Rich, peaceful, and incredibly multicultural, the tiny Grand Duchy of Luxembourg is a pearl in the crown of European postwar integration. Its quick transformation from poor agricultural backwater to big financial center demonstrates the success of Europe’s strategy of focusing on peace through trade in a common market.

Yet Luxembourg is also beginning to serve as an example of what is wrong with Europe.

Caroline de Gruyter
Caroline de Gruyter is the European affairs correspondent for the Dutch newspaper NRC Handelsblad.
Luxembourg’s neighbors are getting jealous. Strapped for cash after a prolonged financial crisis, they accuse the duchy of pursuing aggressive corporate tax planning and encouraging tax avoidance. In this sense, Luxembourg’s success story is an indication that Europe has relied too much on economic and financial competition among peers and too little on political integration and solidarity. The internal market, designed as a tool to bring European nations together, is increasingly pitting them against each another. At a time when the European Union is surrounded by wars and conflicts and faces collective problems—from jihadist attacks to an influx of refugees to sluggish growth—it struggles to provide collective responses. Why? To find the answer, take a closer look at Luxembourg and its place in Europe.

A Love Affair With Europe

All this is not to say that Luxembourgers are bad Europeans or can be blamed for this lack of solidarity. On the contrary: they are the most European of all Europeans. They defend European causes that have become anathema for other member states, including a proposed EU army and the Schengen system of open borders (named after a town in Luxembourg). Euroskeptic, nationalist parties are mushrooming across the EU, but not in Luxembourg. During the country’s presidency of the EU Council of Ministers in the second half of 2015, many Luxembourgian officials found it painful to preside over what one of them called “the unraveling of the European project.”1

Everybody in the duchy is aware that thanks to Europe, Luxembourgers enjoy a degree of stability and prosperity they never had before. If Europe fails Luxembourg will fail, too. “Europe has always given us security as a small state crammed between, and occasionally crushed by, big neighbors,” Hubert Clasen, managing director of crémant (sparkling wine) producer Bernard-Massard, said during a lunch with other prominent Luxembourgers. “In fact, we are so small that our business model is more regional than national. Seventy percent of our private-sector employees are foreigners. Many live over the border in France, Belgium, or Germany. Not having borders is natural for us, even essential.”

Other EU member states talk about clawing back powers from Brussels and building walls to keep foreigners out. Luxembourg thrives on the opposite. Carlo Thill, who directs the bank BGL BNP Paribas, qualified the duchy’s relations with Europe as “almost a love affair.” Speaking at a press conference in June 2015, European Commission President Jean-Claude Juncker, who was Luxembourg’s prime minister between 1995 and 2013, called Europe “the great love of my life.” Juncker worked hard in 2015 to keep Greece in the eurozone and save Schengen. “I am fighting for solidarity in Europe,” he told Belgian newspaper Le Soir.

Some 45 percent of Luxembourg’s population of 550,000 are foreigners, over four-fifths of whom are EU citizens. The ruling coalition of Liberals and Socialists that came to power in 2013 even tried to give longtime foreign residents the right to vote in national elections, although this was rejected in a referendum in June 2015.

Every day, 150,000 residents of other countries cross into Luxembourg to work, mainly in the financial sector, which, according to OECD figures, accounts for 30 percent of the country’s GDP. Even nonresidents get ample benefits from the Luxembourgian government to keep them happy, from subsidized public transportation to child benefits. Employers receive social security reductions if they hire long-term unemployed people or those aged over forty-five. Among the commuters are Luxembourgers who can’t afford housing in their country anymore.

This Mischkultur, or mixed culture, has become part of Luxembourg’s DNA. “Luxembourg,” Prime Minister Xavier Bettel said, “is in some ways the incarnation of the European spirit.” Bettel’s grandparents were born in four different countries.

A foreigner who has worked in the country’s trust sector for years concurred: “We talk little about European integration. We live it. Without Europe, Luxembourg would not exist.” When asked in a May 2015 Eurobarometer poll whether they felt they were citizens of Europe, 88 percent of Luxembourgers said yes, against 53 percent of Italians and 74 percent of Poles. Seventy-eight percent of Luxembourgers said migrants contributed a lot to their country; the EU average was 46 percent.

Luxembourg’s reliance on migrants was visible during the refugee crisis that erupted in 2015. Speaking at a press conference in June, Luxembourg’s veteran minister of foreign affairs, Jean Asselborn, called the EU’s repeated failure over previous months to redistribute asylum seekers “embarrassing.” Luxembourg was the first country to welcome its quota of stranded Syrian refugees from Greece in fall 2015 under the relocation system that EU countries signed up to in September. Other member states still refuse to take any.

