Why Southern Europe's Economies Don't Compete

It's just over a year since the European Union celebrated its half century. Yet the EU looks ever less like a happy family. Last month euro-zone inflation hit its highest level since 1992, raising expectations that the European Central Bank will raise interest rates next month. That could exacerbate the economic divide in the 15-nation euro zone, split between those who've capitalized on globalization, and those who haven't.

Those at risk are the PIGS—Portugal, Italy, Greece and Spain—who earned their nickname by staying stuck as their nimbler competitors revived export and job growth by venturing abroad. Now higher rates designed to slow inflation in hot economies like Germany could choke what little growth is left in the PIGS. That's stoking political tension already peaking over a new EU constitution, and raising divergences in bond prices, which further exacerbate the two regions' fortunes. "The disparity in performance is putting stress on the currency union that binds the region together," says Walter Molano of BCP Securities. "Countries with large current account deficits and currency pegs are being slaughtered by the de-leveraging process like PIGS in an abattoir."

Diverging economies are not new in Europe. The old consensus was that Southern Europe was held back by a more protective attitude toward social policy. The new view is that the south missed the boat on making labor flexible, outsourcing and selling to emerging markets.

Geography, flexible labor policy and a Soviet legacy of skilled workers played a part in placing Northern Europe ahead. Nations such as Germany and Austria shifted labor-intensive production to their high-skill, low-wage and culturally similar neighbors in the east—including Hungary, the Czech Republic and Slovakia—after the fall of the Soviet Union in 1991. Soon after, they began moving plants into China, and exports to these emerging markets followed. Germany now ships 3.2 percent of its exports to China, triple the share in 1998, and is expanding in East European markets, while scaling back its share of sales to the faltering United States.

It's a different story for the south. Geographical and cultural differences, as well as a much smaller wage differential, made it harder for companies in Italy, Spain and Portugal to move plants to the east. Italy and Spain are exporting more to emerging markets, but the growth is slow, and both remain as dependent as ever on exports to the United States.

No wonder Germany's has remained stable at 3 percent, while Italy's fell from 2.5 to 0.3 percent, and Spain's from 4.6 to 2.7 percent. Germany also went global without losing jobs, unlike Spain and Italy. "Something counterintuitive happened after the north opted for globalization: these countries actually maintained their own labor levels," says Andrew Watt, senior researcher at the Brussels-based European Trade Union Institute for Research, Education, Health and Safety. German firms got a leg up because of domestic limits to wage hikes. But more important, according to Munich University research, companies like Siemens and Volkswagen boosted global market share by outsourcing to Asia, and rising sales also created demand for labor at home, raising per capita GDP.

The south now looks to French President Nicolas Sarkozy's plan for a Mediterranean Union of 38 nations in Europe, North Africa and the Middle East. Southern European leaders are saying that the cheap labor and slowly emerging markets south of the Mediterranean is what they need to catch up. Euro investments in the southern Mediterranean rim are rising, almost doubling to €31 billion from 2005 to 2006. Much of this is coming from Southern Europeans hoping that nations such as Morocco, Algeria, Tunisia, Egypt and Leban-on can do for them what Eastern Europe and Asia has done for the North.