The Continent Breaks Into A Run

Can the growth spurt in Europe last?

Heinz Greiffenberger can hardly believe it's true. Sales at his north Bavaria machine and gear company, about $100 million a year, had been seesawing as Europe struggled to break out of the recession that hit in 1992. But he forecasts that after falling 7% in 1996, sales will soar this year by up to 15%. Other German Mittelstand companies also expect to perform better in 1997. "There's a new, more optimistic attitude," says Greiffenberger.

Indeed, Continental Europe's so-called recovery, which has frequently felt more like a downturn, finally seems to be kicking in. Across Europe, economists are revising anemic growth projections upward. Average growth in the European Union, which barely reached 1.6% last year, could hit 2.8% next year, figures BMW economist Oliver la Bonte. For the first time since the late 1980s, European growth should surpass that of the U.S. "I see a trend where Europe is going to be more and more competitive," says Richard M. Donnelly, president of General Motors Europe.

BRUTAL YEARS. But the tough question is how long that trend can endure. What has been so admirable about America's six-year expansion is not so much its vigor as its staying power. Europe has yet to prove it can match the new U.S. formula of steady growth, low inflation, low unemployment, and booming capital markets. And while 1997 and 1998 look promising, Europe's recovery still lacks several building blocks that have been crucial to America's long-running growth spurt (table).

For one thing, Europe has just begun the streamlining that took Corporate America 10 brutal years to carry out. And downsizing is only the start. Without structural change, from deregulation to tax laws to work rules, higher growth rates may not be enough to cure European joblessness and set the stage for a long-running expansion. "It's true that the pressure to adjust is growing around Europe," says Salomon Brothers Inc. international economist Kermit Schoenholtz. "But at Europe's core, structural change still isn't sufficient."

In the U.S., for instance, high technology accounts for nearly a third of gross domestic product, powering growth and creating well-paid jobs to replace those lost in manufacturing. In Europe, high tech's share of output is less than 10%. Even lower-paid service jobs are scarce. In Germany and France, manufacturing accounts for 30% of employment, vs. 15% in the U.S.--one reason Germany, with unemployment at 11.2%, is bleeding jobs at the rate of 300,000 a year. Without deregulation and incentives to create a healthy service sector, Europe's core economies are unlikely to duplicate the U.S. miracle.

Strong, steady productivity growth is another magic element in the American expansion--still largely missing in Europe. U.S. nonfinancial output per hour is rising an estimated 2.4% this year, up from almost zero in 1995. In Europe, by contrast, governments are still struggling to unload unproductive assets in state-owned companies. And France, for example, is using job-sharing and shorter workweeks to deal with unemployment--tactics that add little to economic dynamism.

Still, Europe's economies have the best chance in years to show some real verve. For one thing, a stronger dollar and the lowest interest rates in three decades are boosting exports and, in turn, capital investment. And after a spell of fiscal restraint that will squeeze 1% of GDP from EU economies this year, Europe may next year finally be able to ease off a bit even as it prepares for a single currency in 1999.

In Germany, for example, the government's mid-May decision to revalue its gold reserves means Bonn won't be tightening its finances nearly as much as expected to reach the budget-deficit criteria for monetary union. That should boost growth in Europe's key economy. Several Europe watchers now think Germany may grow as much as 3% next year.

GRUDGING. Italy, meanwhile, has imposed punishing budget cuts and introduced a one-time "Eurotax" to help meet the deficit criteria. That has had a chilling effect on consumer activity--another missing link in Europe's recovery. But when Rome offered a subsidy to boost car sales in January, orders exploded, indicating huge pent-up demand. "What weighs on the economy more than anything else is the feeling that still greater efforts at restraint will be required," says Credit Suisse First Boston Corp. economist Francesco Giordano. If governments can find ways to avoid more restraint, consumers may cheer up.

Beyond consumer sentiment, the real key to long-term economic health in Europe is acceptance of structural reforms. And there are signs that reform has grudgingly become part of the political and social landscape. In Spain, home of Europe's most arcane labor rules, the government recently adopted a business-labor pact to slice compensation for laid-off workers and made it easier for employers to shed excess labor. The reforms are expected to create 200,000 permanent jobs.

Corporate restructuring is forging ahead. After years of honing operations, French steel giant Usinor Sacilor has seen output rise 12% this year, despite weakness in two traditional linchpins of its business--public spending and auto making. Or take Greiffenberger. In addition to working out more flexible work rules with unions, his company has gone on an innovation campaign that's paying off. Some 75% of its sales of gears, for construction equipment and other applications, come from products the company wasn't making three years ago.

Such changes are powering healthy profit increases. Where strategists had been betting on a 10% rise in European corporate profits this year, they recently hiked the figure to 15%. Peter Sullivan, European equities strategist for Goldman, Sachs & Co., figures that's still low. He sees corporate profits jumping 22% this year and a further 15% next year. The impact on Europe's stock markets has been dramatic. Germany's bourse is up 23% in local currency terms this year, France's 19%, and Italy's 20%.

After the ups and downs the Continent has struggled with for five years, the brighter growth picture can only come as welcome relief. Now, the real test will be whether the key economies, France and Germany, use the opportunity to push ahead with reforms that will begin to cut unemployment--and move Europe down the road to U.S.-style economic dynamism.

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