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EUROPE NEWS

MARCH 25, 2010

Europe's Choice: Growth or Safety Net

By MARCUS WALKER And ALESSANDRA GALLONI

BERLINEuropean leaders gathering for a summit in Brussels on Thursday are sprinting to resolve the crisis in Greece. But a growing number of policy makers say the true remedy for the euro zone's crisis of confidence lies elsewherein an overdue shake-up of the region's major economies, including Germany and France. Fears that European Union leaders would fail to patch up their differences over possible aid for Greece pushed the euro to a 10-month low Wednesday. Portugal's credit rating was downgraded by Fitch Ratings, underscoring the risk that Greece's budget crisis could spread to other struggling countries. The turmoil is a world away from the vision that accompanied the euro's launch in 1999. Then, champions of the common currency forecast a European Renaissance prompted by efforts to modernize inefficient welfare states and loosen overregulated markets. A decade later, the euro zone is struggling to join the global economic recovery. Its 16 member nations now face a stark choice. They can spur economic growth across the region by following through on long-overdue pledges to trim benefits and free up labor markets. Or, many economists say, they can face a decade of economic stagnation. Countries across the zone lost dynamism during the common currency's first decade, with annualized growth of 1.7% from 2000 to 2008, down from 2% growth in the 1990s. The next decade could be worse: Higher public debts and a surge of retirees will push up taxes and weigh on companies and consumers. "The real question this crisis poses to all of us is: What will be the capacity of countries to accept true reform?" says former French finance minister Thierry Breton, who is now chairman and chief executive of information-technology services company Atos Origin SA. At Thursday's summit, leaders from the 27-nation European Unionof which the euro zone is the financial coreare gathering to discuss the continent's broad economic goals for the next 10 years. Their plan for looking past a possible Greek default has global ramifications. The euro zone is the world's largest unified economy after the U.S., and a major source of world demand for goods and services. A sluggish Europe makes it harder for the world economy to find more balanced and sustainable growth.

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But the appetite for structural overhaul is low among Europeans, who have long believed that capitalism should be tempered by generous state benefits and strong labor protections. Even in the best of times, Europeans are loath to move toward a U.S.-style economic model, which they criticize for leaving citizens to sink or swim. In bad times, voters tend to demand economic security over change. French conservatives' stinging defeat in regional elections over the weekend was a warning that many people voters have soured on President Nicolas Sarkozy's bid to make France more business friendly and reduce some welfare benefits. While the euro zone as a whole addresses its economic malaise, there's also rising political tension over the diverging competitiveness within the region. German companies' efforts to cut labor costs in recent years have helped them to win a rising share of Europe's markets. But export prowess has come at a cost for German households, whose incomes have stagnated, hurting consumer demand in Europe's biggest national market. French Finance Minister Christine Lagarde has repeatedly chastised Germany over the past week for not generating enough demand for its neighbors' goods. German politicians have countered that France and Southern European nations need to make their own industries more competitive. Despite its strong exports, Germany's overall economic growth has been weak for years, a sign that even Germany has hard choices ahead. "The euro was supposed to achieve higher productivity and growth by bringing about a deeper integration between economies," says Simon Tilford, chief economist at the Centre for European Reform, a London think tank. "Instead, integration is slowing. The lack of flexibility in labor and product markets raises serious questions about the likelihood of the euro delivering on its potential." Structural changes are the last great hope in part because euro zone members have few other levers for lifting their economies. Individual members can't tweak interest rates to encourage lending, because those policies are set by the zone's central bank. The shared euro means countries don't have a sovereign currency to devalue, a move that would make exports cheaper and boost receipts abroad. The remaining prescription, many economists say: chip away at the cherished "social model." That means limiting pensions and benefits to those who really need them, ensuring the able-bodied are working rather than living off the state, and eliminating business and labor laws that deter entrepreneurship and job creation. That path suits Carlos Bock. The business-studies graduate from Bavaria spent months navigating Germany's dense bureaucracy in order to open a computer store and Internet caf in 2004. Before he could offer a Web-surfing customer a mug of filter coffee, he said, he had to obtain a license to run a "gastronomic enterprise." One of its 38 requirements compelled Mr. Bock to attend a course on the hygienic handling of mincemeat. Mr. Bock closed his store in 2008. Germany's strict regulations and social protections favor established businesses and workers over young ones, he said. He also struggled against German consumers' reluctance to spend, a problem economists blame in part on steep payroll taxes that cut into workers' takehome pay, and on high savings rates among Germans who are worried the country's pension system is unsustainable. "If markets were freer, there might be chaos to begin with," Mr. Bock said. "But over time we'd reach a better economic level." Even in France, some erstwhile opponents of reforms are changing their tune. Julie Coudry became a French household name four years ago when she helped organize huge student protests against a law introducing short-term contracts for young workers, a move the government believed would put unemployed youths to work. With her blonde locks and signature beret, Ms. Coudry gave fiery speeches on television, arguing that young people

