by Simon Tilford

There has been a lot of anguished talk about how the EU’s single market is under threat. Much of this alarm has focused on government support for struggling car firms and public bail-outs of crisis-ridden banks. An erosion of the EU’s competition rules would be every bit as debilitating as the impact of the financial crisis and the resulting recession. But how serious is the risk to the single market?

On the face of it, there is plenty to worry those who see the single market as key to Europe’s future prosperity. First, any hope that the impact of the financial crisis on the ‘real economy’ would be limited has ended. In the face of huge falls in industrial output this year and the prospect of several years of very weak economic growth, many European industrial firms will go bankrupt. Wage subsidies and short-time working, and all the other strategies currently being employed to cope with the collapse of demand, can only be sustained for so long. Many of the firms that go bust will be fundamentally competitive, or at least appear so. EU governments will be under huge pressure to intervene to protect such companies. The way in which they intervene will be crucial. The Commission will have a real fight on its hands to ensure that competition is not distorted. It should be strong enough to enforce the rules. But much will depend on whether member-state governments support the Commission and on who is appointed to be the next EU commissioners for competition and the internal market.

Second, the landscape of European banking has changed fundamentally over the past year and competition policy in this sector has effectively been suspended. A number of the biggest EU banks have been nationalised in all but name and governments have moved to provide public guarantees for bank loans. The shot gun marriage of Britain’s Lloyds TSB with another high street British bank, Halifax Bank of Scotland (HBOS), has left the combined group controlling around a third of the entire UK market for consumer banking services. The German, Dutch and Belgian governments have bailed out financial institutions, while governments across the EU have recapitalised banks.

The dramatic increase in government influence over the lending process will need to be reversed if potentially serious distortions are to be avoided. There is a risk that pressure will be put on banks to maintain funding for national champions and to avoid lending to companies based in other EU states. Such politicised lending would undermine the efficient allocation of capital throughout the EU by protecting inefficient companies and reducing available funds for more competitive firms. Once the financial sector has stabilised and normal levels of financial intermediation have been restored, the Commission will have to get serious about ensuring that the EU does not retreat into such ‘capital protectionism’.

Third, a further deepening of the single market can be ruled out. Crucially, faster action to liberalise and integrate service sectors across the EU now looks out of the question. It was hard enough to gain consensus in favour of radical moves to dismantle obstacles to the integration of service sectors before the crisis, but it will be impossible in the face of the backlash against liberalisation. This is bad news. Service sectors account for around two-thirds of economic activity across the EU. Service sector productivity has been extremely weak for a number of years now, holding back economic growth. More competition at both national and European level would do much to change this, and boost economic growth.

The lack of service sector integration will be particularly damaging for the eurozone. Countries that decide to forego exchange rate flexibility as a tool of economic adjustment need to ensure that their economies can be flexible in other ways. If countries such as Spain and Italy are to recover their competitiveness within the currency union, they will have to boost their productivity. This, in turn, requires more competition in service industries. The alternative route to greater competitiveness – wage cuts – would condemn their economies to stagnation. And such wage deflation might not be possible in any case, as Germany is heading for deflation. It will be extremely difficult to cut costs relative to Germany, if German costs are falling.

The legal underpinnings of the single market appear robust. But there are real reasons for concern. The steady progress in reducing state-aid has been halted and is likely to be put into reverse. The partial renationalisation of bank lending is inimical to the emergence of a single capital market. And progress towards deepening the single market in services has ground to a halt. All this bodes ill for Europe’s growth prospects and the stability of the eurozone. All EU governments profess to be committed to upholding the single market. The next couple of years will determine the strength of that commitment. If member-states do not respect the Commission’s right to enforce those rules, the single market could indeed come under threat.

Simon Tilford is chief economist at the Centre for European Reform.

by Simon Tilford

The British tend to deride France as a hopelessly statist, anti-entrepreneurial country full of bolshie workers intent on extracting disproportionate rewards for their labour and a state too weak to resist them. This characterisation is not wholly inaccurate. But the implicit (and sometimes explicit) assumption is that the UK is everything that France is not. This is not the case.

