A spectre is haunting Europe, the spectre of capitalism. Too bad it was unable to cross the Berlin wall last Sunday, but never mind in the end it will.

The winds of change in Europe started to blow with the enlargement of the European Union with ten new countries in central and eastern Europe last year. Their vibrant economies have been growing fast thanks to a liberalised institutional framework that creates a favorable environment for investments and the creation of wealth. Limited government is now a reality Brussels has to deal with. The paradigm of big welfare state governments, including their regulatory harmonization attempts, has at last become debatable in the EU since at least ten member states are sceptical about it. As former Estonian prime minister Mart Laar put it: “If ‘old Europe’ is to compete effectively with ‘new Europe,’ it will have to lower taxes and rethink the social-welfare systems that high taxation supports.”

Then, after the European Constitution was rejected by the French and the Dutch last spring, the speed of the winds of change speed increased to that of a hurricane of category 4. It is true that the rejection of the constitution did not come on the wings of free market ideas. Most of the French who voted “non” did it to shield themselves from the “unfair competition” of Polish plumbers and other low-wage workers from the East. Still, the result of the referendums dealt a blow to the project of creating a centralized European welfare state.

When the winds moved towards East Germany they were stopped for the first time. The center-right candidate Angela Merkel, herself an East-German, was supposed to win the German elections on 18 September. Alas, she did not. Is this bad? Was Merkel going to be different from other center-right leaders? France’s Jacques Chirac is a typical member of the European center-right. He can hardly be seen as a threat to the powers-that-be in Europe. Even an outsider such as Italy’s Silvio Berlusconi has been unable, if he ever was willing to, to significantly change anything. On the contrary, he negotiated a more flexible enforcement of the Stability Pact that requires EU member states to keep their national debts and government deficits within limits.

Why was Merkel different? Because she seemed prepared to pay a lot of attention to the issues of development and economic liberty. Germany ranks only 18th in the Index of Economic Freedom because its fiscal burden is so dismal. The German tax system is very complex, with the highest tax rate of 42 per cent applying to incomes exceeding 50,000 euros. Hence not just the Germans, but many of us in Europe were filled with hope when Merkel designated Dr Paul Kirchhof, a well noted flat tax advocate as her intended finance minister.

Dr Kirchhof’s proposed reform relied on creating a 25 per cent flat rate while abolishing most of the 4,000 loopholes available to tax payers. Though the idea had not been fully endorsed by Merkel she seemed prepared to turn fiscal reform into her most important long term goal. It became the major issue of the election campaign.

If Kirchhof had succeeded there would have been a political earthquake everywhere in Europe. EU efforts have so far been aimed at pursuing fiscal harmonization, preferably with relatively high tax rates. At the time of enlargement the socialist German Chancellor Gerhard Schröder criticized the “unfair competition” from the Eastern countries, many of which already enjoy a flat tax regime. Ironically, for a while during the past month it looked as if Germany was in for a major shift towards a simpler tax model. It is no surprise that Schröder strongly opposed the shift, playing up fears of tax reform. If Merkel had won, tax reform in Germany would have killed all EU attempts at fiscal harmonization because Berlin would have prospered from a flow of capitals and investments. When you are a recipient, you do not want to enforce measures to stop or control capital flow.

The debate in Germany stimulated a similar debate in Italy, where the Istituto Bruno Leoni has been campaigning for the flat tax for a long time. Defense Minister Antonio Martino, a well-known economist, suggested that Italy might adopt the flat tax to spur economic growth as well as to fight tax evasion (the black market accounts for some 25 per cent of Italian GDP). Renato Brunetta, a member of the European Parliament and the chief economic adviser to the President, endorsed the idea. So did a few leftist MPs such as Franco Debenedetti and (to a lesser extent) Nicola Rossi. The path to comprehensive tax reform in Italy is still long, but a few steps have been taken in the right direction. The German elections, however, have slowed down the process. The longer it takes, the more painful reforms will be. The Germans did not do Europe a favour last Sunday, but they will not be able to prevent the inevitable.