Europe has a supply side problem.

• Author: Smick, David M.
• Position: AN EXCLUSIVE INTERVIEW - Interview

In July, TIE founder and editor David M. Smick sat down with Axel Weber, former Bundesbank president and chairman of the board of UBS

Smick: Who would have thought we'd be sitting here talking about French political instability and Italian debt instead of the problems in Spain, Portugal, and Greece? This is a crucial point for the eurozone. Is the goal of fiscal reform lost forever? Where is this all going?

Weber: I hope the eurozone will continue to explore possible ways to bring down debt. The old debt problems are still out there. The biggest problem of the eurozone--anemic growth--is still there. Without major reforms, eurozone economic growth will not improve in the medium to long term. The European Central Bank did a good job in suppressing tail risks, but maybe they did a too-good job. Governments lack the necessary incentives and market pressure to enact full-fledged reforms.

The ECB should allow for more pressure on governments by limiting the scope of its own action so that governments have to come in and supplement monetary policy with more prudent fiscal policy reforms that help lift the long-term growth potential. We knew problems existed in some peripheral countries such as Portugal and Spain. But problems have moved closer to the core, with anemic growth for more than a decade in countries such as Italy, where output is even below the level it dropped to at the beginning of the financial crisis. Actually, Italian GDP is back at the level of the year 2000.

Politicians may see the need for reforms but find it very hard to enact them. Thus, the ECB should keep the incentives in place for reform rather than buy time and allow politicians to postpone doing what is necessary.

Smick: According to the Financial Times, with the European Parliament becoming so powerful, we're in uncharted territory with the European fiscal situation. Are we in a dangerous situation?

Weber: "Uncharted territory" is too benign a term. We are going through a major crisis and are in a transition with heightened uncertainty. The European election has increased the centrifugal forces in Europe, since parties that are focused on national interests and national politics now control a larger share of the vote. Therefore, while the conservative parties still are the largest fraction, both social democratic and conservative groups amount to just about two-thirds of the vote. On some issues, only a grand coalition between them will be able to move Europe forward.

The Commission is also in transition. We will only know later in the year who will hold office as the next commissioners.

So there is a weakness at the core of Europe. Of the three central powers in Europe--the Commission, the Parliament, and the ECB--at this stage the ECB is the only fully functioning European institution. We will likely come out of the process with a weaker European Parliament and Commission, with the ECB potentially continuing to be seen as the one institution that can change the fate of Europe.

At the core, European institutions are going to be weakened again over the next electoral cycle, and key decision powers will still rest with the European Council--the heads of state. That has the potential to distract European politics away from an integrated European agenda and toward an agenda driven by the issues of individual nations.

In the United Kingdom, we will even see a proposed referendum on membership in the European Union. That has repercussions on the room to maneuver for the British government, which additionally faces a referendum on Scotland's membership in the United Kingdom. This in turn limits the scope for Spain and other governments to move on concessions toward the United Kingdom.

We are in a fragile situation in the sense that the momentum towards a more integrated Europe is clearly undermined by these recent developments. There are more federalist dynamics now in Europe that will definitely gain traction and will make life difficult for at least two European institutions--the Commission and the European Parliament, let alone the European Council.

Smick: The Scottish referendum is an interesting development. Do you think there could be a corresponding bank-shot effect on Spain? Could a similar situation develop in that country with the Catalans or the Basques? The implications of such a development would be enormous.

Weber: There is definitely the risk that separatist movements which have existed in many nation-states in Europe could come to the fore if a given nation-state were seen to split. At the moment, it is hard to see how this can be done within the rules that Europe has given itself. But clearly it will be an issue in Spain and some other autonomous regions that are looking for more independence from central government.

The bigger challenge is dissolving the currency union that exists with the British pound. The Scottish referendum in itself is a challenge to the Conservative government in the United Kingdom. It limits the room to maneuver for the Conservatives. On the one side are the demands by the separatist movement in Scotland, and on the other the continental calls for more integration within the European Union. Most likely the United Kingdom will shift somewhat further from continental dynamics and try to find a middle ground.

Europe is increasingly taking majority decisions. There were issues on which the United Kingdom was outvoted by continental European countries that have the euro as a common currency and need a different degree of integration among themselves. It will be very hard for the European Union to navigate between a more centralized currency union with more integration, and at the same time make exceptions for those countries that haven't got the euro and want less integration. Those countries want a Europe based more on free trade and on the free exchange of economic goods and services, but much less...