We have recently observed been a major reversal of the economic fortunes of Europe, Japan and the U.S in the 1990s.
 

Only a few years ago, the US economy appeared as affected by a serious malaise: low growth, a sharp recession in 1990-91, large trade imbalances, a weak dollar, a hollowing out of the manufacturing sector and persistent talk of a structural decline of US power.
 

Conversely, Japan was viewed as an exemplary economic success story and a model of successful economic long-run growth. People talked of "Japan Inc." and the Japanese growth model was being suggested as a case study to be followed by other Asian and developing countries.
 

Europe had not been as successful as Japan but the overall economic performance of Europe in the 1980s was at least as good as the one of the U.S. Also, the 1992 Single Market project and the prospective of a European Monetary Union (EMU) energized the European continent in the early 1990s and led to a phase of Euro-Optimism after a long period of Euro-Pessimism in the 1980s.

Today, the situation appears almost exactly reversed.

We have seen four year of serious economic recession and turmoil in Japan from 1992 to1995 only partly reversed in 1996. The recovery has stalled in 1997. The Japanese model does not work anymore even in Asia (see the recent currency and economic turmoil in East Asia).
 

Europe has been growing very slowly in the 1990s and high unemployment rates remain a serious issue; also, there is skepticism and many doubts about wisdom of a monetary union in Europe.
 

Both Japan and Europe seem afflicted by structural economic problems.
 

Conversely, the US has had five years of dynamic economic performance and competitive resurgence. Because of a dramatic restructuring process over the last decade the US economy is now "lean and mean", highly productive, with low labor costs, highly innovative and very competitive in world markets.
 

Talk about a "new era", "new paradygm", "new economy", "Goldilocks economy"

The US was ranked #1 in competitiveness according to the recent "World Competitiveness Report"; Japan #9; Germany #14 and France #20; Italy #34.  

2. Features of the European Economic Model
 
 
 

• A very extensive welfare state with a central role of the government in regulating markets and economic activities. Public provision of many services: education, health, pension systems, unemployment benefits, wide range of social insurance programs.

• Large size of government spending (on average 50-60% of GDP)

• High tax rates to finance such welfare state.

• Regulation of labor markets, strong labor unions and extensive benefits for workers.

• Regulation of product markets and existence of oligopolistic conditions.

• Heavy use of industrial policies to foster national industries.

• Relatively open trade regime (at least within Europe) and open policies towards FDI.

• Limited capital and labor mobility within Europe.

• A large public enterprise sector.

Is the traditional economic model of Europe now partially flawed and in need of structural change and reform?
 
 
 

Simple answer: Yes. Why?
 

3. Serious labor market rigidities

Labor market rigidities in Europe:

1. Excessive regulation of labor markets.
2. High taxes that discourage job creation and job search.
3. Excessive job security.
4. High levels of unemployment insurance.
5. Excessive fringe benefits (above wages) that increase labor costs.
6. High severance benefits.
7. Union strength leads to power for "insiders" (job holders) relative to "outsiders" (the unemployed).
8. Flat wage differentials not rewarding sufficiently productivity.

4. Fiscal policy problems
 
 

• Excessive deficits in Europe in the 1970s and 1980s led to high public debt (as a share of GDP)

• Fiscal retrenchment in the late 1980s and 1990s

• The Maastricht fiscal criteria imposed extra fiscal discipline.

• The fiscal adjustment in Europe has been difficult and painful because of slow growth and high unemployment

• The long-term problems of fiscal policy have not been addressed yet.

• The aging of population has led to:

•     Large unfunded future liabilities of the public pension system.

•     Large unfunded liabilities of public health care systems.

• Other long-term issue: fiscal burden of extensive welfare state.

• Still limited privatization of public enterprises in Europe.

• The above long-term problems are more serious in Europe than the US.

• In US you had welfare reform, Medicare and Medicaid budget cuts and the Social Security imbalance is not as serious as in Europe.

• Very limited structural fiscal reform so far in Europe.

• Structural changes in the nature of technological innovation
• Globalization and greater trade competition
• Deregulation policies fostering competition
• Corporate restructuring

5. Structural changes in the nature of technological innovation.
 
 
 

• The nature of technological innovation has changed. From the 1950s until the early 1980s, innovation took the forms of already existing technologies and goods that had to be improved in quality (examples are: cars, stereo systems, photographic equipment, other consumer electronics goods).

• The Japanese were best at doing this as being the best in "process innovation", "quality improvement" and "product imitation".

• Today, technological innovation is very different because of qualitative changes in technologies and the rapid appearance of new and very different products (computers, software, Internet and information technologies, advanced chip technologies, telecommunication goods and services, new financial instruments and services). These products are appearing and changing at such at dizzying pace that an imitator cannot catch up with the product and technological leaders.

• The product cycle of innovation has become drastically shorter. Extreme example: the Internet Browsers and the war between Microsoft and Netscape. So, today you either innovate and remain on the cutting edge of the technological wave or you risk to remain forever behind.

• A mainstream view in the United States right now is that in all these new technologies and products Europe (and Japan) are seriously behind the US and may have a hard time to catch up.

• In terms of technological innovation, Europe is currently lagging behind both the U.S. and Japan.

6. Globalization and greater trade competition
 
 

• Increased global trade and lower tarriffs have led to global competition and the need for industrial restructuring.

• The US suffered in the 1980s from freer trade, trade competition and the strong dollar value but this major economic shock led to a dramatic process of corporate restructuring.

