Only economic growth can resolve Europe's crisis

It wasn't a good weekend for Europe. Politicians gathered, hoping to "decisively resolve" the crisis facing the continent. The big idea was to create a super sized bailout fund. Bond investors were going to be shocked at the amount of resources to back-stop EU economies and rediscover that old desire to buy Italian and Spanish bonds with yields similar to those offered on German bonds.

The press releases were ready to go, but the big breakthrough didn't arrive. No one could find a magic wand and conjure up €2 trillion from €440 billion.

Rather than spend their time concocting incredible schemes of financial engineering, EU politicians would have found it more profitable to seriously ponder Europe's most pressing difficulty - a lack of growth.


For at least three decades Europe has grown more slowly than its competitors in North America and Asia. Occasionally, a brave soul would come forward and articulate the causes of this lack of growth. European economies are over regulated, which has built up daunting barriers to innovation and investment. Welfare systems are overly generous and spawned a pernicious web of disincentives, permitting early retirement, discouraging work and encouraging idleness.

This catastrophic collection of misguided policies is what Frenchified politicians call the European social model. It is built upon extremely high levels of public expenditure. To pay for this extravagance, Europeans have faced some of the highest tax rates in the world. Despite oppressive tax regimes, many European governments have failed to balance their books. Expenditures were invariably higher the revenues, leaving large fiscal deficits.

To meet the shortfall of taxes relative to expenditure, governments have gone to the bond market and issued debt. Debt levels have been crawling upwards since the early 1970s. Periodically, governments have gone through a familiar cycle of trying to reduce indebtedness, only to retreat as the social costs of adjustment created loud protests and the formless menace of electoral ruin.

It is not just the public sector that has fallen into the trap of borrowing to pay for current expenditure. That celebrated lack growth also translated into stagnant living standards. Rather than acknowledge this reality, many European households borrowed to preserve high consumption levels. As a consequence, household sector debt in many countries has risen spectacularly.

Banks have been the great facilitator in this colossal increase in borrowing. Banks bought those dodgy European bonds, and extended a massive wave of credit to households. Capital buffers were reduced, dubious enterprises were financed, and the end result was a proliferation of weak and over-extended banks.

After three decades of studiously piling up debt, Europe now has to face the consequences. Five countries in the euro zone - Italy, Spain, Greece, Ireland, and Portugal - are finding impossible to fund their fiscal deficits. At least one government, Greece, will default on its public debt. Naturally, bondholders are reluctant to support borrowers who are unlikely to repay their debts. A debt default would shatter Europe's vulnerable financial system. Bank balance sheets are already weak, while bank capital buffers are inadequate.

As the continent confronts a two-pronged crisis, European politicians remain wedded to a dangerous idea. They believe that the Continent's problems could be resolved by a temporary infusion of cash. At the moment, Europe has available about €440 billion in its bailout fund - the EFSF. Unfortunately, this fund is too small to simultaneously deal with Europe's fiscal crisis and recapitalize its ailing banking system.

Some European politicians would like the European Central bank to step up and fund European fiscal deficits. However, the treaty the established the ECB explicitly forbids the bank from providing liquidity to governments. So the search continues for an untapped source of cash that will permit governments to continue spending more than they generate in revenues.

It is the inability to grow that lies at the heart of this crisis. Ironically, the high levels of debt and weakened banking system would not matter much if economies were growing rapidly. With strong growth, tax revenues would increase, and debt to GDP ratios would fall rapidly. Bank balance sheets could recover, borrowers could repay their debts, and banks could accumulate capital buffers.

European politicians are a cowardly bunch. They have been unwilling to confront the causes of stagnant growth. They have taken the seemingly easier route and look for cash to in a futile effort to maintain high government expenditure, excessive regulation, and bloated welfare systems.

Nevertheless, this crisis is telling politicians that the old way of doing things has reached a terminal point. The European social model can no longer continue. Unfortunately, a breakthrough will only come when European politicians forget about short-term "decisive plans" and seriously begin to deregulate their economies and downsize welfare systems.

It is growth and not cash that will ultimately provide a solution to Europe’s problems.