This article was first published in The Wall Street Journal Europe on 4 July 2014
Europe is stuck in a deep slump and facing the prospect of many more years of stagnation and high unemployment. European leaders are right in their diagnosis that a growth stimulus is urgently needed to end the crisis. But they are wrong in their solution: The Continent doesn’t need more public spending and bigger government. It needs more competition, innovation and the completion of the single market.
Important reforms – including to the structure of labor and product markets and to social security systems – have already been implemented in some of the crisis countries.
But those reforms won’t yield quick results. It took Germany five years after Chancellor Gerhard Schroeder’s labor-market reforms and tax cuts in the early 2000s to catch up with neighbors. Germany was lucky, since its reform agenda coincided with a booming European and global economy. Europe’s crisis countries aren’t as lucky today.
Many political leaders see the solution for breaking the crisis cycle in a fiscal stimulus and bigger government. But government-induced growth is artificial and elusive. And it risks deepening the crisis, since most European governments are too highly indebted to increase spending.
Today’s low interest rates on government debt aren’t the result of virtuous policies, but of an expansionary monetary policy and guarantees by the European Central Bank. The ECB is buying time for governments to implement reforms – not to renege on them. The abandonment of the stability-and-growth pact – the commitment to reduce government debt to below 60% of GDP and limit fiscal deficits is also a fatal signal for Europe’s ability to reform and fight future crises. And most of the additional fiscal stimulus won’t likely be used to finance public investment but rather public consumption.
The answer lies elsewhere. A new study by the Berlin-based German Institute for Economic Research shows that the biggest drag on the European economy is the miserably low level of private investment. Relative to GDP, euro-zone private investment has declined by about 4% cumulatively since 2008. Almost all euro-zone countries have a massive investment gap, amounting to 2% of euro-zone GDP, or about 200 billion euros annually.
Private investment is crucial because it has the power to remedy many weaknesses, both on the supply side and the demand side of the economy. It creates employment and income for households, makes banks more profitable, helps governments consolidate and reform, and ultimately boosts growth and competitiveness.
The Continent thus needs to foster private-sector investment to put it on a path of sustainable growth. A European private-investment agenda should contain three elements. First, national governments and the European Union must complete the single market for services while enhancing competition and innovation. Second, they should provide tax incentives for companies by making investment expenditures tax deductible and lowering costs, similar to what Germany did in 2004 and again in 2009.
Finally, Europe should create a private investment fund – based on the already-existing structures within the European Investment Bank – with the specific task to raise investment among small and medium-size enterprises in the European Union. The fund would then raise and provide financing to nonfinancial SMEs at favorable interest rates. This could be done by providing guarantees to banks offering loans to SMEs, by financing cross-border joint ventures between private firms and between the private and public sectors.
Such a program should be limited in duration, say, up to five years, and not have a regional or specific industrial focus. The underlying goal would be to improve the overall allocation of capital. Such a fund would reduce the risk to individual banks and companies, similar to what the ECB is trying to do through its own instruments, but in a more direct way.
The European political class wants to turn the Continent’s economy around through more government spending. But a much better strategy would be to strengthen the private sector and the functioning of markets by fostering investment, improving competition and innovation, and completing the single market. Brussels, and national authorities, would be wise to give private-sector job creators a helping hand rather than burden the European public with yet more government debt.