• Europe was relatively open to trade but followed trade policies that were overall more protectionistic than the US, especially towards non-European countries ("Fortress Europe").

• However, the 1992 Single Market project (and EMU) will eventually lead to the elimination of barriers to trade in goods, services and factors of production (capital and labor) within Europe.

• Since the early 1980s the US experienced a major process of economic "deregulation" in all sort of sectors of the economy including manufacturing goods, services, traded and non-traded goods. Such policy of deregulation led to competition, pursuit of efficiency and major economic restructuring.

• In Europe, the 1992 Single Market project should lead to significant deregulation and increased competition. The deregulation process has however been much slower than in the US.

8. Corporate restructuring
 
 

The combined forces of:

• Technological Change
• Global Trade Competition
• Deregulation of the economy

a. Re-engineering

b. Out-Sourcing

c. Large scale Downsizing of firms

d. Massive corporate control restructuring through Mergers and Acquisitions, LBOs and Takeovers

Because of this dramatic restructuring over the last decade the US economy is now highly productive, with low labor costs, innovative and competitive in world markets.

Of course, there were very high socio-economic costs of this restructuring process first for blue-collars and now for white collars and managers:

a. Major job turnover

b. Great job insecurity

c. Need for disrupting occupational and regional mobility

d. Little real wage growth for average workers

e. Increase in income and wealth inequality
 

However, such corporate restructuring has led to:

1. higher productivity growth,
2. a resurgence of manufacturing,
3. high employment growth
4. low structural unemployment rates

10. Europe's Response to Global challenges
 
 
 

• Monetary discipline and low inflation.

• Maintenance of labor market system where the "insiders" are guaranteed jobs and high real wages but they have to pay high taxes to support the "outsiders" (i.e. unemployed). Consequence: chronic unemployment rates.

 

• Very limited reforms in the direction of reducing the role and size of the welfare state.

• Very limited privatization of public enterprises.

 

• Single Market project for deregulation and competition.

• Maastricht fiscal discipline but no long-run structural fiscal reform.

 

• European Monetary Union (EMU) project

View of Stephen Roach: "The road to European and Japanese competitive revival is going to be a lot longer and more arduous than which the US has traveled since the early 1980s" (Financial Times, October 22, 1996).

11. Costs and Benefits of EMU
 

Benefits:

• Lowering of transaction costs in trade
 
• Elimination exchange rate risk in Europe
 
• Greater goods market integration and competition
 
• Broadening and deepening of integrated European financial markets
 
• Preservation of inflation discipline if ECB is independent
 
• Maintain fiscal discipline with "Growth and Stability Pact"
 
• Make more urgent the need for structural reforms in Europe. Discipline argument

Costs:

• Possibility of asymmetric shocks that require the use of exchange rate adjustment.

• No monetary autonomy that might fine tune national shocks.

• Limited labor mobility and structural labor market rigidities imply that Europe may not be an optimal currency area.

• Little room for fiscal policy as a stabilization tool in the absence of independent monetary policy

• No central system of federal taxes and transfers to insure against regional/national shocks.

• Monetary policy may work in short-run, not long-run.

• Limited role for fiscal policy in Europe.

12. Euro/Dollar Relations

Features of an international currency:

 
 1. Means of payments role.

• Official use. Reserves of central banks. Vehicle currency and intervention currency. Possibility of greater diversification away from US$ towards the Euro. Risk-reward considerations. Role of low inflation.

• Private use: it depends on thickness externalities in payments systems. Increasing returns to scale in payments. Incumbency advantage and inertia favoring the US$. Greater future use of Euro. Important role of the attitudes of traders in the inter-bank market.

2. Unit of Account Function

• Invoicing of imports and exports. Present dominant role of US$. Invoicing mostly in Euros within Europe. Possible greater use of Euro in Central and Eastern Europe, Middle East Region and Africa. Unlikely use of Euro for primary commodities.

• Will some countries peg their exchange rate to the Euro rather than the US Dollar? If, yes greater use of Euro as an intervention currency increasing official demand for Euros.

• Will public and private investors hold a larger fraction of their portfolio in assets denominated in Euros? If yes, large portfolio shifts leading to greater demand for Euros and causing a Euro appreciation.

• Higher use of Euros in portfolios will depend on economic factors (inflation, value of Euro relative to US$ and Yen, growth in Europe) and political factors.

1. Initial appreciation of Euro relative to US$ as Euro demand exceeds its supply. Overshooting relative to its long-run value.
2. Initial improvement of Europe current account balance because of J-curve effects.
3. Worsening of current account over time as the effects of the real appreciation occur.
4. Financing of the current account deficit through capital account. This will increase the supply of Euro assets.
5. As the Euro overshot its long-run value and the current account worsens, the Euro will depreciate.

Counter-arguments:

• Europe may not like a Euro appreciation because of European unemployment and could prevent it through easier monetary policy.
 
• The Euro may start weak and low growth in Europe may lead to a loosening of fiscal policies. Euro may be perceived as weaker than DM. Caveat: ambiguous effect of fiscal policies on the exchange rate.
 
• Political factors (see France and Club Med in EMU) may make the Euro a weak currency. Political conflicts within Europe will not help.
 
• The structural weakness of the European economies will lead to a relative weakness of the Euro.
 
• Caveat: The ECB will be forced to show its credibility and build the reputation of the Euro by keeping monetary policy tight in the early stages.