In some respects, Britain now looks worse than France. For all its faults, France produces good public services and decent social outcomes, such as relatively low levels of poverty and high overall skills levels. Britain, by contrast, now combines a very big state, patchy public services, generally poor social outcomes and increasing barriers to wealth creation. This is a poisonous mixture. The situation can be rescued, but not without breaking some eggs.

The figures are arresting. Britain has gone from having one of the smallest states in the EU to one of the largest. In 2000, public spending accounted for 37% of GDP in the UK, just three percentage points above the US and a full 15 percentage points below France. By 2010 the OECD estimates that state spending will account for 49% of GDP in Britain, against 53% in France (52% in famously high-spending Sweden). Britain has already overtaken Germany and the Netherlands (44% and 46% respectively).

This unprecedented expansion of the British state would be less of problem if the UK now had Scandinavian (or even French) levels of public services or first-rate physical infrastructure. But improvements in British public services over the last ten years have been nowhere near big enough to justify the increase in expenditure. Most of the money has gone on increased employment and wages, rather than improvements in services. Perhaps unsurprisingly, given the stranglehold that the unions have on the public sector, productivity has stagnated.

It is also notable that Britain’s welfare-state is not comparable to that of Germany or the Netherlands, let alone France or Sweden. Unlike in these countries, many of the ordinary Britons currently losing their jobs will receive only derisory sums in unemployment benefits because these are means-tested. And only a forensic scientist could spot significant improvements in the country’s physical infrastructure. Britain’s roads remain as congested as ever and its railways expensive and unreliable.

Of course, the tax burden in the UK is still lower than in France. In 2008, taxes accounted for 49% of GDP in France compared to just 42% in Britain. But the gap between tax and expenditure in Britain is completely unsustainable, given the parlous state of the country’s public finances. How it is closed will to a large extent determine Britain’s economic prospects. If the gap is bridged by cutting expenditure, the UK stands a chance of returning to a relatively strong growth path. But if it is closed primarily through increased taxes, Britain will have a bleak future. The tax burden will be among the highest in the OECD, but public services (and the country’s social outcomes) will be nowhere near good enough to justify the tax take. In short, Britain will have Scandinavian levels of taxation and American levels of public services and social welfare.

The Labour party is poorly placed to sort out this mess because of its close links to the public sector unions. Under Labour the public sector has become a privileged class that is impervious to change and reform. By way of illustration, public sector wages are currently rising by close to 4% a year at a time of economic crisis. And this despite the fact that public workers are on average better paid than their private sector counterparts and enjoy generous pension entitlements. What about the country’s physical infrastructure? On the government’s forecasts, public investment will halve over the next 4 years. In fact, the only significant cuts the government intends to make are to investment.

The Tories stand a better chance of taking on entrenched public sector vested interests, but it will be a battle. Moreover, they will need to avoid the mistakes of the 1980s when they reduced spending by cutting services and investment rather than by increasing public sector efficiency. If they do this again, UK taxes will remain very high relative to what those taxes deliver in terms of services.

Britain still has strengths, of course. It is straightforward to set up a business in the UK and the labour market remains flexible. But overall Britain looks increasingly like one of the sick men of Europe, and certainly as sick as France. The French state is an efficient provider of services and quasi-state institutions construct and manage first-rate physical infrastructure. France, unlike Britain, has bitten the bullet on public pensions, increasing the retirement age to 65. The French have no qualms about allowing private companies to provide healthcare. Even the Tories do not appear to have the stomach for dismantling the NHS’s near monopoly on the provision of public healthcare.

The British need to get over the idea that they took all the difficult decisions in the 1980s and that Britain is an example for others to follow. It has a huge state, yet has poor social outcomes. Much of its growth in recent years has been down to a turbo-charged financial services industry and an unsustainable expansion of the public sector. Both trends have now run their course and the public sector has become a dead weight on the economy. Britain needs to concentrate on improving the climate for wealth creation. This will require much better public sector productivity and high levels of investment in human capital and physical infrastructure.

Simon Tilford is chief economist at the Centre for European Reform.