The European Envy Effect

Europe—for so long the global economic laggard—is on a roll again. Germany's astonishing turnaround and a fresh breeze of global competition have unleashed a new dynamic on the old continent. With some further reforms, the 13 countries using the euro as their common currency may soon narrow the wealth gap with the United States. Currently, GDP per capita is almost 30 percent higher in the United States than in the euro zone. But since 1999, the euro zone has created more jobs than the United States.

Europe has always been home to myriad nations and cultures, a fact that's crucial to understanding the European economic renaissance. History has taught Europeans to keep a close eye on their neighbors. The French, for instance, worry much more about Germany or the United Kingdom than, say, the average American does about Mexico or Canada. When European nations see their neighbors prospering, they take note.

Call it learning by example, or the "envy effect"—whatever you call it, it works. In the late 1980s, awareness that life was much better in the West contributed more to the downfall of communism in Eastern Europe than any arms race. In the 1990s, the strength of the German mark persuaded France and Italy to end their spendthrift ways and bring inflation down.

Early in this decade, it was Germany's turn to learn a harsh lesson. Corporations fled the overly complacent country to set up shop in the dynamic post-communist countries next door and in Ireland. To regain its edge, Germany had to cut taxes, wages and welfare benefits. German corporations slashed labor costs per car or machine built by 15 percent within five years. Meanwhile, the government reduced the burden of taxes and other public charges from 46.7 percent of GDP in 1999 to 43.6 percent in 2005. The result? After a wrenching adjustment period, Germany has now resumed its traditional role as Europe's engine of growth.

This amazing revival has not been lost on France. Neither has the job boom in London, now the most promising labor market for ambitious French youngsters. Already the envy effect is facilitating change in the euro zone's second largest economy. A pervasive sense of crisis, and fear of falling behind Continental peers, helped sweep Nicolas Sarkozy into power in Paris this spring.

There's plenty for the new government to fix, especially in the rigid labor market. French companies are reluctant to hire because the current laws make it so difficult to fire if necessary. This is especially bad for young people—employers hesitate to take risks on those with no work record, creating a cycle of underemployment. Sarkozy plans to address this by curtailing the power of trade unions, effectively abolishing the 35-hour workweek and relaxing firing rules. Occasionally protectionist, at least in rhetoric (he is French, after all), he could still turn France, which has a skilled and well-educated work force, into a new powerhouse, raising the potential growth rate of the Grand Nation from 2.25 percent to a healthy 2.75 percent per year. If that happens, Italy could be spurred to address its own peculiar problems of red tape, bloated government and unsustainable pension and welfare systems.