How Europe Could Grow Again

The European experiment was supposed to deliver prosperity. It hasn't. But with less reform than you might think, a healthy new economy could emerge.

In the grandiose language employed for such high-level get-togethers, the two-day meeting of European leaders in Lisbon in March, 2000, was billed as "the knowledge and innovation summit." And why not? Everything seemed to be at last coming together for the Old World. Economic growth was spiking upward even as the U.S. economy was beginning to slow. The recent launch of the euro as the new single currency for 305 million people seemed to augur prosperity. For a brief, shining moment, Europe was on a high.

So high that Europe's 15 leaders seemed to lose contact with reality during those two spring days in Lisbon. They solemnly pledged that within a decade, Europe's economy would cruise at 3% growth -- a rate not seen since the early 1970s. The number of employed would swell by 10%. On the back of huge jumps in technological innovation, productivity would soar. By 2010, Europe would be the most dynamic economy on the planet -- or so the Lisbon Agenda promised.

What is extraordinary is that few in Europe at the time questioned these goals. One who did was Poland's then-Deputy Foreign Minister, Radek Sikorski, a former Solidarity Union official who had his own long experience with official half-truths. Watching the news out of Lisbon from his office a half-continent away in Warsaw, he laughed out loud. "In fact," recalls Sikorski, now a specialist in transatlantic relations, "I hadn't laughed so hard and so much since the Communist Politburo used to announce totally unrealistic production targets. It was the same kind of thing."

Propaganda? Well, not too far from it. For the past two decades, Europe has lived through a series of economic lies. The single market would boost economic activity. The euro would turbocharge growth. The expansion of the Economic Union to the East would make Europe mighty again. The bitter reality is that today, the EU is the globe's also-ran economy par excellence, lagging behind the U.S. for the second decade running. And white-hot U.S. economic growth in the third quarter of 7.2%, vs. an expected 0.3% in the euro zone, only underscores the widening gap. This year, even Japan is growing more than twice as fast (chart, page 48). Per capita gross domestic product in Europe, after having risen from 50% of American levels in 1950 to 80% in 1990, has now slumped back to 65% and continues to fall. From the common market to a common currency, Europe's political advances "haven't delivered what they were supposed to," concedes André Sapir, an economic adviser to European Commission President Romano Prodi and author of a devastating critique of European competitiveness. "The truth is that growth in Europe hasn't been favorable for the past 20 years," he says.

There isn't yet much good news to relieve the gloom. But at least Europe's leaders, and many of its citizens, are finally getting scared: They realize they need to start shaking up the postwar European welfare state or fall so far behind the U.S. that they can never catch up. And it's not just the U.S. Europe has to worry about. "China was not on the map" just two years ago, says Erkki Liikanen, the European Commissioner for Enterprise & Information Society. "Now it is the big challenge for Europe." Liikanen's big worry: European investment in research and development not only lags behind the U.S.'s but also East Asia's. "Europe is losing out," says Nestlé's (NSRGY ) powerful CEO, Peter Brabeck-Letmathe.

The other piece of good news: Europe can find the solutions it needs within Europe. Faster-growing countries on the periphery, such as Finland, Ireland, and Spain, have been experimenting with pro-growth policies for years. Even within the Franco-Italian-German core of the euro zone, some of the hallowed precepts of the postwar era are being called into question for the first time. Taxes are starting to be cut, pension systems are being reformed to encourage people to work more, not less, and hugely generous unemployment benefits are being trimmed. In France, merit-based pay is under discussion for the upper ranks of the country's 6 million army of state fonctionnaires. In Germany, Chancellor Gerhard Schröder got Parliament to approve reforms in late October that will cut unemployment benefits next year -- something even ex-British Prime Minister Margaret Thatcher didn't attempt in her 11 years in power. "For years, there was a dam preventing a huge wave of reform," says Kurt Biedenkopf, former Prime Minister of the east German state of Saxony. "Now that dam is beginning to crack."

Biedenkopf, like many critics, argues that current reforms may be too little, too late -- and too long-term. Opponents of change still marshal the argument that market-driven reforms will turn Europe into a raw, volatile, American-style economy that Europeans will not tolerate. Such arguments resonate deeply with many.

That's why a radical shift like massive deregulation of labor markets is unlikely. Yet if Europeans took some short-term steps to reform, they might see a tangible payoff in higher growth rates. It could be the beginning, indeed, of a European New Deal -- preserving key elements of the welfare state that Europeans cherish, such as an absence of extreme poverty, while delivering stronger growth. A BusinessWeek/Global Insight study estimates that a series of smaller steps would raise Germany's annual growth rate by 0.5% over the next ten years. From cutting personal income taxes to 33% (from an average European rate of 38%), to raising the retirement age to 67 from an average of 63, to hiking the pressure on unemployed workers to relocate to take jobs, such measures would be concrete and powerful and show that Europe could win real gains from a manageable amount of change (table). Even an extra 0.2 percentage point rise in the long-term growth rate could add more than 1 million jobs in France by 2010. "There can be a European way to generate growth. It doesn't have to be the American way," says Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Mass.

