The Euro

In one fell swoop, it will create the world's second-largest economic zone. The potential benefits are limitless--and so are the risks

It was a dream of European visionaries: From the devastation of war, a modern Europe would be rebuilt with diverse cultures but seamlessly linked economies. Great corporations would arise in a common market, and workers would prosper as never before. Someday, when a fully integrated Europe was in place, they would cap the achievement by giving everyone a crisp, single new currency to replace those faded marks, francs, lire, and pesetas.

It never happened. Europe's economies remained as Dutch, German, French, and Italian as ever, and its nations prospered better than anyone dreamed by rebuilding their national markets. The U.S. wanted a strong Europe to fight communism during the cold war. The Europeans put their military into NATO, but governments clung doggedly to their own national power. An exasperated former Secretary of State, Henry A. Kissinger, famously asked: "When I want to talk to Europe, who do I call?"

Now, all that is about to change. In a bold step toward eventual political union, Europe is launching a monetary revolution. On May 2, 11 countries--Germany, France, Spain, Italy, Ireland, the Netherlands, Austria, Belgium, Finland, Portugal, and Luxembourg--will set the terms under which they will trade their national money for an untested currency, the euro. They are sacrificing their most sovereign national power--the right to issue their own money. Instead, a European central bank will run the European Monetary Union. Members will surrender two of their most powerful economic safeguards--the right to devalue out of trouble or run budget deficits to counter mass unemployment. In essence, they have handcuffed their government spending and bond and stock markets to a European future. The only way out is to quit, and no nation shows signs of doing that.

The economic shock waves will shake Europe to its foundations. The reform is likely to unleash an unstoppable market process that will sweep away the structures Old

Europe held so dear--national corporations and banks, rigid work rules, generous pension payments. In their place could emerge a competitive $6.4 trillion economy, second-largest in the world. "Monetary union is going to be the catalyst for Europe's revival--economically, politically, and in self-confidence," says Leonhard Fischer, a board member of Dresdner Bank.

But the risks are so great and the consequences of failure so far-reaching that many outsiders remain skeptical that normally cautious European politicians would ever take the big step and implement monetary union. Indeed, the leaders who pushed Europe to the point of no return, German Chancellor Helmut Kohl and late President Francois Mitterrand, were only dimly aware of the economic and financial whirlwind they were stirring up.

Europe's politicians are moving forward for three reasons. First, despite two decades of trying, few Continental European leaders have been able to push through economic reforms by appealing directly to voters. Yet Europe's largest employers almost daily repeat their threat that without dramatic change, they will continue to ship jobs offshore. For reformers, the euro has become a backdoor approach to imposing the pain needed to renew Europe. Neither voters nor special interests will see its wide effects until it is too late. The euro is "a Trojan horse," argues David Bowers, European equity strategist for Merrill Lynch & Co.

Second, many gains have already been banked even before the euro's introduction. The campaign to win admission to the euro club gave governments from Rome to Dublin a reason to do what they had to do anyway--hold down spending against the demands of unions, left- and right-wing politicians, and heavily subsidized companies.

Third, even reluctant politicians have recognized that business confidence is up. The euro campaign has reinvigorated markets and helped kick off more growth than Europe has seen in nearly a decade. Mergers to streamline companies jumped 48% last year, to $384 billion, and a new culture of shareholder value is seeping into executive suites.

But there are many bumps ahead that could hurt the euro's momentum, or even derail it. The currency system officially starts on Jan. 1, 1999, when corporate books, bank transfers, credit-card payments, and even home mortgages can begin to be figured in euros. The European Central Bank will also begin setting interest rates. Euro coins and notes must start changing hands on Jan. 1, 2002. Just the mechanics of making the system work is likely to cause shocks. A strong economy could cushion the blows. But if a recession hits Europe, the euro will be blamed and politicians will run for cover.

JOB TURMOIL. Still, the real measure of the euro's new power will be how much deep-seated economic reform it triggers across the continent. There are formidable tests ahead. As restructuring hits and unemployment rises, politicians will come under intense pressure to raise spending and taxes. But that old approach will only deepen problems in the euro era. High tax economies are likely to weaken, while lower-tax players would gain. Many workers will also suffer. If Spain slumps, for example, will its workers move to Germany to find jobs? The answer now is no--unless governments agree to standardize job requirements and pensions. It seems quite likely, however, that if French socialists try to hold to a 35-hour work week while Portugal allows longer hours, companies will move south to save costs, just as U.S. companies used to move jobs from New York to Texas--and now, to Mexico.

Massive job shifts are almost a certainty. By most estimates, one in five workers will be disrupted by mergers and downsizing, and some 5% of industrial workers could lose their jobs. Even at the peak of America's downsizing and Britain's Thatcher revolution in the early 1980s, job turmoil was not greater than these levels. Take banks. Analysts estimate that as many as a half of the 166,000 bank branches dotted across the Continent may have to close. Tens of thousands of workers in these banks could be early casualties of the euro.

Of course, no government could withstand a protracted siege like this. Europe probably won't have to either. That's because the Continent is in the midst of a rolling revolution. Job cutbacks will be stretched out over several years, even as new jobs--both temporary and full-time--are created in small companies and service businesses. The underground economy, which employs an estimated 1 in 5 workers, will also absorb the job shock.

But the key to the euro's success has to be growth. Much of the restructuring that is gripping Europe now is a result of deregulation as companies get ready to meet global competition. That is laying the foundation for economic expansion, and even new jobs. In the deregulated industries such as telecoms and airlines, new players are coming in and adding jobs.

