The elections in France, Greece and Germany over the weekend will once again reignite the speculation about the euro’s survival. Indeed, the core German-French axis will be put in question with Monsieur Hollande’s intention to renegotiate the austerity pact. Frau Merkel would have none of it.
The European scene is likely to change dramatically in the coming weeks or months. However, the City should not be too jubilant yet. The Franco-German domination may be coming to an end, but not the euro.
What we are seeing is an effort by Germany to isolate France. Already, the German finance minister is traveling to Spain and Italy to award those countries good grades for their tough policies.
This is the euro’s moment of truth. As I wrote at the outset a decade ago (see below), the euro is a mechanism meant to force changes to the European welfare system. Germany understood it and they are reaping the benefits today. Greece and Spain are discovering what the City still does not get. Politicians like Monsieur Hollande will fight it, but the only way for him to change this fundamental premise is to leave the euro. He is unlikely to do that.
Oh, and the City’s belief that only a fiscal union can save the euro may be right, but it would destroy the benefits of a mechanism that is dragging all Europeans kicking and screaming towards a more flexible economy.
Please read on:
European Union: The Americanization of Europe.
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by Hervé van Caloen
The unification of the European economies has started a virtuous circle with consequences that seem to have taken most people by surprise. After a slow start, Europeans are finally realizing the far-reaching structural changes the single market combined with a common currency are bringing to the Old World.
Ironically, most European politicians involved in the design and the construction of the European Union did not anticipate the nature of the changes that are now taking place. Or, if they did, they never shared their thoughts with their constituencies. It is actually most probable that these voters would have rejected the single market had they known it meant a rapid deregulation of the business world as they knew it. In a stable world that was overly concerned with equality, stability and social coherence, the present drastic changes were not really welcome.
It is only recently that some opinion makers have started to contemplate the inevitable consequences of the European Union. It is unmistakably going to lead to American-style capitalism on the Old Continent. The Europeans are in the midst of a spiral of ever increasing economic deregulation that is bringing them every day a bit closer to a free market as we know it here in the States. Like every spiral, this one will be difficult to stop.
A SINGLE MARKET
A decisive step in the unification process was the opening of borders within the European Union. The Europe 1992 project – as it was called – was pretty much achieved on time. Although some sectors, like the postal services, are still in the process of being deregulated, most industries are now open to fair competition. Europe has, by and large, achieved its goal of creating a free flow of goods, people, capital and services within its borders. Tariffs have been eliminated and non- tariff barriers are coming down one after the other. Corporations can no longer seek protection behind national boundaries. Business managers who are not performing satisfactorily are no longer protected from hostile take-over bids coming from their European competitors. And where protectionism still prevails, legal ways now exist to challenge it. One by one, all the old defensive mechanisms are crumbling. The cozy corporate world so characteristic of Europe has been shattered.
A COMMON CURRENCY
After “Europe 1992” came the Maastricht Treaty. Most European countries agreed at a meeting in the Dutch town of Maastricht to share one unified currency, the Euro. It was a logical extension of the opening of borders. A common currency ensures fair competition. One can not have a truly open, competitive and fair market with many different currencies. Before fixed exchange rates and the ensuing European currency, countries were using devaluation and capital controls to protect their economies. This is no longer an option.
A SINGLE MONETARY POLICY
By giving up control over their currencies, member countries have deferred their respective monetary polices to the European Central Bank, an independent body located in Frankfurt. This has had a very positive effect on bond markets as interest rates in Europe have come down in reaction to tight monetary policies imposed by the Treaty.
At Maastricht, the German Central Bank imposed very strict conditions for joining the Euro. Under its strong insistence, the Treaty stipulated that each country willing to join the new, unified currency had to demonstrate its ability to control inflation and public spending. Both these indicators in most European countries subsequently converged at the – low – German level, bringing interest rates down with them. Only Greece did not qualify among the declared candidates and has not yet joined. All the other countries have since enjoyed a low cost of capital and the Euro has succeeded in becoming a virtuous currency. That is a currency that tries to look like the once almighty Deutsche Mark which for years represented economic orthodoxy.
In the long run, however, the German influence is likely to be diluted. A better balance between economic growth and rigorous monetary discipline can be expected. Early on, the countries with a history of lax monetary policies, like France or Italy, had to convince the Germans of their new-found discipline. They implemented a very tight monetary policy without questioning it openly. However, once the national currencies have been abolished, and everybody is fully on board, one can expect these countries to exercise a stronger influence. In the run up to monetary unification, France and some other countries got frustrated with the Germans’ insensitivity to economic growth. They are more likely to voice their viewpoints in the future.
