How To Create A Real European Social Market Economy

Europe’s citizens are torn between the European integration project, which requires market liberalization and competition rules promising greater welfare, and national welfare states, which are the framework for redistributive policies and provide social protection. Yet, the European Union is not averse to social welfare. The European model aims for “a highly competitive social market economy” (art 3, TFEU) but it’s anybody’s guess what that means.

A (not so) Benign Myth

Many commentators such as Fritz Scharpf point to “the asymmetry between policies promoting market efficiencies and policies promoting social protection and equality”. However, attempts to Europeanize social policies are constrained by differences in economic capacities, divergences in national policy preferences and the diversity of national welfare models.

While Europe still promises improved living standards in the poorer countries by raising economic efficiency and allowing individuals to move freely to regions with higher earning potential, European legislation is often seen in rich welfare states as outside interference with cherished national systems, leading to social dumping and lower social standards. However, while the nation state has been the framework for achieving greater social justice, the view that it still guarantees the protection of welfare in Europe has become a benign myth that hides the often destructive effects of national governments protecting the selfish interests of powerful elites.

In defining a European social market economy, it helps to distinguish between competitiveness and competition. Competitiveness is the battle cry of many policy makers, often dressed up in questions like „what kind of bitter medicine is needed to restore the EU’s competitiveness?” They explain Europe’s crisis by macroeconomic imbalances caused by lack of competitiveness in mainly southern member states of the Euro Area. Their remedy then consists in harsh austerity policies with the aim of reducing spending, increasing national savings and improving cost competitiveness, so that current account surpluses serve to repay “national” debt. (It does not always work out that way: for example, unit labour costs have increased in Greece because austerity has lowered GDP by 30 percent since the beginning of the crisis, which has translated into lower productivity.)

The obsession with competitiveness has caused near-fatal damage to the Euro. It is wrong. The fallacy of the argument consists in thinking that a monetary union is some kind of fixed exchange rate system, where countries go bankrupt when they run out of foreign currency. The reality of a monetary union is that no member state can ever “run out of money”, because money is provided by the European Central Bank at equal terms to all banks in the union. Euro debt is no “foreign debt” for member states. What matters for debt sustainability, nationally and individually, is not balanced current accounts between member states, but balanced economic growth in the currency area.

The macroeconomic imbalance theory, with its policy implications for competitiveness, confuses economics with politics. Economically, the currency area is the nation; politically it is not. This is the core of Europe’s crisis. The governments of supposedly “sovereign” states act as they believe their voters wish them to act. But national constituencies only represent a small part of the whole population, while their acts have consequences that affect everyone. Take the resistance of the German government to bailout crisis countries or take the uncoordinated policies of the old Karamanlis and the new Tsipras governments in Greece: they all caused havoc in the financial markets that nearly brought down the Euro (Syriza might still succeed in killing it off if it persists in it sovereignist nationalism). To preserve European welfare, nation states ought to cooperate. But there are reasons why they don’t.

The Whip Of Scarce Money

Competition ought to be distinguished from competitiveness. The Merriam Webster dictionary definition says competition is “the effort of two or more parties acting independently to secure the business of a third party by offering the most favourable terms”. This can be interpreted in two ways. A nasty reading sees competition as the opposite of cooperation when competitors strive for goals that exclude the other and therefore create winners and losers. However, most economists since Adam Smith have recognized competition as a source of prosperity for all, because it lowers monopoly rents, breaks down regional inequalities, fosters innovation, introduces new products into old markets and causes good management. This philosophy has successfully inspired the creation of the single European market. However, competition is not without problems, for it raises issues of social justice, namely who is gaining most and are the losers compensated? In a social market economy, no one ought to become worse off.

If a market economy is based on competition, it must fulfil certain conditions. Most importantly, money must be scarce. In the aggregate this implies that most markets, with the exception of the money market, are “buyers’ markets”: That “the customer is king” means that who has money is in command. To secure business, suppliers must offer “the most favourable terms” and that pushes them to improve the quality of their products and services, increase productivity and raise economic efficiency. Thus, in the long run, the scarcity of money is the whip that generates the sustained improvement of welfare and prosperity.

Democracy v Kleptocracy

While necessary for generating competition, the scarcity of money is not a sufficient condition for a social market economy. Money imposes either/or choices. If I manage to get your order and your money, my competitor will lose out. Money, therefore, creates winners and losers. In theory, losers can be compensated if the system as a whole generates net gains, but that implies that the winners have to give up some of their advantages.

However, in a “free”, unregulated market economy, the winners can successfully resist this redistribution. They become rent-seeking agents who will distort the functioning of the market mechanism. Traditional elites control the state apparatus by setting up extractive institutions in which “small” groups of individuals do their best to exploit the rest of the population. These rent-seeking elites destroy the market system by corrupting officials and creating kleptocrats which serve their interests because they demand less redistribution than the equalized compensation of all losers would require. The extent to which they can do so depends on their power in markets and in politics.

Only the countervailing power of democratic politics can prevent this deterioration of “free” markets into crony capitalism. For democracy is an inclusive institution, in which all citizens have the equal right to participate in the process of decision making, hence in determining the extent of redistribution and compensation. A well-functioning democracy is therefore a source for legitimating market economies.

An Intergovernmental Galaxy

But here is Europe’s problem: while the single market with the single currency will improve wealth creation in the medium and long run, it will also increase inequality and generate winners and losers. Yet, there is no European government that could legitimately compensate the losers of European integration. The awful haggling over net contributions to the EU budget is only one of the visible failures of serving the interests of European citizens who have simultaneously European and national interests.

The European market economy is regulated by an intergovernmental galaxy of national governments and bureaucrats, with a very small “umpire superstructure”: the European Commission. The crux of this governance is that tiny coalitions have veto power to block all initiatives that would force them to give up unfair gains and privileges. These privileges are often anchored in the interests of local elites, although they are usually dressed up as “national interest”. The EU is therefore increasingly behaving as an extractive institution that violates the fundamental norms of justice and fairness.

The integration of the European market is not sustainable in the long run without “inclusive institutions” that can compensate losers in the single market. But if it fails, the benefits of a large market disappear. Small may be beautiful and quaint, but it does not ensure the prosperity and social welfare Europeans are accustomed to. As James Madison recognized already 227 years ago, only a federal government with full democratic control can successfully withstand the pressures from national states which are hijacked by partial interest.

The Fallacy Of Nationalism

The single most important contribution to revive Europe would be starting a wide debate about who are the winners and losers in the single market; who are the extractive elites that resist a fair distribution of advantages and privileges? How is the idea of sovereignty (mis)used as an instrument to protect these elites? What mechanisms must be designed to create a fair system of distributing the net gains from integration? How can one overcome the veto power and “agency capture” of national governments by local pressure groups? The European social market economy – with new institutions – must emerge from these debates. Without them, it will fail.