Europe’s growth prospects are clouded by doubts over the integrity of the eurozone. Some economists believe it’s just a matter of time before its peripheral countries begin to be forced out; others think that to be inconceivable. All agree that at least in the short term, a eurozone break-up would be disastrous for jobs and for growth. But because the outcome is unknowable, and depends on politics as much as on economics, let us leave that frightening prospect to one side and look instead at what we know about the underlying performance of the European economy. In short, how competitive is Europe?
Even if we in this way simplify the question it is still not an easy one to answer. One thing we painfully have learned during the ongoing eurozone crisis is that there still isn’t a single European economy. The last decade has witnessed a remarkable divergence in national economic performances. The German economy, together with a few others with similar characteristics like Austria and Finland, has significantly improved its productivity and cost competitiveness. The results can be seen in a growing trade surplus with the rest of the EU, and in Germany’s case with the rest of the world. By contrast, the eurozone’s southern countries have seen their unit labour costs rise more rapidly than the average, and those cost increases are not being offset by higher productivity. So any generalisations about the European economy must immediately be qualified.
We Europeans nevertheless live in a single market, and have done so for two decades, while many of us also share the euro as a single currency. It is therefore meaningful to begin by looking at the aggregate, or at least at what are often called the EU-15, meaning the member countries before the EU’s enlargements of 2004 and 2007 that brought the total to 27. That’s because it can be confusing to include data from transition economies; although eastern and central European economies are rapidly converging with the West, over the last two decades their rapid catch-up after decades of economic isolation risks distorting the picture.
If we compare the EU-15 with the U.S., what do we find? The most obvious point is that GDP per head in Europe is almost 25% lower, which translates into around $11,000 a year. Productivity per head is also lower, but only by about 15%. Furthermore, EU productivity per head, which is the single most important driver of economic performance, had been converging on the U.S. level for 20 years up to 1995, when Europe was only about 5% below the U.S., but in the decade before the eurozone crisis we lost 10 percentage points. The U.S. had achieved a significant productivity boost from the IT revolution, that Europe was unable to match.
There are other data, too, which suggest that contrasting the U.S. and Europe is not wholly unfavourable to the latter. Europe managed to hold its global export market share during that period more effectively than did the U.S. European companies have on average been more successful at maintaining their share of the imports of emerging markets than have those in the United States. Also, though it may seem surprising, Europe’s job creation performance has not been as bad as many think. A McKinsey analysis of new jobs in the U.S. and the EU from 1995 to 2008 suggests that while the U.S. created 20m new jobs, 19m of them were attributable to population growth. The EU-15 created about 24m new jobs during the same period, with only 9m due to rising population. This job creation success wasn’t evenly spread across the European continent, but it did happen and that means that there are now good success models in employment generation within the EU that we can look to for inspiration.
There is also solid evidence that Europe’s big companies have been doing relatively well in global competition. The number of Fortune 500 companies headquartered in the EU has grown over the last decade, while those based in the U.S. have fallen. As to profits, those of big European companies have grown 50% more rapidly than those of their American counterparts.
Europe has major strengths on which to build, even though in the current straitened budget circumstances it doesn’t look easy to take advantage of those strengths. The talk is of austerity, and more austerity still.
Few would probably contest the need to correct the unsustainable fiscal positions of a number of EU countries, especially those in the south –including France. But that fiscal correction must be accompanied by structural reform. It is quite clear that the labour market reforms undertaken by Germany a decade ago, painful as they were at the time, have put her in a far stronger position to compete globally. Similar reform programmes are urgently needed in countries like Italy and Spain.
It is especially important to reform the service sector. Manufacturing productivity per hour in Europe in fact compares quite well with the U.S., but Europeans work significantly fewer hours per year, which explains why on an annual per capita basis the picture looks different. Where European countries really fall down is in services, where restrictive practices, protectionism and simple inefficiency hold them back.
Spain’s Mariano Rajoy and Italy’s Mario Monti seem to understand these points well, but so far the reform programmes they have unveiled do not seem radical enough to adequately address the challenge. Although Italian employers have dismissed the proposed reform of employment law as far too modest and timid, the Monti government has retreated in the face of trade union opposition and protests from assorted interest groups like taxi drivers who see their protected privileges under attack.
Governments are of course inhibited by the knowledge that the first consequence of labour market reform may well be an increase in the short term in unemployment because employers will find it cheaper to fire personnel. But the hope, and indeed the solid expectation, is that in due course this will translate into a greater willingness to hire in an economic upturn, and that over time this will yield a higher level of employment. But the immediate consequence may be a worsening of the country’s fiscal position, and for elected politicians the long-term will only be reached after a series of short-term electoral challenges, so radical reforming governments may well not survive to reap the benefits. As Luxembourg’s Prime Minister Jean-Claude Juncker remarked not so long ago, all EU governments know what has to be done, but what they don’t know is how to get re-elected once they have done it.
Some economists are proposing what may be a solution to this problem. Among suggestions for resolving the eurozone crisis is the idea of a fiscal union. The architects of the single currency had envisaged that it would be accompanied by an increase in fiscal federalism, with a central EU budget for responding to asymmetric shocks. There’s a great deal of political resistance to this idea, especially in countries like Germany that would be the chief contributors to such a budget. So a variant on this proposal which could possibly find a little more support would be to link fiscal support to labour market reform. If Italy or Spain introduced changes that led to a short-term increase in joblessness, the associated fiscal costs would thus be met from a central EU Budget to ease the pain. This “investment” by wealthier countries ought to pay off for them too if it leads to more flexible labour markets and higher productivity growth in the receiving countries.
Another proposal which might yield similar effects is for a central budget to subsidise the reduction of employment taxes in the EU’s most economically challenged countries. The logic is that a country like Greece needs a devaluation to enhance its competitiveness. Although it could of course do so by leaving the euro, that poses major problems, to put it mildly. The alternative is an “internal” devaluation, which would mean cutting wages in nominal terms. That is hard to do, even though it has been achieved in Latvia and Ireland. Yet another option that would have a similar effect is to reduce taxes on labour, perhaps for a defined period. That would in the short term be costly for the national government, although if it generates an increase in output and employment the “tax expenditure” involved may well be justified, and an EU subsidy to allow this might be a worthwhile investment by the European Union as a whole.
It is not going to be easy for the EU to escape from the fiscal trap in which it now finds itself. To say that the trap is of the heavily indebted countries’ own making may be correct, but it isn’t very constructive. If Europe as a whole wants to find a way back to sustainable growth and high employment, we need to take a hard look at what’s worked well in those countries which have performed successfully over the last decade or more so as to transplant it elsewhere. That will cost money, but EU governments must be prepared to persuade their electorates that it is an investment worth making.
Howard Davies is a former Director of the London School of Economics and chairman of the UK’s Financial Services Authority. He currently teaches at Sciences-Po in Paris. firstname.lastname@example.org