In the late 80s and early 90s, political pressure to stimulate the economy in order to reduce unemployment was often very strong. Only unwavering support for monetary unification in most countries and the dominant role played by the independent German Central Bank prevented a reversal to former practices of growing budget deficits and printing money. This orthodox policy is now paying off. Inflation is low. Interest rates are low. And the economy is on the upswing. All European countries can now appreciate the benefits of responsible economic policies. Yet the price they had to pay was pretty high and it is not at all sure the ECB will be as stubborn in its fight against inflation as the Bundesbank was in recent past. We can reasonably expect a more accommodative monetary policy henceforth but the dominant German influence and the independence of the central bank are major guarantees against former excesses. Politicians will no longer be able to print money ahead of elections.
CONVERGING INTEREST RATES AT LOW LEVELS
Now that interest rates are set at the European level, the nominal cost of capital is the same for all member countries. Companies with the same credit ratings in different countries no longer benefit or suffer from having to borrow capital at different interest rate levels. In addition, converging inflation rates are making real interest rates also more or less equal to all.
The convergence of interest rates at the lowest level is most remarkable. Who would have believed a few years ago that Italians would be able to adopt German monetary discipline? This in itself seems nothing short of a miracle. Early fears of a weak European currency due to Italian-style lax monetary policies were proven wrong. By the time the Europeans had engaged on the unification path, all governments agreed to let the Germans set the tone. It was understood by all that conservative economic policies were long overdue. It required the lofty goal of creating an integrated union for the weaker governments to find the strength to put their fiscal houses in order. This ploy worked marvelously and it is having very positive ramifications for business. Companies headquartered in the areas that suffered from chronic inflation in the past are benefiting tremendously from lower interest rates. The cost of capital in Italy or Spain, for example, was historically much higher than in post-war Germany, giving companies there a substantial competitive disadvantage. They used to pay high nominal interest rates that reflected high inflation rates and included a larger risk premium, resulting in a higher real cost as well as nominal cost of capital. Today, with the Euro, the playing field is level.
JUST A BEGINNING
These achievements are impressive on their own. But this is not the full story. The economic unification of Europe is just starting. The profound consequences of Europe 1992 and the new currency are now unfolding. European unification is leading to accelerated deregulation of the Euro-economies. We are experiencing a trickle-down deregulation. Every decision to deregulate one or the other aspect of the European economy leads to even more deregulation in other areas. Deregulation and privatization of large sectors of the economy is forcing the deregulation of labor markets. The opening of borders has kick-started a round of tax cuts as countries are competing for investments. The planned abolition of capital gains taxes for corporate shareholdings in Germany will lead to the dismantling of the overwhelming power of German banks over the corporate sector.
The trend towards ever more deregulation is strong and irreversible. The only foreseeable threat to this evolution could come from the political front. Politicians in Europe are predominantly from the center-left and unsympathetic to unbridled capitalism. Their background is one of heavy regulation and state control. They are therefore uncomfortable in presiding over this American-style free market tidal wave.
Fortunately the positive effects of a revitalized European economy are making the unification more and more popular. Politicians know very well they would be ill advised to project themselves as old-fashioned socialists who resist the popular unification of the European peoples. They know the unification is more and more associated with the present prosperity. Few politicians want to be seen as spoiling this historic transformation and the ongoing wealth creation. Forget the fact that the union is looking very different from what they had envisioned. They are going with the flow. Any attempt to stop the trend faces the public’s disapproval on top of legal challenges from their European partners.
THE GENIE IS OUT OF THE BOTTLE
By opening up the borders and creating a common currency, Europeans have decided to let competition regulate their economy. A free market means more competition, a rather new concept in countries obsessed with social protection and burdened by state-run monopolies and subsidized industries.
In the past, companies often operated in comfortable national monopolistic or oligopolistic markets. European business elite enjoyed a friendly business environment. They were often protected by their dominant market position and tended to worry only about how not to rock the boat. A rigid regulatory environment reinforced the status quo and it was particularly difficult for entrepreneurs to challenge the establishment. Europe lived comfortably in a “menage a trois” consisting of the government, the management of large, established corporations and very structured unions. Entrepreneurs were troublemakers. At best, if successful, they were looked upon as lucky parvenus. Young people found it much more prestigious to climb the corporate ladder than to start their own companies. Social recognition came from success within existing structures.
The problem was that pre-unification economic systems had run their course and were no longer capable of creating jobs. Europeans knew they had reached a dead end street, but did not know how to get out of it. The press started to talk about Eurosclerosis. Unemployment kept going up. Economic growth came to a virtual standstill. At the same time, in the early 80’s, major changes were under way in the US and in the UK. However, at that time, Continental Europeans rejected them. Old conservative reflexes prevented Europe from liberalizing their economies. Mentalities were not ready to embrace Reaganomics or a Thatcher revolution.
