Europe Is Giving Global Economy a Surprise Boost Amid US Lull

BERLIN – Europe's economy is firing on all cylinders after years of feeble growth, helping to sustain global expansion as the U.S. economy slows and surprising many economists who doubted the Continent could muster enough demand to break its reliance on exports.

Europe's economic recovery was ignited by rising exports, but it is now spreading to investment, job creation and consumer spending. While some countries around Europe's edges have performed well for years, including the United Kingdom and the Nordic countries, prolonged stagnation in its heartland – the 12-nation euro currency area dominated by Germany, France and Italy – earned Europe a reputation rivaling Japan's as the world's economic laggard.

Euro-zone gross domestic product is on course to grow by 2.7% this year, unspectacular by recent U.S. standards but a big improvement on the 1.4% growth the euro zone averaged the previous five years. Even though a U.S. slowdown, a strengthening euro and looming tax increases in Germany could brake euro-zone growth next year, most forecasters still expect an expansion of around 2%. By Europe's lackluster standards, that's nothing short of a comeback – and is good news for exporters and investors from the U.S. and Asia.

"There is no new miracle in Europe. This recovery is overdue," says Jean-Philippe Cotis, chief economist at the Organization for Economic Cooperation and Development, a Paris-based think tank. The long slowdown led anxious Europeans to save their incomes, Mr. Cotis says, creating pent-up demand that is now being unleashed as confidence gradually returns.

Europe's rebound still has flaws, which bolster arguments that structural changes are needed to realize any lasting gains. Much of the improvement this year has occurred in Germany, which is helping to buoy its neighbors after taking some painful steps, while many companies in France and Italy still struggle to cope with fierce global competition. Changes to labor laws and welfare systems prescribed by economists are low on government agendas because free-market measures remain unpopular.

But governments, companies and unions have made enough organic change to restore some of the Continent's lost dynamism. And better growth in the $10 trillion euro-zone economy means better growth in the 25-nation European Union, whose $14 trillion economy is about the same size as the U.S.'s and accounts for 30% of world GDP. (Twelve of the 25 EU nations use the euro.)

Europe's revival is reflected in the rising value of its currency, the euro, which at $1.33 is close to its highest level ever against the dollar – $1.36 – touched at the end of 2004. That partly reflects dollar weakness against many other currencies, but it is also because currency markets believe the European Central Bank in Frankfurt will continue raising interest rates against a backdrop of solid growth.

Germany, for years the sick man of Europe, has led the revival, reclaiming its place as the region's growth engine. Painful measures to boost efficiency and productivity put German companies – especially makers of machine tools and other industrial equipment – in a strong position to exploit the recent boom in global trade. While other euro-zone industries haven't restructured in the same way, they have also enjoyed rising exports amid the fastest pace of global growth in more than 30 years.

Rising corporate profits and a new optimism have led European companies to invest at home again, especially in Germany, where strenuous cost cutting has done much to compensate for high labor costs and stiff payroll taxes.

"It's fun to be an industrial entrepreneur in Germany at this time," says Jurgen Grossmann, owner of steel group Georgsmarienhutte. "The world wants our products. We have record order intakes. There is a renaissance in tangible goods."

Many German companies have found leeway in Germany's labor laws to improve productivity, and have been rewarded with rising profits. Machine-tool maker Trumpf Group, near Stuttgart, is typical of the thousands of midsize family-owned companies that make up the backbone of the world's third-largest national economy. After stagnant or falling sales earlier in the decade, Trumpf negotiated deals with its work force that allowed an extension of the workweek to near 40 hours from 35, with extra pay partly dependent on company profits, in exchange for job guarantees.

At the same time, Trumpf's export sales to fast-growing economies in Asia and Eastern Europe have rocketed. The firm is adding 450 workers to its 6,500 staff this year. Trumpf's investment spending is up 75% this year – most of it in Germany, including a new laser factory.

"Our decision to invest in Germany rather than abroad hinged on the agreements with our workers. A 35-hour week is a joke. You can't compete internationally with that," says Nicola Leibinger-Kammüller, Trumpf's chief executive.

Total investment in Germany is set to grow by 5.8% this year, according to the OECD, up from 1% last year and declines in the four previous years. Revived investment has helped bring Germany's chronic unemployment below four million in November, from more than five million in January.

Germany still has a high jobless rate of 9.6%, and many formerly jobless people have found only low-paid, temporary or part-time work. But rising employment has allowed a modest recovery in consumer spending, which is expected to grow by around 0.8% this year after stagnating or shrinking since 2001.