Locked-up Potential

Lackluster growth and uncertainty about the future have kept Europeans holding on to their euros rather than spending them. If consumers were confident about jobs and feeling richer through income-tax cuts, they'd be more likely to spend that cash and trigger more growth. Even the political Establishment is starting to understand that. In a break with the past, leading center-right German politician Friedrich Merz recently proposed massive simplification of the complicated German tax code and slashing the top income-tax rate to 36% from 48.5%. The proposal would pump an estimated $11.6 billion into the economy. "There is a lot of potential for Europe to grow," says Michael Hume, senior European economist at Lehman Brothers Inc. (LEH ).

That potential needs to be unlocked fast. Today, the U.S. and EU economies are roughly the same size. Extrapolating from present trends the U.S. economy will be twice as big as Europe's in little more than a generation, notes Charles Grant, director of London-based think tank Centre for European Reform. That's even after taking into account the eastward enlargement of the EU. "Because the gap is growing so much, it becomes more and more difficult to fix problems in the transatlantic relationship," says Ulrike Guerot, a foreign-policy expert at Berlin's DGAP. "It will no longer be a meeting of equals in any way."

The political costs of no growth are rising dramatically already. The utter defeat of a pro-euro referendum in Sweden on Sept. 14 is raising questions about the long-term cohesion of the EU. For the Swedes, as well as for increasing numbers of other Europeans -- from the traditionally independent British and Danes to the freewheeling Spanish and smaller, high-growth countries such as Ireland, Finland, and the Netherlands -- the idea of "Europe" is becoming increasingly synonymous with slow growth, high unemployment, protection of sunset industries, and a Brussels bias toward France and Germany. But if Europe's periphery is getting restless, it's precisely the periphery that offers the most hope. In fact, if France, Germany, and Italy were taken out of the equation, European growth rates would look more like America's track record over the past decade. Practically, of course, without those three countries, which account for more than half of EU GDP, there wouldn't be much Europe left. But both Finland and Ireland have grown faster than the U.S. since the start of the 1990s. Christopher Smallwood, economic adviser to Barclays PLC (BCS ), estimates that Britain will overtake Germany to become the largest economy in Europe within a generation. "The differences within Europe are in fact larger than the difference between the European average and the U.S.," says Daniel Gros, head of Brussels-based think tank Centre for European Policy Studies.

Success Stories

Take Denmark. Its move in the early 1990s to make it easier to hire and fire workers has led to a sustained employment boom, giving the peninsular state of 5.2 million a 6% unemployment rate while Germany's hovers over 10%. Denmark's economy has averaged a 2.6% annual growth rate since 1994, compared with just 1.4% in Germany. The Danes cut entitlements, including social security transfers, and raised indirect taxes. That gave them the ability to shift resources into higher education and research and development. Now Denmark is the third-largest exporter of pharmaceuticals per capita and among the world leaders in biotechnology patents.

The success of Denmark and other nations gives the Europeans a benchmark against which to measure their efforts. Thanks to the single market and the euro, it's simpler than ever to track differences in national performance. That is leading to an unprecedented questioning of Germany's Kündigungsschutz legislation that makes layoffs costly and time-consuming. Now, says Jérôme Caille, chief executive of Swiss-based employment-services giant Adecco (ADO ), "if a policy looks like it works in one country, another one borrows it quickly."

Consider, this example: Last June, Germany's Economics & Labor Minister, Wolfgang Clement, paid a trip to Britain to look at the way the new Labor government has used job centers to attack youth unemployment. Impressed, Clement managed to push measures through just four months later creating German versions of the British job centers.

Even the French are giving the British credit. Prime Minister Tony Blair's success in keeping unemployment at almost half Continental levels has garnered a positive hearing at left-of-center daily Le Monde, which ran a glowing editorial on Oct. 27 entitled "Growth and employment: In praise of Tony Blair." It concluded: "It's the heart of [Blair's] New Deal: You can lose your job, but society will guarantee that you find another."

Don't expect a Thatcherite revolt on the Continent, though. "We're not going to have shock therapy," says Renaud Dutreil, the French minister in charge of small-business policy. But Dutreil is attacking the red tape involved in setting up a business in France. He slashed the minimum capital requirement for a new company from 30,000 euro to just 1 euro, one reason why new-business creation is beginning to surge. "It's true, we're culturally behind others when it comes to the spirit of entrepreneurship, but I can tell you we have a growth policy now," he says.

This Frenchman has counterparts in Italy. At first, that's hard to see. Italy's unions are up in arms about plans to keep people working longer before they qualify for pensions, and sporadic strikes make the country look as ungovernable as ever. But small business may soon get a huge tax break. Economics & Finance Minister Giulio Tremonti has moved to cut capital-gains taxes to just 12.5% from 19% for individuals and corporate tax to 33.5% from 50%. "Entrepreneurs now have a better environment in Italy than almost anywhere else in Europe," says Simone Cimino, CEO of Milan-based private equity group Natexis-CAPE.

The big hope of French, German, and Italian politicians is that the cumulative effect of such reforms will be to avoid the need for even more radical steps. They are being carefully watched by smaller countries who worry that reforms won't spark growth quickly enough in the euro zone's heart. Besides, even politicians on the dynamic periphery get timid. Prime Minster José María Aznar has done much to boost Spain's growth but has dragged his feet in deregulating the labor market. Progress on labor deregulation in Germany and France might kick-start the process in Spain. The smaller nations have done their bit. With the goals of Lisbon receding even more into the future, it's high time for the most important members of the European family to do theirs.

By John Rossant

With David Fairlamb in Frankfurt, and bureau reports

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