Luxembourg, one of the six founding EU members, held the bloc’s rotating presidency for the twelfth time in 2015. As is typical for Luxembourg, the country planned to just push the European Commission’s priorities, mainly proposals for jobs and growth. That agenda was hijacked by the refugee crisis and the Paris terrorist attacks in November. “Being a bridge builder,” Bettel said, “is our duty in this difficult period of the European Union.”

But never before have Luxembourgers found it so hard to act as honest brokers. Opinions became so ugly on immigration in some member states that negotiators had to propose compromises they despised. “We are all depressed,” said an official. With so many people commuting across the border to work in Luxembourg every day, the country will suffer if border checks are reintroduced in the Schengen zone amid concerns over migration and terrorism. In November 2015, Asselborn was one of the first ministers in Europe to warn that the European Union could break apart.

Solidarity vs. Competitiveness

While Luxembourg is pushing for solidarity in Europe like no other state, the country also symbolizes the lack of solidarity in Europe. To understand this, one has to take a closer look at Luxembourg’s history and its ever-diminishing size, which have driven the duchy to seek creative ways to compete with others.

In 1913, the English travel writer George Renwick visited the country and marveled at how tiny it was: “It might be the child of some novelist’s imagination, a curious experiment in nation-making.” Luxembourg had lived under Burgundian, Spanish, French, and Austrian domination for centuries, losing territory each time. It was a poor nation of farmers, surrounded by mighty neighbors. When the European Coal and Steel Community, a precursor of the EU, was founded in the 1950s, it was initially headquartered in Luxembourg because France and Germany could not agree on a location for the organization.

Decades later, former prime minister Juncker was asked about his European convictions. He talked about war. His grandfather had fought in the First World War. During the second, his father, a metalworker, was drafted into the Wehrmacht and barely survived. Other countries may see Europe mainly as a market, Juncker once said, but to Luxembourgers it is about making sure Germany and France will never fight again, because Luxembourg is in the middle.

Indeed, the war defined the Luxembourgers to a large extent. But they never got the Europe they needed to feel safe and forget about war. They pushed for federalism and political union. But most EU countries rejected this, fearful of losing national sovereignty. As a result, there are still no pan-European taxes; the common EU budget is minuscule. There is no common defense. The euro and Schengen are crucial building blocks of the EU, but the politics behind them have remained national. The EU is still predominantly a market, without solidarity mechanisms like common bonds or a European treasury.

And in the EU’s single market, Luxembourg has to be competitive, like everyone else. But how does a tiny country without resources remain competitive? By trying to find niches in the service sector, and then milking them as much as possible. Luxembourg is not the only small country doing this. Cyprus, Malta, the Netherlands, Belgium, and Ireland are doing the same. This is why the LuxLeaks scandal, which revealed in November 2014 that Luxembourg had issued preferential tax rulings to hundreds of multinational companies, and the EU’s subsequent clampdown on the financial sector are felt as big blows in Luxembourg. What else, Luxembourgers ask, can the duchy do to keep up with the others?

Luxembourg struggles to compete economically because it is so small. It is almost too small, even, for national symbols. It has only a handful of embassies in the world. It has an airline but few aircraft or destinations. National newspapers publish in three languages. Luxembourgish became a national language in 1984, along with French and German, but was to be used in official correspondence only as was “reasonably possible,” according to a language law. Before the country dropped out of the Eurovision Song Contest in 1994, it often chose foreign singers to represent it. France Gall, a Frenchwoman, won for Luxembourg in 1965 with a song written by Serge Gainsbourg, also French; no one cared.

By that time, Luxembourg was an active member of NATO, the European Community, and Benelux. These institutions gave Luxembourg a way in which it could compete—as a convening hub. For three months a year, European ministers met on Luxembourg’s Kirchberg plateau, not in Brussels. This is still EU practice. It was during the 1960s that the development of the plateau, which overlooks the capital’s old town, took off. “All this,” a retired businessman said recently, standing on that plateau full of glass and steel buildings, “was forest and fields not long ago. The grand duke and I used to hunt partridges here.” Today, the Kirchberg plateau is home to European institutions and bodies like the Court of Justice, the Court of Auditors, the Eurostat statistical office, the European Investment Bank, and the European Stability Mechanism, the eurozone bailout fund.

