ON THE AGENDA

These days, it's easy to despair for Europe, and many economists do. Growth forecasts for the euro zone are down, unemployment is climbing and, while 18 percent of young people cannot find work, political leaders in Germany, France and Italy have gone slow on labor market reforms. The European Union is well behind on a five-year-old plan, the Lisbon Agenda, to create the world's most competitive economy by 2010. Expectations are low as leaders of the EU's 25 member states gather at a Brussels summit this week to discuss ways to realize the Agenda goals. Yet, despite the pessimistic majority, there is an underdog case to be made that change is in the air.

Out in the real world, market pressures for reform are overwhelming resistance from national governments. Global competition magnified by the strong euro is forcing companies to make tough calls where governments won't. Firms are restructuring, entrepreneurs are creating new businesses at a quickening pace, productivity is rising. "Oddly, I feel optimistic," says Deutsche Bank chief Europe economist Thomas Mayer, a longtime critic of the Continent's failure to reform. "I feel like a doctor who has watched a patient with a severe illness for 10 years. Now he's gone into crisis, and the real fight begins."

Brussels is demanding change from above, and new civil-society lobbies are allying with local government to push from below. Recalcitrant national leaders are more and more alone in defense of welfare states. "The biggest politicians in the world, even if they wanted to, could not prevent globalization," says European Commission President Jose Manuel Duro Barroso. "Are we in Europe open to this new world? That is the problem."

Barroso wants Europe to concentrate on growth and jobs so it can afford its environmental and social protections. As Europeans prepare to vote on their new Constitution over the coming months, confrontation will be put on hold. But Brussels is pushing. Barroso is trying to open Europe's service sector to more competition. Neelie Kroes, the new Competition Commissioner, is pressuring cartels and preparing a revamp of state aid that will direct more money to smaller, more innovative companies. "There's been a sea change in the sense of urgency" for economic reform, says a senior Commission official, who calls it a " life-or-death issue."

The private sector is not waiting for an official European Union directive. Small companies have long been the key to job creation in Europe, and they are booming. In France, after reforms simplified the start-up process, the number of new businesses rose 9 percent in 2003 and 2004, after five flat years. In 2004, Germans founded a record 960,000 new businesses, up 18 percent over 2003, due in part to cuts in the red tape required for plumbers, carpenters or hairdressers to set up shop. Entrepreneurs are creating new services, like the dog taxi in Kaiserslautern run by former social worker Karl-Heinz Gerrmann. The EU is trying to redirect more research-and-development spending to these more nimble companies. "Big companies want subsidies disguised as R&D funds," says Isaac Getz, professor of innovation management at the European School of Management in Paris. "Small business drives innovation."

Barroso has firm allies among young entrepreneurs and activists who assume they will never reap benefits from the fading welfare state. In Brussels last week, the pro-reform Lisbon Council brought activists from across Europe to a meeting at which Joeri van den Steenhoven, cofounder of the Dutch reform group Kennisland, called for a "coalition of the willing," including local politicians and small businesses who are less beholden to large vested interests, to push the cause of reform. In Germany, groups like berlinpolis and the Foundation for the Rights of Future Generations are lobbying for labor and pension reform. In France, Liberte Cherie has been growing since its launch in 2003, when it drew 80,000 people to a counterrally against union strikes that had shut down Paris.

Many big companies are no longer seeking protection from change. Corporate investment in IT is driving up productivity in Europe, which grew 1.6 percent in 2004, up from 1.3 percent in 2003. Last year Siemens and DaimlerChrysler cut union deals that boost working hours without extra pay, in exchange for guarantees not to shut down plants. Private takeover firms have swept Europe over the past year, helping sleepy conglomerates sell weak assets and get fit to compete. "The rules are made elsewhere now," says Stefanie Wahl, political scientist at the Institute for the Economy and Society in Bonn. "We no longer set the parameters; we can only react."

Politicians would love to halt the pressure for tough reform, particularly around election time. But they can't. German Chancellor Gerhard Schroder pushed through welfare cuts designed to prod the unemployed into jobs, then suspended further reform in advance of regional elections coming in May. But unemployment jumped from 11.4 percent to 12.6 percent in February, forcing Schroder to join opposition leaders at a "jobs summit" last week. Schroder has announced new reforms, including a cut in the business tax rate, job subsidies for low-skilled workers and a slight loosening of labor rules.

There is even a case to be made that some states are more reform-minded than they let on. Alasdair Murray of London's Center for European Reform calls it the French paradox. Paris is among the capitals most vocally opposed to the Lisbon Agenda. Yet it is now loosening rules that cap the workweek at 35 hours, and Murray's annual scorecard of progress indicates improvement in categories like employment growth. France's big retailers and its professional elite would be among the first to benefit from a liberalized cross-border services market. "The gap between what the French government says and what it eventually does is quite big," says Murray.

As this week's summit gets underway, European leaders are at a crossroads. Economist Jean-Philippe Cotis argues that Europe faces "irretrievable, irrevocable decline" if its leaders cannot achieve competitive reform. But not everyone agrees. No matter what happens in Brussels, "there is a wind of change sweeping across Western Europe," say Barclay's Capital economist Julian Callow. If they fail to join the reform drive, European leaders thus face an unattractive choice: decline, or irrelevance.