What can countries in central Europe do for the European Project? Complete the convergence

Indermit Gill, Naotaka Sugawara, 1 February 2013

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The following charts show what has been happening in Europe in the areas of trade, enterprise, finance, labour and government. There are three groups among these new member states of the EU (the EU 12). Three are in the north, five are continental, and two (Bulgaria and Romania) are in the south. Similarly, there are three groups in the older member states (the EU15). Northern Europe (Denmark, Finland, Ireland, Sweden, and the UK); continental Europe (Austria, Belgium, France, Germany, the Netherlands and, occasionally, Luxembourg); and southern Europe (Greece, Portugal, Spain and Italy).

Staying the trade champions

Let’s start with trade. The ratio of exports to GDP is a good measure of openness and, for small economies, it is probably not a bad measure of economic efficiency. Specialisation helps efficiency and, for smaller economies, specialisation happens mainly through trade.

Figure 1. Central Europe is a trade champion while southern Europe has lagged

Source: Authors’ calculations based on Eurostat national accounts database.

The share of exports to GDP in the central European economies is about 80% (Figure 1). Europe is the world’s trade center, accounting for almost half of global trade in goods and services. Central and eastern Europe is the region’s trade champion. It was not always like this. For just the goods trade (for which data are easier to obtain), the ratio for central and eastern Europe rose from 44% of GDP in 2002 to more than 70% today. In southern Europe it is less than 20%. One group is small and open; the other is small and closed. The trend, however, seems to be small: central and eastern European economies are growing in size and opening up, with those in the south more closed and getting smaller.

Making enterprises more productive

The single best measure of the health of enterprises is probably productivity. Figure 2 shows what happened to productivity in Europe over the last decade.

The advanced economies in northern and continental Europe had positive productivity growth. Of course, some of them – such as Denmark and the Netherlands – could have done better. Central and eastern Europe did well. But the south went the wrong way. Given their productivity levels in 2002, Italy, Spain, Portugal and Greece should have had annual productivity growth of about 3% or 4%. Instead productivity levels fell.

Figure 2. Central and eastern Europe became more productive, southern Europe less

Note: The period of time considered is different for: Belgium and Norway (2003–08), Greece (2003–07), and France, United Kingdom, Czech Republic, Latvia, and Romania (2002–07). The three lines show average values for countries covered by each line. Expected growth for EU15 South is obtained by computing distances in productivity levels between EU15 South and each of the other two groups and then applying these shares to the difference in growth between the first (i.e., European Free Trade Association, EU15 North and EU15 Continental) and the third (CEE) groups.

Source: Gill, Raiser, and others (2012).

While Figure 2 shows productivity growth rates, Figure 3 shows the levels of productivity across Europe. The numbers have been normalised so that the productivity level of the US is 100 in each year. Since the early 1990s, the gap between the EU15’s northern and southern conutries has been growing. At the same time, the productivity gap between the east and the south has been shrinking, and quickly. The timing is not coincidental, starting at a time when the first association agreements were signed in central Europe. But this has happened so quickly that most people are surprised to be presented with this picture. And this is the reason that central and eastern Europe are now almost the economic equals of southern Europe.

Figure 3. The productivity gap between southern and central Europe has rapidly narrowed

Note: GDP per hours worked is expressed in 1990 Geary-Khamis dollars. Source: Authors’ calculations based on Conference Board Total Economy Database (January 2012).

Countries in central Europe still have a long way to go. Productivity levels are just half of those in countries such as Germany and Sweden.They were rising until the crisis, and have to start increasing again. Czechs, Estonians and Poles sometimes ask how countries in central Europe can best contribute to the reinvigoration of Europe? Part of the answer is by continuing to make their workers more productive. And southern Europe can stop being a destabilising influence by not doing things that made Greeks, Italians and Spaniards less productive during the 2000s.

Taking advantage of foreign finance

For countries that are not yet at the global frontiers of technology, a sizeable part of the increase in productivity comes from accessing the knowhow, capital, and markets in more advanced economies. One of the main channels for this is foreign direct investment – the money and ideas brought by multinationals. But finance can come in other forms as well. One is lending for consumption or construction. So foreign capital flows can create both equity and debt.