Since the 1970s, Luxembourg’s financial sector has mainly settled there, too. This sector is still expanding. There are big construction sites and cranes everywhere. In a country where the schedule of the grand duke is broadcast on the radio and most citizens know a minister personally, it is astonishing to see how much people identify with the financial industry. In Brussels, there have been tensions between Belgians and EU officials perceived as rich and snobbish. In Luxembourg, newcomers aren’t resented at all. Europe and investment funds are Luxembourg’s lifeline.

Just as the financial sector dominates everything in Luxembourg nowadays, so did the steel industry in the past. The parallel is important. After the discovery of iron ore at the end of the nineteenth century, steel became the locomotive of the duchy’s economy. Fifty years ago, the industry contributed almost one-third of Luxembourg’s GDP. The country imported thousands of Portuguese and Italian guest workers (no Turks: conservative Luxembourg wanted Catholics). Many steelworkers have stayed. They came when houses were still cheap, a banker explained: “These [houses] are worth millions now, while I rent a small expensive flat for my family.

The sector collapsed in the 1970s, aggravated by the 1973 oil crisis. Luxembourg had to change gears fast. It adapted some banking laws and started attracting foreign banks. The timing was right. Washington encouraged U.S. banks to open branches abroad: if they could tap into large dollar reserves overseas, it would boost the dollar’s strength. German and Scandinavian banks in Luxembourg circumvented banking restrictions at home. Luxembourgers accepted the new immigrants as they had steelworkers earlier.

Juncker was finance minister at the time. He understood that a tiny country with few available resources had to develop niche industries, preferably in the service sector, as this takes up little space. For a while, Luxembourg offered cheap flights to South Africa via Nairobi, circumventing boycotts of the apartheid-era state. During the 1980s, Luxembourg became the center of a European telecommunications and satellite empire: a company called CLT later became RTL Group, today a leading European broadcaster. The country is also Europe’s fifth-largest cargo hub. And Luxembourgers are listed among the world’s heaviest smokers—not because they light up more than other nationals but because they sell more cigarettes. They are allowed to sell cigarettes and gasoline cheaply. People from all over Europe make detours through Luxembourg to fill up their cars and stock up on tobacco.

It is these niches, combined with the gradual abolition of internal EU borders, that made Luxembourg prosperous. According to Eurostat figures, the duchy is the richest EU member state: GDP per capita in purchasing power standards in 2014 was 263 percent of the EU average. Luxembourg’s economic growth for 2016 is forecast at 3.4 percent.

Too Much Prosperity?

This wealth has also created problems for Luxembourg—problems that mirror Europe’s broader economic woes. The state is so rich that its salaries compete with those in the private sector. European institutions have difficulty hiring locals. Someone at the European Court of Justice confirmed: “Luxembourgers find our salaries too low. They prefer government jobs.” Personnel costs at banks and supermarkets are skyrocketing. This, together with high rents, helps explain why basic products like laundry detergent can be more expensive in Luxembourg than in France or Germany.

Economists warn that as well as being the richest EU member state, Luxembourg is also the second most indebted, after Greece. Future pension liabilities are enormous, and pensions can be 90 percent of a retiree’s last salary. The state of the pension system is due in part to Luxembourg’s demographics. Many people who work in Luxembourg’s private sector are foreigners. The director general of the state-subsidized concert hall Philharmonie, Stephan Gehmacher, is Austrian. Enrico Lunghi, who heads the Mudam modern art museum next door, designed by Chinese-American architect I. M. Pei, is of Italian descent. Both venues offer an impressive cultural repertoire for international audiences, befitting the country’s globalized profile.

But Luxembourg is a village. Twenty, thirty families rule the place. When you have a problem, you call a minister. Most people on the state’s payroll are Luxembourgers. “If I hire a foreigner,” one official said, “my director asks, ‘What happened to the Luxembourger on the short list?’” And because only Luxembourgers can vote in national elections, pension reform is almost impossible: the country’s citizens won’t vote against their own interests. This is why Bettel wanted to give foreigners the vote—and why he lost a referendum on the issue in 2015. Carlo Thelen, head of the Chamber of Commerce of Luxembourg, said: “Our pension system is a Madoff scheme. It is crazy that one half of the population decides for all.”

