The Letta Report – the Good and the Bad!

Yes, it’s the report season again!

No, I don’t mean the season of full-year or Q1 reports from Corporate-land but that we have a few months ahead of us with new reports about the EU’s economic future (there’s a link between the two that I’ll come to). First out is Enrico Letta, who was tasked by a few EU countries to come up with a review of the single market, and he is releasing his paper today (April 17). Thanks to some advanced leaks of the report, we already have a fuller idea of what the former Italian premier has in mind for economic reforms.

It has been billed as a bold plan for reviving the single market and make it more consequential for Europe’s economic performance. While there are some truths to that, I would say that the Letta report is more significant for its political realism than its economic ambitions. Generally, the report works mostly with ideas and concepts, and few of them are detailed and come with a deeper view of their market and growth dynamics. It’s not a blueprint for reform. Nor is it similar to past reports attempting to measure “the cost of non-Europe” or putting figures on the cost of inaction. It’s main conclusion? Letta urges the Council to “delegate to the European Commission the task of drafting a comprehensive Single Market Strategy”. More reports to come then!

Still, the Letta report could prove a useful contribution to the political debate. It offers some points of economic realism, and quite rightly suggests that flaws and inadequacies of single market polices, and the general incompleteness of the project, hamstring Europe’s economic performance. The report stands in stark contrast to the current political leadership of the EU, which for the last five years have downplayed single market reforms and rather believed in the pursuit of more regulation of businesses and markets, and entertained notions about regulating Europe to economic success.

True, the pandemic and Russia’s war on Ukraine have forced other policies on the agenda. Then again, deepening the single market and improving Europe’s competitiveness were never part of the von der Leyen Commission’s priorities when it took office in 2019. Remarkably, it was the first Commission ever that didn’t have Europe’s economic performance as placeholder for its own policy programme.

Enrico Letta also points to necessary areas of reform. Creeping economic nationalism has undermined existing EU freedoms and made the single market less useful for companies. Repeated “relaxations” of state aid rules have unleashed massive subsidisation and a total bill of industrial subsidies that simply doesn’t square with a single market based on free and fair competition. The single market for services remains work in progress. Europe’s financial markets are fractured along national lines and, even if there are ample savings, don’t fund corporate growth as for instance in the United States. Letta points to necessary reforms in financial services, energy, and telecoms.

He also suggests we need a “fifth freedom” to complement the other four freedoms. Even if it is a bit unclear what exactly should form part of the fifth freedom, Letta points to forms of economic integration that are based on economic activities with high intensity of R&D, human capital, data, and technology, and that are more sensitive to national variations in regulation and that cannot be effortlessly squeezed into an existing categories of EU freedoms. Whatever the headline of reforms in these areas, it is exactly in this type of a new economy where Europe is falling behind in international competitiveness. Changing the conditions for new growth requires many policy reforms but single market freedoms are definitely important parts of a package.

Boringly but importantly, Enrico Letta also takes aim at the process of reviews and impact assessments in the EU policy process. He proposes better approaches to understanding the real consequences of proposals made in Brussels – and also of changes that are coming along the way. In the best of worlds, the Commission would subject its own reforms to rigorous scrutiny (it isn’t and this Commission has often made a joke out of the process of impact assessments) but as the Council and the Parliament make changes to the reforms, there should be more points of assessment to understand what sometimes fundamental changes to a proposal mean for regulatory efficiency and the broader economic consequences.

Finally, the Letta report also deserves attention for bringing up the “external dimension” of the single market – that is, Europe’s trade with the rest of the world. Brussels have fallen under the spell of “economic and technological sovereignty” and “economic autonomy”, and propelled ideas about reducing its dependence on the world economy. But Europe’s prosperity is heavily dependent on the world economy, and as Europe’s size of the global economic pie shrinks, this dependence is only going to grow. Europe needs a constructive trade policy and it needs to deepen economic integration with friends and allies

Letta’s report can also be critiqued. I think it is giving far too little attention to regulatory developments in Brussels. Letta complains about member state implementation and “goldplating”, and makes the argument that regulation leads to too much variation and, thus, to too high regulatory business costs. Fine. But member states are not the only source of bad regulation and implementation, leading to fragmentation. The reality is that, for the single market to work, it has to be accompanied by a style, culture, and level of regulation that is lighter rather than heavy-handed. Routinely, Brussels now seems to be going for the maximum version of regulatory alternatives, and the single market just don’t work with a massive expansion of regulation.

Take for instance the problem with poorly functioning capital markets that aren’t channelling enough savings into corporate growth funding. It is a problem with many roots, but one root is the design of regulations of financial services that the EU has championed in the past 15 years and that have prompted asset allocations that are not conducive to a market of growth funding. Europe’s under-performing app market is not a result of poor implementation of GDPR but can be connected to the overreach of the GDPR itself – a product of the Commission rather than member states. Ditto the AI regulation. It’s new and not implemented yet, but it is Brussels – not the member states – that have campaigned for a version of an AI regulation that is going to make the EU regulating AI faster, harder, and deeper than any other comparable economy.

Finally, the Letta report is lending strong support to the idea of more industrial policy and more subsidies to firms – with the important addition that this funding should be provided by the EU, not national governments. I am not convinced. There are a couple of discussions to be had in this space, including the problem of market distortions when some governments shower their firms with subsidies and others don’t. Moreover, most governments are providing direct subsidies to companies rather than allowing for investment-based tax credits, which leads to different outcomes. Europe’s problem with industrial policy is that it still consists mainly of providing support to under-performing companies. It’s corporate welfare rather than strong impulses for change.

Still, the evidence for industrial subsidies to generate the outcomes that Letta seeks is, at best, missing. Massive subsidies can move certain aggregates – investment, capital expenditure – for a while but don’t tend to lead to sustained change. Industrial subsidies are poor tools for generating innovation and innovative firms, and it prompts companies to become welfare entrepreneurs and less focused at developing commercially successful technologies and products. Moreover, a big cash bag for industrial subsidies make companies to run in the direction that politicians want them to move, not in the direction of consumers.

Look at some of the corporate reports that have been released recently – or that are due to be released soon. Tesla is struggling because of falling demand. Volvo Trucks, who together with its sister company Renault Trucks represent 70 percent of all electric trucks, have just reported a 23 percent drop in demand for electric trucks. The market for chips is still weak. ASML has recorded a sharp drop in demand; Intel continues to bleed. Profits and net incomes of ThyssenKrupp (steel), Salzgitter and ArcelorMittal have plunged.

Yes, I am choosing these companies or products because they have all recently become targets for massive state support in Europe. Europe is lavishly allocating tax money for vehicle batteries, chips, and hydrogen-fuelled furnaces. The fortunes of these companies may be good or bad, and they can improve over time of course, but there is no evidence suggesting it is them that are going to lead industrial transformation and be globally competitive in the future. Such change usually come from new companies, but industrial subsidies make them less likely to emerge and grow. Hence, this type of industrial support is extremely risky. Financial markets are awash in capital for investment, and the market is telling us something about these forms of investment when asset managers aren’t prepared to make them. It just isn’t credible, as in the Letta report, to talk in general terms of boosting industry support, giving Europe “teeth”, and protecting manufacturing leadership. If you are proposing massive increase in EU led state support, a minimum demand should be that you first bring the evidence of the usefulness of such policies.