Europe has a new economic orthodoxy

There was a time, not so long ago, when Italy and Germany were typically seen as opposite poles of the economic debate in the Eurozone. But today there is a remarkable convergence — at least when we consider the leading economic lights of those countries. Specifically, I mean Mario Draghi, former Italian prime minister and European Central Bank president, and the German Council of Economic Experts, an official but independent advisory body. Both are as close to guardians of the European economic orthodoxy as you can get. Both have also recently issued statements that illustrate how much the orthodoxy has moved.

That is welcome news, and the topic of this week’s Free Lunch. Do you agree? Or beg to differ? Either way, write to us at [email protected].

Here are the three most important things these luminaries’ statements tell us about the new European consensus:

1. Wage repression ‘competitiveness’ is dead (and good riddance)

The term “competitiveness” may never disappear from the European economic policy vocabulary, even though it should. But, thankfully, hardly anybody uses it the way they did as recently as 10 to 15 years ago, when it became the slogan for policies designed to lower wages (remember the obsession with “unit labour costs”?). When policymakers mention competitiveness today, they are likely to mean investment, energy costs and incentives for innovation.

And it matters that this shift has been powered by such influential players as Draghi and the GCEE. Draghi last week gave a punchy speech in Coimbra, while the GCEE this week issued its spring report, the first since the incoming German leadership reformed borrowing rules to launch a big fiscal stimulus. In both texts, the once-dominant focus on wage competitiveness is nowhere to be seen.

“Super Mario” chooses his interventions carefully but has become all the more forceful when he does decide to speak publicly. This time, he doubled down on the “Draghi plus” message that listeners took away from the speech he gave in Paris last December (which I wrote about here).

He does not mince words about the scale of the challenge the EU economy faces:

. . . recent events are a break point. The vast use of unilateral actions to settle trade grievances, and the definitive disenfranchisement of the [World Trade Organization], have undermined the multilateral order in a way that is hardly reversible . . . perceptions among industry, workers, politicians and markets have changed from complacency to alarm. The material risks we face to our growth, our social values and our identity, hang over all our decisions. 

We are seeing major institutional ruptures. The political shock from the US is massive.

Draghi asks “why we ended up being in the hands of US consumers to drive our growth”. His answer is a biting indictment of the policies adopted to address the Eurozone sovereign debt crisis (for which, it should be said, he bears some responsibility as part of the European policymaking establishment at the time), and, in particular, cutting domestic demand and focusing on wage reductions rather than productivity.

The GCEE, too, while focusing more narrowly on Germany, laments stagnant economic dynamics and warns against the trade shock coming from the US. What is absent from the experts’ list of recommendations is as important as what they include: the silence on wage competitiveness speaks volumes.

2. Investment, investment, investment

With competitiveness dethroned, investment is now king, and the foundation of the new policy advice trumpeted by both Draghi and the German experts. The GCEE hits straight at the weak point of German Chancellor Friedrich Merz’s new fiscal stimulus package. That package will ostensibly channel new borrowing, exempt from the constitutional debt brake, into defence spending above 1 per cent of GDP and a €500bn fund for infrastructure spending. But in the wonkier eddies of the German economic debate, there are worries that the extra borrowing may simply fill in spending that was already committed in the regular budget, thus freeing up funds for social spending and government consumption.

The GCEE fears this, too, and is crystal clear that if this happens, the fiscal package will not deliver its productivity and growth-enhancing potential (and may also as a result hit up against European budget rules). It calls for stricter mechanisms to ensure that the extra borrowing is used for extra investment.

For Draghi, the need for investment is an argument for common European borrowing and capital markets, to attract the EU’s huge capital exports back into its own economy. It is an argument, too, for breaking down remaining barriers between EU countries so as to generate a positive supply shock that would raise productivity and wages in response to increased domestic demand. And what this implies is a process of thoroughgoing structural change.

3. Incumbent-friendly corporatism has run out of road

European governments have traditionally been protective of their incumbent industry, and one view of the EU’s history is that it was set up as a largely corporatist bloc (though it has by now been fiercely pro-competition for decades, and more so than the US). The classic example of this is, of course, the German car industry, which together with other German manufacturing has both great political weight and accounts for a disproportionate share of investment.

What Draghi’s speeches — and, of course, his influential report from last year — entail, however, is that holding on to past glories will only make Europe’s economic problems worse. Investment boosts, deepening the single market and redirecting demand — all of these are elements of a strategy that will make the world less comfortable for Europe’s established industrial giants precisely by making it more promising for new, innovative activity. Draghi is lucid about this, calling out the vested interests that are resisting change.

It’s gratifying, then, that the GCEE looks this challenge in the eye, and says “bring it on”. Or in its own words:

Industrial, labour market, regional and structural policies can help reduce the adjustment costs of structural change and improve long-term growth prospects, provided they avoid preserving outdated economic structures [my emphasis] . . . Instead of using costly and inefficient subsidies to preserve jobs that are no longer competitive, structural change should be accompanied by targeted labour market policies focused on training, upskilling, and retraining. This may ensure that workers are efficiently reallocated to sectors with better long-term prospects.

There is much more in both analyses than the few elements I have highlighted here. But the overarching point is that the Copernican revolution in the EU’s economic thinking has largely taken place. That is not sufficient for the required policies to take place — though it is necessary. We also need politicians to fully absorb the new lessons, and act accordingly to break down opposition to change from vested interests. That is a political task, and the ball is in political leaders’ court.

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