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FRESH AIR FROM WORLD BANK ON EUROPE'S MUCH-MALIGNED ECONOMIC MODEL     Print Email

A major World Bank study, published this month, lauds the European Union as an extraordinary economic success story and concludes that the current turmoil, far from being a terminal failure, should be the trigger for reforms to improve the community’s weak points. The thorough, richly documented analysis provides a strong antidote to prevailing prescriptions of the euro’s impending doom.  Such euro-pessimism has prevailed in recent years, as the Eurozone has struggled to address bouts of mismanagement and muddled leadership within its ranks. Deep flaws within the monetary union were exposed, along with the resulting structural imbalances in the system, when the global financial storm broke over the continent nearly five years age.

 

 

But even though some troubled member states are in dire straits right now, the situation should not blind policy-makers to the EU’s historic success in integration and growth. The record of shared prosperity provides the report’s title: “Golden Growth: Restoring the Lustre of the European Economic Model.” Produced by a team under the lead authorship of the World Bank’s Indermit Gill, chief economist for Europe and Central Asia, and Martin Raiser, country leader for Turkey, the report concludes that Europe has what it takes to remedy the deficiencies and rigidities that have staunched its economic dynamic. Some reforms should be easy, notably redirecting capital flows; some will be harder, notably dismantling overregulation of business and liberalizing labor markets and worker mobility. But rescue is doable, the report concludes, pointing out that in every category of international benchmarking for economic excellence, Europe has at least one country that can match the world leader. It is this level of detailed research, accomplished by teams involving a score of researchers that makes this report an invaluable resource. Undertaken ahead of the Polish Presidency of the EU in late 2011, partly at the instigation of Marek Belka, Poland’s Central Bank head and Chairman of the World Bank/IMF Development Committee, the finished work is a brilliantly organized and eminently useful 450-page study that covers, compares and integrates performances and outlooks in the EU-12, the new EU-15, the European Free Trade Area, Switzerland, Turkey, the Balkans and other neighboring countries and prospective candidates for the EU.  With its scores of tables and graphs, annexed case-studies, sound-bite quotes and illustrative case studies, it is an ideal teaching tool, including for policy-makers.

 

The report’s central message is that, given its extraordinary record of achievement, the EU and Europeans must have the confidence to make the necessary changes to preserve their special approach.  “Loss of confidence in the European growth model could be a good thing if this was a bad growth model…but it actually has some very, very good attributes,” Gill told a European Institute seminar where he presented the report.  The model needs to be adapted to cope with two or three big changes in the world in recent years: a billion more Asians entered the labor market, the U.S. - led information and technological revolution, the aging of populations, and the rise of public debts.  “One has to adjust to that; but we worried that, in making these changes, Europe might throw out get off some of the stronger components of the growth model,” he explained. “It is important not to throw out the baby with the bathwater,” was the  colloquial formulation used by Gill, an Indian-born economist who has worked all over the world after getting his degree from the University of Chicago, whose economics department has usually been a critic of European policies of strong social protection and lax monetary discipline.

“I was more optimistic coming out of the report than going into it,” Gill said at the European Institute seminar. At the meeting which involved, commentators -- Antonio de Lecea, Minister and Principal Advisor to the Delegation of the European Union in Washington, Nicolas Véron, Senior Fellow at Belgium-based Bruegel, and Dr. Angel Uribe, Director of Global Economics at Tudor Investment Corporation -- praised the report as a breath of fresh air about Europe.

The report makes a virtue out of many alleged vices in the European model. Indeed, Europe differs from the U.S. and China in key respects, including its unique degree of social protection. The relevant point, the report says, is that Europeans generally are ready to forego bigger incomes for improvements in their lifestyles, notably in the form of a better work-leisure balance. That trade-off, the report says, helps explain Europe’s quality of life, which “made it better to live there in 2008 than in anywhere else in the world,” with the anomalous exceptions of small oil sheikdoms. Another feature of the European model is that people there “expect more” of their business enterprises, in the sense of wanting them to invest for social results as well as profit. All these things are part of Europeans’ larger self-assigned goal of spreading prosperity from rich member states to poorer.

