Europe: Clear The Decks For Reform

A tumultuous week sets the stage for real economic reform

It was a week that rattled nerves in statehouses and executive suites all over Europe. On Mar. 11 in Bonn, Oskar Lafontaine, the powerful, left-leaning German Finance Minister who was the favorite bete noire of European business abruptly quit, retiring to his home in Saarbrucken and vowing to leave politics for good. Five days later, in the wee hours of the morning, all 20 members of the haughty European Commission in Brussels resigned in disgrace, leaving the European Union virtually ungoverned. In the background, two huge, unprecedented hostile takeover battles raged both in Rome and Paris.

What's behind the upheaval? The short answer is that the combined forces of global competition, deregulation, and European Monetary Union are hitting the Old World like a tidal wave. Investors and voters alike are sick of the status quo and clamoring for measurable progress. In business, Europe is moving closer to dog-eat-dog capitalism, where cronyism and protectionist laws can't shelter executives from market forces any longer. Meanwhile, demands for accountability are putting similar pressure on politicians and bureaucrats. In both the public and the private sectors, the old-style back-scratching and featherbedding won't work in the New Europe.

"MOMENTUM." To a pessimist, Europe would appear to be entering a period of damaging turmoil. After all, the old guard may have had its problems, but at least it functioned predictably. Indeed, the Brussels scandal temporarily sent the euro plunging. But the more hopeful scenario is that Europe is entering a period of creative destruction that could hasten long-needed reforms throughout the EU and shock Germany and France out of their high-tax, heavy-regulation habits once and for all. "The trends that are causing Europe to become an ever more integrated market will continue," says Steve Raymund, Paris-based CEO of Tech Data, a big Florida computer distributor now making a major push in Europe. "There's too much momentum to turn back."

In Germany, despite short-term uncertainty, Lafontaine's defection may force German Chancellor Gerhard Schroder to act more like a leader. He can no longer blame fence-straddling policies on the outspoken Lafontaine. Business leaders, who believe Schroder will now move quickly toward more pragmatic policies, are redoubling calls for lower taxes, relaxed labor rules, and pension reform.

In addition, Schroder, who admires British Prime Minister Tony Blair, may attempt to tighten ties with Britain. That could undo Lafontaine's Franco-German campaign for higher taxes and lower interest rates in the euro zone. "If you had asked me two weeks ago, I would have said the business and tax climates in Germany were going in the wrong direction," says Siemens board member Ulrich Schumacher. "Now, I would say there is hope."

In Brussels, similarly, the house-cleaning promises short-term confusion but paves the way for progress once the dust settles. EC President Jacques Santer, who had a reputation for foot-dragging, will step down as soon as a replacement can be appointed. Commissioner Edith Cresson, who was accused of hiring her dentist to supervise AIDS research to the tune of $150,000 for a few months' work, is expected to lose her post. But also among those forced to resign were British free-market champion Sir Leon Brittan and antitrust czar Karel van Miert, a Belgian instrumental in pushing European deregulation. If political squabbling breaks out, it could take months to appoint a new Commission.

Yet in the long term, EC reform could be a major plus for Europe. If van Miert, Brittan, and other reform-minded commissioners are reappointed as expected, energy, airline, telecommunications, and other Brussels-led deregulation initiatives will continue. A new initiative simplifying the Continent's bewildering maze of taxes also could still be enacted by yearend. "This resignation won't change the fact that governments here have decided to open up to the marketplace," says Raymund. And the whole organization could get a boost if heads of government agree on a dynamic new EC head at a Berlin meeting in late March. Among the names under discussion: former Italian Prime Minister Romano Prodi.

Dramatic as it is, this shift toward accountability in government pales next to the upheaval in European business. European Monetary Union was expected to force companies to compete on a Europewide basis, creating pressures that would gradually break up the interlocking shareholdings, old-boy networks, and government protections that have cosseted many European industries. But the speed of change, within the EMU's first three months, has been astonishing.

Take Banque Nationale de Paris CEO Michel Pebereau. His surprise Mar. 9 attack on rivals Paribas and Societe Generale "is a major, major shock to the financial industry in France," says Jean Dermine, a professor at Insead, the Fontainebleau-based business school. "It's totally new." Analysts hope the trend will spread. "Without hostile takeovers, banking consolidation won't happen fast enough," says London-based Credit Suisse First Boston analyst Mark Hoge.

