Europe's Big Chance

Pushing through key reforms could help spawn a U.S.-style New Economy

In the 1980s, France's Renault was notorious for its featherbedded workforce. But what a difference a decade makes. The auto maker now has 20,000 fewer workers than it had in 1989--and churns out 220,000 more cars a year. Its engineers have designed the latest version of the best-selling Clio minicar with 28% fewer parts. No wonder profits at Renault are jumping sharply.

Less than six months after a dangerous flirtation with deflation, the 11 European Union countries that share a common currency are suddenly bursting with economic energy, thanks in part to makeovers at many of the Continent's biggest companies. Even growth in Germany, the region's largest but most downbeat economy, has ignited and is now expected to top 3% next year, vs. a desultory 1.6% this year. Italian tax revenues have zoomed 17%, suggesting an unexpected surge in corporate profits. More French people left dole lines in July than in any month since mid-1993. "We're creating jobs at proportionately the same rate as they are across the Atlantic," says Labor Minister Martine Aubry.

CHEAP CAPITAL. Indeed, the euro zone looks set to outperform the U.S. slightly next year for the first time since 1992, thanks to rock-bottom interest rates and the weak euro, according to many private forecasters. But this time, many European policymakers and economists are hoping for much more than a typical cyclical upswing. Their thinking: If politicians push through some key reforms, the euro zone might be on the brink of spawning a U.S.-style New Economy in which high growth goes hand in glove with low inflation, fast productivity growth, and a boom in jobs. "This is Europe's big opportunity," says Daniel Gros, deputy director of the Center for European Policy Studies in Brussels.

It has long been a European dream to rev up the Continent's capacity to grow without inflation from about 2% to 2.5% a year now toward the 3% needed to take a big bite out of jobless lines. Many of the conditions are in place to give Europe a shot at doing that. Years of tight monetary and fiscal policy ahead of January's launch of the euro have purged core European economies of lingering inflation. A huge new euro capital market is enabling European companies to get funds as cheaply and innovatively as their U.S. rivals. This year, growth-oriented Continental companies are set to raise a record $160 billion in equity and debt, much of it earmarked for mergers or restructuring. With higher corporate taxes pouring into treasuries, Europe's fiscal health hasn't been this good since the heady days of the 1960s.

A key contributor to more robust corporate health is a pickup in labor productivity, which has grown faster in the 1990s than it did in the 1980s (box, page 28). Companies have spent years wringing productivity gains out of their workforces, and they don't intend to let up. "We're always looking to increase our productivity," says Gerd Oltermann, head of manufacturing at London-based tobacco giant BAT Industries. On Sept. 8, French tiremaker Michelin announced ambitious plans to raise productivity by 20% over three years. CEO Edouard Michelin says he will slash European payrolls by 7,500 people, or 10% of his workforce, to hit his target.

By all rights, Continental companies should be world champs in labor productivity. High European wages, taxes, and social security costs, plus stringent labor laws, have driven local companies to invest in plant and machinery rather than people. "The ratio of capital to employees is far higher in Europe than in the U.S. or Britain," says Mary O'Mahoney, a research fellow at Britain's National Institute of Economic & Social Research. "So labor productivity per employee is comparatively high." Consider the state-of-the-art auto plant of General Motors Corp.'s Adam Opel unit at Eisenach, in eastern Germany. Its lean production methods give it some of the highest productivity levels in the euro zone.

HIGH-TECH LAG. So why isn't Europe the envy of the world when it comes to creating a vibrant, full-employment economy? After all, the U.S. has translated its productivity surge into more jobs and greater growth. The short answer is that Europe lags seriously behind the U.S. in fast-expanding high-tech industries. German investment in information technology was just 2% of gross domestic product last year, vs. 4.2% in the U.S., according to International Data Corp. in Framingham, Mass. And such obstacles as union opposition, say some analysts, make it harder for Europe to implement new technology fast. Little wonder that Europe hasn't bred high-tech winners in the same profusion as the U.S.

But there are notable exceptions, such as Nokia, the Finnish telecom giant, that show what Europe can do. With first-half sales up a sizzling 49%, to $8.8 billion, Nokia has orders coming in so fast that Chairman and Chief Executive Jorma Ollila has had to hire 10,000 extra staff just to keep pace. Other European companies are starting to embrace IT to push themselves up the productivity curve--and not only in manufacturing. Amsterdam-based temporary-staffing giant Randstad Holding uses new software to produce more with fewer errors. The payoff from IT and the Internet could be huge in Europe. "Where obstacles to efficiency are greater--as in Europe compared with the U.S.--the growth potential is that much more," says Charles Dumas, director at Lombard Street Research Ltd.

Some of the most startling changes are coming from surprising sources. Mannesmann, once a traditional German steel and engineering company, has poured more than $20 billion in the past three years into telecom as it diversifies from old businesses. Productivity has shot up by over 20% since the start of 1997 in each of its divisions, say analysts, with telecom the star performer, racking up 30% gains.

So Europe is assembling the building blocks needed for a big spurt in growth potential. But it still has to cope with the excesses of 50 years of welfare-state politics. Rules that make it prohibitively expensive to hire and fire workers, rules that hobble entrepreneurs in their quest to raise money and start up new companies, and rules that pile up taxes and hidden costs for employers across the Continent are a big drag on progress. The U.S. has far fewer of these impediments--and has been able to leverage productivity gains by expanding employment by 2% annually for years. Between 1992 and 1997, the U.S. created 13 million new jobs, while the euro zone lost 800,000.

Only if Europe's policymakers and voters sweep away cumbersome business and work rules can they nurture a European New Economy and possibly engineer a noninflationary boom lasting well into the next century. The International Monetary Fund figures that in 1998 alone, Europe could have produced over $300 billion of extra output--5% more than it did--had its unemployment rate been around 5% instead of more than 10%.

