Black economy keeps EU snail slithering along

It is a common view, especially in the US, that continental Europe is shackled by big government and a lack of reform. The corollary is that its economy and its stock markets will underperform those of the US or the UK.

It is true that Europe's long-term growth and return on equity are capped by the size of the state and an inability to free-up product and labour markets. However, Europe's social architecture reinforces stability. It might not be equitable or optimal, but it works, after a fashion.

European households are rich in safe assets and save rather than spend. That means a balanced current account. And some reform is taking place. It is driven more by the forces of globalization than the political process, but it's happening, if at a snail's pace.

Current account balance ($bn)

* estimate

Ironically, the pace of reform does not matter that much because European citizens and businesses are bypassing big government and rigid labour markets through an ever-larger black economy that generates hidden income. This, in turn, funds governments, to which citizens lend. And European corporations continue to restructure and relocate to cheaper locations east of Berlin. It may all result in relatively low economic growth, but at least it is sustainable.

The major European government reforms have been to trim state pension fund liabilities and unemployment and social security costs. This will improve government finances over time and may create a more individualistic, risk-taking environment. But the macro effects will be slow to take effect.

Europe, like Japan, is incredibly stable and will remain so. The differences that will be seen in five years are predictable, like the silver track of a snail across the pages of history.

There are three elements to this stability. The first is Europe's private-sector balance sheet. Households on the continent are as rich as Croesus. Their assets are low-risk, invested in homes in countries that don't have housing bubbles (unlike the US and UK) and in banks that haven't gone bust (as in Japan). And the liability side of the balance sheet is way more conservative, with a debt to income ratio of around 75%, compared with the US's 110%.

The second factor is the income and savings flow. The savings surpluses of the private sector far outweigh public sector deficits. This means a balanced EU current account and, for now, spells a strong euro and a weak dollar.

The final piece of the stability jigsaw concerns reform. I constantly hear three judgments that suggest reform is vital for Europe: government is out of control as the growth and stability pact collapses; social security costs are killing the labour markets; and Europe's product markets don't work.

Are they true? Take government. The growth and stability pact was supposed to bring Europe's governments under control by limiting their deficits. But the target was wrong. It is the size and role of government in a broadly defined sense that matters, not its deficit.

Are the rigidities in Europe's labour markets strangling the economy? The answer involves hidden economic activity in Europe that is as rational and dynamic as euros being spent openly in a supermarket.

A German worker must pay 55 cents or so in social costs and tax for every euro earned. If he is jobless, he gets at least e700 a month in state benefits. But he doesn't stop working. He goes into the black economy and works like crazy because then he gets to keep what he earns. This produces the really efficient part of the economy where the worker is paid to work and I don't have to pay 15% to 25% value-added tax for the work he does for me.

This system is sustainable and dynamic. There will always be enough people who have to work in the big companies where the taxman can get at them. Most of them are more mediocre than the ones who get out and work as entrepreneurs in the black economy. So mediocrity gets taxed and the smart cookie gets productive and rich.

In a study by Linz university in Austria, the average size of the black economy in the OECD was estimated at 17% of GDP, with Italy at 27% and the US at just 9%. The higher the average tax burden in a country, the larger the size of the shadow economy.

The black economy grew over 50% during the 1990s in eurozone countries, more than double the official GDP growth. Let's assume the black economy now equals 25% to 30% of the published economy for labour and GDP in the euro area. Add that income in and GDP rises to over $9 trillion. Suddenly Europe's government spending to GDP falls to 40% from near 50%, budget deficits sink to 2.5% of GDP, and public debt to GDP drops to 45%. This also means the jobless rate in Europe is much lower than published and is not a threat to stability.

Hey presto! Europe is on a par with, or better than, the US in every domain.