Figure 4 tells you what has been happening over the last decade. On the vertical axis, going from top to bottom, countries received more foreign investment. On the horizontal axis, from right to left, people in the country borrowed more. In the new member states, the flows created both debt and equity. In Greece, Portugal, and Spain, foreign direct investment flowed out, not in, alongside a large increase in debt.

Figure 4. Southern Europe became much more exposed to debt, while central Europe got both debt- and equity-creating flows of capital

Note: Arrows begin in 2001 and end in 2011. Due to the data availability, Ireland (EU15 North), Belgium (EU15 Continental) and Luxembourg (EU 15 Continental) are not included. Source: Authors’ calculations based on IMF Balance of Payment Statistics and World Bank World Development Indicators.

Why did the south get debt-creating capital flows, while the east did so well in getting productivity-increasing foreign direct investment? The short answer is the investment climate. If you have a good climate for investment, you attract foreign direct investment. If the climate is lousy, but the global conditions are good, you might get short-term capital inflows to finance consumption.

The World Bank reports a summary measure of the conditions for doing business (Figure 5). In 2011, Greece came in 100th place, Italy 87th, and Spain 44th. At 30th, Portugal did well. Estonia, Latvia and Lithuania did even better and Poland, Romania, Bulgaria, Czech Republic and Hungary all ranked between 50th and 70th.

The 2012 rankings are reassuring, Poland improving to 55. Spurred by the economic crisis, reforms in Greece have moved it to 78th while Italy has improved to 73rd. These are welcome developments. But if you share a currency with economies such as Finland, Ireland and Germany – all ranked in the top 20 countries – this is not nearly enough.

Figure 5. Doing business is easier in the north, and the hardest in the south

Note: Doing Business 2013 shows the business climate in 2012. Source: World Bank Doing Business 2013.

Back in 2000, these rankings would have been similar for central Europe and the south. Since then, the measures, which are based on the raw data and not the rankings, have diverged. But the CEE still has some way to go, especially for the ease of operations such as paying taxes, trading across borders, and obtaining construction permits (Figure 6).

Figure 6. Countries in central and eastern Europe must make it easier for businesses to operate – that is, pay taxes, trade, hire workers, and get construction permits

Note: Indices showing the quality of regulations are computed by principal component analysis using the 10 indicators in Doing Business 2004 to 2012. They are rescaled and range from 0 to 100, indicating that the higher the score, the better the business environment. Business start-up includes indicators for starting a business, registering property and closing a business. The index on business operations covers the aspects of paying taxes, trading across borders, employing workers, and obtaining construction permits. Institutions cover the rules for protecting investors, getting credit, and enforcing contracts. Source: Gill, Raiser, and others (2012).

As a result of poor conditions for business, southern European enterprises are not fit for an integrated European market. Put simply, they are too small. In most of Europe, enterprises with fewer than ten workers account for around one fifth of value added, but in the South it is almost one third. Such micro enterprises have neither the skills nor the resources to ‘go abroad’.

Modernising labour markets

Much of this is well known. What might not be known widely is that since a few years ago, "Doing Business" rankings no longer include measures of the ease of hiring workers. Of course, this is an important part of the investment climate.

Using measures of the ease of hiring and firing workers makes the investment climate look better for countries that already do well in the Doing Business rankings – such as Denmark, Finland, Estonia, Latvia and Lithuania – and makes the investment climate even worse for Italy, Portugal and Spain. Figure 7 shows which parts of Europe have made it easy to hire workers, and where it is cumbersome. The Swiss and other EFTA members do the best, the Spaniards and the south the worst. In the EU, the best performers are the three Baltic economies. It is perhaps not a surprise that their labour productivity growth measures have been the best.

Figure 7. Northern Europe has made it easier to hire and fire workers, southern Europe the hardest

Note: An index ranging from 1 to 7 to characterize the hiring and firing of working (1 = impeded by regulations, 7 = flexibly determined by employers) is shown. Source: World Economic Forum Global Competitiveness Report 2012-13.

The countries that make it difficult to hire and fire workers have the larger shares of workers who fall outside regulatory controls. The south has the highest rate of informality in the EU (Figure 8). In Greece, for example, the share of informal workers is close to half.

Figure 8. Rigid labour markets seem to result in greater informality of work

Source: Hazans (2011), and Packard, Koettl and Montenegro (2012).