Across the euro area, unemployment has fallen to 7.7%, according to the European Commission's standardized measure, from a peak exceeding 9% in 2004. Surveys show consumer confidence is increasing as fear of unemployment recedes.

The winners from higher investment in German industry include services providers with customers in the booming manufacturing sector. Frankfurt-based Commerzbank AG has recovered from years of heavy losses, bad loans and asset writedowns. After losing €2.3 billion ($3.06 billion) in 2003, it posted net profit of €1.2 billion in the first nine months of this year, and is even hiring 700 new customer advisers after laying off more than 7,000 employees in recent years.

SAP AG, Germany's largest software company, is also hiring. But it's doing so cautiously because German labor laws make it expensive to cut the work force when the business cycle dips. "Whenever you hire in an inflexible environment, you want to make sure you can keep these people for 10 or 20 years," says Chief Executive Henning Kagermann.

Investment is also improving in other European countries, but less markedly than in Germany. Companies in Italy, France and Spain haven't cut costs or jobs or raised productivity as aggressively as their German counterparts. Labor costs in Germany have fallen by nearly 1% a year on average since 2000, but have risen by nearly 4% a year in Italy in the same period, according to the European Commission, the EU's executive arm.

In Germany, the severity of the downturn and joblessness led to far-reaching concessions by unions on work rules. But unions in other euro-zone nations have resisted similar demands from employers.

"Some of the changes German industry has made – for example, longer working periods – are not realistic in Italy" in light of stiff union opposition, says Ernesto Greco, chief executive of Italian furniture maker Natuzzi SpA. It has built factories in Brazil, China and Romania recently, while trimming costs in Italy to cope with rising global competition.

Yet companies from other euro-zone nations are also exporting more, in part because Germany's $2.8 trillion economy is buying more goods from the rest of Europe as it grows.

"The recovery in Germany is lifting Italy and helping France," says Mr. Cotis, the OECD economist. In both countries, stronger exports are helping companies to raise investment.

Rising trade among European countries has helped to compensate for slower growth in exports to the rest of the world this year, allowing the euro zone to sustain its recovery even though the U.S. economy is slowing. "It's looking increasingly like Europe hasn't caught a cold from the U.S. sneezing," says Neville Hill, European economist at Credit Suisse in London. That's a break with the past when, if the U.S. economy caught a cold, Europe usually caught something worse.

Consumer spending hasn't improved as strongly as investment, but even here there are signs of improvement. Euro-zone consumption rose by 0.6% during the third quarter, helped by strong spending in Germany. In a sign of the retail market's gradual recovery, Europe's biggest retailer, Carrefour SA of France, recently announced a 7% rise in third-quarter sales, including more than 5% growth in France, where its megastores have struggled against fierce competition from discount chains in recent years.

But the robust outlook could still crumble if the euro rises further against the dollar into next year. The currency's appreciation is beginning to revive bad memories of 2003 and 2004, when a surging euro snuffed out embryonic upturns in the euro-zone economy.

"The impact was very bad in all industries competing with products made in the dollar area. My feeling is we will have a hard time in front of us," says Andrea Tomat, president of Italian sport-shoe maker Lotto Sport Italia SpA.

Other risks to Europe's revival include planned tax increases in Germany and Italy, whose governments are trying to rein in budget deficits to comply with EU fiscal rules. Germany's plan to raise its value-added tax – equivalent to U.S. sales tax – by three percentage points to 19% in January is causing particular worry, given the fragile confidence of German consumers. Most economists believe the increase will cause only a temporary drop in spending, but some point to the case of Japan, where a VAT rise in 1997 prolonged its economic stagnation.

Many economists caution against euphoria about Europe's improved growth. "It's an OK performance compared with the past few years, but nothing is firing tremendously," says Jean-Francois Mercier, an economist at Citigroup in London. "The problems haven't gone away, including structural rigidities and caution by many businesses which prefer to invest offshore rather than at home."

Europe's recovery is also uneven. While German industry is looking strong, consumer spending is still only growing weakly. In France, consumer spending has helped underpin GDP growth, but companies have been losing global market share while investment is growing more slowly than in past upturns.

Thanks to its continuing structural problems, the euro zone is able to sustain a growth rate of only around 2% a year without stoking inflation, the OECD estimates. The U.S. economy can sustain closer to 3%. More-flexible labor rules, more competition in markets for goods and services, and an overhaul of pension and health-care systems would help the euro zone to sustain faster growth, making it easier to cope with the future strains of an aging and eventually shrinking population.

"The case for structural reforms in Europe remains strong," says Mr. Cotis.