How To Fix Europe

Simply cutting budgets won't get the continent's economies growing again

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Photograph by Angelos Tzortzinis for TIME

Abandoned A development sits empty in Seseña, central Spain. After a devastating housing bubble, some 800,000 homes remain unsold

The Polos are a typical Spanish family — unfortunately for them and for the European economy. Jesús, 59, has worked as an accountant at an electrical-parts supplier for 20 years. His job is protected by the extensive rights awarded to the Spanish permanent employee. By his estimate, his employer would have to shell out as much as $120,000 in mandated severance payments to lay him off, a prohibitive expense that likely gives him a job for life. Jesús' daughter María, on the other hand, has a less happy situation. María, 28, once held a regular job in Madrid as a hotel receptionist but gave it up to pursue a career as a flight attendant. When that didn't work out, she returned to the hotel industry — but not to her old job. For the past 18 months, María has floated from temporary contract to temporary contract, some of which have lasted as few as six days. When each one expires, she can be sent off with next to nothing.

And that's the point. Though she usually works a full week for the same hotel chain, María says her employer has told her outright that it would be too costly to offer her a contract similar to her father's. "You live day to day. You always think that you're going to get fired," María says. "I feel unstable because my daughter is unstable," Jesús says. "The young people will replace us as builders of the economy, but right now they are always scared. And when they are 40, they'll feel the same."

The travails of families like the Polos are symbolic of Spain's broken economy. Much of the recent investor concern about the nation has focused on its hefty debt and yawning fiscal deficit — and the potential drag on an already anemic recovery that might be caused if they were reduced. The International Monetary Fund (IMF) forecasts that Spain's economy will contract again this year, by 0.4%, after a steep 3.6% drop in 2009. But those woes are merely symptoms of much deeper, potentially even more intractable problems at the very core of the Spanish economy: a distorted labor market, weak competitiveness and high costs. In a gloomy assessment of the Spanish economy issued in May, the IMF warned that the country required "far-reaching and comprehensive reforms" if it was to avoid stagnation and persistent unemployment, which at 20% is the highest among industrialized economies. "Time is of the essence," the IMF insisted.

The same can be said of pretty much the entire European Union. As the global economy slowly emerges from the Great Recession, Europe appears more and more to be its biggest headache. Not only is the region lagging in the global rebound — the IMF predicts growth in the euro zone to reach only 1% in 2010, compared with 3.1% in the U.S. — it is also facing daunting long-term challenges. The promise of a strong, confident Europe, united by a common market and a single currency, the euro, has been stymied by political divisions, income gaps and continued economic rivalries. Europe's leaders have serious concerns about their ability to provide good jobs for the region's children and care for its growing population of elderly. As the emerging nations of Asia become industrial titans, Europe's high-cost economies need to adapt if they are to grow. Whether or not Europe can resolve these problems matters to everyone, whether they live in Europe or not. With the largest collection of rich consumers in the world, Europe is vital to the prospects of every company from Detroit to Dalian, China.

To reverse its current course, Europe needs to change. The crisis in Europe may have been sparked by fears that tiny Greece might default on its mountain of debt, but solving it will take much more than the proposed bailout of the Hellenic state. Like Spain, the entire euro zone requires fundamental reform. A decade ago, Europe's leaders signed on to the Lisbon Process, aimed at making Europe the most competitive region in the world, and in 2009, after years of haggling, the E.U.'s members finalized a treaty that was supposed to strengthen the union's cohesion. Neither goal has been achieved. A May report by the E.U.'s Reflection Group, an advisory panel, recommended bolstering E.U.-wide economic-policy coordination, improving education, encouraging greater mobility of workers, boosting investment in research and development and a host of other reforms — the same endless list that has been recommended many times before. "Europe is currently at a turning point in its history," the group said. "If Europe does not want to be among the losers, it needs to look outwards and embark on an ambitious long-term reform program for the next 20 years." At stake, says Jesús Banegas Núñez, vice president of the Spanish Confederation of Employers' Organizations (CEOE) in Madrid, is the entire European economic system itself. Without reform, "Europe will not be able to maintain its welfare state," he warns.

Investors are far from convinced Europe can pull itself together. Many remain doubtful that Greece and possibly other euro-zone members — especially Portugal, Ireland, Italy and Spain, which with Greece make up the so-called PIIGS — can undertake the drastic fiscal adjustments necessary to avoid defaults or debt restructurings. Besides, in a classic conundrum, the austerity measures already being imposed in many countries to narrow deficits could further suppress growth and reduce employment. The euro has taken a pounding, losing 18% of its value against the dollar since a recent high in November. Many financial analysts believe the euro may continue its descent, perhaps to parity with the dollar, which would represent a further depreciation of nearly 20%.

Pain in Spain
To understand what ails modern Europe, look at the pain in Spain. The turmoil caused by the debt crisis in Greece would appear a mere tremor in comparison with the damage done to the global economy by a similar meltdown in Spain, the world's ninth largest economy. To some, such fears are overblown. Spain has traditionally been one of the euro zone's more financially responsible countries. According to the Organization for Economic Cooperation and Development, Spain's ratio of government debt to GDP, a main measure of a state's debt burden, was only 63% in 2009, positively modest compared with Greece, at nearly 120%, and Portugal at 87%. Research firm High Frequency Economics declared in a recent report that "reason suggests that funding [Spain's] deficit should be no problem, and that there should not be a crisis."

But Spain is still vulnerable. Its fiscal position deteriorated with alarming speed amid the crisis, and the government deficit jumped to more than 11% of GDP in 2009. Add in private indebtedness and total debt rises to 232% of GDP — higher than Greece's, according to Standard & Poor's. In the past decade, Spain experienced a housing bubble perhaps even more destructive than the one in the U.S. as builders and lenders got caught up in a speculative dance. As many as 800,000 homes remain unsold from the boom years, and the banks are still digging themselves out from the losses.

The nervousness in financial markets is pushing Spain to speed up reform. In late May, parliament passed a slate of measures aimed at a rapid reduction of the fiscal deficit, including cuts in civil-servant pay, state investment and welfare programs. The government intends to bring down the budget deficit to 3% of GDP in 2013. José Manuel Campa Fernández, Secretary of State for Economic Affairs at Spain's Ministry of Economy and Finance, says the government felt the need to show investors it was committed to fixing its finances. The market turmoil "certainly led us to put these measures in place faster than we had originally planned," he says. "Economics is not about fairness."

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