European Stagnation

The euro zone crisis began two years ago and it was evident from the outset that buying time would do nothing. With government bond yields for peripheral euro zone countries — the so-called PIGS (Portugal, Italy, Greece and Spain), as well as Ireland — rocketing, delay in resolving the crisis only meant that their overall debt burden continued to escalate. Germany and France, the European Union’s leading nations, behaved like the dog owner in an old joke, who liked his boxer puppy and didn’t want to cut his tail, so clipped it just an inch at a time.

Even as fiscal austerity and lack of investor confidence pushed highly indebted economies into a severe recession, the interest rates they had to pay on their debt were averaging 5-6%. Even in mid-February, after markets calmed down, Portugal faced rates of around 12%, and Greece 33%.

Now, two years have been lost and a debt spiral has set in. The more tax revenues governments seek, the greater the burden that shrinking economic activity puts on their budgets. Even more alarming, the debt spiral affects not just Greece or Portugal, but also Germany and France, which are dictating austerity measures that effectively bankrupt Greece.

The Greek economy shrank by 7% in the fourth quarter, but that’s no longer the euro zone’s biggest problem. By end-2011, Germany’s industrial production was flat, and its economy contracted quarter on quarter in the October-December period. The French economy expanded during the same time period, but marginally so. Yet, Germany’s debt measures 80% of its GDP, while France’s debt is closer to 90%, both well above the 60% mark generally considered prudent. German long bond yields are extremely low, at around 1.9% as of mid-February, but with a shrinking economy it’s still a dangerous situation. France is paying over 3%, which is twice the pace of its economic growth.

Stalling Innovation

The E.U. can resolve its looming regionwide debt crisis only by growing out of it. This is why 2011 data from Dow Jones VentureSource make such alarming reading. Venture capital investment in Europe was down 14% last year, to the lowest level since 2000, when data collection began. Deal flows shrank by 19%. Traditional favorites of venture capital investors in Europe, which besides Germany include non-euro U.K. and Sweden, suffered sharp declines in funds inflows.

Venture capital flows indicate innovation and technological sophistication, which Europe needs to compete internationally and grow at a pace that could at least in theory reduce debt burdens across the euro zone. At present, however, not only is the region entering a recession, but its flagship companies are faltering. PSA Peugeot Citroën, the blue chip French automaker, saw its profits nearly halved in 2011, largely due to a sharp deterioration of the European automotive market in the final months of the year. Its debt tripled over the past year and the company announced that it will scale down its crucial expansion plans in India.

Equally indicative is the fate of Nokia, the Finnish company which is still the world’s largest producer of cellular handsets; its market position has been severely undermined in recent years by the success of more technologically sophisticated North American phone manufacturers.

Such bleak trends have emerged clearly in 2011 corporate reporting season. German engineering companies retain some cachet and can benefit from the rise of the newly wealthy in Asia, Latin America, Eastern Europe and elsewhere. But their European markets — including Greece, Italy and Spain, which used to borrow heavily to buy German cars — look set to remain dead in the water. Europe’s crisis will likely undermine these companies’ ability to innovate and hence charge a premium on their products in a highly competitive global environment.

Alexei Bayer is an economist and author based in New York City.