Until recently, much of the debate over Economic and Monetary Union has concentrated on the line-up of participating countries, the process and mechanics of transition or the stewardship of the European Central Bank.
Yet the key topic for professionals must now be the shape and nature of Europe after the event. It will be a whole new world – a world of new political pressures, new financial priorities and new business perspectives.
Cost and price transparency across national borders will have unpredictable behavioural implications on individuals, institutions and companies, and governments.
They will feed on and interact with each other in different ways, at different speeds, in different sectors and in different countries. There will be no simple conversion from the current state to the future state. There will be no standard response to the new financial circumstances. It will be a lot more complicated than that.
My perspective on the economic framework within which Europe’s future may evolve has two sharply divergent outcomes – one very bearish for Europe’s capital markets, the other very bullish. My own belief is that the outcome will not only be a positive one, but that Europe post-Emu has the potential to become the emerging economy of the next century.
On one side of the rails are those who debate whether much will change in the real economy as a result of Emu. It is argued that monetary union without political union is a nonsense and that ultimately, political divisions will undo any gains realized from monetary union, leading to all manner of imbalances.
Exchange regime
According to this school of thought, Emu amounts to little more than a nominal change in exchange rate regimes. Yet, it is accepted that swapping domestic currencies for the euro will reduce transaction costs and introduce price transparency across Europe. But will it do any more?
After all, France, Germany and the Benelux countries have come close to sharing a unified monetary policy for much of the past decade and have operated with closely aligned exchange rates. That has not promoted an economic upsurge, rather the reverse as the governments involved have deflated their economies to conform with the Maastricht criteria.
Then there are those who argue that Europe is destined to collapse under the weight of its own contradictions. A unified monetary policy that cuts some slack for France and Germany at the current stage of the economic cycle would be overly accommodating to the likes of Spain or Ireland. The absence of a devaluation option could be a problem for Finland if a downswing in wood pulp prices prompts a recession as it did in the early 1990s.
Under the post-Emu stability rules it will be difficult for governments to deal with localized problems through old-fashioned fiscal policies.
Taking shocks
And because nobody wants a centralized government with full powers to tax, Europe will lack the mechanisms for dealing with what economists love to call asymmetric shocks. There will simply be no central government in place to operate elaborate transfer mechanisms. Social unrest will escalate.
Old ways of dealing with ailing industries will increasingly fall foul of the Brussels ban on subsidies. However much governments attempt to reinterpret the rules, intervention will look less viable and perhaps less attractive under Emu.
Perhaps the biggest issue of all is the rigidity of the labour markets. The counterpart to price transparency within a single currency is wage transparency. There are widely divergent wage rates and social costs across Europe. These are reinforced by a variety of labour restrictions which will slow down any levelling process.
But, even in their absence, that levelling process would demand unaccustomed mobility on the part of Europe’s workforce. That looks unlikely in the short term. While American workers will move from one side of the States to the other for work, Europe’s workforce is notoriously inflexible. Catalonians are not going to work in Bavaria. The landed workforce of southern Italy will not suddenly decamp to Holland.
And, of course, there is the leadership of the European Central Bank. A case can certainly be made that it has been politicized by recent events.
Put all of this together and it sounds like a recipe for disaster, the prelude to a protracted recession. And it could be. But I don’t believe it will be. The reason for my faith is simple. The freeing-up of Europe’s capital markets will prove such a powerful driver for change that other forces will bend in its path. It will have the same impact on restrictive labour practices that a meteorite is believed to have had on the dinosaurs 65 million years ago. It will transform the industrial landscape.
Falling into line
One by one European governments have made far-reaching changes to the structures of their economies in an effort to meet the Emu convergence criteria. Changes such as privatization, financial market liberalization and prudent fiscal policies are all designed to bring Europe’s economies increasingly in line with each other. While they are not yet fully in line, who would have thought five years ago that they would today be in the shape that they are in?
The question I would like to pose is this: is Emu the Trojan Horse for a new European economy?
One way to think of this is to view two core dimensions of the European economy in relation to each other: the financial markets and the labour markets. Examine the range of flexibility from low to high while considering things such as the degrees of openness, international competitiveness, adaptability, freedom of action, price elasticity and innovation.
