The Euro on Trial

The currency isn't helping Europe to avoid an economic slide

Just a few months ago, European economists and policymakers were boasting that the 12-nation euro zone would easily weather the storm that has pummeled corporations and households in the U.S., Japan, and Southeast Asia since the second half of last year. Foreign trade accounts for just 18% of the euro zone's economy, they pointed out, so manufacturing and service companies would hardly be hurt by slumping demand elsewhere. Even if they were, 300 million European consumers, buoyed by tax cuts, would power domestic demand forward. What's more, the debut of euro notes and coins on Jan. 1, 2002, would inspire a new bout of restructuring, boosting business confidence and giving growth yet another welcome push. Some pundits even predicted that Europe would become the world's economic locomotive.

How wrong they were.

With six months to go until so-called E-Day, it's clear that Europe is in trouble. In the first two weeks of June, the corporate news has gotten dramatically worse. Nokia Corp., the company that can do no wrong, reports it won't meet its projections for cellular-phone sales. Siemens, the giant German electronics and electrical engineering company, has been so hard hit by tumbling demand for its products that it is cutting 8,000 workers. Swissair, once the bluest of blue-chip airlines, is threatened by the imminent collapse of its French affiliates, AOM and Air Liberte.

Those are the individual tales of woe. Entire industries are taking a fall as well. Steelmakers seem caught in endless restructuring. Auto sales in Germany, which slumped 11% last year, just cannot recover. Truck sales, traditionally a bellwether of economic activity on the Continent, are projected to drop by up to 9% this year. Airlines are being battered by high oil prices and slowing demand.

Shocked economists and policymakers are scrambling to revise their growth forecasts downward. Even the European Central Bank, which has repeatedly insisted that the economy would lose little of its vigor, has had to eat humble pie. Last December, it proudly predicted that growth would come in at around 3.1% this year and 3.0% in 2002. Take that, America! In June, the ECB forecast Europe's economy would grow about 2.5% in 2001 and 2.6% in 2002.

That's still above projected U.S. growth levels. But it's nowhere near high enough to give European companies a boost, let alone foreign companies that do business on the Continent. Far from it. The downturn could actually hit corporate earnings around the world. U.S. companies like Hewlett-Packard, Intel, and McDonald's are already seeing the effects of Europe's slowdown on their bottom lines. Europe's weakness makes it that much harder for the global economy to reignite.

Germany looks especially vulnerable. On June 18, the Kiel Institute of World Economics forecast that the German economy will be lucky to muster growth of 1.3% this year. The next day, German Economics & Technology Minister Werner Muller said the economy probably didn't grow at all in the second quarter. Germany is doing particularly badly because its industry is hampered by labor-market rigidities and other structural problems. In addition, the country entered monetary union at an overvalued exchange rate. Since Germany is the largest market in the euro zone, that's bad news for the entire bloc.

STAGFLATION. Nokia, STMicroelectronics, and Alcatel are just a few of the many high-tech companies that have recently told shareholders more bad news is on the way. A plunge in semiconductor sales has also prompted an earnings warning from Philips Electronics. "We don't see improvements in the second half of the year," says Chief Financial Officer Jan H.M. Hommen. Johannes Reich, head of equity research at Frankfurt's Metzler Bank, says that in Europe, "the New Economy looks as if it never existed." And it's not just techdom that's hurting. Old Economy companies like Kinowelt Medien, a German film rights company, and Dutch bank Rabobank Group have slashed earnings forecasts. Savino Rizzio, president of VIR, an Italian valve company, says the European slowdown has hit sales after 30 years of steady growth. "We have yet to touch rock bottom," he says.

To make matters worse, Europe seems to be hovering on the brink of stagflation--a noxious mix of accelerating inflation and slumping growth. In April, industrial production fell for the second month in succession. "Industry is already in recession," says Julian Callow, chief European economist at Credit Suisse First Boston.

Meanwhile, inflation in the euro zone surged to an annual rate of 3.4% in May from 2.9% in April. That's way above the 2% the ECB maintains is consistent with price stability. The higher prices--stemming in part from a weak euro and expensive energy--have neutralized the stimulus that should have come from this year's round of tax cuts, which put an estimated $50 billion into consumers' pockets. "Potentially the biggest threat [to Europe] is the emergence of inflation," says Niall FitzGerald, chairman of Unilever PLC. "If it gets beyond 4% for any period, that feeds into wage demands, and it becomes self-perpetuating."

The waves of bad news coming out of Europe explode the idea that the Continent had its own growth dynamic as it prepared to launch the paper euro. "Far from Europe being able to decouple [from the slowing world economy], there is increased integration," says CSFB's Callow. Take Gucci Group, the Italian luxury-goods producer. It has been hit by a slump of nearly 5% in U.S. sales. Chief Executive Domenico de Sole says the situation is unlikely to improve in the second half. Other European companies have gone on major buying sprees in the U.S. and are being directly hurt by the downturn there. Also important: Euro-zone portfolio investors who have bought hundreds of billions of dollars of non-European bonds and equities have been slammed by losses in U.S. and Asian markets.

PAINFUL STEPS? The euro zone's depressing performance shows that economic and monetary union hasn't fostered industrial restructuring and fiscal reform on the grand scale needed to reverse the Old World's relative economic decline. To be sure, the currency has knit the economies of Europe together. And the discipline of the Maastricht treaty, which sets strict limits for government deficits and borrowing, has done wonders for public finances. Most euro-zone countries now boast budget surpluses and show no inclination to spur inflation further by spending their way out of the slowdown. But the euro has not yet forced the politicians--many of whom face reelection soon--to take the painful steps necessary to deregulate labor markets and trim lavish social security systems. Some countries have actually made life more difficult for industry. France has introduced a 35-hour workweek that has increased most companies' wage bills. Germany has buttressed the system of "co-determination," whereby workers are given equal representation with shareholders on supervisory boards.

To be fair, some countries have moved on reform. Many of the smaller economies, such as the Netherlands, are much more flexible than they were three or four years ago. Even Germany has cut taxes and embraced pension reform over the past year. That's why Unilever's FitzGerald says it "would be foolish in my view to underestimate the speed at which these [euro-zone] economies are changing." But much more needs to be done if Europe is to buck the global slump. The gloating about Europe being the world's growth locomotive was premature. Europe now must restart its own engine.

By David Fairlamb, with Christine Tierney in Frankfurt, John Rossant in Paris, Stanley Reed in London, and bureau reports

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