Atlantic Council

The broadening cracks in the European economic framework now appear to be undermining the whole European structure, as if a ‘contagion’ is spreading from the Southern European economies outwards.

As the most serious challenge to Europe since the end of WWII, the actual policy decisions that result will likely be too little and too late to make a difference.

The risk to the future of European currency is further aggravated by the fact that too many different strategies continue to be under serious consideration. This lack of consensus and decisiveness does not sit well for the future of the euro zone.

In considering historical examples that might serve as a guiding light out of the current quandary, it might seem ironic that perhaps the best example is found in the original European project itself. At the end of WWII, Europe was devastated economically, politically and socially. From the seemingly impossible emerged the political will and determination to overcome extreme forms of nationalism and create a federation of Europe.

While the roots of the European project were political in nature, its goals were economic. Indeed, the first move was to revitalize the whole of the European economy at the time, starting with the coal and steel community. That was More than 60 years ago. While the EU has modernized and expanded in ways that its founders may not have envisioned, the architecture that underpins the Union has not adapted to the realities of a globalized twenty-first century.

Institutional Makeover

According to Christian Noyer, France’s central bank governor and a governing council member of the European Central Bank, “We are now looking at a true financial crisis–that is a broad-based disruption in financial markets.” While the halls of Brussels are full of talk of treaty changes that would create more power over euro zone countries’ budgets, these changes would likely require a lengthy political reckoning in all member states. Markets will not give the EU this luxury of time. An appearance of democratic legitimacy is important, thus the treaty convention process could begin while a short-term immediate plan is put in place.

However, there is one member country, whose position is key for how the crisis developed and where it is going–Germany. In order for China and others to consider investing in new IMF measures it must first see that the euro zone’s own members, namely Germany, cannot do more. This has not happened.

Germany must in effect be willing to put all of the distressed euro zone economies on its balance sheet and pay to keep them afloat. The German position is that any such option would be contingent on first addressing the issue of a true fiscal union, where fiscal discipline is enforced in a manner that does not undermine the efforts to save the Euro.

A New Framework for the Future

The roots of the economic problems of the euro zone lie ultimately in the structural imbalances at the heart of the EU. While the severe macro-economic disparities are at the center of the crisis, Europe’s structural imbalances are also on political, economic, and social terms. European economies have been overwhelmed by increasingly unrealistic expectations about the role of governments. In this regard, leaders could choose to address the fact that the current socio-economic model is unsustainable. As Cato Institute economist Jagadeesh Gokhale finds, the average European country would need to set aside 8 percent of its economic output each year in order to fully finance future pension obligations. This is, quite simply, a practical impossibility.

Even prior to the current crisis, Europe’s unfunded pension liabilities averaged about 285 percent of GDP. Richard Disney of the University of Knottingham calculates that if social policies are kept unchanged, tax hikes of as much as 5 to 15 percentage points will be necessary over the next couple of decades merely to avoid the rate of indebtedness increasing any further. One alternative is for increased government intervention in the market, coupled with increased tax revenues and spending cuts, further straining already weak government budgets. It is impossible for Europe to tax its way back to growth. From where, then, would growth come?

“Creative Destruction”

A different way forward would be to implement the changes that would allow an increase in European productivity. Europe’s ‘productivity gap’ has been the subject of much debate during the past 20 years. Greece is not the only country with productivity and competitiveness challenges. Europe’s overall per capita GDP is 24 percent lower than that of the United States, a gap that amounts to a total of $4.5 trillion in annual income.

To address this gap, the European business community has long called for a genuine framework that promotes innovation, productivity and entrepreneurialism. And, according to the Organization for Economic Cooperation and Development, an important mechanism that drives innovation and productivity gains is “creative destruction.” This is the process by which new firms and technologies revolutionize the economic structure from within and those that don’t innovate are forced out.

Instead of incentivizing the private sector so, governments without realistic sources of income and growth have been determined to spend their way out of recession. Realizing that this option is no longer viable, EU leaders could implement measures, such as a revamping of its painfully rigid labor market, to ignite entrepreneurship, innovation, productivity, and growth.

In effect, we are all Europeans now, as the euro zone crisis threatens global economic security and threatens to evolve into a renewed global economic crisis. Witnessing its slowest growth since 2009, China recognizes that a healthy Europe is important for its own well being. China’s move to cut its reserve requirements for the first time in three years shows that it has not completely turned its back on the rest of the world.

This is even more true for the United States. The interconnectedness of the Transatlantic market means that when a European bank is pinched, a bank in the U.S. flinches. The U.S. has its own economic problems that are compounded by a lack of political will from all corners. For Europe, and the rest of the world, the changes required will be painful. Ultimately, this means rebuilding Europe from the bottom up and laying the foundation for a new era of European growth.

Alexander Mirtchev is President of the Royal United Services Institute for Defence and Security Studies (RUSI) International, President of Krull Corp., and a member of the Atlantic Council's Board of Directors and Strategic Advisors Group. This commentary was originally published on Forbes.