Europe pre-1990, that is at the start of the final Emu conversion process, was in the “low/low” flexibility box. It is worth bearing in mind that the liberalization of Europe’s capital markets is a relatively recent occurrence. Exchange controls were not universally removed until 1992. Permitting foreign firms access to local markets is also a relatively recent change. In short, much of Europe has had low financial market flexibility.
Still today many investing institutions are constrained as to the asset mix they can choose and are obliged to hold minimum allocations of domestic government bonds.
Labour markets in much of Europe are plainly less flexible than those of the Anglo-Saxon countries. The list of costs and rigidities is extensive – collective bargaining arrangements, notice periods, social benefits, co-determination and employment protection. They are the result of deliberate governmental policies and robust popular defence. Clearly, flexibility of labour is not one of their objectives.
The mobility and flexibility of European capital, decidedly low until 1992, is rapidly being transformed. On January 1 next year, capital market flexibility moves up into the “high” box. But the mobility and flexibility of Europe’s labour markets remain unchanged. While capital is increasingly free to move at lightning pace, Europe’s labour markets remain protective and inflexible.
The evidence is that the process of convergence and the preparation for Emu membership has had a two-pronged impact on investor attitudes and behaviour. The equity genie is out of the box and no amount of backsliding on the part of governments will put it back in. With it has come a new pressure for investment performance and an appreciation of the gains to be had from international diversification. Removal of restrictions on intra-European investments will immediately create a whole new level of cross-border capital flows as institutions rebalance their portfolios.
Pools of transparency
In such circumstances European countries will be exposed to the implications of mobile capital. Asset managers will start to move money to places where it can command the best risk-adjusted returns.
This does not happen so much today for a number of reasons, including the fact that prices are not yet transparent – so comparisons across markets are not so clear. A second reason is that asset managers have not had sufficiently large asset pools to be able to impact national behaviour.
But once they start to have such pools and the responsibilities that go with them they will be obliged to do their duty and move investments either to the most productive parts of the EU or to investment centres completely outside the EU.
It is the likelihood of this behaviour by capital market professionals which leads me to conclude that the proposed final stage of Emu is unstable. The best stable arrangement is achieved when the labour markets liberalize.
It will be the labour leaders more than the politicians who will lead this revolution in working practices. They will do this because they will quickly see the instability of the previous situation, where capital is mobile but labour is inflexible. This will not be a uniform process across Europe. But the more adventurous labour markets will make the change more quickly than we think. As an example, we all know that the UK has been the principal beneficiary of inward investment into Europe over the last few years and it has a more flexible labour market.
Of course, the other option will be to regress to the first box, where a kind of stability formerly existed. But this would mean unwinding most of Emu’s gains. It would mean re-imposing capital controls, restricting financial market activity and risking driving the capital offshore.
That is not only unthinkable, it is also unworkable. Forces are already at work that will act upon each other to free up the labour markets. This labour market flexibility will then unleash even more integration and growth in the capital markets. These forces create a virtuous circle.
The driving forces are not just Emu. European demographics, technological change and globalized markets are also driving capital markets change. These drivers will have the following effects.
Surge in supply
They will promote a rapid integration of many European capital markets while also driving a massive increase in the level of financial activity. That is because markets will be more pan-European and more liquid. A homogeneous government bond market will enable the emergence of a corporate bond market.
There will be massive new flows of pension fund and mutual fund money and a shift of savings from government bonds and bank accounts into equities. Increased demand will be met by a surge in new issue supply. Together these trends will fundamentally change the nature of financial competition, and that in turn will spur a surge of product innovation.
Emerging out of these huge changes we will see a fundamental change in managerial behaviour by governments, companies and financial institutions. Reduced capital costs resulting from financial market efficiency and an increasing focus on shareholder value will drive out weak management. In effect, governments will let the capital markets set the standards for management.
And it is this that will drive profound changes in the behaviour of the labour markets, prompting a process of competitive labour market devaluation, more flexible employment arrangements and increased acceptability of equity participation on the part of the individual. That, in turn, will further boost capital markets activity and integration, creating a virtuous economic circle that will transform the Europe of the 21st century.
Ian Cormack is global head of investment industry at Citibank
