EUROPE: NAVIGATING THE STORM
Robin Niblett, Chatham House
Introduction
This is a difficult and uncertain time for Europe, as it is for much of the world.
Europe faces its own set of challenges in the current environment. But, its
deeper problem is that the current economic crisis might combine with some ofEurope’s structural weaknesses to create a toxic long-term effect that drags it
down. The risk is that this could happen precisely as other countries might
emerge strengthened from this crisis in the long-term.
EU leaders need to make the right choices now in order to take advantage of thecontinuing potential for EU economic growth and strengthen their politicalinfluence over their own destinies.

1.

Europe and the Economic Crisis

The financial crisis has spread gradually across Europe, to the point where
overall EU growth is now predicted to slow into a recession for all or most of
2009 (IMF says – 0.5%).
What started in the UK as a spill-over of the sub-prime crisis from the UnitedStates into its own highly-leveraged economy has not been contained there.
Almost all EU economies have now been hit one way or another.
Bank crises have hit the UK, Germany, Austria, Denmark, Hungary, Ireland,
Slovakia and Slovenia. Spain’s unemployment is expected to rise to 15% nest
year on the back of a 0.9% decline in its GDP. Britain has already had 2 quartersof negative growth.
After initial divisions, European governments have responded well andpragmatically in their national and collective response to the crisis. Britain led theway with a dramatic decision to under-write the national banking sector andfinancial system with a £500 billion combination of purchases of major equitystakes in three of Britain’s leading banks; huge lines of credit to back banklending; and deposit guarantees.
Other EU countries have followed this lead with a similar combination of policies.
Germany (€400 bn. to back bank loans plus €80 bn. “top-up” capital for them);
France (€320 bn. and €40 bn.).
Equally remarkable at the political level, the members of the Eurozone
coordinated with Britain (a non-Eurozone member) their collective response.

Europe: Navigating the Storm
Robin Niblett, Chatham House – 11/08

Interest rates have also been coordinated across the EU and with otherinternational players.
There is now growing consensus that support for the financial sector andmonetary policy (interest rate cuts) will not be enough to see Europe through thecrisis. There is growing support for a set of Keynesian stimulus packages acrossthe EU to avoid too steep a drop in economic activity.
In the meantime, the existence of the Eurozone has helped avoid competitiveactions (such as devaluations between national EU economies) and has offeredsomewhat of a safe haven for the small EU economies, such as Ireland and theNetherlands, from the global economic and currency turmoil. Those outside thesafe harbour – Denmark and Iceland, in particular – have suffered economically.
However, the decline in the value of the Euro (and the pound) relative to the US
dollar may reflect market belief that the US has better potential for recovery thandoes the Eurozone or the UK.
Why is this so? What are the longer-term risks for Europe? What are some ofthe deeper, structural factors that will determine how it navigates its way though
the current storm?

2.

Europe’s structural risks•Demographic change

European nations are aging faster than any other major countries in the world,
except Japan. By 2050, 7 of the 10 oldest countries in the world are projected tobe European (including Spain, Italy and five from central and eastern Europe)with average ages over 50.
Although some progress has been made in recent years, few European nations
have adapted their pension systems sufficiently to prepare for this reality.
Budget deficits are likely to rise, constraining economic growth.
•Unreformed welfare systems

Overall, generous post-World War II social welfare contracts (ensuring generous
protections for retirement, labour laws, healthcare and education) have still notbeen adapted to the more competitive realities of the 21st century. Examples
include German and Italian retirement systems and French healthcare andeducation.

