Europe is changing. Against all expectations, the advent of a single European currency, backed by a strong fiscal "Stability and Growth Pact", could prove the catalyst for a much more efficient corporate sector. Despite the economic absurdity of the Maastricht criteria, the struggle to meet them is producing what Europe needs most a smaller government take from national income.
And labour's share in Europe's national income is about to fall too. That means profits in Europe are set to rise through more efficient use of capital and labour under conditions of increasing global competition. Europe is on the brink of something momentous that should make its equity markets outperform the world's over the next five years.
How can this be? Up to now, the return on assets for corporate Europe has been much lower than that for us corporates by a massive amount, under 15% compared with the us at nearly 19% this year. The reason is competitiveness and capital productivity. Europe's small national markets and administrative "mind-over-market" approach to liberalization produce sub-optimal use of labour and capital.
In a truly competitive market place, with its sharp price signals and high rates of business creation and failure, Schumpeter's "creative destruction" is at work. And investors ultimately make more money investing in competitive corporate environments than in sclerotic ones.
Europe's relatively high savings and investment rates compared with the US do not produce the same quality corporations (or the same quality of services and goods for consumers) as their US peers. Nor, over the long haul, do they produce the same value-added output. Between 1985 and 1995, the US generated $1.50 of GDP for every $1 of investment. In contrast, Germany generated only $1.10 of output for that same $1 input.
A recent OECD study, comparing the efficiency of selected industries across national borders, found that the US level of corporate productivity ranked among the top three nations in nine out of 12 manufacturing sectors. In another survey, by the McKinsey Global Institute, US productivity levels were found to be way higher than Germany in many key sectors in food processing nearly 50% more productive, in telecoms and utilities nearly twice as productive. Only in autos were German manufacturers more productive.
But things are about to change. De-industrialization and globalization are irreversible international trends affecting Europe's economy and corporate sector. They will increase competition momentously over the next decade. Europe's development of a single market and currency, with openings to the east, is one response to these pressures. And corporate rationalization and its impact on labour markets is another. The third is government downsizing. This conjunction of corporate and government rationalization will have an explosive impact on European corporate profitability.
Single currency
What will be the impact of the single currency on Europe's competitiveness? Contrary to the views of many, I think the euro will be a strong currency, at least initially. The first reason is what might be called technical. At present, individual European central banks maintain foreign exchange reserves equivalent to 22% of total imports compared with the average for industrial countries of 15%. This will make the euro one of the most over-reserved currencies in the world. Ultimately, excessive reserves would be used to redeem up to 4% of GDP of euro area government debt.
And the euro will become an important international currency, nearly as big as the dollar in international trade and as a reserve asset. Demand for euro-denominated transactions and bank reserves could be as high as 1.5 times the existing share of euro area countries in international trade. Thus, the global appetite for euros as a reserve currency could be closer to the ratio of international reserves to imports that the dollar commands (15%) rather than that of the collective European currencies today (10%).
The euro will also be a strong currency because the European Central Bank will be run on Bundesbank lines and the newly-agreed stability pact will maintain fiscal discipline. Both will boost the credibility of the new currency.
The clever thing about the stability pact is that the politicians have signed on to the opposite of what they, particularly the French, were aiming at. Instead of a political process to fudge fiscal policy, they have set up a great credit rating agency in the sky. It will make all European budget arithmetic transparent on a statistically comparable basis. That much is implicit in the reporting method of the European Commission and ECB to the EU finance ministers, who will decide whether to impose fines.
If the politicians violate the draconian rules they have set themselves on budget deficits (which Europe as a whole has met only once in the last 17 years), the markets will drop a barbell on their collective feet. That will raise interest rates on the euro right across Europe and push bond yields for the weakest economies even more. So politicians will be forced to reverse course in days not months. This is the true deterrent effect of the stability pact and not the threat of fines.
A strong euro will have three benefits for corporate Europe. Competition is placed squarely in the product market and will be translated from there to the job market, a process set to accelerate as vital bits of the single market get put in place (deregulation of energy, telecoms, government procurement and services). The only way to create jobs will be to deregulate the labour market.
Systemic competition will mean that within the euro area good economic systems will drive out bad, because devaluation and subsidy cease to be tools of economic policy to protect the inefficient. The absence of exchange risk within the euro area will encourage foreign investment by the most powerful corporations, so that the strong and efficient grow stronger and the weak weaker.
A strong euro is the key to faster European growth. Higher global demand for euros will lead to lower interest rates and higher domestic growth in EMU countries. That, in turn, could reduce budget deficits closer to the levels stipulated by the stability pact and become self-reinforcing for the euro.