Make governments work better, or keep them small

High levels of informality also mean low tax revenues. If public spending is high, this means that deficits are high too. Below is a chart that shows how much of the country’s GDP is spent by governments (Figure 9). Two things stand out. The first is that governments in Europe spend about 50% of GDP. The exceptions are the Baltic countries and the eastern Balkans, where this ratio is about 40%. The second is that social protection is a big part of government spending in Europe. It is more than 20% of GDP in the EU15, and more than 15% in central Europe. It appears that northern Europe’s advanced economies spend more on social protection than the south. But we have also found that when adjusted for contributions collected to pay for them, it is the south that is the biggest net spender.

Figure 9. Social protection is the biggest part of large government spending in Europe

Note: “Social protection” includes benefits related to sickness and disability, old age, survivors, family and children, unemployment and housing. Source: Authors’ calculations based on Eurostat government finance statistics.

This is something that central European countries – especially Hungary, Poland and Slovenia – should be worried about. In this respect, the continental countries of central and eastern Europe look more like the south than their Baltic Sea neighbours.

The fiscal adjustment needs in southern and continental Europe are simply staggering (Figure 10). To bring debt levels back down to 60%, the countries in the south have to affect a fiscal adjustment of 9% of GDP, those in continental Europe about 4.5%. Addressing the expected increases in pension and healthcare costs over the next two decades also requires an additional adjustment of 4.5% in western Europe. When countries are faced with this massive task of fiscal consolidation, it is irresponsible to advocate more government spending as some observers have in recent months. Governments in central Europe should ignore the calls to spend more.

Figure 10. Huge fiscal adjustments lie ahead for southern Europe, though central Europe also needs a sizeable fiscal consolidation

Note: Adjustment in the cyclically adjusted primary balances is assumed to be implemented by 2020. The calculations are based on the IMF WEO forecasts 2010 and, therefore, some of the fiscal adjustment measures announced by European governments in late 2011 and 2012 are not considered. Source: Gill, Raiser, and others (2012).

What should central Europe do?

One of the authors of this article was in Berlin some months ago, discussing the recent report by the World Bank on European growth (Gill et al. 2012). We told them about the greatest achievement of Europe over the last five decades: the convergence of European economies. We told them how, just as the US has been taking in poor people and making them into high-income households, Europe has been taking in poor countries and making them high-income economies. The chair gently interrupted us. He said that he could guess the question that was on the minds of the people in the room: why should 40 million German workers have to carry so much of the burden of European convergence?

The countries of central Europe have carried out a responsible accession to the EU, and have, looking back, convinced even the most skeptical that the European project has brought many benefits to both new and older member states. When the achievements of central Europe are carefully catalogued, it is easier to recognise that what happened in the South during the last decade is an aberration, not the norm.

What has been the norm in Europe is an extraordinary convergence: in the 1970s and 1980s, the European project helped a hundred million people in Greece, Portugal, Spain, and southern Italy get achieve a high income. In the 1990s and 2000s, it helped another 100 million people in central Europe experience the best years in their history. Now it is helping another 100 million people in the Balkans and Turkey get closer to high income. If things go well, it will help the 75 million people in the Eastern Partnership countries, such as Belarus and Ukraine, do the same.

But this convergence is not complete. And the best way for the countries in central Europe to contribute to the reinvigoration of the European project is to continue, and even accelerate, this convergence. How can this be done? By facilitating trade and foreign investment. Make finance more resilient to crises by both welcoming foreign capital inflows and worrying about them. Improve the investment climate to make sure foreign capital makes the economy more efficient. Make workers more productive through freer enterprise and better education. Make governments solvent by borrowing only for the most-needed public investments. Make government spending more growth-oriented by providing social protection to only the most unfortunate, the old, and the infirm.

The countries of central Europe can best reinvigorate the European project by reinvigorating their own economies. For now, this may be enough.

Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.

References

Gill, I, M Raiser, and others (2012), Golden growth: Restoring the lustre of European economic model, World Bank, available at www.worldbank.org/goldengrowth.

Hazans, M (2011), “Informal workers across Europe: Evidence from 30 European countries,” World Bank Policy Research Working Paper 5912, World Bank.

Packard, T, J Koettl, and C Montenegro (2012), In from the shadow: Integrating Europe’s informal labor, World Bank.

Topics: Europe's nations and regions
Tags: central Europe, economic convergence

Indermit Gill
Chief Economist of the Europe and Central Asia Region, World Bank
Economist, Europe and Central Asia Region, World Bank