by Stephen Roach (from Amsterdam)
This was a fascinating week to have been in Europe. A week after the shock that hit the Continent, this six-city swing is nothing but doom and gloom. First, the economy, now politics – the consensus believes that Europe is hopelessly adrift. The skeptics are muttering, “I told you so.” The optimists have thrown in the towel. The psychological capitulation is broad and deep. The dream of a United States of Europe is in tatters.
As a card-carrying euro-skeptic, I have certainly expressed my doubts over the years about the hopes and dreams of Euroland. From the start, I worried that “one size did not fit all” – that Europe was still a heterogeneous combination of diverse nation-states that would not take well to a single currency, a single interest rate, and a fiscal rule. The conditions for the “optimal economic zone” were far from satisfied, and political fragmentation only served to underscore the region’s inherent differences. How could Europe pull together, if its macro disparities were pushing it apart?
That question now takes on much deeper meaning in the aftermath of the stunning rejection of the EU constitution. It boils down to an assessment of the potential synergies that might have arisen from the interplay between political, economic, and financial-market integration. While the theory made sense, the proposed application of that theory never did, in my view. A supra-bureaucracy was the last thing Europe needed at this stage in its drive for unification. In my opinion, it was far too soon in the integration process for Europe to bring political unification into the equation. With this possibility now having been all but quashed by the French and Dutch electorates, Europe is free to focus its energies on the sad state of its economy. That gives Europe a much cleaner shot at the heavy lifting of structural change and productivity enhancement. That is a very positive development, in my view.
As a student of structural change for longer than I care to remember, I suspect that too much is being made of the successes or failures of Europe’s government-sponsored reform initiatives. The US experience tells us that private-sector corporate restructuring is the main agent of change. That has also been the case in Japan in recent years, and is now the case in Europe, especially Germany. In all of these instances, politics was a secondary consideration, at best. All the government had to do was get out of the way and let competitive forces take their normal turn of events. By endorsing trade liberalization and deregulation of long sacrosanct service industries, politicians exposed bloated and complacent companies to the harsh market-driven pressures of creative destruction. Once sheltered, then exposed, the choice for businesses boiled down to restructure or perish. It was that simple — that brutal.
So now the French and Dutch have spoken — the EU will have to face a future without a constitution. As long as Europe does not put up new walls — either externally through trade protectionism or internally through re-regulation — I suspect that corporate restructuring will continue to gather momentum over time. The odds of Europe putting up significant barriers to foreign trade are exceedingly low, in my view. As Eric Chaney notes, the EU is the world’s largest exporter; it accounted for 14.7% of total global exports in 2003 — well above the US (9.6%), Japan (6.3%), and China (5.8%), the world’s second, third, and fourth largest exporters. For an externally-dependent European economy and the world’s dominant exporter, Europe has everything to lose and nothing to gain by going protectionist. The EU’s recent imposition of quotas on selected Chinese-made textile products should be viewed as nothing more than a minor skirmish on the trade front. For Smokestack Europe, competitive pressures are likely to get increasingly intense in the years ahead — leaving restructuring and efficiency imperatives as the only means of survival.
Nor do I buy the view that Europe is about to turn back the clock and go on a re-regulatory binge. I do not believe that France will reinstate the 35-hour workweek. And I do not think German labor unions will rise up again — reversing a ten-year decline of eroding bargaining power. At the same time, I will concede that service-sector deregulation is now a big question mark in Europe — not because of constitutional issues but due to a late March setback in the approval of the so-called EU Services Directive. Fearful of mounting pressures from disenfranchised workers, French President Chirac and German Chancellor Schroeder jointly backed down from an earlier draft proposal that would have opened the door to intensified intra-European competition in a variety of nonfinancial services. This was hardly encouraging news on the deregulation front.
The lessons from the US experience underscore that there are three legs to the stool of service sector restructuring — deregulation, foreign direct investment, and judicious applications of information technology (see my 1991 article in the Harvard Business Review, “Services Under Siege — The Restructuring Imperative”). For Europe, the first leg could well weaken if pan-regional competitive pressures do, indeed, end up being muted by political considerations. The other two legs, however, remain firmly in place; cross-border M&A activity is surging in European services and corporate spending on IT is on the rise. Far be it from me to wade into European politics, but the now-tenuous political positions of Messrs. Schroeder and Chirac raise the possibility that the recent setback for the EU Services Directive may be only a temporary development. If political change brings intensified reforms in Europe, I suspect services competition policy will be high on the agenda.
Germany, once the engine of Europe and still, by far, the largest economy in the region, may well hold the key to what lies ahead. If that’s the case, there is good reason for optimism. Corporate restructuring is taking off in Germany right now. M&A activity is surging and our bankers tell me the pipeline looks stronger than ever. Private equity investors are swarming over Germany right now — encouraged by visible signs of turnaround in investments they have made in the past several years. German labor markets are far from flexible but they are changing before our very eyes. Unheard of headcount reductions are being announced regularly by the stalwarts of Corporate Germany — Deutsche Bank, GM-Opel, Daimler-Chrysler, Siemens, Deutsche Telekom, and IBM-Germany, just to name a few. Part-time and temporary employment is on the rise — now amounting to more than 30% of the total German workforce and providing German companies with much greater flexibility in managing labor input and cost efficiency. Shortened work schedules are on the way out, and the days of industry-wide wage agreements by once powerful German labor unions are over. Germans are despondent but their corporate turnaround story is increasingly powerful. From my perspective, today’s German angst has much in common with the experience of the American worker in the early 1980s and again in the early 1990s. For both cases in the US, there was no gain without pain. Germany is certainly going through the pain phase, but the gains cannot be minimized.
I don’t doubt that the demise of the EU constitution is a very important development on the long road to European integration. It is fascinating to watch this process from afar and then to see it up close in travelling through Europe. Financial markets can be both dumb and very wise at the same time in deciphering this interplay between economics, reforms, and politics. The cycle can also cloud this interplay. Timing is everything in shaping sudden swings in asset prices. Europe is currently being hit both by the downside of the business cycle and an important shift in the political cycle. Markets know this — suggesting that the bad news is largely in the price. The depressed sentiment on the Continent speaks to the same point — a crescendo of capitulation out of which important market bottoms are often formed.The world has given up on Europe. Europe has given up on itself. As a long-standing Euro-sceptic, I never thought I would pound the table on this region. But there is something big happening in Europe right now that cannot be ignored. Now that the political decks have been cleared of the ponderous constitutional debate, Europe can finally get on with its long overdue restructuring.