At the same time, Europe has distinguished itself by pursuing its own vision of economic growth; one that is distinct in stressing that growth should be multi-faceted socially and culturally and should aim at a better overall quality of life-- not just ever-greater quantities of goods and services. As a result, the model has produced a global brand, “Europe,” recognized worldwide as the trade-mark of the “lifestyle superpower. Europe’s  growth is “different from other countries’ in two respects, reflecting its cultural and demographic maturity…Europeans want growth to be smarter, kinder and cleaner  and they are willing to accept less for ‘better’ growth.” In other words, Europe has a “distinct” model for facing the twin current challenges of globalization and an ageing population. It would be wrong-headed and futile for Europe to turn away too sharply from its social model and historic roots. But to make their distinct model emerge as “distinguished,” Europeans need to make some changes – some fairly easy but others much more difficult. Can it be done?  Can Europe salvage its position globally despite some internal hurdles and in the face of the separate U.S. and Asian economic models with their emphasis on American innovation and Chinese manpower.  In the words of author Gill, there is every reason for European policy-makers to keep their nerve and work to turn the challenge into an opportunity

Within this general “European model,” EU member states function with varying national approaches.   For example, the education systems in France and Finland are both excellent, but very different from each other. The EU’s ability to conciliate such divergences within an overall common framework has made Europe function as what report describes as the “greatest convergence machine” in history, taking in poor countries and helping them become high-income countries. In and around the EU, neighboring countries have pacified their antagonisms and poor new member countries been helped to become comparatively rich. This “leveling up” in Europe has occurred across the continent on a scale unmatched in Asia or in Latin America, the report shows. Crucially, the differences in specifics – such as bank regulations or health systems – do not rule out the existence of a common approach to economic growth and social progress that is distinctly European.

The weighty but lucid and readable report on “Golden Growth” conveys a bottom line – that Europe has “a culture of maturity,” meaning that the countries of Europe have weathered much together and want to stay the course together. That insight is then tested with multiple metrics and comparisons that bring out the specific strengths and points to current weaknesses. As Véron commented at the Institute’s meeting, the report is valuable in affirming that there is a “European” economy but it is vital to move beyond that to address the hard-hitting conclusions about changes needed in labor mobility and the early age of pension entitlements.

But these benefits come with associated costs, some cumulative. For example, even the “culture of maturity” points to another truth about Europe: the change in age-balance in the population. Prosperity has permitted Europeans to retire younger and live longer and take more vacations compared to people elsewhere. The cumulative effect overcomes gains in productivity and, especially with Europeans having fewer children and poorly-managed immigration, the social security bill increases while government revenue from payroll taxes decreases. The result is increasingly unsustainable deficits. Similarly, if contemporary Europe often appears cautious about grasping new technological opportunities or making radical political departures, it is partly because the European consensus prioritizes social cohesion. This value itself -- “cohesion” -- has often seemed to blind governments to bolder changes designed assimilate minorities – a problem exacerbated in recent years when the costs of immigrant welfare have fueled social and ethnic tensions in most European countries.

In the report’s analysis, the EU’s triumphs – unprecedented regional integration, global economic influence and high living standards – correspond to three clusters of economic activity. Trade and finance have promoted integration; business enterprise and innovation have sustained Europe’s economic power, and regulations on labor conditions and governments’ relations with markets have ensured higher living standards.

In reviewing Europe’s problems and some prescriptions for recovery, the report avoids dealing with the specifics of the euro crisis and the issues of sovereign debt that dominate headlines these days. But keeping the focus away from the headlines does not detract from the value of the report, which stresses the need for Europe to remain sufficiently competitive to retain its identity. What this approach does omit, as pointed out by Veron, is any discussion about the institutional structures of the eurozone and the EU itself and the questions about how much more EU-wide economic governance may be needed.

Instead of focusing on the euro crisis per se, what the report does so thoroughly is get at undamentals which Europe needs to get right in order to find as sustainable place for itself between factory Asia and high-tech America. To do this, it explores three pairs of central economic functions for the EU -- trade and finance, business and innovation, labor and government – and finds that the EU performs well in the first pair, is mediocre in the next and fares poorly in the final two.

