Wonderland or wasteland? Waving or drowning? What fate awaits those doing business in Europe in the 21st century?
It is the year 2020, and Europe has recorded another year of rapid growth alongside low inflation. The European Union, which stretches from Madrid to Moscow, is an extraordinary success, the envy of the Americas and of Asia. Strange to think that people used to worry about the potential economic dominance of the tiger economies and China. The euro has become the world's most sought-after currency, with its 25 constituent countries, and is gradually replacing the dollar in international reserve holdings. For European business, with its vast single market and economic and financial stability, the 21st century is turning out to be an era of unparalleled prosperity.
Far-fetched? Well how about this? It is 2020 and the leaders of Germany and France refuse to admit other countries into the single currency, on the grounds that it would be highly destabilising in the financial markets. A small core of countries - Germany, France, Belgium, the Netherlands, Luxembourg and Austria - have already moved forward to monetary union (albeit after a somewhat difficult birth) and now Europe has been increasingly divided between these prosperous 'insiders' and a large group of resentful 'outsiders'. Outside the core countries, which attract virtually all the inward investment coming into Europe, there is stagnation. With the Spanish peseta and Italian lira falling sharply against the euro, France imposes protectionist measures, which effectively kills off the single market. Hence there develops a mini Fortress Europe, anxious to protect its domestic markets.
Still not right? OK, it is 2020 and unemployment is 20% to 30% of the workforce. People are looking with nostalgia back to the time when unemployment rates of 11% or 12% in Europe were considered high. European business has become chronically uncompetitive, weighed down by high social costs and excessive taxation. Europe has become an economic backwater, and those living on the continent cast their envious eyes upon the dominant Asia-Pacific region.
Crystal ball gazing can be fun, but for every business in Britain, the future economic climate of Europe in the 21st century is a deadly serious issue. But how should one judge between competing visions, particularly when, in the case of Britain, the future of Europe has become such a fevered political issue? The answer is to set out a series of scenarios, each internally consistent but each implying a very different 21st century story, before attaching some probability ratings to them.
In this most optimistic of scenarios, European economic growth accelerates to a rate of between 3.5% and 4% a year (roughly double recent annual rates), without pushing up inflation in the process. A series of favourable factors come into play - the opening-up of eastern Europe, the completion of the single market and the eventual adoption, by most member states, of the single currency. The last of these cuts transaction costs, increases financial stability and lowers average European interest rates significantly. Faster growth provides a stable environment in which Europe tackles its competitiveness problems, including inflexible labour markets.
The key to this optimistic scenario is, of course, the single currency. Separate currencies are, in effect, the final big barrier to trade within Europe. As countries adopt the euro, so those other aspects of the single market yet to be completed fall into place. A virtuous circle is created, in which an initial period of faster growth encourages member states to be less protectionist, and in which industrial restructuring and measures to increase job market flexibility, painful in a period of economic stagnation, can be implemented relatively painlessly.
Is it asking too much of the single currency, and the modest gains from lower transaction costs that it will usher in (usually calculated to be 0.3% to 0.4% of gross domestic product) to put Europe on the road to economic nirvana? If transaction costs were the only potential gain, it certainly would be. But there will also be significant gains in the form of lower interest rates for all participating countries, simply through exchanging higher, risk-affected, national interest rates for a common European rate - an averaging down of rates.
Another potential benefit is that Germany's current high interest rates and increased budget deficit bought about by unification will fade away as the economic impact of unification is absorbed. Christopher Taylor, a former senior adviser to the Bank of England on Europe, estimates that the combined impact of averaging down and fading costs of unification could be to reduce real interest rates in Europe by between 1% and 1.5%, with consequent, highly significant, growth benefits.
There are other Renaissance effects. In 1989, when the Berlin Wall came down many predicted substantial economic benefits for both eastern and western Europe. In fact, it has been a slower process than was thought. Now, however, in nations like the Czech Republic, economic reforms are starting to bear fruit, and a recovery pattern is emerging. Think of a single market, not just of 370 million people but of as many as 500 million people as eastern Europe is assimilated. And in this rosiest of outlooks, we stop fearing the Asian countries, be they the smaller tiger economies or China. The American economist Paul Krugman points out that growth in these economies will slow from its present breakneck pace and, more importantly, that there is nothing miraculous about their current pace of development.
In this golden scenario, Europe's renaissance will be clear to all. Europe confirms its place at the hub of the world economy - rich, politically stable and the largest and most vibrant single market in the world. Opportunities for new business alliances abound, partly based around liberalised telecommunications and transport systems and widespread opportunities for exploiting economies of scale. The forces of comparative advantage will exert themselves, leading to greater specialisation within countries, although this will mean dropping out of certain industries altogether. Britain will be able to exploit its comparative advantage in financial services and pharmaceuticals, Germany in mechanical engineering and capital goods, Italy in designer luxury goods, and so on. The key is that specialisation and rationalisation will occur in an environment of expanding employment and opportunity, minimising any adverse consequences. The Renaissance scenario, in which everything that could go right for Europe does so, is probably too good to be true, however, though not impossible. Mature economic groupings do not tend to double their growth rate on a sustained basis.
