The Euro on Trial

Just a few months ago, European economists and policymakers were

boasting that the 12-nation euro zone would easily weather the storm

that has pummeled corporations and households in the U.S., Japan, and

Southeast Asia since the second half of last year.

Foreign trade accounts for just 18% of the euro zone's economy, they pointed out, so

manufacturing and service companies would hardly be hurt by slumping

demand elsewhere. Even if they were, 300 million European consumers,

buoyed by tax cuts, would power domestic demand forward.

What's more, the debut of euro notes and coins on Jan. 1, 2002, would inspire a new

bout of restructuring, boosting business confidence and giving growth

yet another welcome push. Some pundits even predicted that Europe would

become the world's economic locomotive.

TALES OF WOE. How wrong they were. With six months to go until so-called E-Day, it's clear that Europe is in trouble. In the first two weeks of June, the corporate news has gotten dramatically worse. Nokia Corp., the company that can do no

wrong, reports it won't meet its projections for cellular-phone sales.

Siemens, the giant German electronics and electrical engineering

company, has been so hard hit by tumbling demand for its products that

it is cutting 8,000 workers. Swissair, once the bluest of blue-chip

airlines, is threatened by the imminent collapse of its French

affiliates, AOM and Air Libert

Those are the individual tales of woe. Entire industries are taking a

fall, as well. Steelmakers seem caught in endless restructuring. Auto

sales in Germany, which slumped 11% last year, just cannot recover.

Truck sales, traditionally a bellwether of economic activity on the

Continent, are projected to drop by up to 9% this year. Airlines are

being battered by high oil prices and slowing demand.

Shocked economists and policymakers are scrambling to revise their

growth forecasts downward. Even the European Central Bank, which has

repeatedly insisted that the economy would lose little of its vigor, has

had to eat humble pie. Last December, it proudly predicted that growth

would come in at around 3.1% this year and 3.0% in 2002. Take that,

America! In June, the ECB forecast Europe's economy would grow about

2.5% in 2001 and 2.6% in 2002.

VULNERABLE GERMANY. That's still above projected U.S. growth levels. But it's nowhere near high enough to give European companies a boost, let alone foreign

companies that do business on the Continent. Far from it. The downturn

could actually hit corporate earnings around the world. U.S. companies

such as Hewlett-Packard, Intel, and McDonald's are already seeing the

effects of Europe's slowdown on their bottom lines. Europe's weakness

makes it that much harder for the global economy to reignite.

Germany looks especially vulnerable. On June 18, the Kiel Institute of

World Economics forecast that the German economy will be lucky to muster

growth of 1.3% this year. The next day, German Economics & Technology

Minister Werner Müller said the economy probably didn't grow at all in

the second quarter. Germany is doing particularly badly because its

industry is hampered by labor-market rigidities and other structural

problems. In addition, the country entered monetary union at an

overvalued exchange rate. Since Germany is the largest market in the

euro zone, that's bad news for the entire bloc.

Nokia, STMicroelectronics, and Alcatel are just a few of

the many high-tech companies that have recently told shareholders more

bad news is on the way. A plunge in semiconductor sales has also

prompted an earnings warning from Philips Electronics. "We don't see

improvements in the second half of the year," says Chief Financial

Officer Jan H.M. Hommen. Johannes Reich, head of equity research at

Frankfurt's Metzler Bank, says that in Europe, "the New Economy looks as

if it never existed."

BRINK OF STAGFLATION. And it's not just techdom that's hurting. Old Economy companies such as Kinowelt Medien, a German film rights company, and Dutch bank Rabobank Group have slashed earnings forecasts. Savino Rizzio, president of VIR, an Italian valve company, says the European slowdown has hit sales after 30 years of steady growth. "We have yet to touch rock-bottom," he says.

To make matters worse, Europe seems to be hovering on the brink of

stagflation -- a noxious mix of accelerating inflation and slumping growth.

In April, industrial production fell for the second month in a row.

"Industry is already in recession," says Julian Callow, chief European

economist at Credit Suisse First Boston.

Meanwhile, inflation in the euro zone surged to an annual rate of 3.4%

in May from 2.9% in April. That's way above the 2% the ECB maintains is

consistent with price stability. The higher prices -- stemming in part from

a weak euro and expensive energy -- have neutralized the stimulus that

should have come from this year's round of tax cuts, which put an

estimated $50 billion into consumers' pockets. "'Potentially the biggest

threat [to Europe] is the emergence of inflation," says Niall

FitzGerald, chairman of Unilever PLC. "If it gets beyond 4% for any

period, that feeds into wage demands, and it becomes self-perpetuating."

The waves of bad news coming out of Europe explode the idea that the

Continent had its own growth dynamic as it prepared to launch the paper

euro. "Far from Europe being able to decouple [from the slowing world

economy], there is increased integration," says CSFB's Callow.

DEPRESSING PERFORMANCE. Take Gucci Group, the Italian luxury-goods producer. It has been hit by a slump of nearly 5% in U.S. sales. Chief Executive Domenico de Sole says the situation is unlikely to improve in the second half. Other European

companies have gone on major buying sprees in the U.S. and are being

directly hurt by the American downturn. Also important: Euro-zone portfolio

investors who have bought hundreds of billions of dollars of

non-European bonds and equities have been slammed by losses in U.S. and

Asian markets.

The euro zone's depressing performance shows that economic and monetary union hasn't fostered industrial restructuring and fiscal reform on the grand scale needed to reverse the Old World's relative economic decline. To be sure, the currency has knit the

economies of Europe together. And the discipline of the Maastricht

treaty, which sets strict limits for government deficits and borrowing,

has done wonders for public finances. Most euro-zone countries now boast

budget surpluses and show no inclination to spur inflation further by

spending their way out of the slowdown.

But the euro has not yet forced the politicians -- many of whom face reelection soon -- to take the painful steps necessary to deregulate labor markets and trim lavish social

security systems. Some countries have actually made life more difficult

for industry. France has introduced a 35-hour work week that has

increased most companies' wage bills. Germany has buttressed the system

of "co-determination," whereby workers are given equal representation

with shareholders on supervisory boards.

To be fair, some countries have moved on reform. Many of the smaller

economies, such as the Netherlands, are much more flexible than they

were three or four years ago. Even Germany has cut taxes and embraced

pension reform over the past year. That's why Unilever's FitzGerald says

it "would be foolish in my view to underestimate the speed at which

these [euro-zone] economies are changing." But much more needs to be

done if Europe is to buck the global slump. The gloating about Europe

being the world's growth locomotive was premature. Europe now must

restart its own engine. By David Fairlamb, with Christine Tierney in Frankfurt, John Rossant in Paris, Stanley Reed in London, and bureau reports