An outstanding strength of the EU for decades, and continuing today, is its performance in trade and financial flows. They have worked well in European integration, with investment flowing from richer member states to poorer countries, and in their development then feeds back to raise growth levels all around. “Europeans have finance or tradein their DNA, so they should never be counted out on in this regard,” Gill says. Improving this dynamic can be done fairly easily, he finds.

On the second point, the climate for business and the spirit of innovation work better in Europe than many outsiders seem to think. Britain, Germany and other northern European nations are success stories in innovation (thanks in part to information technology pioneered in the U.S.). The climate for doing business in these countries is among the best in the world. Northern EU nations in their own ways (for example, Britain is very different from the Baltics just as Norway is from the Netherlands) have developed business cultures that encourage entrepreneurs and attract foreign investors.  On this point more broadly – whether Europe has what it takes to keep its special place alongside Chinese manpower and American innovation – the report has a fascinating table that lists a score of key categories of economic performance (from debt reduction to innovation) and finds that Europe has at least one country that matches the world’s top performer in each and every category. For example, as a leader in value-added, the Slovak Republic ranks at the top of global bench-marking alongside Singapore just as Ireland developed a pre-crisis record in job creation on a par with New Zealand, the world leader. So, the report concludes,  these national best practices should be susceptible to spreading more broadly across the EU.

The Achilles heel of Europe today is the poor situations in two related categories: the labor market and government relations with business – particularly in the “south,” meaning Greece, Italy, Portugal and Spain. As Gill explains it, the EU economy can be viewed as three lanes of traffic, a slow-speed lane in Western Europe, a high-speed lane in formerly Communist Eastern Europe and a third lane,  the South – “where cars are going in reverse.”  This pattern is partly explained by recent history: the new democracies that emerged from Communism have been magnets for investment as Western Europe shifted its financing there. Privatization of state-owned industries offered ample opportunities in new democracies for investors to harness the unleashed energies of the Communist-educated workforce there. This opening diverted financial flows from the industrially-stagnating countries in the South of Europe, which share a common plight in their inability in recent years to increase productivity, especially in Greece and Italy, with Spain and Portugal only slightly better off.

The common problem of all these countries in “the South” is a business and regulatory climate that breeds “entrepreneurial midgets,” the report explains. Enterprises with fewer than 10 employees account for nearly half of the gross domestic product in these weak economies. (In comparison, other western European countries generate less than one-third of their gross domestic product from such micro-enterprises.) The “incentive” (actually the problem) that keeps privately-owned companies small in southern Europe is perverse: by staying small, they can stay off the official radar and hope to dodge taxes and duck labor rules. But there is a cost to the economy and job market: by staying so small, these enterprises cannot accumulate the resources to scale up and compete in Europe’s single market. So German products enter the Greek market, but few Greek companies have the critical mass to innovate their own competitive products and then market them as exports to Germany or other EU countries, much less to the wider globalized market. In other words, the familiar mantra -- “small businesses are the engines of job growth” -- does not apply in situations such as Greece where companies are kept too small to capitalize on their assets.

Broadly, these stagnating economies in southern Europe, where weakening productivity was masked by cheap euro funded credit, all suffer from two problems.. On the labor side, rigid rules of seniority and job protection function to keep older workers in their positions and keep out young people. Without jobs, these young people draw unemployment benefits worsening government debt.

