The (New) Sick Man Of Europe

If there's a threat of dangerous deflation--a general fall in prices--the causes lie as much in Europe and Japan as in the United States. The inevitable collapse of America's speculative boom need not have been especially damaging if the world's other advanced economies were healthy. Their expanding appetite for imports would have bolstered the United States and so-called emerging-market countries, from Brazil to South Korea. The trouble is that other advanced economies aren't healthy.

Far from offsetting the U.S. slowdown, Europe and Japan--almost a third of the global economy--are aggravating it. Jim O'Neill, Goldman Sachs chief economist in Europe, forecasts that the European Union's economy will grow only about 1 percent in 2002 compared with 2.4 percent for the United States. Japan's economy will decline by about 1 percent. The Federal Reserve's decision to cut interest rates last week implicitly recognizes an unspoken reality: America's recovery has received almost no support from abroad.

Deflation could emerge from simultaneous slumps in the world's three major economies. Prices drop because there's too little global demand chasing too much global supply--everything from steel to shoes. Japan's ills are well known. An economy dependent on exports stagnated once exports faltered. Its banks are awash in bad loans. Less understood (at least in the United States) is the fact that Europe's troubles stem significantly from Germany. It's the engine that drives other countries: its population (82 million) is about a fifth of the EU's; its gross domestic product (about $2 trillion) is almost a quarter.

The engine is sputtering. In 2001, German GDP grew a meager 0.6 percent; this year it is expected to be 0.4 percent. Since 1991, unemployment has averaged about 8 percent; the number of jobs in Germany today is roughly what it was a decade ago. Worse, things won't get better soon. "German underperformance could easily persist for another decade or more," concludes a study by economists Dirk Schumacher and David Walton of Goldman Sachs.

As they diagnose it, Germany has two major problems. One is common in Europe: overregulation, especially of labor markets. Laws make it hard to fire workers, so companies are reluctant to hire. Generous and lengthy unemployment benefits discourage the jobless from seeking new work. Wage bargaining remains too centralized; companies have too little flexibility to fashion contracts that fit their needs. High payroll taxes raise labor costs.

But Germany also suffers from mistakes made during unification a decade ago. The goal was to equalize East and West German wages, even though Eastern workers were only a quarter to a third as productive as their Western counterparts. East Germany's currency (and wages) were converted into West German marks at an unrealistic exchange rate of one to one; then, East German wages were raised more than 50 percent from 1991 to 1995. Instantly, high labor costs made many firms uncompetitive and rendered Eastern Germany unattractive for new factories. Massive unemployment resulted; it still exceeds 18 percent.

The impulse to weld the country together quickly was understandable, if overambitious. "Germany is a rich country," says economist Saul Estrin of the London Business School. "But suppose the United States had to integrate with Mexico and raise its incomes [to U.S. levels] in five years. It would be a stretch."

What now connects Germany and Japan is a refusal to deal with their problems. There's no consensus to do anything unpopular (write off bad bank loans in Japan, overhaul labor laws in Germany). In Germany, huge government payments (3 percent to 4 percent of GDP) go to Eastern Germany for unemployment and welfare benefits. People seem content to bear the costs, says Walton. If anything, the recent electoral victory of Chancellor Gerhard Schroder seems a triumph for the status quo. Germans and Japanese hope that a recovering world economy will rescue their economies through higher exports.

This may be wishful thinking. The danger is that weak economies in the United States, Europe and Japan feed on one another and create a collective global weakness. Lower interest rates and bigger government budget deficits--a.k.a. "economic stimulus"--would be standard antidotes. Perhaps the Fed's rate cuts will succeed. The Bank of England (the Fed's British counterpart) and European Central Bank (the bank for the "euro area" of Germany and 11 other countries) last week declined to cut rates; they may ultimately do so. But lower interest rates may not overcome obstacles to economic growth that are essentially political, legal and cultural. As for budget deficits, they're already large in Japan, Germany and much of Europe.

Japan is already experiencing mild deflation, which--if it spread--might trigger a vicious circle. Falling prices could lower profits, which could lower investment. The irony is unavoidable. Germany is Europe's "sick man," just as Japan is Asia's. Only 15 years ago, these countries seemed poised to assume leadership of the world economy. Now they are dragging it down.