians for supposedly being insufficiently responsive to divergences in the eurozone. Even if the ECB were not part of the problem it could still be part of the solution. The ECB should commit to respond to structural reforms with more accommodative monetary policy. When economic potential rises through reform, all else being equal, inflationary pressures abate. But the ECB has only emphasized how lack of reform holds policy back, not how it would respond to progress. They could instead, for example, acknowledge that the German Hartz IV labor reforms lowered the unemployment rate that could be attained before inflation would rise.

Such recognition of reform should lead to rate cuts today. More importantly, it would increase the time expected before interest rates would be raised in the next recovery-and such changes in expected central bank moves can influence long-bond interest rates and thus investment. It would indicate that the central bank is supporting growth, decreasing room for politicians to scapegoat the bank.

Inevitably, there will be pressures for industrial policy. Rather than waste money on national champions, the European Union should turn that impulse into building infrastructure for hydrogen fuel and committing to shift government transport fleets to the technology. Only with such investment and commitment will there be a market for non-fossil fuel automobiles with the attendant environmental and foreign policy benefits.

This follows best practice for government investment. First, it sets a goal rather than picking a specific winner. Second, it guarantees sufficient demand to make research and investment in hydrogen (or other advanced fuel) transport potentially profitable. Third, it is tied to outcomes and therefore could not become an ongoing transfer to industry. It also buys off illiberal auto interests.

The European Union also needs to make a positive offer to the Chinese on exchange rates-China's recent 2.1 percent revaluation of the renminbi and shift to an exchange rate basket resolves nothing. In fact, without significant further appreciation of the renminbi against the dollar, there is likely to be an escalation of protectionist threats against China from the US Congress, if not the Bush administration.

Europeans have at least as much stake as Americans in seeing China's and the rest of emerging Asia's currencies rise-otherwise the coming adjustment of US trade deficits will cause significant appreciation of the euro, hurting growth and further feeding reactionary impulses. An escalating trade conflict between the United States and China would inevitably harm European commerce and investment, and perhaps scuttle the Doha round; it would certainly abet the illiberal politicians in continental Europe (table 1).

The eurozone governments should offer Asia a greater voice in international financial decision-making in return for a revaluation of the renminbi and other Asian currencies. The eurozone could offer to consolidate its constituencies and shares in the International Monetary Fund (IMF) and World Bank, transfer some shares to China and still retain enough for a veto power. An EU good cop to the US bad cop could be both effective and preempt an economic conflict.

It might appear incongruous to invoke the evils of Europe's interwar politics and then suggest a technocratic response such as reallocating IMF shares. Yet it was mainstream parties' lack of response in the 1920s and 1930s to such matters as declining prices for Italian farmers' products and competition for German doctors from immigrants, along with their neglect of high unemployment, that gave the fascists, communists and other radical parties political space. To prevent illiberal movements from gaining influence today, small policy measures to preempt reactionary initiatives and buy off some voters should be sufficient. They are no less vital, and may be more viable, for being small.

Of course, if growth were strong in the big eurozone economies, illiberal voices would not be a threat. Though there is no quick fix for European growth, recent political events and Europe's history both suggest that it would be ill-advised to continue doing nothing until the benefits of structural reform and wage pressures arrive.