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STRATFOR.COM: Europe's Coming Disharmony

STRATFOR.COM: Europe's Coming Disharmony

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Stratfor.com's Global Intelligence Update - 8 September 2000

Europe's Coming Disharmony

Summary

On Sept. 7, the euro hit a record low, falling to about 87 cents to the U.S. dollar. As the European Central Bank simultaneously battles inflation by raising interest rates, there are signs that the continent's economy will slow significantly over the next several months. After years of driving toward economic unity, governments will seek divergent strategies in reaction to these events. In the next few years, Europe will be increasingly divided over everything from the role of the euro to the now fading hope of standardizing the continent's complex tax regime.

Analysis

After years of driving toward a single economic bloc, bound by a single currency, Europe in stark contrast to the United States is battling severe economic headwinds. On Aug. 31, the European Central Bank boosted interest rates from 4.25 to 4.50 the sixth increase in 10 months in an attempt to reduce inflation beneath the 2 percent ceiling dictated by the 1992 Maastricht Treaty on monetary union.

Contrary to expectations, this move has not bolstered the euro; instead the currency struck an all-time low of 0.8691 to the dollar on Sept. 6. This followed a week of losses as a booming American economy sucked away investment dollars. The trend will continue until the EU adopts needed structural reform, particularly in its labor laws.

But Europe's current troubles indicate a long-term trend: The drive to unite the continent's economies is stalling. And the euro, once expected to bind small economies like Portugal's to large ones like Germany's, is producing unintended side effects. There is inflation on the edges of Europe, as in Sweden and Portugal. At the same time, growth is slowing in the heart of the continent. The European Union's member governments are fretting separately over how to deal with monetary union, not about how to unify further.

Europe's central bank in Frankfurt admits that the immediate problems facing the EU high oil prices and a weak euro cannot be solved with interest rate hikes. High oil prices now over $34 per barrel of Brent crude oil can only be alleviated by some unforeseen event abroad or a long-term drop in consumption.

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A weak euro can only be strengthened by deep structural reforms, like changing corporate tax laws or breaking down the continent's labor laws. But these are beyond the power of the central bank. By raising rates the ECB is at least attempting to bring inflation under control. The ECB attributes more than half of the 2.4 percent inflation in areas where the euro is now used to factors distinctly unrelated to high energy prices.

But rate hikes slow growth and a number of statistics indicate that Europe's growth is indeed slowing significantly. The combined economies of the continent were expected to grow 3.4 percent this year, the highest in a decade. However, several negative indicators are creeping upward.

Consider Germany. At the top of the list is the rising cost of oil, up 77.2 percent in Germany from the year before, according to the German Statistics Office. Furthermore, oil must be paid for in dollars. The euro's 25 percent drop against the dollar since January only compounds high oil prices. Germany did post an impressive 4.7 annualized percent growth rate for the quarter ending in June, but with energy costs, borrowing costs and expansion costs rising quickly, it is unclear how long this will last. Business and consumer confidence both dropped in July and August. Industrial production is tapering off, too. In June, industrial production fell 0.4 percent in areas where the euro is in use; France and Germany Europe's economic engines led the way. This is hardly the mark of an economy in the middle of a boom. New rate hikes, which the ECB says are already in the works, will only slow these economies further. To make matters worse, European investment is crossing the Atlantic in search of better returns. This forces business to borrow in order to finance expansion a proposition the central bank just made more expensive.

The effect is divisive: Germany, France, Italy and the Low Countries will experience anemic growth while the states on the edge of Europe are churning ahead on what is comparatively cheap capital. Finland, Spain and Sweden are all on track to top 5 percent growth this year while Ireland could top 10 percent. All face rising inflation. Interest rates that are too high for core are too low for periphery. The ECB's Aug. 31 rate hike will be no more than a passing blip on these states' radar, while inflation threatens to spiral out of control. Ireland already has an inflation rate that is triple the ECB's 2 percent ceiling.

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These problems are about more than oil prices; they point to the lack of structural reforms. Few states Ireland, the Netherlands and the United Kingdom being the notable exceptions have flexible labor policies. It is prohibitively expensive to hire workers and nearly impossible to fire them.

Part of the logic behind France's February decision to shorten the workweek from 39 to 35 hours was to encourage new hiring and reduce chronically high unemployment, currently at 9.1 percent. Instead the move has promoted the use of cheaper contract and part-time labor. French unemployment actually increased to 9.7 percent in July, and labor costs have shot up 11.2 percent over the past year, contributing to inflation. Corporate tax rates also remain prohibitively high, topping 40 percent in Belgium, France, Germany and Italy. There is no sign that the continent's political systems will tackle these problems any time soon.

As a result,individual governments will pursue their own reform programs as they decide for themselves which is more important: stimulating growth or battling inflation. This every-man-for-himself mentality is the opposite of what the union set out to do in 1992. France, Germany and Italy are all implementing various tax-cut packages to boost consumer or business spending and, by extension, economic growth.

Germany has embarked on the most drastic reform. Plans to shave a fifth off its corporate tax rates will save businesses $24 billion annually. But the reforms will not be implemented until 2005. France's $16 billion in cuts will occur over the next three years. However, the French government is pitching the reforms with an eye toward re-election. The cuts address popular income-tax and fuel-tax relief instead of cuts on corporate tax rates that would boost investment and growth. Italy's tax-cut package is focused on stimulating demand, but at $5 billion it may not be enough of a stimulus to keep growth rates up.

Deprived of the ability to raise their own interest rates, Ireland, Portugal and Spain are actually considering the politically unpopular step of jacking up taxes to combat inflation. Other inflation-control measures include limiting credit or establishing price controls all steps that would be anathema to the hands-off economic system that generated Ireland's stunning growth rates in the first place.

The idea of monetary union is driving the various fiscal policies further apart the opposite of what Europeans thought would happen when they signed the Maastricht Treaty eight years ago. This will hearten integration foes who prefer to keep national sovereignty as untouched as possible, while hindering any union attempts to coordinate tax policies. The euro much less the union is not dead, but it is very, very ill.

(c) 2000 Stratfor, Inc.

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