x Abu Dhabi, UAEMonday 24 July 2017

Despite the debt, don't write off Europe just yet

Emerging markets may salivate at the prospect of taking over, but they will need to get their act together on skilled workforces and trustworthy institutions.

Some European countries will have to default selectively on their debt before the end of decade. Chris Ratcliffe / Bloomberg News
Some European countries will have to default selectively on their debt before the end of decade. Chris Ratcliffe / Bloomberg News

After Greece, Ireland, Portugal and Spain, Italy is now the latest casualty of the euro-zone debt crisis.

The Greek banking system is on the verge of collapse and foreign and domestic capital could leave overnight. British and French treasury officials are quietly preparing for the possibility of a sovereign debt crisis in their countries.

Europe struggles with such high levels of public debt that given the weak level of future growth and the considerable future social security and retirement benefits payments, most southern European countries, including France, will not be able to pay their debt service without borrowing heavily.

A number of European countries will have to default selectively on their debt before the end of decade. Default will imply lower public spending, lower public employment and wages, and higher taxes. Governments will be tempted to protect their companies by resorting to protectionism and distortions of free and fair competition.

So, is this the decline of European economic power?

Europe can survive the debt crisis in the long run if it sustains sufficiently high growth. That can, in turn, generate government revenue through taxation.

In Europe two key long-term assets drive growth: the skill of its workforce and the quality of its legal and institutional environment.

The continent has one of the most educated workforces in the world - and this translates into real economic gains: economists estimate that raising the number of years of education of the overall active population by one year increases productivity per worker by 6 per cent.

The high level of education of the European workforce is also key to innovation and the production of high-quality differentiated goods bought by the upper end of the market, such as cars and luxury products, machinery, planes and high-speed rail.

Europe also has a high-quality legal and institutional environment, with a relatively fairer and more transparent judiciary than in many emerging markets. There, fear of expropriation and substantial institutional uncertainty is hindering prospects for foreign direct investment and economic growth.

One of the most cited examples is the rocky Anglo-Russian partnership between Rosneft and BP.

But there are still significant worries for Europe's long-term growth.

In both dimensions - education and the quality of the legal environment - Europe's governments are under pressure to favour short-term remedies over long-term investments.

Europe's basic education system desperately needs more investment per student and a larger role for private funding. In the UK and in France, about 100,000 students leave school every year without any qualification, thus relying on welfare benefits - publicly funded - or working in low-paying jobs that are most likely to be exposed to international competition. Nevertheless, both countries are cutting expenditures in basic education.

In higher education too, Europe needs more investment per student and a larger role for private funding.

Italian and French universities' international ranking in science is falling year on year. The UK government lifted the cap on university students' tuition fees.

Also, governments in France and Italy are tempted to disrupt free and fair competition in public tenders.

Nicolas Sarkozy, the French president, intervened in the purchase of new carriages for high-speed lines, disgruntled that the national railways chose to buy carriages from a foreign competitor rather than from the local supplier.

The party led by Silvio Berlusconi, the Italian president, erupted in anger when the French group Lactalis attempted a takeover of the Italian group Parmalat.

If European governments do not invest in their educational system, do not preserve their legal and institutional environment, and are forced into default by the debt crisis, Europe's gradual decline will pave the way for the emergence of a new world economic order.

Worryingly for Europe, in some sectors, emerging markets do not rely on European technology any more: the latest high-speed train carriages connecting Beijing and Shanghai do not come from European design offices.

Airbus and Boeing are not the aircraft industry's sole players any more on the mid-sized jets sector.

The most pressing issue for many emerging markets is the quality of their legal and institutional environment.

A highly predictable legal system, with low levels of corruption, and the legal enforcement of property rights, where companies can reasonably count on the rules of the market rather than on government interference and cronyism, is the key to economic development.

Timothy Besley, a professor at the London School of Economics, highlighted the role of property rights as the key to long-term economic development in an address to the European Economic Association.

Ilian Mihov and Antonio Fatas at Insead have shown a strong link between growth and economic and political institutions.

Without significant improvement in the skill of their workforces, and improvements in their legal and institutional environments, emerging markets will not be able to seize the opportunity of the European debt crisis to leverage their growth and capture new markets.

The sovereign debt crisis could just be a transitory episode in Europe's economic history.

Amine Ouazad is the assistant professor of economics and political science at Insead business school