Catching Up with the Rest of Europe: Challenges and Opportunities from the EU Enlargement

The timing for this seminar is very appropriate because Europe has been in the headlines for quite a long time, especially after the enlargement this May. In the last month Europe really hit the headlines because of the problems with the newly nominated commissioners and it looks like that deadlock might be solved soon, but we are still really stuck. The new commission, which was supposed to be in office on November 1, was withdrawn a few days ago. The disagreement was about the commissioner nominated by the Italian government, but that was a sort of pretext because something was going to happen between the European Commission and the European Parliament as there had been conflicts for quite a long time between them.

I am citing this episode to say that Europe is really at a turning point at the moment and needs to reform and rethink the way some of its institutions work in order to be ready for the new challenges ahead. In particular, Europe now is a sort of monster, with 25 member states, which are likely to become 27 in three years' time when Bulgaria and Romania are due likely to join. It has become a huge institution with serious problems of governance because in some respects, a lot of the rules were set more than 40 years ago when only six states (France, Italy, Germany, Belgium, Holland and Luxembourg) created a free trade area. Therefore, Europe has to rethink the way it functions, particularly how to reconcile the elected European Parliament and the unelected European Commission, which increasingly reflects the interests of national governments. In addition to economic and structural reforms, this is something that should be faced.

The feeling is that things could go terribly wrong and the whole European project might implode because of these internal tensions. We are really at a turning point and we need to think about what to do next in order to be ready for the future challenges, with the big challenge being for Europe as a whole to become a global economic power in 30-40 years' time.

Looking at the 2004 enlargement, it is certainly a milestone in the history of Europe and the end of a long process that started in 1989 with the fall of the Berlin Wall. Soon afterward, the Eastern European countries that were under Soviet influence became independent and, in May of this year, became part of a wider Europe. The significance of the 2004 enlargement is largely political because it is the end of a reunification process. Incidentally, of the 10 countries that just joined, eight are in Eastern Europe and two are Mediterranean islands (Malta and Cyprus). But in my talk I will refer only to Eastern Europe.

Despite the large political significance of the enlargement, the economic impact is quite marginal, especially in the short and medium term. The difference in the level of development between Eastern Europe and the "old" European Union is very large, but there are some other differences as well. For example, you are probably aware that the main economies of the old EU (France, Germany, and Italy) have a problem in that they are stuck in a very low growth pattern. In particular, the euro area, which in principle should have all the advantages of a free trade area and currency union, has performed rather unsatisfactory - with a very modest growth rate no higher than 2% on average in the last 12 months - and it does not look set to grow substantially faster in the future.

The new member states, in contrast, consistently outperform the old EU, with an average GDP growth rate above 3%. This is partially explained by the fact that they are catching up with the EU's most developed economies. As a result they have more dynamic economies, which have benefited from the long process of enlargement that began when they first applied for membership. One of the advantages of this enlargement is more trade integration. The trade integration index of Poland, for instance, increased from 19 in 1995 to more than 30 in 2003. Also, Germany (1995: 20; 2003: 28) and Austria (1995: 24; 2003: 35), which border the new member states, have seen their trade integration indices rise significantly.

However, although the new member states have potentially very dynamic economies, they are too small to make an impact on the EU as a whole. But when we consider the new enlargement as the addition of 10 sovereign states, it increases the problem of EU governance immensely. Yet, in terms of the potential size of this market, the population of all these countries put together is still smaller than the population of Germany. Therefore, they have less potential to make an impact

Furthermore, this enlargement has brought in countries that are remarkably poorer than the rest of the EU. In terms of GDP per capita, they lag behind the old EU. For example, the Czech Republic, one of the strongest of the new economies, in terms of GDP per capita, is well below Greece, which is the poorest member of the old EU. Also, agriculture still constitutes a significant sector in these countries.

Another interesting comparison is to look at the other enlargements, especially involving countries at a lower development level than the rest of the EU; for instance, the southern enlargement (Greece, Spain, Portugal) in the 1980s of what was then the European Common Market (the six original members plus the UK, Ireland, and Denmark). At that time, the GDP per capita of the southern countries was about 65 (taking the EU 9 to be 100). In contrast, in the new Eastern European countries, the index is 38, against 100 for the EU 15. This shows that the poorest countries of the EU in the south, when they joined, had a level of GDP, relative to the EU average, twice that of the Eastern European countries today. Moreover, Greece, Spain and Portugal have obviously improved since joining, but the improvement has not been that remarkable considering the amount of EU funds that was poured into those countries over the last 20 years. A satisfactory level of development has yet to be achieved, and using EU funds to promote development has proved rather inefficient. One of the resulting features of the new enlargement is that the amount of funds from Brussels will be much lower compared to previous expansions, partly for political reasons.