Scenario probability: 10%
In this still generally optimistic scenario, Europe gains from the growth of world trade, despite the gradual loss of market share to the emerging economies of Asia. The growth of world trade is fast enough to compensate for Europe's slowly declining share. The single market is gradually completed and the single currency extends its reach step by step, beyond the initial core countries which join at the outset. Closer integration, and the absence of internal and external shocks, lifts sustainable European growth to just above 2.5% a year. However, European integration continues to be economically-driven, with member states balking at any attempt to force through big bang moves towards political union.
In 2020, the western industrial countries import in far greater quantities from the Asian region. The traffic, however, is not one-way. Growth in exports to Asia from the older western economies matches the rise in imports. The emerging economies of Asia may be highly competitive producers, but they are also consumers.
Average labour costs are brought down by the gradual integration of the former centrally-planned economies of eastern Europe into the trading and production system of western Europe. Even allowing for lower productivity levels, wages in Poland, the Czech Republic, Hungary and the other former Soviet bloc countries are a fraction of those in the west. With GDP per head, expressed in dollar terms, typically 10% to 15% of the EU average, Europe has its own competitive low-cost producers.
Neither the single market nor the single currency (which only develops slowly beyond an initial core of countries) will bring early and substantial growth gains for Europe. But the absence of internally-generated shocks, such as German unification, and the assumed absence of external shocks such as oil crises, will make a big difference to European growth. This scenario is no growth miracle, but assumes the removal of constraints on growth, some self-inflicted. While it disappoints those who expect to see a European superstate in the 21st century, it reassures those who see the continent as a haven of economic stability.
European business, weighed down for the most part with high social costs and slow-growing domestic markets finds its feet again. The gradual completion of the single market and adoption of the single currency increases the pressure for restructuring and, unlike the first scenario, some of this proves painful in its employment consequences. Gradually, however, the exploitation of comparative advantage, the expansion of the EU and the realisation that Asia will not claim all Europe's markets, home or overseas, will promote a better business environment. conditions in the home market are very tough, but European corporations find they are able to respond to the challenge.
The Muddling Through scenario most certainly does not mean that nothing changes. Instead, Europe moves roughly halfway between the super-integrationists and those who would like to stop the process in its tracks. It also assumes, with some justification, that some of the present gloom over Europe's prospects is overdone, as it has been on previous occasions this century.
Scenario probability: 35%
In this gloomier scenario, monetary union proves to be a defining moment in the history of Europe, and of European integration - but for the wrong reasons. A small number of core countries move ahead to the single currency, built around five of the original six - France, Germany and the Benelux countries. This does not, however, pave the way for an extended EMU, taking in other EU states. Instead, monetary union becomes an exclusive club for the core countries, who are able to attract inward investment on the basis of their economic and political stability. After failing to enter in the first wave, other countries diverge economically from the core, and are unable to negotiate the hurdles for subsequent entry. In Italy, the ignominy of exclusion leads indirectly to increased pressure for a breakaway by the rich north from the poor south. In Britain, permanently confined to the EU's fringes, Eurosceptical pressure to leave the EU grows. EMU, rather than uniting Europe, splits it irrevocably.
The idea of a multi-speed Europe, within which some countries move faster to integration than others, is well-established. The single currency is, however, different. Those countries that moved ahead initially enjoyed the interest rate benefits, albeit with the requirement to pursue strict budgetary policies. But those, like Italy, Spain and Portugal, who failed to make it into the first wave witnessed their currencies fall. Instead of continuing to converge with the core EMU countries, their economic performance starts to diverge, moving them further and further away from the prospect of joining the single currency.
Now consider the response of, for example, French industrialists to this situation. Fearful of being undercut, they press for new barriers to trade against these outsiders. The Treaty of Rome, as amended at Maastricht, allows such barriers in the face of 'temporary' balance of payments difficulties. The core countries not only have the single currency to themselves but they also become a mini Fortress Europe. The single market is seriously, perhaps irreversibly, compromised. Many other countries, including the new EU entrants from eastern Europe, are adrift and distant from it.
For business, operating within an 'insider-outsider' Europe will at best prove unsatisfactory and at worst impossible. The benefits of the core economies - an integrated market, a single currency and high living standards - will be obvious. Business, however, will be torn between the access advantages of directing investment towards the core economies and the lower costs of other European locations.
This will, above all, be a Europe of great uncertainty. Uncertainty about trade liberalisation, with the ever-present threat that the core economies will establish their own de facto single market, and uncertainty about the extent to which eastern Europe, for example, can maintain its reform process without the carrot of a realistic prospect of benefits from EU entry. The spur for restructuring and improving competitiveness will remain powerfully driven by competition from outside Europe, but combined as it will be with persistent mass unemployment in the outsider economies, government and business leaders will find themselves deeply unpopular.
