Is Europe's social model becoming a drag on its currency? In recent months a perception has grown that a reluctance to implement structural reforms is damaging the euro.
Despite the rhetoric to the contrary at the recent Lisbon summit, several EU governments are backtracking on reforms. French Prime Minister Mr Lionel Jospin recently halted a much-needed pension reform owing to pressure from unions, and Germany and Italy have suffered similar failures of political nerve.
Social models are not usually linked to currency movements. Yet a case can be made that euro weakness may indeed partly reflect such policy.
Consider, first, the pattern of capital flows. The US holds greater appeal for foreign investors than Europe. Indeed, western European investors appear to see the US as the world's biggest and most attractive "emerging market". There is marginally more enthusiasm for Europe in the bond markets. The euro zone saw a net inflow of €35 billion (£28 billion) last year.
But it is largely a one-way street. This appears to support the idea that US equity prices have driven up the dollar at the expense of the euro. But it hardly squares with the US equity sell-off in January, during which the dollar strengthened and the euro fell through parity against the US currency. If there is a relationship, it is between the dollar and the new economy. For while the Dow Jones is down so far this year, the Nasdaq index is up by more than a fifth.
The currency-equity market relationship is more plausible on the European side of the Atlantic. The euro-zone equity outflow in January for the euro was €18 billion, four times the average 1999 monthly outflow.
There are, of course, other influences on the two currencies. Last week the dollar rose conventionally in response to the US interest-rate change. At the same time, OPEC's suddenly enlarged oil revenues gravitate more naturally towards US IOUs. Yet the equity flows clearly matter. And there is a tendency for Anglo-Americans to argue that if only the Europeans would abandon their pay-as-you-go state pensions for a structurally sound funded system, they could simultaneously solve their demographic problems and remedy a lack of demand for their own domestic equity.
This is wrong-headed. A demographic problem cannot be solved by changing the way pensions are financed unless funding leads to higher rates of economic growth. Whether it does so is controversial in the economic literature. And even if continental Europe did have more pension funds, their managers would still have to sell euros and buy dollars because Europe suffers from a sectoral deficiency in high-tech stocks other than telecoms. Anglo-Americans often forget that European pensions have been a brilliant and historic feat of financial engineering.
What impairs the system now is the generosity of provision, which inflates payroll costs and erodes competitiveness. And financial problems arise because equity markets are small in relation to gross domestic product. US investors already own a disproportionate amount of the equity in many of Europe's larger companies. So for want of an equity market capable of absorbing more foreign capital, the euro is undersupported by portfolio flows. And a poorly developed equity market carries another handicap in a period of global structural change. The merit of the hyperactive US market is that it speeds up the recycling of capital from the old economy to the new.
The good news for Europe is that the single currency is doing more for structural reform than the politicians. It promotes competition and capital market development, notably for debt.
As for the equity market, the reallocation of capital from the old to the new European economy could speed up dramatically if the cross-border hostile takeover process, initiated by Vodafone's bid for Mannesmann, accelerates. It might be argued that a bias towards currency weakness is no great disaster in a large continental economy. The weak euro has contributed to Europe's recovery, without yet posing a particularly worrying inflationary threat. But what Europeans need to recognise is that to raise the longrun economic growth rate structural nettles have to be grasped. The weak euro is symptomatic of structural weakness.
The euro will recover, if only because currencies go up as well as down. The world's biggest emerging market, with a huge current account deficit, may yet have an emerging market crisis. But that does not invalidate the market's current message. Call it a wake-up call for Mr Jospin.
