What’s wrong with Europe?

Isabella Baldini, Paolo Manasse

04 November 2013

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The US and Europe: a tale of two cities

While the recovery is well underway in the US, with growth back to 2.5% and falling unemployment, the Eurozone economy is struggling to recover. Why? And why did some European countries suffer much more than others during the crisis? In CEPR Policy Insight No. 67, We argue that the answers to these questions are intertwined. The crisis has slowed down the process of convergence between European countries, shedding light on unresolved structural problems. In some peripheral countries, price and wage rigidities have amplified the recessionary impact of demand shocks, the credit crunch and budget consolidations. As a consequence, the crisis has exposed the inadequacy of the (new and old) European institutions to cope with aggregate, as well as idiosyncratic shocks.

Per capita GDP

It is useful to compare the trend of per capita real GDP in the US (blue line) and in the Eurozone (yellow line), as shown in Figure 1. The graph shows a decline in real average incomes since 2007-2008 in both areas. The impact of the crisis on the US is larger, the decrease in per capita income is of - $2,459 at constant prices (-6 %), compared a fall of -€1200 euro (-4.7 %) in the Eurozone. However, in 2012 the average US income has recovered to pre-crisis levels, whilst Europe’s is still 2.5 points below.

Figure 1. Real per capita GDP

In order to understand why, it is useful to look at the state-level data. Figure 1 shows two bands – blue and yellow – for the US and the Eurozone respectively, whose upper and lower limits describe the per capita income in the richest and poorest state: the District of Columbia and Mississippi in the US; Luxembourg and Estonia in the Eurozone. From the graph it is clear that internal differences are much greater in the Eurozone than in the US. Between 2000 and 2012, real per capita income of the richest US state is five times that of the poorest state. In the Eurozone this ratio is 8.6 to 1.

The data on unemployment confirms this pattern – both countries experience a sharp rise during the crisis years; however, aggregate unemployment rate in the US has been declining since 2010, whilst it is still increasing in Europe. In 2012 the gap between the lowest (4.3% in Austria) and the highest (25% in Spain) rate skyrocketed.

A closer look at convergence/divergence

According to the standard model of economic growth, poor countries should grow faster than rich ones. This is because in such countries capital, compared to labour, is relatively scarce, and thus more productive. Consequently, one would expect poorer countries to save and invest more, as return on capital is higher. This process of convergence has occurred in Europe between 2000 and 2007; however, the speed of convergence has halved in recent years. In Figure 2, each dot represents a country in the periods 2000-07 (in blue) and 2007-12 (in red). The figure shows the relationship between the initial level of the real income per capita, on the x-axis, and the average increase in income in subsequent years, on the y-axis. When the data points lay around a downward sloping line it means that, on average, countries that initially had lower per capita incomes have grown faster. The steeper the (more negative) slope of the line, the higher the speed of convergence. The figure shows that in the post-crisis period Europe’s convergence rate has almost halved compared to the previous period (the slope of the red line is about half the slope of the blue one). In the US (Figure 2.2) the relationship between growth and initial income is much more confused and statistically insignificant, although the graph suggests that recently the divergence between states has increased.

Figure 2.

Productivity

On the supply side, countries which before 2008 had lower (incentives for) productivity growth, are those that are suffering more as a result of the crisis. Figure 3 shows the relationship between cumulative growth of total factor productivity in Europe in the pre-crisis period, 2000-08, and the subsequent change in real GDP per capita, 2008-12. Countries whose productivity had risen less before the crisis are those where average per capita GDP falls more (or increases less) during the crisis.

There are, of course, exceptions. Greece, in the lower part of the graph, suffers a meltdown of GDP per capita during the crisis (-17%), despite having experienced a modest rise in productivity (+1.5%). Slovakia, the point towards the right in the chart, experiences a decline in per capita income (-2.8 %) despite a spectacular cumulative growth in productivity between 2000-08 (+31%). The case of Greece is clearly due to the sovereign default and the harsh austerity measures; that of Slovakia is largely due to the sharp contraction in exports (Manasse 2013). Both cases highlight the role of aggregate demand factors in addition to supply rigidities (see below).

