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Economics: Old Europe?
New York: May 13, 2005
By John R. Stephenson

Recently, some strange things have been happening in Europe. Two of the six original members of the European Union (France and The Netherlands) have just voted against the adoption of the European Constitution and the British have said they won't even hold a vote. With the notion of a European Constitution on life support, is a strong economy and strong currency in the cards?

Probably not! While the U.S. is mired in problems of its own - namely too much spending and too little saving, Europe is certainly not the economic powerhouse that currency traders who have bid the Euro up of late thought it was. For starters, European economic growth is anemic - with economic growth rates in the 1 percent range a year. Unemployment in Germany is at 10 percent and Italy, France and Germany are racking up huge deficits in a bid to keep the economy and incumbent governments on track.

The "no" votes of the recent past highlight just how concerned citizens are with the state of the economy in Europe. Exit polls conducted after the referendum indicated that the lower a person's income the more likely it was that he/she would vote against the European Constitution than for it. In other words, this was more of a referendum on the European economy than on a political union.

With the political future of further European integration twisting in the wind, is it likely that the economies that underpin the Euro Zone will recover from their nosedive? Hard to say, but the "no" vote seems to underscore the reality that politics and economics do not make good bedfellows. With fifteen member countries all trying to move in economic and political lockstep, the chances of an individual nation state trying to cheat seem high. In fact, the history of the European Union seems to underscore the fact that local politics always trump the political and economic will of Brussels.

The European Union seems no stranger to the will of individual states. Even the creation of the Euro, the European currency, has been plagued by compromise. To make the Euro a reality, the European Union and twelve of its fifteen members (Britain, Sweden and Denmark opted out of the plan) voted to adopt the Treaty of Masstricht which, among other things, called for the creation of the Euro. The tough part of making the Euro work, was that the countries that made up the European Union each had very different economic and financial underpinnings. Some were creditor nations and others debtor nations, some had strong currencies and others had weak currencies. Of course, combining a crumbling currency with a strong currency is a recipe for disaster so the signatories to the treaty realized that they had to stipulate that each member country "converge" to a certain standard (budget deficits of 3 percent or less). That standard was that they each had to put their economic houses in order. That meant keeping their budget deficits within a certain band or pay enormous fines for violating the terms of the treaty.

The currency itself was created, largely because the process was driven by the Germans who for fifty years had been the paragon of sound fiscal management. The Euro, as it was originally conceived, was really a Deutsche Mark in disguise. But as the 1990's progressed, the original sound money governments that signed the treaty were replaced with easy-money governments who were not inclined to stop spending and as the deadlines for currency convergence loomed, they began cooking the books. The French concocted a plan that called for them to take huge amounts of money out of the national pensions fund, use it to balance the books and then return the money after the deadline had passed. They were even audacious enough to announce the plan out loud. In the end, all of the countries cooked the books to show that they were in fact in compliance with the necessary standards of convergence.

Unfortunately, the concept of a common political and economic union is in crisis. The recent "no" votes have underscored the political reality. With a common currency, the member governments have one less tool at their disposal when they get into trouble - the printing press. When the various member countries had their own currencies, they could turn on the printing press and create money which would ultimately debase the money but would cause a short-term blip in the stock market and in consumption. Things would be good - for a while. The other option that individual nation states could adopt in the short-term is to borrow abroad. This is the circumstance in the United States today. With a common currency, the individual governments can no longer print money and the only option when they get into financial difficulty is to borrow abroad or to run a sound competitive economy. Fat chance.

But, more concerning than some of the immediate threats to the European Union in the form of a weaker currency and struggling political integration, is the headwind of demographics that it is facing. Today, Europe has more than twice the population of the United States. But unlike the U.S., Europe is not the land of immigration - taking in just 376,000 immigrants a year as opposed to the more than one million that the U.S. accepts. Not only is immigration to Europe anemic - but the European fertility rate (children per woman) is clocking in at just 1.38. This contrasts with the U.S., which has a fertility rate of 2.0. But to keep the population from declining, either immigration must make up the shortfall or the average woman must have at least 2.1 children (i.e. to replace the parents) in order to keep pace. But that just isn't the case in Europe. In fact, both immigration and fertility rates are on a collision course with economic policy.

The European governments have promised hundreds of trillions of dollars of social benefits over the coming decades. This in countries like Belgium and France where the average age of retirement is 58.1 and 58.8 respectively - which contrasts with the retirement age of 65 in the U.S. The problem? European governments don't have the cash. But what to do? The solutions are straightforward but extremely painful - cut the subsidies, increase economic growth or raise taxes. For France, Germany and Italy a near doubling of payroll taxes to two-thirds of GDP would be necessary to meet the promised spending. But who is going to pay these new taxes? Younger workers? I think not. Chances are they would bolt for greener pastures overseas.

But perhaps the solution to Europe's woes lies in increased immigration? While this certainly could make sense, Europe has not demonstrated a strong inclination towards immigration. But could the numbers work? For starters, immigration to Europe would have to rise some 500% to 1,917,000 per year just to keep the population base from declining. But to be sure that the Union was brining in worker bees (people aged 15 to 64), immigration would need to soar some 900% to 3,227,000 per year just to keep their numbers constant. Additionally, the United Nations also calculated what it would take to keep the European dependency ratio constant, that is, the proportion of working age persons to those over age 65 and under 15 years of age. According to the UN, this would require an increase in immigration of 7,100% or some 27,139,000 workers annually. An unlikely set of circumstances.

The numbers are truly staggering. But even if a sea change were to occur in the European political mindset would immigration work? Probably not. To begin with, there are only some 175 million immigrants in the entire world. The United States has 20% of this total at 35 million. A total of 3% of the global population are immigrants, but that amount, sliced and diced as you please, would not even come close to providing the necessary help for the looming pension shortfall in Europe.

With an aging population, not enough workers and not enough immigrants, the fuse has been lit for increased political unrest in Europe. But strikes and public protests cannot fight the forces of demographics. Only drastic changes in government policies can make a dent. No country or state can continue to thrive unless it is growing and increasing its tax and economic base. Unfortunately, the opposite appears to be happening in Europe. Investors, concerned about the plight of Europe, might be well advised to avoid the Euro and European equities and consider Canadian or Asian currencies and markets where the fundamentals are looking a whole lot brighter.


StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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