After Greece and Spain, Italy is the latest European casualty of the Euro zone debt crisis. The Greek banking system is on the verge of collapse and a sudden bank run with foreign and domestic capital leaving overnight is a possibility. British and French treasury officials are silently preparing for the possibility of a sovereign debt crisis in their own countries.

Europe struggles with such high levels of public debt that given the weak level of future growth and considerable future social security and retirement benefits payments, most southern European countries including France will not be able to pay their debt service without borrowing heavily. A number of European countries will have to default selectively on their debt before the end of the decade. Default will imply lower public spending, lower public employment and wages, and higher taxes. Governments will be tempted to protect their companies by resorting to protectionism.

So, is this the decline of European economic power?

Europe can survive the debt crisis in the long run if it sustains sufficiently high growth – that can, in turn, generate government revenue through taxation. In Europe, two key long-term assets drive growth: the skill of its workforce and the quality of its legal and institutional environment.

Educated workforce

Europe has one of the most educated workforces in the world, and this translates into real economic gains: economists estimate that increasing the number of years of education of the overall active population by one year increases productivity per worker by 6 percent.

Europe also has a very high-quality legal and institutional environment, with a relatively fairer and more transparent judiciary than in many emerging markets. There, fear of expropriation and substantial institutional uncertainty is hindering prospects for foreign direct investment and economic growth.

But there are still significant worries for Europe’s long-term growth.

In both dimensions – education and the quality of the legal environment – Europe’s governments are under pressure to favour short-term remedies over long-term investments.

Europe’s basic education system desperately needs more investment per student and a larger role for private funding. In the UK and in France, about 100,000 students leave school every year without any qualification, thus relying on welfare benefits or working in low-paying jobs that are most likely to be exposed to international competition. Nevertheless, both countries are cutting expenditures in basic education.

Governments tempted

Governments in France and Italy are also tempted to disrupt free and fair competition in public tenders. President Nicolas Sarkozy intervened in the purchase of new carriages for French high-speed lines – disgruntled that the French national railways chose to buy carriages from a foreign competitor rather than from the local French supplier. And Italian President Silvio Berlusconi’s party erupted in anger when the French group Lactalis moved to take over of the Italian group Parmalat. It eventually succeeded.

If European governments do not invest in their educational system, do not preserve their legal and institutional environment, and are forced into default by the debt crisis, Europe’s gradual decline will pave the way for the emergence of a new world economic order.

A recent study of educational systems by the Organisation for Economic Cooperation and Development (OECD) put many Asian countries at the top of their rankings: Korea is first in the OECD digital literacy study and Singapore ranks at the very top of the list.

Worries for Europe

More worrying for Europe, in some sectors, is that emerging markets do not rely on European technology any more. The latest high-speed train carriages connecting Beijing and Shanghai do not come from European design offices. Airbus and Boeing are not the aircraft industry’s sole players any more for mid-sized jets. Brazil (Embraer), China (Comac) Canada (Bombardier) and Russia (Irkut) are all on-board as well.

The most pressing issue for many emerging markets is the quality of their legal and institutional environment. A highly predictable legal system with low levels of corruption and the legal enforcement of property rights is the key to economic development. Timothy Besley, a professor at the London School of Economics and member of the Bank of England Monetary Policy Committee, highlighted the role of property rights as the key to long-term economic development in his recent address to the European Economic Association. Ilian Mihov and Antonio Fatas, my colleagues at INSEAD, show the strong link between growth and economic and political institutions. [Click here for more].

The European debt crisis has presented emerging markets with the opportunity to leverage their growth and capture new markets. This should also be a wake-up call to the Europeans.