Meanwhile, as larger companies retool and shift to faster-growth areas, new service companies are springing up around them. These, too, are providing new jobs--but often at less pay. The Netherlands is a model. It has pushed unemployment down to 5.2% from an 11% European average by deregulating, holding the line on wages, and encouraging flexible employment. The labor and financial markets are leading change, notes Jon Chait, chairman of Manpower Inc.'s European operations in Brussels: "European governments are running along, trying to keep up with a train that has already left the station."

Perhaps the most important pro-growth effect of the euro will come as it spurs price competition. As prices become visible in one currency across the Continent, costs and productivity will be instantly measurable. Companies will quickly reallocate investment to the most profitable regions. While jobs will be lost, many more European companies should be able to compete globally. The euro "will tend to lower prices and could hurt profits, at least short-term," says Manfred Gentz, chief financial officer of Daimler Benz. But, adds Louis R. Hughes, president of General Motors Corp.'s international operations: "Whether in two, three, or five years, Europe will be a lot leaner and more competitive."

On a personal level, the euro could bring unexpected changes, too. For the first time, average Europeans will be able to look across the Continent and easily compare their salary, taxes, and take-home pay to comparable workers and executives in other countries. That could cause Europeans to become far more demanding when it comes to pay hikes and tax cuts. With prices across the Continent posted in euros, costs of consumer goods are expected to plunge. That could spark a new burst of consumption.

The new competitiveness could be further sharpened as Europe's governments start comparing their tax and spending rates. High corporate taxes will become increasingly difficult for governments to maintain once monetary union is in full operation. Finland's top corporate tax rate, for example, is just 27%, vs. 57% for Germany. Once the euro is in place, governments will no longer be able to devalue to lower costs, so companies will have to move to better locations. Says Ravi Bulchandani, a Morgan Stanley Dean Witter & Co. economist in London: "If you remove currency as a safety valve, governments will be forced to focus on real changes to become more competitive: lower taxes, labor-market flexibility, and a more favorable regulatory backdrop for business." If that happens, analysts predict euro-club economies could expand an average of 3% or more annually over the next decade.

Foreign investors, led by finance companies, will also drive jobs and growth. "It's a huge, huge opportunity," says Howard Lutnick, CEO of New York-based government securities broker Cantor Fitzgerald Securities, which is spending "tens of millions of dollars" on European expansion. Investment banks such as Morgan Stanley, Goldman Sachs, and Merrill Lynch are shifting teams of dealmakers from New York to London to exploit the EMU's possibilities.

The lure is a giant new financial market. "If one thing is certain about the EMU, it's that it will bring about a revolution in European financial markets," notes Antonio Borges, dean of INSEAD, the French business school. For starters, the euro zone government bond market, at $1.9 trillion, is almost as big as the U.S. Treasury market. Strapped central governments, which traditionally have done nearly all the borrowing, are expected to push more spending onto provinces and municipalities, greatly diversifying the mix of securities.

On top of that, the corporate bond market in the euro zone is valued at just $160 billion, one-sixth the size of the U.S.'s. And its stock markets have a combined capitalization of just $3.6 trillion, less than one-third the size of U.S. equity markets. The corporate-bond market is expected to quadruple in size in coming years, to around $800 billion, creating a vast new pool of capital for companies to tap. Fragmented Continental equity markets also are likely to merge into two or three big bourses.

UPSTART CHALLENGERS. The prospect of cheaper money and shareholder demands for higher performance are also changing corporate Europe. Under-performing French and German conglomerates have been shucking off units that can't match profits of rivals elsewhere in Europe. Siemens last year spun off its dental-products unit into a leveraged buyout, now a company called Sirona. Alcatel Alsthom in France and Philips Electronics in the Netherlands have been paring down, too. As a result, companies are slowly shifting from propping up losers to investing in winners.

In this swirl of corporate restructuring, one point has been obscured: Workers are grudgingly becoming more flexible. From Daimler Benz to tiny knitting-needle maker Gustav Selter, for example, German companies are quietly negotiating plant-by-plant pay and work-rule concessions they never could before. That's one reason unit-labor costs in Europe will be up just 0.7% this year, says Goldman Sachs & Co. Germany's will fall by 0.5%, after dropping 1.7% in 1997.

As the euro kicks in, it's also likely to speed deregulation, which has already reordered Europe's corporate landscape. Since the European Union mandated deregulation of the airline market last year and of telecoms as of last January, upstart challengers have been taking on national giants such as air carrier Alitalia and Deutsche Telekom. Now, Germany says it will totally open its postal market by 2003. Klaus Zumwinkel, the ex-head of mail-order giant Quelle who now is CEO of Deutsche Post, says he will be ready for rivals in all his businesses within three years. "In the real world, things are going to happen much faster than politicians expect," he contends.

Indeed, some European investors are now talking about a "golden" scenario for the continent. In this view, Europe will begin to take on attributes of the American "New Economy," with its high productivity, low inflation, and steady growth. If all this happens and Europe becomes a greater economic power, it will have gained the wherewithal to pursue its own global political agenda. Cementing European economic union will inevitably lead to talk of greater political integration.

The big question now is how European citizens themselves will react to all this change. Europe's elites have promised average citizens that the new Europe will be able to hold its own against the best in the global marketplace and eventually create jobs. What they have left unsaid is that in this new era, Europeans will face a more economically insecure future, without social protections they have enjoyed until now.

But optimists believe the politicians are unleashing a process that will lead to major progress. "The market tends to push things much faster than regulators expect," says Mark Frevert, head of European operations of U.S. energy giant Enron Corp. That's perhaps more prosaic than the great rebuilding that led European visionaries to dream of a common currency 40 years ago. But if it works in this age of global markets, it could prove to be just as significant.

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