May 2, 2004

Jury out on 'super' Europe

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What does the future hold for Europe? Will it be a great, democratic, vibrant continent providing security and prosperity for all its citizens?


Or will enlargement do for Europe what reunification did to Germany?

This is a huge question that is not being addressed at all this weekend as the great multilingual jamboree kicks off in Dublin.Will the east be a blooming or a blighted landscape? Will it be denuded of its best and brightest?

Will we be paying for four-lane motorways in and out of Bratislava before a dual-carriageway  links Dublin and Cork? Culturally, what difference will 40 million Slavs make to Europe’s view of the world?

Let us analyse this on three levels: economics, philosophy and politics.

Economically, there are numerous blueprints for enlargement, ranging from Ireland’s accession in 1973 to the disastrous reunification of Germany in 1990.

It is worth reflecting on the unfortunate East German example, because it combined the overwhelming popular expectations with underwhelming economic fundamentals.

Ultimately, this led to a bitter experience both in the east and in the west. The former laboured under double-digit unemployment, while the latter was burdened by ongoing transfers of subsidies to keep the political lid on the former Communist statelet.

Productivity was the main economic problem for East Germany in the 1990s, just as it is for the rest of the accession countries today. Productivity measures output per worker, and is a function of a variety of things such as skills, technology, knowhow, systems and perspiration as well as inspiration.

Productivity holds the key. For an investor, productivity determines the return on equity. The h igher the productivity in a country, the higher its profit margin. Investment will flow to the country, region, industry or company with the highest productivity.

Productivity is also crucial for the worker, because it sets the wage rate that can be paid in that country. Again, the higher the productivity, the higher the wage payable.

For the economy in general, the level of productivity determines where the exchange rate can be, the level of interest rates and the trade balance. Put simply, productivity measures the amount you make, and so the amount you consume (if prudent) should also be determined by productivity.

If you consume more than you make, you will have to borrow the cash.This is a crucial issue for these developing countries, because they must get their productivity levels up if they want to compete. If their productivity levels remain low, they will be condemned to selling off their prize assets for a song.

At present, the gap between the west and the east is startling. For example, in the EU today, the average worker produces €57,000 of stuff per year. In Poland, the corresponding figure is €17,000. So the average Polish worker is more than three times less productive. It will take a long time for this gap to narrow.

In the meantime,the accession states, all of which have floating currencies, will be subject to repeated currency crises. Why? Because, they will spend more than they earn in the next few years, and this will cause their trade deficits to rise.

The bigger the trade and current account deficit, the bigger the risk that their currencies might have to devalue to make their companies competitive.

The problem with this is that their interest rates will have to rise to protect the currency. The higher the domestic interest rates, the slower the growth rate, and the slower the growth rate, the more the currencies look overvalued.

Don’t take my word for it, listen to George Soros, the Hungarian financier whothis week warnedof repeated speculative attacks on currencies. In fact, Hungary is a good example of what is likely to happen elsewhere.

The average Hungarian worker produces €17,000 worth of stuff every year, but buys over €19,000 worth. So Hungary has a current account problem. The country needs to borrow to pay for this profligacy.

Not surprisingly, Hungarian interest rates are 12 per cent. At 12 per cent no one is investing enough (apart from the Paddies buying property). A large fall in the currency is highly likely in the next few quarters as currency speculators bet that the government cannot rule with such high interest rates.

The speculators reckon that the only way to force interest rates down is a much cheaper currency that will boost exports and rein in some of Istvan’s more conspicuous consumption. Once the Hungarian forint goes, the markets will turn on the currencies of better-run economies like Poland and the Czech and Slovak Republics.

Quite apart from the currency dilemmas, the ongoing migration of the best and brightest will hollow out the productive capacity of the accession countries. If you want to get an idea of what the accession countries might look like in their first 20 years of EU membership, look no further than Ireland from 1973 to 1993.

In hindsight, it is hard to believe we screwed things up so badly. But despite, or maybe because of, European handouts we embarked on what can only be described as an economic suicide pact leading to stagnation and emigration.

The source of our economic dilemma was a search for a quick fix for our productivity problems. In 1973, our productivity relative to Germany was similar to that pertaining today in the accession countries. Low productivity meant low levels of wages and employment. Taken together with the freedom to move, this meant high levels of emigration.

In an effort to rectify this, governments tried all classes of policy tricks to shortcut the way to higher productivity. Nothing worked, and we spent two decades taking one step forward and two steps back. Expect something broadly similar in the accession countries.

Therefore, for cyclical and structural reasons, the euro will have to weaken before and after these countries join full EMU to take into account the productivity deficit of Eastern Europe. Meanwhile, as expectations are high, it is highly likely that fiscal transfers from us to them will become the norm.

It will not be as bad as East Germany, because the transition has been going on for some time now and will continue to proceed at a gradual pace. But it is hard to see the blooming landscapes envisaged by some.

Quite apart from economics, there is very good reason to worry about the schizophrenic philosophical disposition of the new Europe.

Let us take a bit of altitude here. Ireland can be reasonably accurately described as having European international politics and American economics. Most are against the war in Iraq, but vote in favour of lower taxes.

New Europe has the opposite outlook.They support the Americans in international politics, but vote for higher state spending and higher taxes. This will inform Europe’s view of the world, and will also solidify the high-tax, statist bias in Europe’s economic policy.

Until the Eastern countries get over their understandable fear of Russia, and historical mistrust of France and Germany, a pro-American international view will prevail.

The Baltic countries in particular will use the corporate tax system to attract capital, so we should expect intensive Irish-style beggar-my-neighbour tax competition for inward capital.

An even bigger question surrounds whether big intra-country blocs such as the EU are the way of the future. In the past 10 years the English-speaking countries, along with small independent states, have all experienced growth rates far in excess of those in continental Europe.

There is a body of opinion that suggests that due to technology and communication networks, we do not need large blocs to advance our economic interests. The future, this school believes, will belong to small, nimble trading states – similar to medieval city-states – like Ireland, Singapore and Hong Kong.

This would imply a move away from pooling sovereignty. Small states like the Baltic countries might just be joining the EU at the wrong time, because their latitude to manoeuvre will be limited.

So the future for Europe is far from clear. Behind all the razzmatazz of this weekend lie some very serious questions that have yet to be addressed fully. Eastern Europe in 2009 – a blooming landscape or a barren wasteland? The jury is still definitely out.