Sluggish EU 'Lisbon Agenda' bodes ill for modernisation

Europe has gotten off to a bad start in 2006 with a fresh battering of the 'Lisbon agenda.' Protectionism is on the rise across the European Union. Headlines carry ominous news of governments' moves to oppose foreign takeovers and defend their national champions. Political leadership is weak and voters are increasingly turning their back on economic change. In Italy, the center-left opposition under Romano Prodi won the election with a very narrow margin and with a potentially factious coalition untried in governing. In France, the government caved in to “the street” and dropped its proposed law creating a more flexible job contract for young first-time workers.

It has been six years since EU leaders launched the Lisbon agenda of economic reform as a comprehensive and longterm program to make the EU more competitive and prosperous. The results so far show Europe failing to make headway in their attempt to close the gap economically with the United States or even to catch up. It seems clear that most EU countries will not meet the Lisbon agenda targets by 2010. The overall EU performance is being dragged down particularly by the lackluster performance of the eurozone's biggest economies – France, Germany and Italy. The recent electoral outcomes in these three leading countries make it even clearer that these governments are ill-positioned to pursue any self-proclaimed reform ambitions. These very economies have been trying to modernize for years with little success, so the trend raises more acutely than ever the question:Will Europe ever “get its act together” and accelerate the pace of change? Or is it doomed to a gradual economic decline?

Europe is more than three countries, but Germany, France and Italy contribute about two-thirds of the gross domestic product of the eurozone. These three countries were the leading forces in the advance of European economic integration in the last half-century. Today each of these countries has politically-weakened leadership, and all three suffer from sluggish economic growth, declining productivity and high unemployment rates. Although the European Commission this spring raised its estimate for economic growth in the eurozone this year to 2.1 percent (instead of 1.9 percent), the Economic and Monetary Affairs Commissioner Joaquin Almunia said that, overall, EU countries' growth is “far from exploiting their full potential.”

The three countries that previously led European economic integration now have politically-weakened leadership, sluggish economic growth, declining productivity and high unemployment rates.

In December 2005, the unemployment rate was 9.5 percent in Germany and 9.2 percent in France. (This compares with about 5 percent in the United States and United Kingdom.) In Italy, the employment rate of the working-age population is only 58 percent – the lowest in Western Europe. Italian competitiveness has declined dramatically, and Italy, like France, has a relatively poor export performance. The “Lisbon scorecard” – an annual country-by-country ranking of EU efforts to implement the Lisbon agenda – shows a disappointing, though not disastrous, performance for France and Germany (see table). Based on the European Commission's criteria for structural change, the table offers a rough guide to the “heroes” and “villains” of economic change. In the 2006 edition, two countries moved up sharply (by more than five positions): the Czech Republic and Slovakia. In this year's scorecard, the most worrisome among the EU's newcomers is Poland: it has high unemployment, fairly restricted competition in its product markets and a government that seems unlikely to kick-start reforms. Among the “old” member states, Italy ranked the lowest (again this year).

But no matter how obviously these three countries need economic change, progress will not come easily. Nine-week street protests in France against laborlaw reforms and the hair's-breadth outcome of Italy's fractious election campaign show that voters are reluctant to swallow the necessary changes. In Germany, the grand coalition is tying Chancellor Angela Merkel's hands as the country tries to finish the job of digesting the new eastern dimension it gained in reunification. The French government is much weaker: its recent decline leaves scant prospect for a new push on reform before the next presidential election, scheduled for May 2007. Prime Minister Prodi understands the need for change in Italy, but his 15-party coalition includes two unreformed Communist parties that are opposed to market-oriented economic modernization.

Meanwhile, Europe has experienced a new rise of protectionism. The threat from “foreign predators” against so-called national champions has become a convenient rallying cry for enfeebled European governments in countries as disparate as Spain, Poland and Luxembourg. France, publicly deploying the banner of “economic patriotism,'' has taken a restrictive approach to the EU takeover directive supposed to provide minimum standards for handling crossborder takeover bids. It has also proposed a new law to protect eleven “strategic sectors” from foreign takeovers. The list ranges from research and production of chemicals that could be used in terrorist attacks to casinos (which the government says it fears could be used to launder money, as they apparently have in the past). The backlash against liberalism extends further. In February, the European Parliament watered down the European Commission's “services directive” by removing the “country of origin principle” which would have allowed a company to offer services anywhere in the EU under the rules and regulations of its home country.

