Global: Old Europe's Wake-up Call
By Stephen Roach (New York)
morganstanley.com
Nov 11, 2005
2005 will undoubtedly go down in history as Europe’s annus horribilis. A failed constitutional referendum, a disappointing German election, and now riots in the streets of France -- the fabric of Old Europe is torn and hopes of New Europe may well be meeting their sternest test. As bad as it sounds, the stresses and strains of political and social backlash may be just what the tired and sclerotic Continent needs. They underscore perhaps the only way out -- the heavy lifting of structural change and the concomitant restoration of economic dynamism. The angst of 2005 could well be Europe’s wake-up call.
Europe has spent the past 60 years dealing with the ravages of World War II. There have been three distinct phases of its postwar experience -- reconstruction, division (i.e., the Cold War), and now reunification. Europe’s social contract and the vast public sector welfare state it spawned were critical by-products of the first phase of this continuum -- the ultimate safety net for a war-battered Continent. Over the span of six decades, Europe’s social and economic context has changed dramatically. But the trappings of the welfare state have remained largely unaltered. Therein lies a key source of tension for modern Europe -- in effect, a tug-of-war between the dynamism of economic restructuring and the inertia of social policy. In my view, a unified Europe is a large and potentially powerful economy -- perfectly capable of standing on its own without the life-support promises of another era. That doesn’t mean the European social contract needs to be torn up. But it could mean that a major contract renegotiation is in order. The angst of 2005 leaves Europe with little choice but to finally respond to the critical tradeoff between its new economy and its old social policies. The outcome of this balancing act could well shape its economic prospects for years to come.
I am actually optimistic that Europe will rise to the occasion. This is quite a switch for someone who has been a chronic euro-skeptic for the better part of the past 15 years. But I like what I see on the structural change front -- especially in the core of Old Europe. And I continue to find Germany, by far Europe’s biggest economy and still the third-largest economy in the world, the most interesting story of all. Germany, despite its bad press, is very much on the move. Yes, it still has one of the most expensive and rigid labor markets in the world. But the rigidities are not as severe as they were just a few years ago. For example, German labor unions have lost significant power in recent years -- they no longer bargain across industries but confine their negotiations to individual companies. Moreover, led by the metals sector, Germany is now moving away from the shortened 35-hour work week. And in an effort to avoid the high fixed costs of hiring and firing, Corporate Germany has hired increasingly large numbers of part-time workers and contract temps; collectively, such “flexi workers” currently make up about 39% of the total German workforce -- up sharply from the 29% share a decade ago. At the same time, German businesses are now moving aggressively to increase IT spending -- making up for the shortfall in the late 1990s; the IT share of German capex has increased from 30% to approximately 50% over the past ten years. Last but hardly least, there has been a dramatic recent increase in German corporate restructuring; M&A activity in Germany has increased from $73 billion to $138 billion over the last three years.
The net result of this confluence of forces -- improved labor market flexibility, IT spending, and corporate restructuring -- is a long overdue and meaningful improvement on the German productivity front. Productivity growth is currently running at a 1.6% annual rate -- fully half a percentage point faster than trend increases of 1.0% recorded over the preceding ten years. Reflecting that improvement and in conjunction with a moderation of nominal wage inflation in recent years, labor costs in Germany’s manufacturing sector have fallen by a total of 10% over the past 10 years. Slowly but surely, an uncompetitive, high-cost German economy is turning the corner in dealing with its structural problems. This conclusion is very much at odds with popular impressions of Germany. The nation is far from becoming the “next Japan” that many have feared would be the case. Nor should Angela Merkel’s disappointing showing in the recent national elections be construed as a “no” to reforms and restructuring. Her narrow victory may, instead, be more of an outgrowth of her deficient campaign style -- especially when compared with Gerhard Schroeder’s long-standing strengths as a campaigner. There will undoubtedly be more bumps in the road. Upcoming fiscal consolidation on the back of a proposed VAT hike may be seen as a setback for cyclical recovery prospects. But as long as Germany stays the course of an Anglo-Saxon style productivity-led recovery, the tailwinds of structural revival should prevail. This is the key lesson from every successful macro restructuring story of the past 25 years.
A German turnaround could be a very big deal for the rest of Europe. Most significantly, Germany is the engine of intra-European trade -- accounting for 50% of the combined sum of intra Euro-zone exports and imports. As the German engine shifts gears, the rest of the Euro train could follow. There are signs that is already happening. Notwithstanding the undercurrent of social tensions, France is also making good progress on the structural reform front. Michelin, Schneider, and HP have led the charge in the dismantling of the 35-hour workweek -- a trend that is now spreading to the French public sector in the form of overtime allowances for hospital workers. Pension reform is progressively raising the retirement age of French workers from 60 to 65, and a new legal work contract was introduced last July that makes layoffs much easier. And France is holding its own in the developed world restructuring sweepstakes, having taken the manufacturing share of total employment down from 18.3% in 1990 to an estimated 12.5% in 2005. At the same time, since Italy’s new “job contract” was put into law in 2003, some 600,000 new jobs have been created in the Italian economy (see Vincenzo Guzzo’s 7 November research note, “Italian Labor Market -- How Much of a Miracle?”). The decline of Italy’s unemployment rate is now the fastest of any country in the euro zone. Europe’s social and political problems make great front-page material, but behind the sclerotic headlines is meaningful progress in the restructuring of Germany, France, and Italy -- countries which collectively account for 69% of euro-zone GDP.
This debate is not lost on financial markets. As the angst of 2005 has deepened, foreign exchange markets have become increasingly priced for euro-sclerosis. To the extent these fears are overblown, a euro rally is a distinct possibility. There are equally important implications for global growth. In particular, structural improvement in the European economy could fill an important void for the global economy in the event of a slowing of the US consumer. The greater the growth contribution from Europe, the smaller the risk of a disruptive strain of global rebalancing.
Ultimately, the case for Europe boils down to a resolution of the tension between corporate and social productivity. A social model that was essential for postwar reconstruction has lost its relevance for a rebuilt and reunified Europe that must now find its own way in an era of globalization. This is not the first time the heavy lifting of restructuring has challenged deeply entrenched social contracts. Nor will it be the last. But now it’s Europe’s turn to face this trade-off head-on. There is always the risk that Europe turns back the clock. But to do so, it would have to look inward -- in effect, shielding its workers from globalization. I think the odds of that are low. Unless Europe is prepared to go down a protectionist route, its social contract will undoubtedly become part of the global labor arbitrage. The angst of 2005 is Old Europe’s wake-up call that a New Europe is at hand. |