Instead, Europeans embarked on a longer path that would eventually, and ironically, lead to the same results. The way out, it was thought, was the unification of the European economies. This would lead to economies of scale that would allow Europeans to compete with American multinationals. The outcome, as we now know, was much more far reaching. Size does matter, but more importantly, the process lead to the present wave of deregulation.
Here are the reasons for profound and sustainable changes in the Old World and the causes of the trickle-down deregulation that is unfolding at an accelerated pace.
CHANGES
First, the new competitive environment brought substantial cost reductions. Massive layoffs have been implemented in corporate Europe. This on an even grander scale than what was experienced in the United States in the last two decades of the 20th century. European companies have become leaner and meaner. Workers, organized or not, have had to show more flexibility. Production costs and labor rigidities had driven costs to unsustainable levels in the past. This had to be remedied. Moreover, with open borders and the elimination of currency risks, corporations gained a lot of bargaining power. They started relocating manufacturing facilities to the most attractive areas within the EU. With the elimination of borders, it became much easier to move production facilities to countries that enjoy lower labor costs, lower corporate taxes or a more flexible working environment.
In the past, it often made sense to set up small manufacturing facilities in various European countries to circumvent all kinds of tariffs and non-tariff barriers. Opening of the borders prompted a consolidation of these facilities. Today, companies’ investment decisions are easier to make. Production is moving to the most business-friendly areas and goods are then freely shipped to the rest of Europe. The UK, Ireland and Spain have thus experienced large direct investments. On the other hand, Germany, which happens to have the highest level of corporate taxes in the Union and the highest labor cost in the world, has experienced large net outflows of direct investments in the last decade. Increasing outflows of capital into Germany’s neighboring countries’ production facilities are not being matched by foreign direct investments in Germany. There is little enthusiasm among corporations to set up production facilities in Germany. Why bother since the German market can be accessed from Ireland or the UK with little additional transportation cost?
Not surprisingly, Germany is reacting by bringing corporate taxes, income taxes and capital gains taxes down. Others, like the Irish, have preceded them on this path. More will have to follow suit. Just watch what will happen in France in this regard. They have no choice but to go in the same direction.
Management’s decision to allocate funds has been further simplified now that different countries’ monetary policies and currency risks are out of the equation. Countries differ-or compete- mostly on the degree of business “friendliness”. It is thus no surprise that pro-business Ireland is presently enjoying an economic growth rate comparable to the Asian Tigers when they were still roaring.
LABOR FLEXIBILITY
This is not good news for labor unions. They are feeling the heat. Membership numbers are coming down all over Europe. But this could be good news for most employees. As the European workforce is becoming more mobile, top management has to offer better deals to key employees in order to keep them. Mobility of the people is crucial for better compensation. It was in great part because of the unwillingness of employees to change careers and to relocate that management was able to get away with very low compensations. Deregulation and increased competition are bringing better salaries and also new compensation methods like bonuses and stock options. For the first time, a large German company is now offering stock options to its top managers. The losers in this transformation of the labor environment are organized labor and big government. The latter will have to learn to live with stricter budgets and with a reduced influence on the economy.
VIRTUOUS CIRCLE
As soon as corporate tax rates start to go down in one country it becomes inevitable for others to follow suit, thus setting in motion a trend that is accelerating with time. The question is where do corporate tax cuts end? One can compare it to the United States with the states imposing different tax rates. Corporations are lured to those states that offer the best deal, i.e. the lowest state taxes. But state taxes come on top of the more important federal tax rate. In Europe, the divergence in tax rates is magnified by the fact that it concerns the national corporate tax rate, i.e. the bulk of the tax. It is inevitable that the different countries, just like the states in the US, try to outbid one another.
The lack of an overarching body setting equal rates for all companies is presently leading to corporate tax cuts all over Europe. It is not foolish to believe that Europeans may gradually move to a zero corporate tax rate as countries keep outbidding one another to attract business. The reduction in government income can, for example, be compensated by other forms of taxation. Or better, European governments may discover the virtues of spending less. If this seems like a stretch of the imagination, consider people’s disbelief a decade ago when told that Europeans would actually deregulate their markets. It is like a heavy truck gaining speed. Who has the means to stop it? Countries can only reverse this trend through unanimous decisions, which seems unlikely in the foreseeable future as I illustrate on the next page with the attempt to tax interest payments.
