EU Has Major Challenges to Confront

In a column for the business daily the Australian Financial Review, Senior Fellow Nicolas Véron describes the successes and follies of the European Union in the aftermath of the crisis and warns of the many challenges that await the EU. These include a restructuring of the banking industry and the creation of cross-border co-ordination mechanisms; the establishment of a clear framework to address the possibility of sovereign default from member states; and a closing of the gaps in the EU institutions' democratic accountability in order to make fiscal federalism a possibility.

European nations used to dominate the world, and no longer do. The European Union, ostensibly created to avoid new wars, can also be seen as a device to remain globally relevant by pooling resources.

Jean Monnet, the entrepreneurial father of the EU, declared in 1954 that "our [European] countries have become too small for the world of now, scaled against the means of modern technology, compared today with the US and Russia, and tomorrow with China and India" - almost half a century before anybody started speaking of the BRIC (Brazil, Russia, India and China).

Since its humble beginnings in 1950 as an effort to organise coal and steel markets, the EU has been a spectacular success, probably the largest expansion in history of a political and legal system without military means of conquest.

But until 2007, its rise had coincided with a period of almost uninterrupted economic expansion. The current financial and economic turmoil therefore is an unprecedented test of the EU's resilience as a framework for collective action and ultimately of its usefulness to improve the welfare of its citizens.

On the face of it, the EU's performance in the crisis has been mixed. European banks were collectively found carrying much of the US sub-prime housing risk. Supervision proved inadequate in early cases of bank failures, such as IKB and Sachsen LB in Germany or Northern Rock in Britain.

When the market meltdown hit Europe's shores in late September 2008, the spectacle of European governments failing to build a common front contributed to the spiral of panic.

Economic nationalism against the common EU interest appeared to flourish, for example when Germany gave preferred taxpayer support to a bid on car maker Opel that would protect jobs in German plants to the detriment of those elsewhere in Europe.

The European institutions seemed either absent, as the European Commission failed to take a lead on regulatory reform, or fixated on sideshows, as with the European Parliament's questionable crusade against private equity and hedge funds. Conversely, if the noise from the headlines is filtered, a number of striking policy successes emerge.

First, the credibility of the European Central Bank, a young institution created in 1998, was enhanced by its surprisingly bold and decisive response to successive emergencies.

Second, in mid-October 2008, EU leaders managed, after two weeks of cacophony, to put a show of unity for their short-term crisis response, which contributed to stopping the market crash not only in Europe but globally as well.

Third, Europeans accepted the transfer of primacy for international economic policy co-ordination from the Group of 7/Group of 8, where they were numerically dominant, to the Group of 20 leading economies, thus helping to shape a more balanced global governance framework.

Fourth, targeted policy efforts succeeded to avert macro-economic disruption in central and eastern Europe in 2009, even as the dominant view a year ago was of an impending contagion similar to Asia in 1998.

Fifth, vigorous action by the European Commission's competition directorate maintained discipline to prevent state aid provided to "national champions" from irreparably distorting the single market, including in the Opel case.

Sixth, following the report of a group led by former central banker Jacques de Larosiere in February, the EU is committed to building supranational financial authorities that should play key roles in making its cross-border financial integration sustainable.

These are no small achievements, and surprised many sceptics. Even so, the challenges ahead are large enough to break the EU. The banking system has not been restructured and restored to normal and a severe lack of transparency as to where losses are located risks putting a long-term, Japanese-lost-decade-style drag on the entire EU economy.

Meanwhile, there is no credible co-ordination mechanism to address a major cross-border banking collapse. The fiscal situation of some member states is dire, Greece most spectacularly, and the absence of a clear framework to address a sovereign default in the euro area compounds market jitters.

Europe's policymaking machinery, reasonably equipped to implement long-standing policies, does not perform well when it comes to inventing new ways to address unprecedented challenges. The gaps in the EU institutions' democratic accountability make fiscal federalism a non-starter for the foreseeable future, severely restraining the range of available policy options.

Altogether, it is too early to make a definitive assessment of how Europe is passing the crisis test. A failure of the EU would mean more instability globally. Conversely, EU successes may provide useful ideas for others, at regional level such as in east Asia and also at the global scale. Monnet reportedly believed that the methods he championed could have unlimited reach and the conclusion of his memoirs is that European integration may be a laboratory for new ways of organising public action in the rest of the world. Europe is no longer the centre of the global economy, but what will happen there in 2010 does not matter only to Europeans.

Nicolas Veron is a senior fellow at Brussels-based think tank Bruegel and a visiting fellow at the Peterson Institute for International Economics.