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

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The Great Divide
Budget cutting is only the beginning of what Spain needs to do and probably not the most important thing. Spain has lagged in making the tough internal reforms it needs to ensure its companies can compete with those in the rest of Europe and the world. That failure has prevented the economy from becoming more productive and creative in ways that would help it match the advanced manufacturing capabilities of Germany and stay ahead of low-wage China.

Spain isn't the only euro-zone nation facing this predicament. One of the major sources of instability within the monetary union is that it has obscured huge differences in the competitiveness of European economies. A recent study by the World Economic Forum (WEF) ranked E.U. nations by their level of competitiveness, looking at everything from quality of education to Internet-penetration rates. It discovered that some members, including Germany and the Netherlands, were more competitive than the U.S., while others, such as Spain, Portugal and Italy, languished behind.

The single currency has facilitated these disparities by allowing the weaker economies, like Greece, to put off reform. Membership in the euro zone — on the same terms as titans like Germany — enabled them to raise debt at lower interest rates than they would have gotten on their own. But there are huge differences between euro-zone economies, and these have shown up in persistent economic imbalances. While Germany runs a giant current-account surplus, other nations, like Spain, post deficits. With so many poor performers in the monetary union, the euro's value and the overall growth of Europe could suffer. "The truth is coming out," says Jennifer Blanke, a senior economist at the WEF in Geneva. "Being a member of the euro zone isn't related to competitiveness. At the end of the day, they need all of the economies making stuff that other countries want to buy."

Getting to that point will require reform throughout the euro zone. The focus so far has mainly been on fixing the PIIGS, but to solve the euro zone's problems, countries in much stronger positions must chip in — and not just with bailout funds. Europe needs even greater integration, which would allow its companies to take advantage of a true single market. For example, the E.U. has tried for years to pry open national gas and power markets to more unionwide competition, which could reduce energy prices for companies, but has faced resistance from member states with large, dominant utilities. In a March report, the European Commission, the executive body of the E.U., called on countries with surpluses, like Germany, to stimulate domestic demand. In doing so, they would import more from their euro-zone neighbors and aid growth in weaker economies, like Spain's. "Divergence of current accounts and competitiveness are a source of potential concern," the commission said. For balanced growth, "the structural weaknesses of domestic demand need to be identified and tackled."

Facing these E.U.-wide problems, the idea of more coordinated policymaking is gaining acceptance. Since the inception of the monetary union in 1999, critics have contended that it needed a matching set of political institutions so that real economies could be coordinated. Without that discipline, it was feared, some nations' profligate ways would endanger the whole European economy — which is just what has happened. But European leaders have been wary of turning over too much sovereignty to the intergovernmental institutions of the E.U. In the wake of the Greek debt crisis, there is renewed talk of forming an "economic government" that would coordinate the national budgets of euro-zone members. That, believes Javier Díaz-Giménez, an economist at IESE Business School in Madrid, is crucial for the survival of the monetary union. "You can't have a single currency without fiscal-policy coordination," he says. "If we don't do this, we won't have a euro."

But it is unclear how far European leaders are willing to go. Germany, for example, has brushed off pressure to reduce its current-account surplus. The German leadership sees its strong economy as the result of years of hard reform and frugality and hasn't been willing to sacrifice its position to help euro-zone neighbors that the public perceives as irresponsible. German Finance Minister Wolfgang Schäuble recently dismissed criticism of its surplus as tantamount to "praise" for German industrial prowess. Meanwhile, the E.U. governing bodies lack the sticks required to keep members in line. The E.U. "needs to go after the countries that don't reform," says the WEF's Blanke. But "they might not have the political oomph to do that." Thus troubled countries like Spain may be left to solve their own problems. Investors "want to see the basics for sustainable growth in the future," says Campa of Spain's Economy Ministry. "They would like to see some structural reforms that lead in that direction."

Laboring over Labor
The response to the crisis in Europe so far has focused on cutting budget deficits, but no single reform might be more important than fixing the distorted labor market. In Spain, the strict laws have increased the costs of hiring to the point where companies are reluctant to take on new staff in permanent positions, thus perpetuating joblessness. That's why employers like María Polo's hire on short-term contracts. Not only has that left about a third of the salaried workforce with little job security and few benefits, it also weakens Spain's corporate sector. With almost no hope of receiving permanent positions — a mere 5% of those on temporary contracts are "promoted" into regular jobs — there is little incentive for the employee or employer to invest in job training. That inhibits the development of new, high-tech industries. The laws have created something of a generational conflict, with older workers in jobs for life while youngsters, as new entrants to the workforce, exist as a giant underclass of underpaid, poorly trained peons. "It's a very divisive system," says Juan José Dolado, a labor economist at Carlos III University of Madrid. "It's parents against kids, men against women." If the labor market isn't fixed, "we are looking at a big crisis, a road to destruction," he says.

Patricio Rodríguez Carmona couldn't agree more. The 40-year-old entrepreneur is founder of the Tie Gallery, a retailer of ties, cuff links and other accessories. Amid Spain's crushing recession, Rodríguez was forced to close six of his 10 outlets over the past two years, laying off 12 full-time employees, which cost him $90,000 in severance payments. After that experience, Rodríguez says he's reluctant to open new shops or hire more workers until he's certain the recovery is irreversible. "It's too expensive to invest in people," he says. "That doesn't make any sense." The labor laws, Rodríguez complains, are representative of a highly regulated business environment that creates endless hurdles for small businessmen like himself. Getting a government license to open a new retail store, he says, can take as long as two years. He also has to contend with conflicting layers of regulation between the city, regional and national governments. "It is very difficult to be an entrepreneur in this country," Rodríguez says. "If we don't change that, we will always be behind our partners in Europe. It will be difficult for us to be competitive."

With pressure mounting, the government decided to act. In June, Prime Minister José Luis Rodríguez Zapatero approved a slate of labor reforms aimed at encouraging companies to hire, including a reduction in severance payments for most newly hired employees and restrictions on the use of temporary contracts. Critics attacked the plan from all sides. Employers lamented that the reforms don't go far enough, while union leaders called a general strike for September to protest them. "This decree is very negative," says Javier Doz Orrit, international secretary at Comisiones Obreras, the country's biggest union. "It is based on a false assumption, that in order to reactivate the economy, labor reform has to be done."

Zapatero, however, will face only more such politically dangerous decisions. Spain finds itself in the most difficult of positions — pressured to reform in order to start growing again but lacking the very growth that will help the economy adjust to reform. "We have a problem that requires time to be solved, but we're not being given time," says José Manuel Entrecanales Domecq, CEO of infrastructure and energy giant Acciona in Madrid. "We don't have growth as a medicine. We are treating this patient with shock treatment, and the patient is pretty sick. That's what worries me the most." Yet if Spain fails in its reforms, it could face a protracted period of stagnation, with low growth and sustained high unemployment. "The weight of responsibility on the government is enormous," says the CEOE's Banegas. "I cannot accept that we are not able to do the things we need to do." He'd better be right.
— With reporting by Cristina Mateo-Yanguas / Madrid

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