PRINCETON – Everyone now knows that we are in the worst economic crisis since the 1930’s. The protectionist responses are sadly familiar: protests against foreign workers, demands for trade protection, and a financial nationalism that seeks to limit the flow of money across national frontiers.

In the 1930’s, however, economic nationalism was not the only show in town. Many people started to think of regional integration as the answer to depression. But the sort of integration that occurs in times of economic crisis is often destructive.

The most unattractive versions of 1930’s regionalism came from Germany and Japan, and represented nothing less than a practical extension of their power over vulnerable neighbors, which were forced into trade and financial dependence on the basis of Germany’s Grosswirtschaftsraum or its Japanese equivalent, the Greater East Asia Co-Prosperity Sphere.

As a consequence of the horrors of the 1930’s, there remains substantial suspicion of concepts like "Greater East Asia.”

In the second half of the twentieth century, Europe had the chance to build a much more benevolent form of regionalism. But today, the European Union is stymied by having squandered the chance to build stronger institutions when times were better and tempers less strained.

The EU is suffering from a number of problems that have been widely discussed for many years, but never seemed to be that urgent. Suddenly, in the face of the economic crisis, these problems have become major sources of political instability.

There is a common monetary policy in the euro-zone countries, and an integrated capital market with financial institutions that are active across national frontiers.

But banks are regulated and supervised nationally – as they must be, because any rescue in the event of a large bank failure becomes a fiscal issue, with the cost borne by taxpayers in individual states rather than by the EU as a whole. But this set-up makes little sense in the face of the economic logic of European integration.

The second obvious problem is the smallness of the EU’s budget relative to those of the member states. The vast part of government activity takes place on a national level. But different governments have different degrees of fiscal room for maneuver.

Italian, Greek, or Portuguese public debt is so high that any attempt to use fiscal spending as part of a strategy to combat the economic crisis is doomed to fail.

But Ireland, with previously modest deficit and debt levels, also suddenly and unexpectedly faces the same kind of issue, owing to the government’s need to take over private debt from the banking sector.

France and Germany, by contrast, have an inherently strong fiscal position. So only the EU’s strongest countries can really do anything against the sharply worsening recession.

Moreover, the whole idea of Keynesian demand stimulus was developed, again in the 1930’s, in the context of self-contained national economies.

Keynesians filled up the warm water of fiscal stimulus in a national bathtub. When the national bathtub has holes, and other people benefit from the warmth, the exercise loses its attraction.

In any case, it only ever worked for the larger states. The smaller states could not do Keynesianism in a hand basin. There are ways to fix both the banking and the fiscal problem. Control of banking is the simplest.

The European Central Bank clearly has the technical and analytical capacity to take on general supervision of European banks, using the member central banks as information conduits.

The fiscal problem could be dealt with by issuing generally guaranteed European bonds, which might be a temporary measure, restricted to the financial emergency.

Both bank regulation and fiscal policy require a great deal more Europeanization. The most obvious way is to use existing mechanisms and institutions, in particular the ECB or the European Commission.

The difficulty with such a suggestion is that it would imply a relative weakening of the national states, including the largest, Germany and France. They would most likely resist, and try to stay in their own bathtubs.

Copyright: Project Syndicate, 2009.
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