This scenario is a major worry for those companies which fear being left behind. And while it is both economically undesirable and politically dangerous, it is also perfectly possible.
Scenario probability: 25%
The Dark Ages
In this scenario, Europe's slow growth of the 1990s is not a consequence of temporary factors - it is the new reality. EMU reinforces rather than suppresses Europe's sclerotic tendencies, before other forces condemning the continent to a grim future - mainly the burden of ageing populations - come into play. EMU, in these circumstances, doesn't last, but there is no economic liberation for Europe from a return to flexible exchange rates - it is too late. As average unemployment in Europe climbs towards 30%, EU countries adopt protectionist measures to try to protect their remaining industries, only exacerbating the problem in doing so. Far from becoming a cohesive, united force, the EU fails to survive as a free trade area, even within the core.
The basis of this scenario is that Europe in the 1990s is fundamentally uncompetitive, beset with high taxation, inflexible labour markets and a loss of business dynamism. The future, far from ameliorating these disadvantages, sees them becoming reinforced. In particular, EMU does not bring forward more rapid growth because the European central bank, in its attempt to invest the single currency with credibility, is forced to pursue tight monetary policies. Not only that, but the EMU stability pact forces member countries to maintain tough budgetary discipline. The slower economic growth in Europe (and thus the higher unemployment rises), the harsher the action needed to keep budget deficits to 3% or below of GDP.
Even if this effect lasts only for the first few years of EMU, it will give way to another effect - the need for much higher taxation to finance the burden of ageing populations. Calculations based on OECD data show, for example, that as a percentage of GDP, the cost of funding public pension schemes will rise by between 2% (Britain) and 12% (Austria and the Netherlands). This means, for most countries, current ratios of tax and public spending to GDP will rise from about 50% to nearer 60%. Europe will become a chronically high tax region, with consequent adverse effects on incentives and growth. With the US and Asia the fast-growing regions of the world, Europe becomes, in the words of Jacques Attali, formerly head of the European Bank for Reconstruction and Development, 'a Venetian continent, visited by millions of Asians and Americans, inhabited by tourist guides, museum caretakers and hotelkeepers'.
For European business, the Dark Ages scenario will mean what it suggests - a prolonged period of struggle and retrenchment. All those hopes of a dynamic, integrated European economy will have been dashed, replaced by a series of separate, stagnant markets. The burden of high social costs, far from diminishing, will be exacerbated by the effects of even higher unemployment and ageing populations. Businesses will, of course, look outside Europe for the best opportunities - and shift production to lower-cost regions, thus adding to Europe's difficulties. The problem of this west-to-east shift is that it will bring European business into direct competition against the best of Asian and American companies, which will have the additional advantage of buoyant domestic markets as well as lower costs. High European tax levels will mean that, for many international businesses, even maintaining headquarters in Europe will prove prohibitively expensive. In this declining Europe, business survival may mean emigration.
This scenario assumes that most of the current economic gloom in Europe represents the shape of things to come and that the continent's current sclerosis has happened as a result of fundamental, and largely irreversible, weaknesses. Very gloomy - and probably a little too gloomy for most observers.
Scenario probability: 20%
In this grimmest of visions, the Europe of 2020 is beset with tribal and nationalist tensions. The rest of the world achieves economic dominance over Europe and the rise of Islam and an aggressive China forces European countries to increase defence spending when they can ill afford to do so. EMU fails catastrophically through its imposition of high unemployment on member states and a split in the Franco-German axis.
In fact, EMU imposes high unemployment on both those who take part and the outsiders who are permanently excluded from the core group. EMU also exposes poorly converged economies - with competitive problems for the French economy after a few years in the single currency forcing the break-up of the difficult and ultimately ill-fated EMU experiment. With European integration in reverse, and economic circumstances adverse, the forces of nationalism could come to the fore.
Mass unemployment and its link to the fierce resentment of neighbours has had its dreadful consequences in Europe before in the 21st century. It could do so again. In this scenario, the usual business parameters of markets, tax, means of payment and convertible currencies disappear as Europe splinters. The more tribalistic Europe becomes, the more vulnerable businesses are to asset seizures and other unpredictable losses. In an apocalyptic 21st century, large parts of Europe become business no-go areas.
This scenario is in many ways a mirror image of the Renaissance, one in which everything that can go wrong does go wrong. The fact that it could happen is an obvious concern. But while it is as worrying as the Renaissance scenario is encouraging, it is also as unlikely.
Scenario probability: 10%
Forecasting is a hazardous process. The scenarios here offer a range of possibilities from the highly optimistic to the deeply pessimistic. Of course, there will be nasty shocks and pleasant surprises. Europe's 21st century obviously won't turn out exactly as any of the five possibilities here - real life is always more complicated. But, particularly for business, they give an indication of the parameters involved. One should hope for the best in Europe while thinking about how to respond to the worst.
David Smith is Economics Editor of the Sunday Times. This article is based on his book Eurofutures, published by Capstone.