Income tax rates are similarly coming down. In a world where people become more mobile, it is increasingly important to motivate talented people to stay put. Young people, unlike their parents, are willing to move to neighboring countries to seek a better future. Even young French entrepreneurs are trying their fortunes across the Channel in order to be able to retain a larger portion of their income.
PRIVATIZATIONS
The need for privatizations all around the world has become so obvious to most that it is difficult to remember what a revolutionary idea it was at the time Mrs. Thatcher started it in the early 80s. In Europe, at the time, large private companies and state-run corporations were often sharing a comfortable and unchallenged position. A shake-out was needed both in the private sector and in the very large public sector. The idea was, however, very unpopular because it meant massive layoffs.
Here again Continental Europeans did not embrace the radical changes outwardly. Instead, privatizations became an “unfortunate” byproduct of the unification of the European economies. Free and fair competition within the European Union was incompatible with national monopolies or state-owned companies.
For a long time, telephone operators, electric utilities and national airlines – among others – were considered “public services” and were not open to competition. The belief was that since the private sector is solely interested in making profits and since telephone lines and electricity have to be available to everyone, no matter the cost involved, only a government operated monopoly will provide equal access to everybody. As far as airlines were concerned, national airlines were losing a lot of money in a highly fragmented European market and the only way to keep them alive was by pumping in public money year after year. Governments thought it was in the public’s interest to sustain their national airlines. It was somehow every country’s pride to have planes flying around the world with its national flag, even at a high cost to taxpayers.
Needless to say, all these public companies were hugely overstaffed since governments do not lay off redundant workers. Instead of focusing on profitability, governments tend to manage companies with the next election in mind. It is so convenient to hire more people when unemployment statistics do not look good…However this flawed logic of mixing private companies and state run enterprises does not stand anymore. “Public services” are being privatized. And now that telephone companies are no longer a service to the public at large, telephone services are rapidly becoming affordable.
European countries often went well beyond controlling just utilities and transport companies. The last attempt by a European government to control all the largest corporations came, ironically, at the same time as the “Thatcher Revolution”. Before getting elected, President Mitterand had promised to nationalize most of France’s large companies. He kept his promise. A large number of France’s companies were taken over by the socialist administration in attempt to create a “different economic model”. Years later, France is re-privatizing these companies, as required by the European Commission and to the delight of investment bankers. In the process, French taxpayers had to pay for one the world’s most expensive bank bail out.
With the fall of communist regimes in Eastern Europe reinforcing the view that governments should not run businesses, attitudes have rapidly evolved. It is now obvious to most that state owned companies have a disruptive effect on the economy and society.
THE END OF HOMO POLITICUS ?
Here is the good news: political unification is far behind economic unification. In the EU, important decisions have to be taken unanimously. Thus, for European bureaucrats to stop this wave of deregulation, all member countries have to agree. At the present time, for example, every European country but the U.K. and tiny Luxemburg want to levy a European tax on interest payments on bonds. Since this is viewed as a threat to the City’s business, Her Majesty’s government is vetoing it. As long as they continue to do, nothing can be done. Any measure to regulate or to create other taxes at the European level are similarly difficult to implement because it runs against one or another member’s interests.
Unlike the United States of America that has a strong federal government, the European Union is merely an association of nations. A lot of different countries –and different interests – have to come together on these issues after the European Commission has made a recommendation. Hence, considering that the number of members seems to multiply even faster than a family of rabbits, resolutions are becoming increasingly difficult to agree on. It will be very hard to reverse the trend of deregulation unless all countries agree on giving up even more sovereignty to a new, more effective political entity. Some hope this power could be given to the European parliament but this seems unlikely in the foreseeable future.
Today, the European Commission in Brussels can only make proposals to the member countries and the European parliament remains a rubber stamping body. It is this lack of a strong and overarching political body that is Europe’s best guarantee to achieve a profound and lasting transformation. Politicians, who have a natural tendency on the Old Continent to intervene in economic matters, do not have the means to spoil the party this time. There is no one to stop the deregulation of Europe!
BETTER ALLOCATION OF CAPITAL
Changes bring new thinking. New thinking brings even more changes. As companies focus more on competitiveness, they pay more attention to allocation of capital and return on investments.
There were a lot of justifications for stocks’ poor returns in the past and inaction tended to be portrayed as wise behavior. For example, often management was praised for sitting on piles of cash. This was viewed as a prudent thing to do: better keep some reserves for difficult days than risk losing money in uncertain investments. Managers did not loose their jobs for being inactive. And, if returns were not satisfactory, one could always blame it on the macroeconomic or the political environment. Shareholders did not exercise their power and this gave the corporate establishment virtually full control over their destiny. Shareholder value did not exist in Europe’s vocabulary. The tyranny of the status quo became prevalent and resulted in the well-publicized Eurosclerosis.
