Forget the hymns and fix the economy

By Martin Wolf

Financial Times

Published: June 1 2005

An earthquake has hit Europe. The move towards ever closer union turns out not to be inevitable. This is a source of both pleasure and pain: pleasure over the humbling of arrogance and pain at the triumph of reaction.

Before the vote, Jean-Claude Juncker, Luxembourg's prime minister and current president of the European Council, declared that France and the Netherlands should re-run their referendums, if necessary, in order to obtain the "right answer". Mr Juncker is all too representative of the contemporary European elite, which does not merely deserve, but needs, the kicking the French have given it.

Who could better deliver that rebuff than the French? "Bureaucracy tempered by revolution" is, after all, not an entirely unfair characterisation of the country's politics down the ages. The voters, it appears, had a host of enemies: an incomprehensible document; their elite; Jacques Chirac, their president; Anglo-Saxon "ultra-liberalism"; globalisation; low-wage workers from eastern Europe; the enlargement of the European Union; prospective Turkish membership; economic change; high unemployment; immigrants; and foreigners. When the French look at contemporary Europe, they no longer see themselves in the mirror and when they look at their economy, they no longer see anybody in control.

If one asks why this rage was poured onto Valéry Giscard d'Estaing's hapless "tidying up" exercise, the answer seems to be: "why not?". Confronted by this indigestible mass, any normal person would wish to cast it on the fire. What, however, does this rejection mean for the future? I suggest five probabilities.

First, the treaty is dead. I presume the Dutch will vote No. If the British cannot be threatened with isolation, they will also reject it. It is impossible to overturn the verdicts of the disgruntled citizens of two of the six founding members and two of the three most powerful countries in Europe.

Second, further movement towards deeper integration among all members of the EU is off the agenda. The Europe we have today is as much as - quite possibly more than - all will share.

Third, enlargement beyond Bulgaria and Romania has become unlikely. There will be referendums on Turkish entry. In current circumstances, these would be lost.

Fourth, France has set its face not just against the European project but against the modern world. That is going to make it far more difficult to pursue liberalisation, domestically, within Europe and globally. For that outcome, the French elite bear heavy responsibility. Their ceaseless indulgence in infantile anti-market rhetoric has had its consequence.

Last but not least, there is a chance of some unravelling of the European project, which has relied on a version of the bicycle theory: if it does not go forward, it risks toppling over. The belief that it must go forward is now dead. It is possible that some achievements, including the single market, will go backwards.

So what should be done? The place to start is with economics. For if there is a single source of the malaise, it is there. Thirty years ago Europe was associated with stunning prosperity. Now, it is tainted, instead, with high unemployment and weak growth. Moreover, this is not just a question of atmospherics. The survival of the monetary union depends on economic success. Political will is not enough.

A currency union requires greater flexibility and so more intense internal competition than independent national monetary areas. The failure to make this clear before starting the union was the great political and economic blunder of the 1990s. That is one reason why market-oriented reform is no luxury for the members of the currency union but a necessity. Yet the Lisbon strategy of concerted movement does not work. The principal force for reform will, instead, be competition among the different economic policy regimes across Europe. Reforms will happen once member states realise that they will fail to load excessive costs on competitors. It is possible that some politicians will consider closing off their national markets. But this bluff would be implausible and should be called.

Almost as important is reconsideration of how the eurozone is managed. In its latest Economic Outlook, the Organisation for Economic Co-operation and Development states, bluntly and rightly, that "the case for easing the monetary stance in the euro area looks indeed rather compelling". It is becoming increasingly evident that the monetary policy doctrine is an obstacle to good performance and even to fiscal stability.

The eurozone has, according to the OECD, tightened rather than loosened its cyclically adjusted fiscal balance, from a deficit of 2.4 per cent of gross domestic product in 2001 to one of only 2 per cent in 2004. Thus the principal reason for the consistent failure to achieve fiscal objectives is weak growth (see chart). Behind that, at least in part, lies an insufficiently aggressive monetary policy. The growth of nominal GDP has simply been inadequate (see chart).

It is desperately hard for politicians to promote painful reforms and tighten fiscal policy when they can expect no monetary policy response. The ECB should adopt a symmetrical target for inflation. Ideally, it should also be higher than 2 per cent, to allow room for needed changes in relative prices, without pushing some countries into outright deflation.

Why is the right response to the rejection of the treaty this apparently narrow focus on economics? My answer is simple. Ordinary people want security and prosperity. What has gone so wrong in contemporary France is the belief that the best way to obtain more of the latter is to legislate more of the former. Europe must try to go round this obstacle by allowing the logic of the market itself to work through internal competition among the different policy regimes. But the ECB can also help by doing whatever it can to secure adequate nominal demand in the eurozone as a whole.

Another round of grand gestures of unity would be futile. Europe has suffered from a surfeit of such gestures. For better or worse, the treaty is dead. Equally clearly, much trouble now lies ahead. But Europe should at least try to deliver durable prosperity to its people in today's challenging world. That will not be easy. But it is essential. Without it, the European project may yet founder.