May 7th, 2012 | By Nick SargenIt was widely expected that these policy measures would result in recession in the euro-zone, and the latest data confirm that ten member countries have experienced two consecutive quarters of negative growth. What is grabbing market attention now, however, are the deteriorating labor market conditions in many of these countries and the political backlash to the austerity programs: Core countries such as France and Holland have changed governments in the past couple of weeks, adding to the list of European governments that have fallen since the Great Recession. Newly-elected French President Hollande, who is committed to the euro-zone, has stated that he will seek to renegotiate a fiscal pact with German Chancellor Merkel to make it more pro-growth.
A recent commentary in the Financial Times (May 3, 2012) offered the following assessment: “The whole debate between the Keyneseans and austerityists is moving towards a victory for the Keyneseans.” At the same time, two Keynesean-minded U.S. economists – Larry Summers and Paul Krugman – have written op-ed pieces to the effect that European austerity programs will only worsen the situation.
My own take is that these portrayals, which assert that Europe’s unemployment problems stem from insufficient aggregate demand, are one dimensional and ignore structural and competitive issues that are at the heart of the problem.
Consider the employment picture in Europe today. According to the latest data, unemployment in the euro-zone rose in March for the 11th consecutive month to hit a new record high of 10.9% of the labor force. Much of the rise occurred in Southern Europe, especially in Spain, where the unemployment rate reached 24.1% and more than half of the workforce under 25 is out of work. Italian unemployment also rose sharply, to 9.8% which is the highest level since 2000.
Contrast this situation with Germany where the unemployment rate has fallen to 5.6% in March from 10% at the onset of the Great Recession. Perhaps, even more impressive, the unemployment rate for German youth (under 25 years) is 7.9%, compared with more than 20% for the entire euro-zone.
This comparison begs two questions: (i) How can such large disparities exist in the euro-zone? and (ii) What is Germany doing right that the other countries are not?
The answer is that Germany was in similar straits to other European countries a decade ago, but it has since implemented structural reforms that have transformed its economy and made it highly competitive. In this regard, I have found a Wall Street Journal article (February 17, 2012) by Donald L. Luskin and Lorcan Roche Kelly of TrendMacro to be very illuminating. They make the following observations:
“Starting in 2003, Germany under then-Chancellor Gerhard Schroeder began to implement a program of long-term structural reform called ‘Agenda 2010.’ The idea was to transform Germany into an economy where business has an incentive to invest, and where labor has an incentive –and an opportunity – to work. This was pro-growth reform that would be very familiar to Ronald Reagan and Margaret Thatcher.”
“The centerpiece were labor-market reforms designed by a former human-resources executive at Volkswagen AG. The power of unions and craft guilds was curtailed, making it easier for unskilled youth to enter the job market and easier for employers to hire and fire at will. Germany’s lavish unemployment benefits were sharply cut back. An unemployed person in social-democratic Germany today can draw benefits for only half as long as his counterpart in capitalist America.”
Luskin and Kelly also point out that the new governments in Italy under Prime Minister Monti and Spain under Mario Rajoy are deeply committed to this vision and are well on their way to implementing it. The need for this type of approach resonates with me, because of frequent visits I made to these countries a decade ago. At that time, Spanish unemployment was hovering around 18%, and I asked a government official what could be done to rectify the situation. He explained that Spain had a large underground economy where people worked and were paid in cash but did not report income to the government. Also, because unemployed workers received considerable benefits, they lacked incentives to find jobs where they would have to report taxes and lose their benefits.
One of the reasons it is hard for younger people to find jobs in these countries is that it is prohibitively expensive for companies to let higher-paid workers go, because the companies would be obliged to pay them a high portion of their salaries until the official retirement age was reached. One illustration: A colleague of mine had a cousin in Italy, who was 27 years old and an engineer by training. He was still living at home with his parents, and did not expect to get a full-time job for another five years, when attrition would create some openings in his field.
Faced with these circumstances, Europe has little choice but to abandon antiquated rules that make it difficult for young people to find work and for the respective economies to be competitive. Luskin and Roche note that in Spain, the newly-elected government has legislated new rules allowing companies to drop out of collective bargaining agreements and lessening lavish statutory requirements for severance pay. In Italy, the Monti government has raised the retirement age and, is shaking up labor markets – crushing barriers to entry in previously protected professions from pharmacy and banking to taxi-driving.
The debate over Europe today is frequently depicted as one between those who favor fiscal austerity versus those who favor fiscal stimulus. In my opinion, however, the debate should be recast between those who favor market-oriented reforms that will improve competitiveness and create job opportunities versus those who favor the status quo.
Viewed from this perspective, it is easier for investors to assess whether or not Europe is moving in a direction that will make it more vibrant, much as Germany did a decade ago. If that is the case, there is reason for optimism that Europe eventually will be transformed and the sell-off in European financial markets of the past two years will have provided a long-run opportunity. However, if European governments remain wedded to anachronistic labor laws, it will continue to be viewed as suffering from a self-inflicted malady.
On caveat is that I recognize it is more difficult politically to embark on reforms when Europe’s economy is weak than when times are better. For that reason, I do not believe investors should be overly-fixated on whether countries such as Spain and Italy meet arbitrary fiscal targets provided they are serious about continuing the reform process.