FRANCE BALKS. The chances of implementing radical reforms might look iffy. Yet there are signs that Europe's politicians are ready to take the heat and do so. Last year, Spain loosened restrictions on part-time and temp work. One in 10 Spanish workers is now employed under such a contract, and joblessness has tumbled to 15.6% from 18.9% in the past 12 months. Other once-unthinkable changes are starting to happen, too. Some German shop owners have been flouting laws that force them to close on Sundays. Berlin's Kaufhof department store recently labeled all of its goods "souvenirs of Berlin" to exploit a loophole that allows the sale of tourist items on Sundays. "It really is tantalizing," says Steven Englander, an economist at Salomon Smith Barney in London. "We're gradually seeing more labor flexibility and deregulation. That's enormously important for economic growth."

Fierce political battles in Germany could largely determine the outcome for the rest of the Continent. Despite his drubbing in the Sept. 5 and Sept. 12 regional elections, Chancellor Gerhard Schroder has pledged that his coalition of Socialists and Greens will fight to slash corporate taxes, cut state spending, and push through overdue pension reforms--in short, move to a more market-oriented and less state-dominated economy. That's in line with the pact he recently signed with Britain's market-oriented Labor Prime Minister Tony Blair calling for far-reaching free-market reforms.

Not all center-left leaders fully agree with the initiative. French Prime Minister Lionel Jospin, who declined to join the pact, rejects the Americanization of Europe's economies. Jospin mistrusts Blair's "Third Way" policies that call for greater privatization and a rollback of the state in economic life. "The French are pulling out all the stops to keep Schroder and the other euro zone heads of government on their side," says one senior member of the European Commission. "The last thing they want is for major euro zone countries to start introducing the sort of reforms Blair is championing."

MERGER FRENZY. But even in France, there are signs that politicians are bending. Take the introduction of a compulsory 35-hour workweek. It looks like a prime example of an old-school effort to divvy up the economic pie rather than make it grow. Yet while it may seem to be a step backward, Jospin's move has forced major concessions from French labor. Hypermarket chain Carrefour has been able to introduce more shift work, something that it once found hard to sell to labor unions.

So, provided some reform is implemented, Europe might be able to escape its self-destructive cycle. Indeed, as business confidence perks up, companies are again investing at home after years of fleeing the Old Continent. German chemical company BASF recently decided to build a $127 million fungicide in Germany rather than abroad. Deutsche Bank forecasts expenditures on new plant and equipment in the euro zone to expand by a healthy 5.2% this year and by 5.1% next year.

And, facing sharp competition from rivals both inside and outside the euro zone, companies are merging and restructuring like crazy. Mergers and acquisitions worth a cool $930 billion will be finalized this year, well up on 1998's record $777 billion, according to London-based Thomson Financial Securities Data. And the euro zone's Internet economy is finally starting to take off. French bank BNP-Paribas, for example, announced on Sept. 10 that it will launch a pan-European brokerage. There's also a new breed of venture capitalists, such as Bernard Arnault, head of luxury-goods maker LVMH-Moet Hennessy Louis Vuitton. His $525 million Europ@web high-tech fund has invested in 30 tech startups, including a French search engine called Nomade.

HIGHER LITERACY. The danger is that Europe's present export-led recovery will sputter and turn out to be yet another brief cyclical upswing. Some powerful interest groups that want to keep things the way they are wouldn't be too displeased if that happened. "Politicians will put off the reforms we all know they should make," says Denis Payre, head of European Technology Ventures, a Brussels-based firm that invests in European high-tech companies. "They'll say that since the economy is growing, the system is working."

But that would mean ignoring years of advice and warnings from businesspeople and central bankers alike. "We've done our part to stimulate the economy by cutting interest rates," said European Central Bank President Wim Duisenburg after he cut euro interest rates to a record low of 2.5% in April. "Now it's up to governments to do theirs by tackling the economy's structural problems." Skeptics doubt that day will ever arrive. Says Roger Bootle, managing director of London-based economics consultant Capital Economics: "I just can't see the new paradigm actually taking hold as long as those labor and other rigidities persist."

Even so, other trends are positive. Literacy levels are much higher among younger Europeans than among their elders. And research by polling organizations SOFRES in France and Allensbach Institute in Germany suggests that young Europeans who are entering the labor force are far more interested in making it in technology and business than were their predecessors. They have the skills, including fluency in English, to find work in modern service sectors that are expanding.

However slow governments are to reform, the pace of change in business is frenetic. Chairman Gerard Mestrallet has transformed France's Suez Lyonnaise des Eaux, once an unwieldy financial conglomerate, into a global utilities player. It has just bought U.S. water-treatment company Nalco Chemical for $4.1 billion. Germany's Hoechst and France's Rhone-Poulenc merged their pharmaceutical businesses this summer to form the $20 billion Aventis in an imaginative cross-border deal that wouldn't have happened a few years back.

The euro's arrival is one reason why European governments are being forced to confront their structural problems whether they want to or not. "Now that they can no longer compete by manipulating interest rates or exchange rates, they'll have to do so by improving their economic infrastructures," says Gros of the Center for European Policy Studies. Hans Tietmeyer, the just-retired president of Germany's Bundesbank, couldn't agree more. "[Governments] have to realize that the euro has ushered in a competitive society in which a new strain of dynamism challenges traditional welfare systems," he says. In other words, European countries can't use cheap money and currency depreciations to prop up ailing welfare systems.

In such an environment, governments have little alternative but to stare down vested interests and push ahead with reform. Europe's companies and markets are demanding change. If they get it, entrepreneurs will finally have the flexibility and lower costs they need. It may be hard to believe, but Europe's big chance has arrived at last.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE