Demolishing five myths about Europes decline

Indermit Gill, the chief economist for Europe and Eurasia at the World Bank

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Five wrong notions have encouraged Asia and America to misdiagnose Europe’s ailments, Indermit Gill writes. And although Europeans need to make big changes, he believes the EU’s economic model can still be made to work

Europe has been getting a bad press. The Greeks and the Italians have been excoriated for endangering the euro, and Iceland, Ireland, Portugal and Spain have been criticised for their reckless financial policies. Endless summitry in Brussels hasn’t helped. Europe is increasingly seen by Americans and Asians as sluggish, even spoilt. Five wrong notions that have led to this misdiagnosis.

Myth No. 1: Europe is in decline

Actually, it isn’t. One way to tell is the size of Europe’s economy, its gross domestic product. During the 2000s, Europe’s share of global output stayed steady at about 30%, while the U.S. share actually fell from 31% to 23%. Over the last two decades, Europe’s GDP increased at about 2% per year, a bit better than the United States with some EU countries doing a lot better. Ireland became one of the world’s richest 10 countries since joining the European Union and, despite the crisis, is still in the top ten. After the fall of the Berlin Wall, when eastern and central Europe’s communist countries adopted market systems and re-established economic ties with the West, their economies have grown faster than the rest of the world other than China. In Poland, for example, per capita income has increased from $2,000 in 1990 to more than $13,000 last year.

Ireland and Poland are not exceptions; Europe is a busy place. About half of the world’s trade in goods and services involves Europe. Two thirds of it stays within Europe, and this may be its most attractive feature: regional trade has helped poorer countries in Europe catch up with the wealthier ones, making Europe easily the best neighbourhood for developing economies. Between 1970 and 2009, the poorer European economies grew by almost 4% a year and even the wealthier ones grew by almost 2% yearly. This is spectacular progress: U.S. growth at about 1.8% over a long period made America’s the biggest economy in the world.

During the last few decades, Europeans invented a “convergence machine” the like of which has never been seen before, in Europe or elsewhere. Just as the United States takes in poor immigrants and turns them into high-income households, the European Union has been taking in poor countries and making them into high-income economies. To become wealthy in other parts of the world, a country had to be extraordinarily fortunate or fierce – finding oil like Saudi Arabia or sacrificing consumption and civil liberties like the East Asian tigers. But in Europe, just being disciplined – keeping regulations reasonable and governments solvent – has since the mid-1980s helped a dozen countries become advanced economies.

Myth No. 2: European finance is the worst in the world

It might well be the best. Money should flow from richer, slower growing economies to those that are poorer and faster growing. Yet in much of the world we have seen the opposite – let’s call it the “China syndrome”. Countries that sent money to Western Europe and the United States did better than those that tried to do what seems to make sense – borrow abroad, invest at home and grow faster. In Europe, capital behaves in a way that economists would like it to; Austrian, French, Italian, and Swedish savings are invested in Bulgaria, the Czech Republic and Poland, helping both sides of the bargain. Banking in countries that were communist just a couple of decades ago is now the most advanced in the world. Occasionally, the money has been misused – consumed rather than invested – but for every country where this happened, there are two in Europe that used the money well.

Overly indebted governments, companies and households are easy to find around the Mediterranean, but much rarer in central and northern Europe. Unfortunately, like air crashes, financial accidents are spectacular, and the few countries that used foreign capital poorly have been getting all the attention. For many more countries in Europe, foreign savings have been helping millions escape poverty.

Myth No. 3: European enterprises have become uncompetitive

The numbers tell a different story. While Asia had a noisy economic crisis in the late 1990s, followed by a big boom, and the U.S. engineered a productivity revolution and a spectacular financial crash, European enterprises have quietly flourished. Between 1995 and 2009, western Europe’s entrepreneurs created jobs faster than the U.S. The European economies also exported more of what they made than Brazil, Russia, India and China, and companies in eastern Europe increased productivity faster than those in East Asia.

To be sure, Europe does face a problem. But it is because of faltering enterprise in a few countries. During the last decade, productivity growth has gone into reverse in Greece, Italy, Portugal and Spain. With the continent’s markets and institutions so closely integrated – in this case, the four even share a common currency – economic slippages in even a few countries can quickly trip up others.

Germany has been showing how economic integration can be used to become a global leader. Helped by pragmatic labour unions and welfare reforms at home, its companies have become more competitive by acquiring subsidiaries and partners in eastern Europe. They have been making formerly state-owned enterprises in places like the Czech Republic more efficient, and giving them progressively tougher things to do. French and Italian companies are doing the same in Romania and Turkey because it’s a good business model. Volkswagen bought Škoda a decade ago and last year it made a record profit of $21bn while automakers in the U.S. and Japan struggled. This year, it became the largest car company in the world.

Myth No. 4: European governments are too big

It depends. Governments in Europe are bigger – they spend about 10% of GDP more than their non-European peers. Almost all of this is because of just one reason: they spend more on social protection – pensions, unemployment insurance and welfare. This is the core of the European social model. It has helped Europe become the world’s “lifestyle superpower”: by most objective measures, the quality of life in the advanced European economies is the best in human history.

But it has had two side-effects: it has weakened the incentives to work and it is straining public finances. Just as in the U.S., Japan and South Korea, greater prosperity has meant that people have shorter working weeks and longer vacations, but in many European countries, generous social security rules are encouraging people to retire sooner while enjoying longer lives. Men in France now retire nine years earlier than they did in the 1960s and also can expect to live six years longer. No pension system can take such a hit unless people are working more hours each week and more weeks each year. In the 1970s, the French worked many more hours per year than the Americans. Today, the opposite is true.

With 10% of the world’s population and 30% of the world’s economic output, Europe accounts for about 60% of global spending on social protection. Unless these systems are fixed, it will be impossible for Europe to get the most from a workforce that could shrink by a million every year for the next five decades.

Myth No. 5: Europe has to gut its economic model

Europe needs to adjust its approach, but not abandon it. Some parts of the model, like trade and finance, are working well though they could be improved. Trade in digital services would be much greater if the European economies all had similar regulations, and finance could be made steadier if regulators were to collaborate more with each other. This is beginning to happen. Other parts of the model, such as enterprise, work quite well in many countries, though governments in Greece, Italy, and Spain have to improve the conditions for doing business. But southern Europe is the exception, not the rule: more than half of the top 30 countries for doing business are in Europe. Iceland and Ireland are among the ten best. Greece is 100th – its biggest problem is neither an over-valued currency nor inadequate public investment, but regulations that make it hard to do business there.

Europeans fret that they aren’t as successful as the U.S. in the ‘new economy’, lamenting the absence of young giants like Apple, Google and Microsoft. But to become more innovative, the bigger European economies such as France, Germany and the UK don’t need to look across the Atlantic. They could just take a page out of the playbook of their northern neighbours. Denmark, Sweden and Finland top the world innovation rankings, and even little Estonia has been incubating world beaters like Skype. They’ve done it by borrowing a few features of the American system: a steady supply of university-educated workers, R&D funding rules that push universities and companies to collaborate and a respect for intellectual property rights. The trouble is that their economies don’t add up to that of Texas. The fix is not difficult; a common European patent and a more efficient Single Market for digital services would go a long way. This may soon happen.

It is Europe’s approach to work and government that needs changing, and quickly. Some countries have shown how it can be done. Facing an economic crisis in the early 1990s, Sweden revamped its social security systems and lightened the regulatory burden for businesses, providing an example for other Nordic economies such as Finland. In the early 2000s, Germany – the “sick man” of Europe – overhauled its economic structures and inspired neighbours like the Slovak Republic to do the same. It’s time for countries on the Mediterranean to follow in their footsteps.

Calls to reduce public spending in Europe are often countered by the argument that Sweden spends a lot on government and has had a growing economy. But since its economic crisis in the early 1990s, the Swedes have made it costly to remain jobless or to retire early, and easier to start a business and pay taxes. And they have made sure that taxpayers get their money’s worth in public education, health and other services. Other Europeans will have to seriously consider “less government” until their governments become as well-run as those in Scandinavia. What is exceptional about Europe is that better-off neighbours are willing to give countries in crisis a helping hand.

Europeans will have to make some big changes, but it has been shown that Europe’s model can be made to work. Europe’s detractors should note, though, that the biggest successes and the quickest cures have involved more Europe, not less.

Post-Crisis World Institute