Why Europe Sags [Editorial, The Wall Street Journal, August 18, 2003] Europeans wondering why Europe is registering 0% growth and the German economy has shrunk for three straight quarters are coming up with the usual suspects. It's the euro, or the European Central Bank, or the heat wave, the argument goes. Wrong all. Let's start with the euro. There are usually two cases put forth to explain how the euro is holding back European economies. The first, usually made by English Tories, is that the single currency restricts the national use of monetary policy to spur growth. In these times, so the story goes, German interest rates should be much lower than the ECB's 2% key refinancing rate, which is applicable to all 12 nations in the euro. The second, more sophisticated case is that the euro's Stability Pact, which in theory at least bars budget deficits from rising above 3%, makes it impossible to run a "stimulative" fiscal policy. Though this is a better argument, it is also unsound. Those who make these arguments are saying in effect that a country ought to be able to devalue its currency to help exporters. Devaluation is a tax on savers -- especially the middle class. Externally, it often leads to rounds of competitive devaluations (beggaring they neighbor) that bring on inflation and global monetary instability. Because it had the experience of Weimar doing just this, the pre-euro Bundesbank never allowed its precious mark to be savaged. On the contrary, it defended the coin like a lion. It is sophistry to suggest matters would be different now if Germany still had a separate currency. We would have a great deal more sympathy for the arguments against the Stability Pact if Keynesian spending and supply-side tax cuts were not mindlessly equated. Government spending usually means the misallocation of scarce resources, and must be funded by taxes, whether in the present or future through borrowing. We can't see how any of this can get an economy out of recession. But it is true that the Stability Pact has stopped tax cuts, which do stimulate economies, especially when they lower top marginal rates. Even borrowing to cover a deficit caused by tax cuts often makes sense, as the new business generated will probably pay for the financing without the need for higher taxes. More and more European governments are acknowledging this truth and going ahead with tax cuts, though it is still too early to realize the effects. Lowering the interest rate central banks control seldom helps, as years of 0% rates in Japan should attest. If businesses have no confidence that things are getting better they won't make investments, no matter how inexpensive money is. The bank should rather aim at keeping money supply in equilibrium with the demand for it. ECB President Wim Duisenberg shares this sentiment. Soon after the bank's last rate cut, on June 6, he declared: "We have done our part. It's now the case that governments . . . can no longer hide behind the ECB in order to cover up their failure to enact the structural reforms, which are so urgently required for Europe." Which brings us to the real culprit for Europe's stagnation: "social policies" that sap initiative and creativity. These laws also make markets so sticky that they are often unable to react to rational policies. The welfare state has the very antisocial consequences of high structural unemployment and no growth. Companies hit by the current high value of the euro, or the global recession, are prevented from laying off workers at the same rate as their competitors overseas, to take one of the most egregious examples. So productivity has sagged in Europe during this recession. This makes the recession longer and more painful for everyone. The euro is high for exporters in every country and it prevents all from devaluing. And yet, we observe that those countries that have the least rigid economies -- such as Ireland and Spain -- have been growing these past two years. Their economies are more susceptible to stimulus, and less costly. The German economy, on the other hand, has shrunk in five out of the past six quarters. Where Germany goes so will Europe. Chancellor Gerhard Schroeder has put his finger to the wind and has had to introduce some reforms this year. But he'll need to be more courageous than he's been so far. So will his counterparts. Hitching their wagons to the U.S. locomotive won't do this time.