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Robin Niblett, Chatham House – 11/08•

Low immigration rates

With few exceptions (Britain and Spain, among them), immigration rates have notrisen anywhere near the levels needed to compensate for societal aging, in termsof workers and payments into social security systems.
Large numbers of those Immigrants who do arrive find it difficult to integrate
effectively into the national economies. This adds to welfare costs andcontributes to rising social and political tensions (Italy and East Germany areexamples).
•An incomplete Single Market

At the EU level, potential drivers of growth from the Single Market have come toa halt. Most importantly, barriers to the trade in services (which account foralmost 70% of EU GDP) remain in place across the EU, whether in banking,transport, postal and communications services or professional services such as
law and medicine. This could be a key area for productivity growth and new
employment.
Most importantly, the lack of an integrated EU energy market creates
vulnerabilities as well as price distortions and bottlenecks across the EU.
•National economic divergence across Europe

Complicating, Europe’s response to the crisis, Eurozone and other EU
economies enter the recession in different economic shape and with different
strengths and weaknesses.
o The Eurozone’s major economy – Germany – still relies heavily on exports
to drive its growth and is more vulnerable to external shocks than areother major economies.
o Some countries (Italy, Belgium, and Hungary, among others) are carrying
heavy government debt levels already and are not well-positioned tohandle the costs of stimulus packages over time. Britain has relatively low
debt, but very high government deficit forecasts (5%).
o 10-year bond yield spreads over Germany have grown for some of theEurozone’s weakest countries – 150 basis points (Greece), 110 basis
points (Italy), and 80 basis points (Portugal).
Despite the existence of the Eurozone, therefore, the European Central Bankand national EU governments will find it difficult to coordinate monetary and fiscal
policies in ways that do not have divergent impacts in different EU economies.

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Robin Niblett, Chatham House – 11/08•

Political divergences

The failure to ratify the Lisbon Treaty which would introduce new institutional
reforms for an enlarged EU, has not led to grid-lock in EU decision-making. But
it does create a more fragile political context in which EU leaders must deal withthe economic crisis and its after-effects.
There is a risk that long-standing protectionist sentiment in some EU countries(France and Italy, in particular) might undermine the future cohesiveness ofEurope’s response. France’s national sovereign investment fund andBerlusconi’s championing of state subsidies stand out as examples.
The transition to a new US president makes this more possible during anespecially complex next few months. President Sarkozy, in particular, wants toseize the opportunity to impose EU-led change on the international financialsystem. There will be resistance to this not only in Washington, but also in otherEuropean capitals.

3.

What are the positives and what will be the best steps to take to achieve asustainable recovery?

It is important to note that, for all of its structural weaknesses (and othercountries have their own!), the EU does have some inherent strengths and also
scope for improvement.
It has a diverse and mature set of economies that can be competitive
internationally if well-governed and motivated.
While its demography and aversion to immigration can hold it back, most EU
countries have extensive room to achieve gains in productivity, through labour
market reforms, raising levels of employment among women and older workers,
and greater incorporation of ICT into their economic processes.
With stronger national economies, new benefits can be secured through a
deepening of the Single Market, especially in the fields of services and energy.
If protectionist instincts can be held back in the near-term, then European
countries can grow as magnets for foreign direct investment. At one level, thiswill be so that foreign companies can gain improved access to wealthy EU
domestic economies.
Perhaps more important in motivating increased FDI into Europe, given that EUmarkets may not be as inherently dynamic as others, is the fact that Europeancompanies are strong in areas of design, technology and marketing which can be4

Europe: Navigating the Storm
Robin Niblett, Chatham House – 11/08

of added value to the emerging economies with large foreign exchange reserves
that are now looking to expand their own international presence.
The EU also has scope to expand its own trade deals internationally, using theleverage of access to its large market.

Conclusion
Europe has some structural problems which may make it harder for it to emerge
strongly from the current economic crisis.
On the other hand, it also has scope to improve its own economic performanceand to remain an attractive destination for FDI as its own capacity fordomestically-driven investment declines.
Whether the more optimistic or negative scenario plays out will depend on thedecisions that EU leaders take over the next 3 – 6 months. They will need to use
the current crisis to push forward reforms to make their own economies morecompetitive and to be open to well-regulated trade and investment which would
have been necessary under any circumstances within the next five to ten years.

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