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deserved the cradle-to-grave contracts that older employees enjoy at most French companies. Critics in France and abroad saw the protests as a shocking sign that twentysomethings were among the strongest opponents of efforts to modernize the European economy. The measure was eventually repealed. Today, the now 31-year-old Ms. Coudry runs a nonprofit organization that encourages French corporations to hire more university graduates. Ms. Coudry, while not repudiating her activism, says she realizes that past job protections are untenable. "The state has huge debt, 25% of young people are jobless, and so I am part of a new generation that has decided to take matters into our own hands," she says. "We've decided that we can't expect everything from the state." The euro itself was supposed to help cure Europe's sclerosis. Launched in 1999, the single currency had an immediate impact by smoothing cross-border trade, travel and flow of workers. Yet efforts to undergird longer-term growth were feeble. Euro zone members agreed in the late 1990s on fiscal rules that capped annual budget deficits at 3% of gross domestic product, and limited overall public debt at 60% of GDP. But governments that fell short weren't penalized: In 2003, euro zone finance ministers voted down a proposal to subject France and Germany to a legally binding decision to reduce deficits. Governments also didn't embrace the EU's so-called Lisbon agenda of 2000, which outlined structural overhauls that many economists said would prepare Europe's economies to adjust to globalization and aging populations. The agenda's long list of reforms, from making it easier to start a business to increasing spending on research and development, included no enforcement mechanism. Former Italian Prime Minister Romano Prodi, who was one of the single currency's foremost advocates in the 1990s, says the attempt at economic integration was "half-baked." "There are differences, even budgetary ones, among U.S. statesbut there is also a central government with an economic policy," he says. "Europe wasn't ready to accept this. There was no political will to go further." Overhauls were left to national governments. Some made progress initially. Starting in 2003, German Chancellor Gerhard Schrder shattered European taboos by slashing benefits and pushing the long-term unemployed back to work. In Italy in 2004, Prime Minister Silvio Berlusconi's government accelerated a 1996 pension overhaul that changed the rules by which employees could retire, aiming to reduce the state's future social spending. These changes proved to be the high-water marks. Europeans voted out many of the politicians who engineered them. After Mr. Schrder's government fell in 2005, new chancellor Angela Merkel quickly backed away from her unpopular proposals to shrink the German state and deregulate the labor market. She reinvented herself as a consensus-seeker, diluting Mr. Schrder's benefit cuts. Ms. Merkel said in an interview last year that the German economy is healthier now than under her predecessor and no longer needs as much overhaul. German businessman Stefan Kirschsieper doesn't buy it. "At the moment, nobody in German politics is thinking strategically about the big reform questions," says Mr. Kirschsieper, head of family-owned toolmaker Walter Kottmann GmbH and chairman of Germany's young entrepreneurs' federation. He says he has been deterred from adding new workers in part because of high payroll taxes and laws that make layoffs bureaucratic and costly. In France, Mr. Sarkozy won the presidency in 2007 with calls for a revitalized French work ethic that would energize the nation's solid but sluggish economy. He cut some taxes for individuals and businesses, allowed more price

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competition in the retail sector, relaxed rules for starting a business and diluted the extent of a law mandating a 35hour work week. He also promised to reduce the number of civil servants. But as the financial crisis unfolded and his popularity declined, Mr. Sarkozy also showed his attachment to traditional French dirigisme, or state intervention in business. He set up a fund for building government stakes in industry, granted loans to carmakers Renault SA and PSA Peugeot-Citroenon condition that they wouldn't close factories and granted tax cuts to companies that vowed not to cut jobs. In late 2008, he mused: "Have I become a socialist? Perhaps." So far, Mr. Sarkozy and his EU peers have failed to find a solution to a major big long-term problem created by Europe's welfare traditionshow to create opportunities for a new workforce while shielding the existing one. Around 21% of all euro-zone workers under the age of 25 were unemployed in the fourth quarter of 2009, compared with under 9% of workers 25 and over, according to the Organization for Economic Cooperation and Development. An insecure younger generation that can often find only temporary jobs will be asked to shoulder the burden of their elders, who are living off state pensions in steadily increasing numbers. "I only know one person who went straight from university to a job. Everyone else is unemployed, or studying for another degree because there are no jobs," says Katerina Karamatsiou, a 26-year-old Athenian. Ms. Karamatsiou lives with her parentswho have solid jobs in accounting and bankingand says that generation has stitched up the job market. She's thinking of looking for work in the U.K., which is outside the euro zone but also struggling with high debts and slow growth. "It can't be worse than here," she says. Politicians across Europe say the cause of reform isn't lost. Xavier Musca, deputy secretary general to Mr. Sarkozy, says that while France started late on the reform path, momentum has picked up again since 2007. "This administration [is] encouraging employees to work more and pushing for competition in the retail sector...We're also going to speed up the pension reform." Ultimately, some governments will have no alternative. Germany recently passed a law guaranteeing the elderly that their pensions would never sink, a costly promise that economists say will haunt future workers and companies unless the pension system is fundamentally revised. "We will have no choice but to undertake reforms," says Michael Fuchs, a leading lawmaker in Ms. Merkel's Christian Democratic Union. Write to Marcus Walker at marcus.walker@wsj.com and Alessandra Galloni at alessandra.galloni@wsj.com

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