However, it would be wrong to conclude that Europe has proved incapable of reform. Something is stirring at the heart of Europe's economy. Despite signs of re-emerging economic nationalism, businesses are increasingly taking advantage of the single market. In particular, mergers and acquisitions are booming across the European Union. In 2005, almost 5,000 EU businesses were acquired by non-national firms. In the first three months of 2006, the value of cross-border deals announced in Europe reached almost $173 billion, a level unrivalled since the peak of the dot.com boom in 2000. In total mergers and acquisitions, the EU – for once – outpaced the United States in the value of deals in this quarter. So while a handful of recent cross-border deals have attracted unwanted government attention, thousands have not.

This new wave of cross-border activity is being driven by several factors: strong corporate profits, cheap credit and shareholders' renewed support for takeovers. These are powerful forces, and the trend is a sign that the single market is working, driving companies towards consolidation. Europe includes some strong performing economies such as small countries like Ireland, as well as the UK and the Nordic three. Also, the EU's eastward enlargement and growing competition from emerging East Asian economies are increasingly forcing Europeans to accept change.

The 2004 big bang accession of ten new members has already brought significant economic gains both to the “old” and the “new” countries.

The threat of relocation of factories to Eastern Europe (or further afield) has helped to focus the minds of European governments and made workers more willing to accept wage restraint and new flexibility in labor-market rules. Despite the signs of “enlargement fatigue” in the EU, the Commission has produced strong evidence that the 2004 “big bang'' accession of ten new members has already brought significant economic gains both to the “old” and the “new” countries. While most of the older member states have kept restrictions on the arrival of workers from the new countries, the three that opened their labor markets – Britain, Ireland and Sweden – have benefited from an expanded workforce. And for the new members, the impact of EU aid has been dwarfed by an influx of direct foreign investment, often from older EU member states. The European Bank for Reconstruction and Development's figures showed direct investment in central Europe rising to $25 billion last year – more than double the level in 2003.

Nowhere are the results of this new current of economic energy more visible than in Germany. Thanks to a painful (and still limited) restructuring process, the country has restored its international competitiveness.With exports of nearly $1 trillion in 2005, Germany regained its position as the world's biggest exporter of goods. Investment and domestic demand are also picking up at last, so Germany's economic outlook at home, too, has brightened.

All EU countries over the last several years have made some progress in introducing labor and product market reforms. For instance, even though France is sometimes the scene of spectacular resistance to proposed changes, the country continues to open up and modernize its economy. The current government has managed to break two economic taboos, first by reforming the tax system, second by introducing more flexibility into hiring-and-firing rules for firms employing fewer than 20 workers. Perhaps more importantly, the French people are increasingly debating how France needs to change in order to compete in the future and are starting to call into question the sustainability of the so-called “French social model.”

In France as across Europe, the question is not whether reform is possible but what is needed to make it happen. Policymaking elites are obviously conscious of the challenges, but they seem unwilling to explain them with enough clarity to push through often-painful changes on the necessary scale. Some rules of the road seem to be emerging. First, economic reform cannot take place unless there is a national consensus among voters, businessmen, trade unions and others about the need for change. Governments cannot impose reforms on their own. They need social partners which will negotiate on the principles and terms of the reforms, share responsibility for the results and help defend and implement the changes on the ground. That is difficult to achieve in countries such as France, whose adversarial political culture – in which negotiations are a sign of weakness and compromise is equated with defeat – is an obstacle to negotiated change.

Second, a country needs strong and determined political leaders who have a coherent and long-term vision of what needs to be done. Too often, national governments settle for getting by with minimal short-term reform without assessing what was done previously or pursuing a clear long-term economic objective. Any new government, instead of undoing what was done by its predecessors, should take stock, assess the outcomes of previous reforms, learn lessons and draw a roadmap accordingly. This would help to ensure that counterproductive measures are removed while efficient ones are kept or reinforced. This assessment could also contribute to a clearer and more transparent public debate about economic reform.

At the same time – and more importantly – it is vital for Europe's leaders to cast their case for change in more appealing ways by stressing their potentially positive outcome. For too long, in confronting the challenge of modernization, European politicians have sold reforms purely in terms of belt-tightening. With this astringent approach, it may prove all too natural for electorates to remain reluctant to envisage change – because it seems to promise only pain. It is time for a change in emphasis. Without a positive case and a clear blueprint, EU leaders can hardly expect to gain the necessary support to push through economic reform.