Beyond the sovereign debt crisis - time for a rethink

While France, Italy and Spain are too big to fail, they are also too big to bail-out

Europe's fiscal crisis still shows few signs of abating. Despite the grand rhetoric, Chancellor Merkel and President Sarkozy's joint announcement last Tuesday to establish a European "economic government" headed by Council President Herman Van Rompuy failed, predictably, to appease the markets. With European bank shares tumbling by 20 per cent this month and investor fear of contagion spreading to Italy, Spain and France still high, what was needed was concrete action, rather than yet another lofty – and arguably unfeasible - statement of intent.

Tackling the sovereign debt crisis remains the number one issue for European governments. Yet of the measures currently on the table – tighter oversight over profligate member state budgets, mandatory debt limits, tax policy harmonisation or even the establishment of much-vaunted Eurobonds, which until now have been vehemently resisted by Merkel – none, individually or even as a package are likely to suffice. Steps towards closer fiscal union might ease market jitters, but in the long term, something more is needed to get Europe on a lasting stable economic footing.

Indeed, if Europe's health is to be restored and its reputation as the world's largest single economic market to remain even partly intact, politicians and policymakers will need to address an even bigger issue: namely, figuring how the continent as a whole can regain its competiveness. Particularly, but not only, those countries on the periphery. For too long, Germany's export sector has been the undisputed and at times solitary driver of European growth, while other member states – particularly the so-called Club Med economies – over-consumed with the aid of German bank credit.

The result has been to leave behind huge structural imbalances within the European Union and, for all their troubles, a bill that Germany and the other northern member states are now reluctantly picking up. Despite the European Central Bank twice stepping in to rescue Greece and ease debt repayment terms for Ireland and Portugal, a permanent "transfer union" will be difficult, financially and politically, to sustain. At the same time, the prospect of extending the European Financial Stability Facility to cover the larger indebted member states, in the event that they need a budgetary injection, is for most Germans out of the question. It is likely to remain this way. While France, Italy and Spain are too big to fail, they are also too big to bail-out.

Recovery and renewed competitiveness cannot come soon enough for Europe. Yet, as Adam Lent and I argue in a new IPPR paper, European leaders will have to contend with at least two other major challenges to securing these objectives, aside from their countries' current fiscal woes. The first of these is well-known, namely the shifting balance of global economic power to the east. The second is less talked about, but potentially equally transformative. It is the way business practices and techniques across all sectors are being radically altered by new and emerging interactive web technologies.

Faced with the increasing dominance of China, India and other emerging powers in the global market place, as well as changes to the way business is done, European and other advanced economies will have two choices. Either retreat to narrow protectionism or compete. Given their higher labour costs, the latter is likely to require them to move higher up the value chain and contest markets on the basis of skills, productive investment and business innovation. Although, here, some advanced economies are in a better position than others.

Despite the relative stability of our public finances, the UK economy has long suffered from low levels of business investment, a relatively weaker skills base, less productive and innovative firms, all compared to our core competitors - including Germany, France, Japan and the US. British companies also have a limited presence in the most dynamic emerging markets. In 2010, less than 7 per cent of UK exports were destined for the BRIC countries of Brazil, Russia, India and China.

Unless measures are taken to address these problems now, the UK might find itself in the European slow lane when other countries exit the current crisis. The government should start by accepting the role it can play in leveraging investment by setting up a British Investment Bank, modelled on the German KfW. With a one-off capitalisation of £15bn, over a period of five years, the bank could raise an extra £200bn on the capital markets to support a more diverse range of innovative business sectors and investments in supporting infrastructure. This will help reduce our dependence on financial services and our volatile housing market and help achieve the rebalancing to which UK policymakers aspire.

Other European policymakers need to think long and hard about their own national circumstances and the specific interventions required to fix structural weaknesses, yet for Britain the situation is clear. Only with these foundations in place will we have a fighting chance of adapting and competing in the new global economy.

David Nash is a research fellow at the Institute for Public Policy Research think-tank, in the UK