Is Luxembourg at a crossroads again? Will the financial industry, like steel production before it, become a thing of the past under EU pressure? Since LuxLeaks, many Luxembourgers have drawn this parallel. Still, the country’s high finance is booming: between 2008 and 2014, employment rose by 21.3 percent—mostly in fund management, not traditional banking. “We used to get Belgian dentists here with undeclared cash,” Thelen said. “They stopped coming. Our new clients ask for services like Islamic banking or renminbi clearing. In the past year, six big Chinese banks have settled in Luxembourg, intending to cover the EU from here.

Switzerland also specializes in financial services. But the Swiss want to restrict immigration, endangering their bilateral agreements with the EU. Some hedge fund managers have moved from Geneva to Luxembourg, the EU’s biggest wealth management center and the world’s second fund management center after the United States. According to Luxembourg for Finance, a governmental lobby group, there were 3,905 investment funds in Luxembourg in 2014, with €3,095 billion ($4,228 billion) in assets.

Luxembourgers have digested the loss of their banking secrecy after the 2008 financial crisis. Getting over LuxLeaks is harder. Many believe foreign media published the revelations on purpose just before Juncker became European Commission president. “It was below the belt,” Economy Minister Etienne Schneider said in the cozy parliament next to Grand Duke Henri’s château. “First, tax issues are a sovereign matter in Europe. All member states agree on this. No one ever wanted minimum or maximum rates. What we did was not illegal. Second, 22 member states such as the Netherlands have tax rulings, too. Why single out Luxembourg?

The country has made tax rulings more transparent. Until 2013, one man, Marius Kohl, in a downtown federal office called Sociétés 6, decided in one sitting how much tax companies should pay. He retired and has been replaced by a committee of six. The process now takes months. The duchy houses around 50,000 foreign firms, mostly holding companies. By shifting money around between daughters worldwide, these companies minimize their tax bills in several jurisdictions.

What Future for Luxembourg’s Niches?

Luxembourgers have gone far with their tax niche business, putting neighbors at a disadvantage. “Luxembourgers are nouveaux riches,” said Rolf Tarrach, a Spaniard who was president of Luxembourg’s first university, founded in 2003. “In one, two generations they got tremendously rich. A small country can only survive by being smarter than others.” But it is a rat race. Eurozone countries cannot boost their competitiveness with currency devaluations, so they compete directly.

To protect its business model, Luxembourg seeks alliances with other small states that rely on financial niche services, like Belgium and the Netherlands. “Politically we have to be shrewd,” said a diplomat. “We need allies or big countries will crush us.” The prime minister meets his Benelux partners before European Council meetings. He said Benelux “can be a model for European initiatives, as is the case currently in fighting social dumping.”

Some Luxembourgers warned for years that the country had relied too much on the financial sector. Big countries will tolerate this, they say, till the money in Europe dries up and irritation bubbles over. This is exactly what happened. The LuxLeaks revelations came months after eurozone leaders used Cyprus’s bankruptcy as a justification to finally crush the country’s oversized niche banks.

Juncker was already defending Luxembourg’s tax rulings in Brussels during the 1990s. He then proposed harmonizing tax rates in Europe. None of his EU colleagues wanted this, and Juncker saw no reason to stop the country’s taxation practices. Since the European Commission decided in October 2015 that tax rulings that lower a company’s tax burden are illegal state aid, talk about diversification has sprung up again in Luxembourg. There is Freeport, a bunker-like building at the airport where investors can buy art, wine, and other expensive goods tax free. The state has also invested some €140 million ($151 million) in biomedical research at its university, hoping to develop innovative tools in health diagnostics and therapy. The university is meant to attract clever foreigners to help set up a knowledge-based economy using available financial expertise. From fine art to healthcare, Luxembourgers are eager to maintain their role as pioneers of niche markets.

Europe’s multiple crises and the nationalist responses in many EU countries have profoundly shaken the Luxembourgers. They feel vulnerable and exposed. European integration has made their nation prosperous, so if Europe is not doing well, they can never be safe. At the same time, Luxembourg’s own ailments are often symptomatic of a more general European malaise. This is why Luxembourg is a bellwether for both Europe’s successes and its weaknesses.

As a sign of this renewed insecurity, the country’s government recently conducted a nation-branding exercise. Tired of being identified as the row of banks on Boulevard Royal, Luxembourg wanted to find a better image. The result was published in July 2015: most participants associated their country with building bridges. Alas for Luxembourgers, building bridges is one of the hardest things to do in Europe these days.

Caroline de Gruyter is the European affairs correspondent for the Dutch newspaper NRC Handelsblad.

Note

1 Unless otherwise stated, all quotes come from interviews or private conversations held by the author in Luxembourg between December 2014 and January 2016.