MERGER PRESSURE. Big, hostile deals are giving fresh impetus to the cause of shareholder value in Europe. Just look at Telecom Italia's defensive strategy now that the former phone monopoly is under siege from much smaller Olivetti. Telecom Italia CEO Franco Bernabe aims to slash some 40,000 jobs to boost profits--a move he probably would not be considering if he weren't under threat.

Nearly every European company is under pressure to move quickly. Chemical giants Hoechst in Germany and Rhone-Poulenc in France had been planning to take as long as three years to complete the merger of their drug operations while selling off lower-margin chemical units. Key shareholders in Europe and Kuwait said that wasn't good enough. Now, the timetable calls for completion by yearend. "Investors told me they like the deal, they like the direction, but a full merger taking two or three years is too long," says Rhone-Poulenc President Igor Landau.

Such pressure is reaching deep down into once sleepy companies. Under attack from disappointed shareholders, Siemens plans to spin off its $3.8 billion semiconductor operation in an initial public offering. It will reduce its stake to less than half and list the business in the U.S. as well as Europe. Schumacher, who will run the new unit, is excited at the prospect of being able to offer his executives options and other performance-enhancing incentives. "This is one of the major things that will make us attractive to investors," he says.

Even European governments are starting to feel a sense of urgency about keeping up with a changing world. Relentless pressure from the private sector was largely what drove Germany's Lafontaine to resign. With the German economy threatening to tank, executives revolted against his wishy-washy tax reforms. Schroder began holding marathon meetings with corporate chieftains to boost confidence in his faltering government. But the testy peace he had forged with Lafontaine broke at a Cabinet meeting in Bonn on Mar. 10. Schroder railed that he wouldn't take the heat for any new initiatives that riled business--a barely veiled snipe at Lafontaine. The next afternoon, Lafontaine quit.

German executives may have reason to celebrate. The Chancellor quickly appointed Hans Eichel, outgoing Prime Minister of the state of Hesse and a relative moderate, to replace Lafontaine. Some analysts think he eventually may dump the Green Party, his current coalition partner, in favor of the pro-free-market Free Democrats if the Greens continue to push for measures such as a big hike in energy taxes and a phase-out of nuclear power. They also think Schroder now will be open to pension reforms and slashing the top corporate income tax rate to 35% from 50%-plus now. "Schroder doesn't have any fixed ideological positions," says one banker. "This is an opportunistic situation."

Lafontaine's resignation may have broader European implications, too. He had loudly criticized the new European Central Bank for not slashing interest rates. Schroder, by contrast, is expected to drop shrillness in favor of quiet lobbying. That takes political pressure off ECB President Wim Duisenberg, who is eager to establish the new bank's independence among global investors anxious about its integrity. And if Schroder gets tighter with Blair, he could help the British Prime Minister ease his nation into the euro zone by 2003. Britain's entry would add a powerful new voice for free-market policies.

There is, of course, peril in all this turmoil. In addition, plenty of entrenched forces are still resisting change in Europe. For instance, in the wake of the BNP bid, the French government quickly issued a thinly disguised warning: No wholesale layoffs of BNP's, SocGen's, or Paribas' combined 89,000 employees must ensue.

Paris is also likely to oppose a non-French counterbid--again, to protect French jobs. That became apparent on Mar. 14, when the government announced plans to privatize troubled Credit Lyonnais. Outsiders such as German insurer Allianz may invest, but no private investor may take more than a 10% stake. "The government wants to prevent a merger with high social costs," says Insead's Dermine.

But government interference will just make private companies increasingly vulnerable. One reason French banks are so desperate to merge is that government constraints on cost-cutting and mergers have kept their profits and market value way below rivals' in less restricted markets such as Spain, the Netherlands, and Britain. Even giant Deutsche Bank, still No. 2 in Europe in terms of assets, has seen its market capitalization plummet from first place to 12th in Europe since 1990. The lesson for governments and companies alike is that the rules of the game in Europe are changing almost overnight. One turbulent week in mid-March proved that to one and all.

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