Henceforth in a liberalized economy, cash rich companies are becoming takeover targets. Like their American counterparts in the 80’s, European managers are feeling the heat. Undervalued stocks attract the attention of raiders and poorly managed companies offer easy targets. Managers are thus becoming accountable. Since raiders tend to get rid of bad managers, better performance and higher valuations are the best means to keep them at bay.
To take one example, in the past, Siemens, the large German conglomerate, could afford to sit on huge amounts of cash for years without even thinking of giving it back to the shareholders or find a better return for it. This is no longer possible. Siemens’ management was never threatened by a potential takeover in the past, to say nothing of one from abroad. German regulations allowed poison pills that gave management the needed weapons to fight off any intruder. The result was that managers were running their companies as if they owned them. Shareholders very often had no say and were treated accordingly.
Today, as shareholders become more active, stock performance becomes more of a focus. Also, better returns on stocks attracts more capital to the stock market and with more money available for stocks, new entrepreneurs levy more capital by floating shares of their companies. Here again, this is a radical change in attitude. In the old days, European companies went to their banker and borrowed money when capital was needed. Total market capitalization relative to the countries’ economy in Europe used to be a fraction of the ratio in the US or the UK. Going public or issuing additional shares were not the preferred way of levying capital in the cozy business world of the past because it meant sharing both information and power. Instead, management preferred to continue its comfortable relationship with their predictable bankers.
This was a costly way of doing business. The new businessmen in Europe have now understood the importance of the stock market and, as stated before, have more capital made available to them. In the last few years, for example Germany created a new stock market, the Neuer Markt, for small and young companies. In Brussels, a pan-European market, the Easdaq, was set up for the same purpose. The US Nasdaq will soon launch its own European small cap stock market. They all contribute greatly to the funding of new, often technology or internet-related companies.
RETURN ON CAPITAL AND CONTROL OVER ONE’S DESTINY
Investors’ returns are benefiting from a better allocation of capital as an increasing portion is being invested in stocks rather than bonds. Capital made available to corporations tends to be allocated more efficiently under the renewed pressure of shareholders. And now even governments are becoming more aware of the need for better capital allocation and for capital formation. One of the major characteristics of the European social model is the direct transfer of income from the working people to the retired citizens. Under that system, governments levy a contribution directly from wages to provide for the elderly. This is in contrast with the pension system prevailing in Anglo-Saxon countries, where one’s life-long savings provide for one’s retirement.
Recently Europe’s social security system has run into major financing problems due to the lack of funding and the rapid growth of the number of retirees. Meanwhile Europeans are realizing the crucial role played by large pension funds in financing the economy. France discovered this recently when they found out that foreign pension funds own sometimes up to 40% of their largest companies. It came as a shock. France does not have a large pool of capital to invest in their stock market and consequently their managers have to report to dreaded Anglo-Saxon pension funds who keep pressing for more efficient operations and higher shareholder value.
Some countries like The Netherlands and Italy have already voted reforms to create a pension fund system. Other countries have a harder time selling the idea to the public as politicians have heralded the pay-as-you-go social security system for so long. This latter system was viewed as the quintessential solidarity system compared to the “selfish” Anglo-Saxon pension fund system. How can governments now promote the pension system so quickly after giving in on the nationalization debate and on Reaganomics-style tax cuts? Time is needed to build a new consensus, but the outcome is inevitable. Social security systems are bankrupt and are now taking up a too large part of administrations’ budgets. Better allocation of capital is now also required from governments. Creating a pension fund system will be a much better allocation of public savings. It will reduce budget deficits and it will create a new pool of money that can be redirected to the productive part of the economy.
THE INTERNET:
THE CATALYST FOR CONTINUED DEREGULATION AND INVESTMENT OPPORTUNITIES
The Internet is spreading all over Europe faster than it would have without the privatization and the deregulation of telecommunications. This has brought competition, a real choice of services and lower telephone prices. Without this rapid deregulation Europeans would not experience the present boom of the Internet.
The Internet is deregulating economies all around the world. It is thus also reinforcing and speeding up the deregulation of Europe. It is acting as the accelerator of the virtuous circle Europeans have embarked on when they chose to create a single market. Responsible fiscal policies together with a moderate monetary policy will keep interest rates at low levels. Increased competition will continue to put downward pressure on prices. The threat of moving operations to different locations will guarantee increasing labor flexibility. More privatizations and more deregulation is being actively enforced by the European Commission. Taxes are bound to come down much more and, most important of all, a revival of entrepreneurship is making Europe the place to invest your money.
