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The European Union Is Over

The decision by the European Union last week to create a permanent bailout fund may not end the sovereign-debt crisis but it will—eventually—end the European Union as we know it.

The idea behind a common currency was to allow free trade and investment between European countries without the risk of competitive currency devaulations. It was supposed to make Europe more inviting to global capital and credit investment. It was an attempt to create monetary stability without the imposition of a centralized fiscal and political regime.

All of these were noble goals. But the attempt has failed.

The permanent bailout fund will create moral hazard, inviting euro zone members to engage in budgetary brinksmanship and free-riding that will make bailouts more likely. To ameliorate the moral hazard—and to satisfy the demands of the Germans—the Europeans promise that the bailouts will come with “strict conditionality.”

The first effect of “strict conditionality” will be the loss of fiscal independence by euro zone members. The European Union will exercise far more control over how its members tax and spend.

"It was wishful thinking to assume it was going to work without a much stronger—not a straitjacket, but something more coercive, and stronger in terms of discipline," French Finance Minister Christine Lagarde told my brother Brian Carney in an interview that ran in the Wall Street Journal over the weekend.

This will likely mean that European countries will no longer be permitted to compete for investment by adjusting their tax and regulatory structures to be more inviting to business. Countries such as France and Germany always regarded this as “poaching” by countries like Ireland, which attracted investment and jobs by lowering its corporate tax rates.

The Europeans—well, mostly the French and Germans—believe that this will redistribute the jobs and investment from the low tax poachers—ending what they view as a “race to the bottom.” But they are wrong. As the downward pressure this competition exerted on taxation and regulation is relieved, taxes and regulatory burdens will rise and Europe will become less hospitable to business and investment. Many jobs and investment will be redistributed right out of Europe altogether.

Europe will not only lose the advantages of competitive taxation and regulation—it will lose the advantage of diversification. The fiscal and political independence of euro zone members allowed for a variety of tax and regulatory regimes to proliferate, allowing businesses to choose forums in which to operate. Because businesses and investors have diverse needs, this diversity meant it was more likely that they would be able to find a home in Europe. A tech start-up might be more at home in Ireland, while an industrial giant might find Germany a better place to headquarter.

In a more unified regime, some businesses will not only be pushed out of Europe—they may just not start at all. The error of a single system of taxation is that it assumes that a single system can ever be the correct one. In fact, however, businesses of different sorts require different sorts of taxation to prosper. Destroying the tax diversity of Europe will undermine business formation.

What’s more, the end of tax diversity will make European tax regimes less friendly to start-ups. Special interests—particularly large corporations in France and Germany—will dictate tax policies. These will inevitably create barriers to entry to protect existing corporate power from start-up competition. Incumbent corporate powers will exercise their political muscle to prevent business dynamism, block competition, and secure subsidies of their own corporate structures.

The end of diversity also increases the risk of error costs. When a homogenous regime is imposed, it means that any errors in that regime are spread to all the euro members. If a level of taxation is growth-destroying, it won’t just destroy growth here or there. It will destroy it everywhere. And, since there won’t be any room for departures from that regime, it will be hard to even detect that the tax is destroying growth. The “test subject” will have been assassinated.

The second effect of a permanent bailout fund will be to create “strict conditionality” even without a bailout. Credit markets will charge a premium for any state that appears not to be meeting the EU’s bailout requirements. Eventually all euro zone members will have to abide by fiscal policies set by the French or Germans on the pain of finding the global credit markets closed to them. The price of disobeying the Eurocracy will be the inability to borrow. It’s a takeover disguised as a bailout.

You can expect to hear lots about this loss of fiscal independence as Europe moves closer to a fiscal union. But the euro zone members are losing more than their fiscal independence. While the strictures on being a candidate for funds from the “European Stabilization Mechanism” are currently imagined to be strictly fiscal—tax and spending—they will in very short order become regulatory. Whether it is banking regulations or worker safety regulations, no country will be permitted to depart from European standards.

The power of the purse will not end with economic regulation. It will eventually include non-economic regulation—in other words, social policy and human rights. Once the Eurocracy realizes it has gained control of the power of European governments to finance their operations, it will begin to exert its control over every policy conceivable. Everything from immigration policy, to abortion laws, to military policies will be held hostage by the “strict conditionality” of the European Stabilization Mechanism.

If that sounds far fetched, recall that the national government of the United States was able to raise the drinking age in every single state—something that was far beyond its direct authority—by holding federal highway funds hostage. Now imagine what a centralized government could accomplish if it had the power to completely shut off access to credit markets by any local political authority. That’s exactly the world that the members of the euro zone are on the verge of creating.

Sure, the national and local governments of Europe will be allowed to keep a few inconsequential quirks. Those are good for tourism, after all. But anything important will be a candidate for centralized regulation.

It’s simply stunning that this revolution in the European political system is about to take place under the guise of a “limited treaty change” that European officials say will not require the votes of member states. It’s hard to believe that anyone truly thinks this is minor; more likely the EU officials are just frightened that the peoples of Europe will not accept the new regime. Better to impose it before the people can oppose it.

The independence of European governments is passing from the earth. The stars across the flag of the European Union are flickering one last time just before they are extinguished.

“This is the way the world ends,” T.S. Eliot once wrote. “Not with a bang but a whimper.”

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