Europe is 50, But not Middle Aged

It is 50-years this week that six countries, France, West Germany, Italy, Netherlands, Belgium and Luxembourg signed the Treaty of Rome and founded the European Economic Community. And so began in earnest the process that has culminated in the creation of the European Union and a shared currency for 15 of the members. Just because it is 50, though doesn’t make it middle aged, which would imply some termination point.

To grasp the implications of this point is to recognize that at its very core, Europe is a political construct. Academic research is mixed whether Europe is even a continent or just the tail end of the large Eurasian land mass. The creation of Europe has been integral in the euro-centric narrative that has been taught in the West and in the past 20-years or so has begun being re-examined by scholars. Some, like Andre Gunder Frank (ReOrient: Global Economy in the Asian Age), Kenneth Pomeranz (The Great Divergence: China, Europe and the Making of the Modern World Economy) and John Hobson (The Eastern Origins of Western Civilization) offer a corrective narrative that places greater emphasis on the role of Asia (until early in the 19th century China accounted for nearly a third of the world’s GDP).

It is not just Europe that is a political construct, but the integration of Europe has been driven more by political issues than economic issues. Many historians link the impetus for the Treaty of Rome to two political events: the French parliament’s rejection of a European Defense Community proposal (1954) and the Suez Crisis (1956). Even the advent of a single currency seems to have grown out of political considerations. Economic and monetary union was an economic solution for a fundamentally political question: on what terms can Germany be reunified.

Although American historians and political scientists often suggest the US is a great experiment (classical political theorists argued a republic form of government could not be sustained over a large territory) however, the newer grand experiment is in Europe. Can economic and monetary integration be sustained without political unification?

The fact that the euro-zone may not be an optimal currency zone by economists reckoning is beside the point. Yet the good should not be the enemy of the perfect (after all the US was not an ideal currency zone for nearly a century after the Declaration of Independence). Rather the more important context is to compare the half century since the Treaty of Rome with the 50-years before it.

Nevertheless, many Anglo-American observers fault Europe for its weak economic performance. The heavy regulation and inflexibility of the product and labor markets produce an economic sclerosis. The solution is obvious to the critics and it is essentially the same solution for nearly every economic problem. The Washington Consensus. Liberalization. The Lisbon Treaty (Nov 1997) seemed to embrace liberalization as a means to improve growth, but the implementation has been half-hearted at best.

Europe, though, is the wrong level of analysis. Some countries in the European Union, like Denmark, Finland, Sweden, Britain and even Spain have experienced strong growth in recent years. Four of those seven countries share the single currency. The core—Germany, France and Italy,--have generally under performed. The fact that these three account for roughly 2/3 of the euro-zone GDP explains why on the aggregate level growth seems so anemic.

The aggregate level of analysis may be more justified if there was greater economic convergence. However, convergence should be a hypothesis not an assumption. And below the surface, it appears that divergence is taking place and in a profound way. Since the advent of the euro, German unit labor costs have actually fallen slightly. In contrast, consider that in the same period, unit labor costs have risen more than 30% in Portugal and Greece, about 25% in Italy and Spain and around 13% in France.

Analysis on the aggregate level also conceals the divergence in the external accounts. Germany enjoys a current account surplus of about 4.8% of GDP. Although its economy is about a quarter of the size of the US economy, the dollar value of its exports is roughly the same. The Netherlands boasts a current account surplus of more than 7.5% of GDP. On the other side of the ledger, Britain’s current account deficit is around 3% of GDP and Spain’s deficit is about 8.5% of GDP. Many of the new members of the European Union also have significant current account deficits, like Hungary (~5%), Czech Republic (~3.3%) and Poland (~2.3%). Romania and Bulgaria joined the club earlier this year. Romania sports a current account deficit around 10% of GDP and Bulgaria’s deficit is closer to 16% of GDP.

These examples of economic divergences may increase the tensions within Europe. These divergences also are important for investors. In the past, to make up for the loss of competitiveness, countries would be able to devalue their currencies. Portugal, Italy, Greece and Spain are the obvious examples. This path is unavailable now. Barring years of wage restraint and/or sharp increases in productivity, it is difficult to envision how many countries are going to be able to recoup their competitiveness. If the competitiveness is not improved, there is a risk of a capital strike, where by investment is deflected to more robust economies, and a decline in per capita GDP.

However, talk, which emerges from time to time, that a country, like Italy would chose to exit the euro-zone is far-fetched. Whatever economic dislocation that the naysayers want to place at the euro’s shrine, it is nothing compared to the cost of exiting. Interest rates would soar. The new currency would plummet. Large parts of the economy would likely become insolvent. The political elite would be discredited.

While the economic challenges are serious, the political challenges are arguably even more intractable. There are three significant challenges. First, the EU continues to operate under “rules of engagement” that are similar to the US Articles of Confederation. Even though the 13-fledging colonies were able to defeat the most powerful empire at the time with such a document, it was terribly flawed. It had a weak executive. It did not have the power to tax. Decisions required unanimity.

The EU needs a constitution and the need is all the more urgent as it has succeeded in expending eastward. There does not appear to be sufficient political will. Indeed, even in the US experience, there was not a political will for a constitution. The Continental Congress was to reform the Articles of Confederation, but instead pulled a fast one by holding a constitutional convention. Today such an end-run seems more illegitimate than it may have then. Moreover, even then, it took some last minute deal-making and compromises, as well as a sustained campaign by the Federalists to ensure ratification of the US Constitution.

A second political challenge is Turkey. If Europe is largely a political construct, then to say that Turkey is not part of Europe is not really an argument. Turkey is regarded sufficiently as European to be an important member of NATO. Just as the debate about who lost eastern Europe at Yalta used to flare up on occasion, if the European Union does not embrace Turkey, then Turks will have little choice but to look eastward for its future.

As the narrative of world history is retold recognizing a more prominent role for the eastern part of the Eurasian landmass, so too will a retelling locate Islam as a part of the Judeo-Christian tradition. In fact, Abraham, who is regarded as the first Jew, had two sons, one Isaac, regarded as one of the forefathers of Judiasm, the other son, Ishmael, as the founder of Islam. Even leaving the religious issue alone, many west Europeans worry about the costs of the integration of a large and relatively poor populous. Perhaps having a larger and relatively poor neighbor that has been rebuffed may be even more costly in the long run.

The third political challenge is a vision of the role for Europe in the post-Cold War world. In many areas, it is so pre-occupied with enlargement that it is reluctant to project its power and leadership in the world. The hope of some that it could provide a counter-weight to the adventurous and more militaristic US foreign policy has been dashed in recent years. The risk is that Europe continues to become marginalized in the global political economy, which increasing takes on Asian characteristics.

The single currency itself has been successful by most measures. It accounts for an estimated 25% of the world’s currency reserves and is seen by many countries as an alternative to the dollar. Bonds issued outside of Europe and North America are denominated in euros just as much as dollars. In the anniversary week of the EU, the euro climbed to its best level against the dollar in two years and recently traded at its best level against the Japanese yen and Swiss franc since its inception at the start of 1999.

The fourth quarter of 2006 was the first quarter in five years that Europe grew faster than the US. It is likely to be more of a fluke than a trend, though it could be repeated in Q1 07. The near-term outlook for the euro is generally constructive, underpinned by expectations that the ECB has not completed its interest rate cycle yet. By many econometric calculations the euro is beyond fair-value and may already be in an overshoot. This does not rule out additional gains, as the overshoot thus far is modest by past experience, the euro is likely to finish the year lower than where it is trading now.