Investors’ European equity valuations are pricing in a successful Emu. Markets believe the euro will be strong and corporate profitability will stay high.
There are good short-term arguments for expecting the euro to start off strong. First is the critical mass argument. Until now, European countries have accounted for a bigger share of world savings and trade than the volume of transactions in their currencies reflects. But the advent of a single European currency will generate a “natural” demand for euro transactions that will make it strong. Once that happens, central bankers of the world will want to swap into euros some of their international reserves, where, at two-thirds of the world total, the US dollar is over-represented.
Then there is the economic cycle. Whereas up to now, the peripheral economies in Europe – Scandinavia, Ireland, the UK and southern Europe – have been growing at 3% to 5% a year, from now on, the core of Europe is going to catch up. Until now, Germany has relied on the contribution of net trade to raise growth. But in the first quarter of this year Germany’s domestic final sales surged, to close the gap with France. In France, labour earnings are rising as employment and wage income begins to grow. France’s employment is growing at its fastest pace of the 1990s and the trend is clearly improving in Germany.
Yet the monetary policy of the Bundesbank and the Banque de France remains historically lax as inflation remains crushed. That’s highly stimulative for the consumer. Moreover, fiscal policy in both countries has been neutral rather than contractionary this year. It will be stimulative next. With core Europe getting stronger and peripheral Europe already growing too fast, the European Central Bank will be forced to raise interest rates aggressively.
And the dollar is going to weaken against the euro in 1999. The US economy is slowing down and its external deficits with the rest of the world are widening. The Emu area will continue to accumulate a modest surplus.
But will the euro stay strong? The economic omens look bad. For Emu, European leaders have harmonized budget deficits as well as inflation and interest rates. But beyond that, the European economies are highly divergent. Economies with such different characteristics, deprived of the means of adjustment normally offered by exchange rates are likely to grow apart in a single currency area. The crucial issues that the Maastricht criteria never tackled enough are the role of the state and its size. On these issues, the key Emu players have philosophical positions that stand a mile apart.
Deficit junkies
Europe’s core problems are the size of government and sclerotic labour laws. Although the pressure of Maastricht has lowered European government spending from a peak of 52% of GDP in 1993 to 48.5% now, the ratio is still way above that of the US, now 32% (up only 2% points in 15 years). And the greatest structural disparities between European states are in the state sector. State employment as a proportion of total employment is twice as large in France as it is in the Netherlands and nearly three times as big in Sweden. Finland’s government spends half as much again as a share of GDP than Ireland’s. The public debt to GDP ratio in Belgium and Italy is more than twice that of Germany. And the differences in unemployment rates, GDP per head and real GDP growth rates between Emu states range from two to six times, while there is no more than a 50% variation between the states of federal America.
France’s big-state, high-tax regime will mean French corporations increasingly investing in countries with the opposite characteristics. So France’s structural joblessness and budget deficits will get worse and France will end up being fined several percentage points of GDP under the terms of the Emu stability pact. And in Europe, unlike the US, each country has a ready nationalist and populist political lobby to reject any penalties imposed under Emu and so make monetary union unworkable. When the going gets tough, as it will under the increased competition of the single market and the single currency, it will become evident that Europe’s “social contract” has not been modified and harmonized to match Emu realities.
Indeed, today’s European governments, pandering to their nationalist/left-wing lobbies, would rather price people into jobs by cutting the working week and raising the cost of labour.
And the stability pact, which is intended to oblige Emu member states to balance their budgets over an economic cycle, will be stranded. Europe is still running a full 2% of GDP structural budget deficit and yet the stability pact insists that Emu states must run balanced budgets. To get a European balanced budget implies spending cuts as large as the 1.9% points of GDP reductions in (non-interest) spending achieved between 1993 and 1996 – the most painful years of fiscal austerity needed to get Emu done.
Worse, in countries like Italy, around half the reduction in the budget deficit between 1995 and 1997 was due to falling interest rates. As soon as European interest rates start to rise again, so will the budget deficits.
Italy will still pay 3.5% points more of GDP than Germany on annual debt servicing. So it will be able spend that much less on schools, the health service and highways. In 20 years, its colleges, hospitals and roads could be half the quality of Germany’s.
The temptation will be great for politicians to spend. Before Emu, each percentage point of GDP on the budget deficit in Italy kept adding the equivalent to its public debt and, in turn, its interest rates and debt servicing costs. Post-Emu, the cost of individual countries’ profligacy will be shared out among all Emu members and have only a marginal impact on the region’s overall debt-to-GDP ratio. So euro-area interest rates will rise only fractionally as a result of extra spending by any one state. It’s almost a free lunch.
At today’s prices, investors in European financial assets are betting on a lot of things coming right. They expect a deep supply-side revolution to boost profit-share in national income through productivity gains from a single currency and single market. They expect lasting benefits from fast growth and a high return on capital. And they assume continuing low inflation as a strong currency holds down corporate pricing power. That’s too many ticks in too many boxes. The economic fundamentals are unlikely to be in place to achieve what is needed.
David Roche is president of Independent Strategy, a London-based research firm
