Europe's mechanical crisis

My wife and I recently returned to America after living in Spain, where I was a visiting professor at Carlos III University in Madrid. We lived in a vibrant, multi-ethnic neighborhood within walking distance of Madrid's famous museums. Nightlife swirled on our street -- dinner didn't get going until 9 p.m.

Madrid is a safe, civil city. The crime rate is low. People enjoy life, and they live three years longer than Americans, on average.

Yet anyone who follows the news knows that things are not going well in Spain, and in Europe more generally. European countries are burdened by debt, with Portugal, Ireland, and Greece either insolvent or nearly so.

English students are protesting higher college tuition; French workers marched in the streets when the government raised the retirement age, and Spanish air traffic controllers shut down every airport in the country with an unauthorized strike. Most of the protests have been peaceful, but not all.

Such unsettling events raise big questions: What is the future of Europe? Can the continent compete in the global economy? Can its vaunted welfare state survive? Can Europe maintain a civil society?

The search for answers has to begin by recognizing Europe's many strengths. One is a highly educated population. More than half of Europeans (56 percent) can converse in a language other than their mother tongue. Many speak three languages. Contrast that with the United States, where, unless you or your parents are immigrants, you probably speak only English.

Second, European companies are leaders in key industries that rely heavily on developing and applying technology, a perfect fit with that well-educated workforce.

Airbus, a consortium of European defense and aerospace companies with government backing, overtook Boeing in 2003 as the world's leading producer of jet airliners.

High-speed trains are another example. While America dithers, Spain has built the largest high-speed rail system in Europe, with 2,056 kilometers of track reaching major cities from Madrid.

We walked from our apartment to the Atocha station and took the train 535 kilometers to Seville in 2 hours, 20 minutes (top speed: a blinding 391 kilometers per hour). France and Germany also are leaders in high-speed rail.

All that said, Europe also has weaknesses. Foremost is an imploding population that threatens the comfortable welfare states to which Europeans are accustomed.

Among the major European countries, only France and England have fertility rates (the number of children born per woman) that approach the replacement rate of about 2.05. If women have fewer children than that, barring net immigration, a population will shrink.

More threatening, the age distribution of the population will shift upward, with the most numerous group becoming people older than 80.

Given these pressures, it is inconceivable that European welfare states can survive. Change is already in the works, with the retirement age increasing from 65 to 67 in Spain and Germany.

French workers will have to toil until age 62 instead of 60 for partial benefits and 67 instead of 65 for full benefits -- the same retirement ages as in the United States.

Immigration could provide some relief, but European countries have been hostile to immigrants. This has been attributed to prejudice against Muslims, who comprise many of the continent's immigrants. There is some truth to this claim, but the problem runs deeper.

Prior to World War II, many European nations had polyglot populations of different nationalities and ethnicities. The war changed that. In his monumental book "Postwar," historian Tony Judt explains how, through a combination of forced migration and genocide, the war made European countries more homogenous -- and, as a result, less welcoming to immigrants.

Most were Spanish speakers from poor countries in South America. They were Catholic as well, so they fit in. Spain is lucky to have them working and paying taxes to support Spanish retirees.

Europe's second big weakness is its inefficient labor markets. Workers are organized in "guilds," with pay and positions protected by law or union contracts. Unions in key sectors like transportation can hold whole countries hostage.

Labor laws make it extremely difficult to lay off workers. In Spain, laid-off workers are entitled to 33 days of severance pay for each year worked (this was recently reduced from 45 days).

As a result, about 90 percent of workers are hired on temporary contracts with few benefits and little hope of advancement. The unemployment rate among workers under age 25 is a staggering 44 percent.

Europe's third major weakness lies in the economic policies of its constituent countries. The origins of the problem lie not in the depressing present, but in the aftermath of World War II, when the victorious western allies embarked on a grand strategy with a singular goal -- to ensure that Germany would never again start a catastrophic war.

The strategy has been spectacularly successful. Western Europe has enjoyed 65 years of peace and prosperity. One can travel across Europe today without a passport and without changing money. But the economic policies of European countries have not kept pace with the integration of their economies.

Back in the old days, European governments printed money to cover chronic budget deficits. Inflation would reduce the real costs of government debt, and currency devaluation would lead to more exports and fewer imports, which tended to grow the economy. Meanwhile, lenders demanded higher interest rates under these circumstances.

The adoption of a common currency, and the European Stability and Growth Pact, supposedly changed the old way of doing things. The European Central Bank, with strong guidance from Germany, was placed in charge of monetary policy, with the goal of maintaining inflation at 2 percent or less per year.

Signatory countries agreed to control their fiscal policies, with pledges to keep annual deficits below 3 percent of gross domestic product and national debt below 60 percent of gross domestic product. As a result, countries had stellar credit ratings and could borrow at low interest rates.

However, there was no mechanism to enforce those pledges. The debt-to-GDP ratio across the whole European Union (EU) jumped to 73 percent in 2009, with Ireland and Portugal over 90 percent and Greece and Belgium over 100 percent. A problem known as "government moral hazard" was rampant.

Sooner or later, the party had to end, and it did. Interest rates in weaker economies have soared, to the point where Spain and Italy are struggling to refinance their debts. Unless the European Union can control government moral hazard, the euro currency area and possibly the EU itself will collapse.

Like many other economists, I think the only solution is fiscal integration -- the culmination of postwar policy leading toward a United Europe.

The moral of this story is that if you want to borrow like Germany, you have to act like Germany. If European integration comes to pass, Germany will play the central role, because it has the largest economy and the strongest fiscal policy.

Ironically, the very strategy that aimed to prevent Germany from starting another war of conquest may ensure that Germany becomes the future leader of a United Europe.

The most difficult question is whether Europe can maintain a civil society. There are troubling signs, like the rise of right-wing political parties and anti-immigrant laws. However, there are also positive signs, especially in Spain, where protests against the dismal economic situation have been peaceful and democratic.

Somehow, I think they will muddle through the crisis.

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