The Competitive Edge -- European Weakness a Problem for U.S. Manufacturers

The spring of 2010 brought hope to the world economy, as growth was widely dispersed and strong in Asia, including Japan, as well as in North America and Brazil. The laggard was Europe, and April, the "cruelest month" as T. S. Eliot put it, brought a financial crisis that threatens the recovery story. Deep-rooted problems are behind the crisis in Europe, and its impact will be felt around the world for years to come.

European unification was at the start a political reaction to the two World Wars and economic chaos of the first half of the 20th century. It has been an impressive achievement, but political and cultural trends have failed to match the rapid development and success of the economic union. Indeed, the early benefits of the single currency (low interest rates, widely available credit, enhanced efficiency and trade) tended to mask the fundamental underlying problem of trying to pay for an advanced welfare state with a slow growing and -- at least in southern Europe -- noncompetitive economy.

Some demographic numbers underscore the long-run problem. In Germany, the median age of the population is 44 years, and the fertility rate is 1.32, well below the 2.1 rate needed to keep the population stable. In Italy and Spain, the numbers are similar: median ages of 43 and 40 years and fertility rates of 1.38 and 1.43, respectively. By contrast, the median age in India is 25 and the fertility rate is 2.76. China's numbers are 34 years and 1.77, while those for the United States are 37 years and 2.09.

The European financial crisis was touched off by steady increases in government spending and accumulation of unsustainable sovereign debt levels. The fiscal austerity and private sector deleveraging required to bring debt levels down will dampen already weak growth for many years. Political opposition to austerity, both in terms of reducing the size of the welfare state and transferring funds from the more prosperous north to the south, may preclude the restructuring needed to overcome the fiscal crisis. A worst-case scenario is either defaulting on sovereign debt, which would weaken the already-challenged banking system in Europe, or a partial breakup of the Eurozone, which could result in a new spiral of global financial panic. The recent history of a determined march toward European unification argues against this latter scenario but, given negative political reaction to recent bailout packages, it cannot be fully excluded.

At best, the European crisis will result in years of economic weakness as governments cope with the need to cut spending and deleverage. Euro weakness is further exacerbated by the almost inevitable erosion of confidence in its value as a reserve currency.

U.S. manufacturers will be caught in the downdraft of the European weakness. Europe is still the source of over 20% of U.S. merchandise exports, and European affiliates of U.S. manufacturers produced over $510 billion in value added in 2007. The weak euro also means that U.S. exporters will lose some competitive advantage in third markets, such as China, where Europe already outsells U.S. producers. Europe is China's biggest export market, and a drop in its imports could marginally weaken Chinese growth and that of other Asian nations. China has already signaled that currency instability in Europe will be the latest reason to avoid allowing the yuan to appreciate, hence further adding to competitive pressures for U.S. exporters.

American policy makers should take note of the sustained selling waves by bond investors which triggered and sustained the European crisis. The United States has much deeper financial markets, more flexible labor and capital markets, better productivity growth, and a well-established national political system that can be mobilized to address regional problems more efficiently than in Europe. But the nervous bond investors won't tolerate 10% of GDP in annual budget deficits much longer.

Dr. Duesterberg is president and CEO of the Manufacturers Alliance/MAPI Inc., an executive education and business research organization in Arlington, Va.