Eurosclerosis

Economist.com | European economic reforms
The Euro itself has done well, but the European economies have not. This article lays out a good case that the usual culprits — German unification, the stability pact — are not to blame for the bulk of Europe’s economic problems. Instead, it’s their failure to embrace free markets in both labor and goods that has caused Europe’s low growth rates. Makes sense to me. It’ll be difficult to change given the power of organized labor in both countries, but it will be necessary if Europe is to prosper. Reform would also take the burden off the U.S. as the world’s economic engine.

EUROSCLEROSIS. An ugly word, coined for an ugly phenomenon in the 1980s, is back. The heady days of January 1999, when Europe’s new single currency, the euro, was hailed as a certain harbinger of economic revival, are a distant memory. In fact the performance of the 12-country euro area over the past five years has been a bitter disappointment. And at the heart of that poor performance lie France and Germany, which account for roughly half of euro-area GDP. Unless France and Germany recover their zip, the euro area will be condemned to remain an under-achiever.

That is why the current debate over economic reform in the two countries matters so much. On October 17th, after this newspaper went to press, the German Bundestag was expected to approve, albeit by only a tiny majority, a set of labour-market and tax changes that are central to Chancellor Gerhard Schröder’s “Agenda 2010” economic-reform programme. In France, the government of President Jacques Chirac is pursuing its own reforms, which it cheekily calls “Agenda 2006”. Both countries’ governments face opposition to their proposals from political rivals, public-sector workers, trade unions and others. For Europe’s sake, they must defeat that opposition and continue their reforms.

Various explanations have been put forward for the sluggishness of Europe’s biggest economies. Some pin the blame on the European Central Bank, for its overly tight monetary policy. Real interest rates have indeed been uncomfortably high in Germany, where inflation is dangerously low; but other economies in the euro area have done better, and average euro-area inflation remains over 2%. A stronger case can be built against Europe’s “stability and growth pact”, which has kept fiscal policy in both Germany and France tighter than it should have been. But in practice both countries have readily breached the supposedly inviolate ceiling for budget deficits of 3% of GDP. In any case, experience suggests that fiscal stimulus is not the best long-term route to growth.

A third culprit is the after-effects of German unification. Partly because it happened more than a decade ago, this is now easy to forget. Yet, thanks in large measure to the mistaken decision not only to equalise the western and eastern currencies but, worse, to equalise most wages and benefits, the eastern Länder of Germany have continued to act as a huge sponge, soaking up German public subsidies, and sucking down the economy’s competitiveness and growth. That in turn has dragged down the rest of the euro area.

Even unification can no longer take the main blame for Germany’s (and hence France’s) sclerosis, however. Over the past ten years, the British economy, once the sick man of Europe, has grown at an annual average rate of 2.9%. In Germany, once the continent’s Wirtschaftswunder, the equivalent figure has been a meagre 1.3%. Macroeconomic, demand-led differences, such as monetary and fiscal policy, and even the strains of unification, can account for only a small part of this big gap. The bulk of it must have microeconomic, or supply-side, causes. Specifically, rigidities in labour and product markets in France and Germany, aggravated by high taxes and social-security contributions, have discouraged investment and the hiring of labour, keeping growth down and unemployment high.

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