Club Med Chills

The global economic storm clouds have reached the Continent. Germany's business confidence, as measured by the economic research institute Ifo, fell to its lowest level in more than two years while similar indexes in France, Belgium and the Netherlands dropped as well. Such sobering data out in the past week point to a slowdown for the euro zone.

It was always wishful thinking that Europe could somehow avoid the pain from a U.S.-centered credit crunch, record energy prices and a fast-rising euro. But a crisis can be salutary, assuming the right policy responses are applied. Germany provides a good model here. Thanks to reforms and corporate restructuring, the euro-zone's largest economy has notched up steady growth, driven by strong exports.

The outlook looks especially grave for France, Italy and Spain. About the only thing the big "Club Med" economies have going for them is recently elected leaders with fresh mandates for reform. Now if only they'd use them.

France's President Nicolas Sarkozy and Italy's Prime Minister-elect Silvio Berlusconi are looking for an easy monetary fix to their troubles by calling on the European Central Bank to ease up. They had better look elsewhere. With inflation hitting a record 3.6% in March, the ECB has sounded the warning on rising prices, and the next rate move may be toward further tightening.

The solution lies in economic rather than monetary policy. Italy is in the worst shape of any large EU country. Growth has been below the euro-zone average since the 1990s. The Italian state eats up a whopping 48% of GDP, among the highest in the OECD. That's still not enough to pay the bills: Rome's debt ratio is about 105% of GDP.

Pensions are the obvious place to start the mending. The current pay-as-you-go pension system with large mandatory contributions for employers and employees is a huge drain on the economy. With one of the lowest birth rates in Europe, it can only get worse.

Italy also needs to lower various restrictions to competition that make doing business there so hard. Mr. Berlusconi promises to try harder this time than in his first two terms atop the Italian government.

Spain used to grow almost twice as fast as the the rest of the euro zone. Prime Minister José Luis Rodríguez Zapatero, re-elected last month, was riding on the reforms passed by his predecessor, José María Aznar, and the country's real-estate bubble. Now that bubble is bursting.

Some 246,000 people were added to the unemployment rolls in the first quarter, bringing the jobless rate to 9.6%, the second-highest among the 27 European Union members. The government just cut its growth forecast for this year and next to 2.3%. Most private-sector economists see growth below 2% next year. That's going to feel like a recession after 3.8% average annual growth over the past decade.

Mr. Zapatero has proposed a stimulus package worth about 0.9% of GDP. The measures range from tax rebates to speeding up approvals for public works programs. They may actually bring about a short-term stimulus, but no long-term recovery. The best idea he has proposed so far is the abolishment of the wealth tax.

But the main challenges for Spain's long-term outlook lie elsewhere. Red tape and overregulation remain a burden in spite of two decades of liberalization efforts. It takes 47 days to launch a business in Spain compared with the OECD average of only 15 days. R&D spending is just 1.12% of GDP, below the already low European average of 1.74% and less than half the 2.62% in the U.S. Productivity, measured as economic growth per hour worked, rose a paltry annual 0.9% on average between 2001-2006. That's even below the measly euro-zone average of 1.3% and less than half of the 2.2% in the U.S.

In Paris, Mr. Sarkozy rose to power a year ago with the promise of "rupture." He's not lived up to expectations. At 53% of GDP, French public spending is even higher than Italy's. Labor markets remain overregulated while reforms have been cautious. Just yesterday the government introduced a draft law to loosen retail price controls and offer tax breaks for small firms. Certainly welcome and in the right direction but "rupture" it is not.

Reforms make as much sense in good times as in bad. But in bad times, politicians don't have the luxury of putting them off. Maybe that's what it will take to bring about change in the Continent's laggard economies.