Figure 3. TFP and crisis in the Eurozone

Data source: European Commission, Eurostat.

Fiscal austerity

The explanation of the heterogeneous impact of the crisis on Eurozone’s economies cannot abstract from the impact of fiscal consolidations on aggregate demand. Figure 4 shows the relationship between the severity of fiscal tightening in the period 2009-12, measured by the improvement in the budget balance in % of GDP (x-axis) and the growth of GDP per capita in the same period (y-axis). On average, a reduction of one percentage point in the deficit / GDP ratio is associated with a fall of 0.84 points of GDP per capita.1

The figure also shows a strong heterogeneity in the response of European countries to the budgetary tightening, which suggests that fiscal austerity alone is not enough to explain the differential impact of the crisis. The most significant cases are Greece and Ireland – two small economies that have lost access to international capital markets, have suffered the consequences of a credit crunch, and have resorted to conditional loans from the 'Troika'. In Greece, on the bottom right of the graph, GDP per capita fell by nearly 20 percentage points during the period, whilst the budget improved by about 5,6 points of GDP. In contrast, in Ireland, to the right in the graph, per capita income has remained largely unchanged despite a tightening of over 6% of GDP.

Figure 4. Fiscal adjustment and per capita GDP in the Eurozone

Redistribution in Europe and the US

The lack of an adequate EU federal budget does not only prevent the Eurozone countries from sharing a macroeconomic policy to contrast “aggregate” shocks, such as the global recession; it also precludes the implementation of an effective insurance system based on inter-state transfers, in order to address 'country-specific' shocks, such as the banking crisis in Ireland or Spain. Italy, the largest net contributor relative to its GDP, pays to the EU budget 0.38% of its GDP per year; Hungary, the country that most benefits from the EU budget, receives transfers equivalent to 4.67% of its GDP. The size of the transfer scheme in the US is of a much larger magnitude. The poorest states, such as West Virginia, Mississippi, and New Mexico in the decade 1990-2009 have received transfers between 244 and 261% of their GDP in 2009, while rich states, such as New Jersey, Delaware, and Minnesota have given contributions that in total amount to 150-206% of their 2009 income.

Conclusions

The crisis has slowed down the process of convergence between European economies. This happened because the effects of demand shocks were amplified by pre-existing supply-side structural problems in the markets for goods, labour, and credit. The crisis has also highlighted the inadequacy of European institutions, and has exposed the faults in their design (Wyplosz 2013).

Unlike the US, the integrity of the Eurozone ultimately depends on the political will of each member state; this makes the Eurozone intrinsically vulnerable to speculative attacks. The way to shed the Eurozone from the risk of disintegration is long, and fraught with political obstacles. It requires each country to jumpstart the path of structural reforms, and it requires Europe to gradually establish a federal budget, an inter-state insurance scheme, and enforce a no-bailout commitment. Last but not least, the Eurozone needs to move away from centralized system of ineffective and invasive rules (Leipold 2013). This is a path worth pursuing, since the alternative – the disintegration of the Eurozone – is quite dire. The benefits of free movement of goods, persons and investments – the factors that make the US economy strong – could be at stake.

References

Leipold, Alessandro (2013), “Lessons from Three Years of Euro-Area Crisis Fighting: Getting It Right Next Time”, The Lisbon Council, June.

Manasse Paolo (2013), “The Roots of the Italian stagnations” VoxEU.org, 19 June.

Manasse, Paolo and Isabella Rota Baldini (2013), "What's wrong with Europe?", CEPR Policy Insight No. 67.

Wyplosz Charles (2013), “Europe’s Quest for Fiscal Discipline”, European Commission, European Economy, Economic Papers, n. 498, April.


1 Note however that this number is likely to overestimate the negative impact of domestic austerity on demand for smaller countries, which are more exposed to the negative spillover effects from other countries’ consolidations.

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Topics:  EU institutions

Tags:  US, productivity, Eurozone crisis

Editorial Coordinator, Link Tank

Paolo Manasse

Professor of Macroeconomics and International Economic Policy, University of Bologna

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