On the government side, the bureaucracy itself has become part of the problem. In northern Europe, even if governments are “big” as a part of the national economy, they work effectively because of low corruption, high mutual trust and efficiency in delivering public services. By contrast, in southern Europe, governments are generally too ineffective to justify their size and therefore are a burden on the economy, absorbing capital, distorting business decision-making and helping create an uncompetitive work force. Throughout these countries, regulatory red tape, dysfunctional tax systems and corruption work against entrepreneurial growth and fail to create a pro-business climate that can attract foreign investment. These inter-linked problems – government barriers to foreign investment and business growth, on the one hand, and rigid labor markets, on the other, are the core of southern Europe’s plight and a pivotal issue for the eurozone, of course, because countries that can no longer devalue their currencies have few other levers to make adjustments to falling productivity. The main remaining levers are austerity (widely applied and widely unpopular) and labor mobility (improving, but hard to do across Europe’s language barriers). This World Bank analysis highlights the importance of restructuring, especially in the labor marketplace, as a key to recovery and growth. Heroically, Italy’s Prime Minister Mario Monti has grasped this political nettle and launched an assault on his country’s fossilized rules against firing workers. Privatization and steps to force closed professions (from taxis to pharmacies) to open up to competition are part of this same approach to restructuring being tried across Europe. As encapsulated at the Institute’s discussion by Angel Ubide, the question is how can Europe maintain its standard of living and growth. “You have to spend better, not necessarily less…[but] this implies breaking special interests and breaking traditions that have been entrenched for ten years.”

The decade Ubide referred to is of course the lifespan of the euro, which he acknowledged has made many Europeans complacent. As the problems of the European model crept higher, screened for a decade by euro-optimism, the conventional quick explanation of the EU’s financial deficits has been “over-spending on social protection.” As illustrated by the Economist magazine in its review of the report, while America has become the hard-power superpower by spending almost as much on defense as the rest of the world put together, Europe has become the lifestyle superpower by outspending the rest of the globe on social benefits.  .

But that general point obscures the actually question about misallocations of investment in public goods, according to the report, which finds the operative point in the details of social spending. Actually, it finds, “European states are not big spenders on either health or education…the reason why Europe [especially the South, the biggest spender in the EU] spends more than its peers on public pensions…is largely because of easier and earlier eligibility for pensions.”  In other words, the reason for Europe’s ballooning social protection is not primarily its ageing population or the amount of its pensions, it is because, with postwar prosperity, European countries have gradually taken too much time off for leisure. Over the years, it has become an entitlement to work fewer hours a week, take more holidays per year and retire younger. As Gill explains, “you can do two of these things but not three” if you want to maintain productivity and competiveness. In other words, Europeans have allowed the benefits of prosperity to get ahead of their productivity growth. So more work is needed to keep up, perhaps best found by raising retirement ages so workers continue to produce, continue to contribute payroll taxes and delay drawing benefits.

So, Europeans, starting with Greeks but including most of the rest, are going to have to stay at work for many more years. Even then, given low birthrates, the workforce will decrease. So Europeans will have to rethink their immigration policies. “Today the debate is about how to best manage migration from North Africa. Tomorrow’s debate should be about the policies and practices that will make Europe a global magnet for talent,” according to the report. Young immigrants will be vital not only to compensate for an ageing population but also for innovation and international diffusion of European innovations in the service sector.

Assuming that Europeans have the political will to make such changes, the outlook for success in restoring Europe’s position is good. “These reforms are feasible …and are already being implemented in some countries,” according to another commentator at the Institute’s session, Antonio de Lecea of the EU Delegation in Washington. “In innovation, Germany and the U.K. rival the U.S. and Japan.” For closing productivity gaps, he quoted the report as citing Sweden, Finland, Denmark and Germany as showing what works and what can be replicated across the EU.

Indeed, the report said, countries such as Austria, Denmark and Ireland have adapted the European model of work and income so that security is combined with flexibility in hiring and firing to foster both efficiency and equity. Still, for most of Europe, imbalances between work and leisure need to be corrected. (Switzerland early this year voted against a plan to increase annual vacations by two weeks.) European societies will have to modernize social welfare systems so that disincentives to work are minimized. Denmark, Germany and Ireland may inspire others how this can be done, the report noted. Its final word on reform: “What needs to be done is not hard to see: Europeans will have to work for more years.”

All these changes, not only pension entitlements but also fixes to deregulate labor markets and business monopolies, will take time, especially to turn around deeply-indebted countries.  As grounds for optimism, the report cites European countries’ post-war record of mutual generosity and solidarity. If that spirit is maintained, Europe can gain the breathing space necessary to adjust social policies and surmount the EU’s biggest-ever collective crisis.

 

European Affairs