Confessions of a Euroskeptic: Don’t Write Off Europe
Does the EU's constitutional setback spell trouble for the European economy?
June 1, 2005
The risk, in my view, is that this is an overdone story of cyclical angst. While the economic outlook for Europe is far from terrific, it’s not nearly as bad as the consensus mindset would lead you to believe.
We know the bad news: Europe could well be tumbling into yet another recession. The euro is trading at a seven-month low against the dollar.
The French have rejected the EU constitution. German reformer Gerhard Schröder is putting his political career on the line by standing for an early reelection. There is nothing pretty about this picture.
But the good news is that the bad news is already in the price. Financial markets move quickly to adapt to changing circumstances, and that’s exactly what has occurred.
There could be more of that to come, but it is important to stress that it will take more bad news to keep fueling the “eurotrash” trade. For those who want to take the other side of this bet, all you need to remember is that the bad news only needs to be “less bad.”
Put me in that camp. The bull case for Europe has always been one of painstaking progress on the road to structural reform. Today, the emphasis is on the painful aspect of that transformation — and on how it has left euroland overly exposed to cyclical vulnerability.
Courtesy of high and rising unemployment, the European consumer is all but absent from the region’s growth equation. The headline unemployment rate across the region has risen from a cyclical low of 7.8% in 2001 to 8.9% in early 2005.
Moreover, according to OECD estimates, after adjusting for business cycle effects, the “structural” unemployment rate in the euro area currently stands at about 8.2% — well above the 6.5% average prevailing in the mid-1980s.
Reflecting the resulting lack of job (and income) security, euroland private consumption growth has slowed to just 1% over the 2002-04 period — leaving the region with a thin cushion of support for domestic demand.
Little wonder the European business cycle is now listing to the downside. The lagged effects of a stronger euro — up nearly 60% against the dollar from early 2002 through late 2004 — have done serious damage to the region’s external demand drivers.
Like the downside of most cycles, this too, will pass. The euro has already fallen about 8% relative to the dollar, and oil prices — a formidable headwind for domestic demand — have eased off somewhat as well.
In both cases, these developments are “less bad” than they were five months ago. Largely as a result, Europe will see a now-typical cyclical rebound — a return to 2% growth in 2006 — driven mainly by a rebound in consumption growth from 1% to 1.7%. This is a muted recovery by U.S. standards and even by European standards of the past. But it is a rebound, nevertheless.
The real case for Europe lies beyond the business cycle. It is first, and foremost, a productivity story — one driven by the potentially powerful combination of IT-enabled capital deepening and improved labor market flexibility.
There are plenty of signs that corporate Europe will increase IT spending — a belated catch-up to the late-1990s trend that swept through corporate America.
I’ll be the first to admit that it’s a real stretch to extol the virtues of European labor market reform. Yet, while Europe still has among the most rigid labor markets in the world, they are slightly less rigid than was they were three years ago.
France has all but abandoned its 35-hour workweek, and Germany is doing away with shortened work schedules on a case-by-case basis.
Moreover, German labor unions have lost considerable power in the past five years, and the country’s work force has become heavily populated with “flexi-workers” — part-timers and temps.
Even for the creaky labor markets of Old Europe, this is legitimate change at the margin. And that’s all that really matters in the realm of productivity growth.
As a result, overall euroland productivity growth probably accelerated to around 2% in 2004 — doubling the anemic 1% trend of the preceding decade. Some of that was a cyclical pop, to be sure.
But it’s also a hint of the potential productivity payback that awaits Europe if it stays the course of structural change. This latter presumption — Europe’s willingness to stay the course of structural change — is what is now being drawn into question by the political battle over the EU constitution.
Personally, I think those fears are overblown. Pan-regional ratification of this bulky 470-page document was probably an exercise in futility from the start.
Just ask yourself this question: Would the legal strictures of a European constitution make much of a difference to the push for cross-border euro-zone efficiency enhancement?
The answer, in my view, is unequivocally “no.” From the standpoint of economic performance, a single currency, a uniform interest rate and the pan-regional harmonization of taxes, pricing and regulatory conventions count for a good deal more than agreement on constitutional rights.
Political unification would, of course, be the icing on the cake if it ever does occur — in effect, tightening the straightjacket that forces pan-regional efficiencies. But in the same sense, I do not believe that a French-led setback on the political front will unwind this shift to increased economic convergence.
From the start, the European Monetary Union has had to cope with political fragmentation. The effective demise of the Stability and Growth Pact — and the fiscal discipline it was supposed to have delivered — has been apparent for many years.
This is not new news. The problem comes when political bickering impinges on the structural reform agenda. On the surface, the early March 2005 scrapping of the EU Services Directive is worrisome in that regard.
The same can be said about the recent outbreak of protectionist sentiment in Germany, where minimum wage hikes were aimed at preventing “wage dumping” by Eastern and Central European workers.
These setbacks, however, should not be blown out of proportion. They may simply be an outgrowth of the increasingly tough cyclical environment.
In my view, it would take a full-blown politically inspired break-up of the EMU to do serious and lasting damage to the European structural reform agenda.
The hopes and dreams of European unification have come full circle over the past six years. Wide fluctuations in the euro versus the dollar have been a good barometer of these shifts in sentiment.
From a low of 0.82 versus the dollar in late 2000 to a high of 1.36 in late 2004, the mood swings have bounced back and forth between near-euphoria and near despair. At 1.25, today’s foreign exchange value of the euro is about 15% above the average of these two extremes and 19% above its post-launch average.
On this basis, the euro can hardly be judged as weak — although that comparison may be distorted by a dollar that is tainted by America’s record current-account deficit. Whether the euro falls further from here is anyone’s guess.
Stephen S. Roach
Former Non-Executive Chairman of Morgan Stanley Asia Stephen S. Roach is a senior fellow at the Jackson Institute for Global Affairs, Yale University, and a member of the Yale School of Management faculty. He was previously the Non-Executive Chairman of Morgan Stanley Asia (a position he held after serving as managing director and chief economist […]