Europe's economy reviving; But nations must accept that more reform is needed

DISCOVER; Pg. D12

The Economist

As every actor knows, it is easy to be typecast. The role assigned to Europe for the past decade has been that of sclerotic underachiever: a slow growing, work shy and aging continent that is destined to be left behind by the United States, China and India.

Unnoticed by the audience, Europe, under new political leadership first in Germany and Italy and now in France and Britain, has changed the plot. Since the end of 2006, GDP has outpaced America's. In 2007, it should grow by 2.7 per cent, ahead of both the U.S. and Japan. The euro is at new highs against the dollar and yen. Unemployment has fallen to 7 per cent, the lowest since the euro started life in 1999.

The transformation has been most remarkable in Germany, the biggest European economy, once tarred as the sick man of Europe. From 1995 to 2005 German GDP grew at an average of only 1.4 per cent a year. But in the first quarter of 2007, it expanded more than twice as fast despite a large rise in value-added tax.

The 2004 reforms in labour markets and welfare made by the previous government under Gerhard Schroeder are bearing fruit. On international definitions, unemployment is down to 6.4 per cent, not much above the level in Britain. German business is doing spectacularly well. The country is again the world's biggest exporter, profits are at a record, competitiveness has improved sharply.

Where Germany leads, the rest of Europe follows. In truth, the picture of an entire continent in a slump was always distorted. Several countries in Europe have been doing well for some years. Britain and Spain have grown consistently.

Ireland has produced the nearest thing to an economic miracle outside Asia and smaller east European economies seek to emulate it. Scandinavia boasts three countries that top most league tables for competitiveness. The truly troubled economies of Europe were always Germany, France and Italy. Now that Germany has picked up speed, the other two are improving, too. The new French president, Nicolas Sarkozy, is promising to boost growth.

Some Europeans may be tempted to conclude their economic problems are behind them, their structural faults have been put right and there is no need for more painful reforms.

Such a conclusion would be wrong on pretty much every count. There have been structural improvements in the core euro area, especially Germany. But much of the recovery is really cyclical. When the global economy is registering a fourth successive year of near 5 per cent growth, it would be surprising if the world's biggest exporter did not benefit. Indeed, growth of 3 per cent seems rather modest.

Moreover, much of Germany's renewed vigour reflects stringent control of real wages, which has secured a fall in unit labour costs when they have been rising elsewhere. Yet merely squeezing pay to gain competitiveness is not a long-term solution.

The gain also comes at the expense of other euro-area countries, such as France, Italy and Spain. This creates tensions of its own, much on display this week when the hyperactive Sarkozy dropped in to a meeting of euro-area finance ministers in Brussels.

He announced that France might again flout the euro-area stability pact's restrictions on budget deficits, and repeated his previous complaints about the strength of the euro and the tight monetary policy of the European Central Bank.

He ran into a stony hostility, notably from the Dutch but also from the Germans. The French president has similarly been to the fore in attacking European Union competition rules and talking up the causes of industrial policy and economic patriotism. The charitable explanation for this nonsense is that laying into Brussels is a way of diverting French voters from the genuine (and long overdue) reforms Sarkozy is planning for the labour market, welfare and taxation.

But his agenda seems also to be driven by a common belief in France (and in other parts of Europe) that the euro's macroeconomic management and the obsession in Brussels with pursuing pro-competitive reforms are to blame for the region's economic ills.

This is to get things entirely backwards. As is obvious from the divergent performance of individual countries, the euro area's troubles are not macroeconomic in nature. They are microeconomic, reflecting the failure of several countries to reform rigid labour markets and overly regulated product markets.

These countries have been suffering not from too much competition, but from too little. For too long, too many of their workers and producers have been sheltered from competition.

Nor will partial reforms of the kind so far carried out be sufficient. This can best be seen in the labour market in Germany, which (like Italy's) has been only partly freed up. The result has been not just a welcome explosion of temporary and part-time jobs, but, more insidiously, the entrenchment of a two-tier labour market.

Insiders have permanent, protected contracts. Outsiders have short-term, unprotected ones. This will fuel resentment among outsiders, often the young or immigrants. It also threatens to introduce new rigidities into the wage-bargaining process because insiders may feel sufficiently insulated to demand higher pay in the knowledge that any resultant job losses will fall on outsiders
 
The unpalatable truth remains that Europe's economies need substantial further reform if they are to prosper in an ever more competitive, globalized environment. And the recent upturn may make it harder for political leaders to get their voters to understand this.

European countries that have introduced radical reforms have usually done so in times of serious economic crisis: Britain in 1979, the Netherlands in 1982, Ireland in 1987, Denmark, Finland and Sweden in the early 1990s. Yet as all these countries found, it is easier to change when times are good, not when they are bad. That is a lesson Germans, French, Italians and other Europeans should ponder as they bask in today's sunshine.

Photo: Hamilton Spectator File Photo , Nicolas Sarkozy's France is benefitting from stronger performance in Germany.