The question then becomes how long it is going to take to bring these countries to the level of the EU average, and whether the growth rates will be high enough to close the income gap reasonably soon. Using a simulation model for the four biggest markets in Eastern Europe, disregarding regional differences and that a larger, stagnant Europe might be detrimental rather than advantagous; and comparing our Chatham House forecasts with those of the Economist Intelligence Unit, we project it will take between one and three generations to close the income gap. This is quite a striking result because a lot of decision- and policy-makers have not yet fully realized how long convergence may take.

The next question is how we can actually help these countries develop faster, and how they compare to such countries as the "BRICS" (Brazil, Russia, India, China), the biggest and most promising emerging countries. The long-term scenario clearly shows that the BRICS are likely to be much more dynamic than Eastern Europe because they have a big size advantage - that is, a big potential market and many natural resources. However, being a big country is not a necessary condition for rapid development, as illustrated by the case of Ireland: When it joined the EC in 1973 it was a backward country but it now has a GDP per capita well above the EU 25 average. For 20 years nothing happened, but during the 1990s Ireland enjoyed remarkable development, helped by a good mix of macroeconomic policies, geographical and cultural proximity to the U.S., the spillover effect of the strong boom in the U.S., and the fact that it was a small and open economy with a well-educated labor force - all of which led to increased FDI and a virtuous circle of higher growth.

In terms of the necessary factors (size of the economy, wages, competitiveness, trade advantages, and others) for FDI, we can see that the BRICS have the size and low labor costs, while the EU 10 scores well in terms of wages and competitiveness, but lose ground otherwise. One result of the integration is that wages in Eastern Europe will slowly adjust to those in Western Europe and the Eastern Europeans will move up the value chain, with more focus on high-value production rather than labor-intensive and traditional manufacturing.

If Eastern Europe does not have the capacity to move up on its own, the role of policy, domestically and at the European level, becomes to accelerate the development process and to stabilize the economy; to adjust current account and public deficits, to improve productivity, to create a favorable business environment, to attract FDI, to generate domestic capital formation, to improve cross-border trade, to attain full labor mobility and, importantly, to increase labor market participation rates.

In the future, I do not expect to see the new EU member states repeat the "Irish miracle." Their big strength lies in being part of Europe. What I see in the decades ahead is a shift in economic power where size will matter more, with big countries becoming the dominant economic powers. This does not mean that you cannot have successful small, open economies such as Ireland, Switzerland and Singapore, but they are not going to be the countries or even regions that are strong decision-makers at the global level. This trend can already be seen in the G-7/G-8, IMF and World Bank. These institutions were founded 60 years ago when the global scenario was completely different, but now they themselves have to go through a substantial revision of their governance because they have countries at their doorstep asking to join, especially China.

The big challenge for Europe is to be in the driver's seat of this economic power shift, which I see being occupied by the U.S., China, possibly Russia (if it is able to solve its institutional and democratic problems), perhaps Japan, and Europe (rather than one of its constituents). I do not see France, Germany, the UK or Italy in the driver's seat in 40 years' time because they are too small, have big demographic problems, and are mature economies. The chance for Europe to be influential, therefore, is to be a big integrated area. Otherwise, these countries are likely to become irrelevant.

To conclude, the challenges ahead are reforms, with a good mix of macroeconomic policy. At the moment, there is the Lisbon Agenda, currently under revision, and the Stability and Growth Pact of the monetary union. There is also a need for reform of the European Central Bank (ECB). The debate currently is polarized between those who want to give more power to Europe and to make sovereign states less autonomous with more rules and non-compliance sanctions on the one side; and on the other side, with the UK as its most prominent representative, those who want the national states to have more power vis-a-vis Brussels. I believe the debate should focus more on which policies are compatible with the needs of each national economy in the context of a larger union and economic area.

Considering further enlargements ahead, a really hot political issue involves the Balkans, which still have a lot of ethnic tension and are remarkably poor. Most pressing and the hottest topic of all, however, is whether Turkey should become a member of the EU. This is really something for the future. I do not really think Turkey will join any time soon and the most plausible and earliest date, if at all, would be 2015.

Q: Given the long period of time required for the enlargement process, from the economic point of view, there is a time inconsistency, especially considering the fiscal situation and the introduction of the euro. From now, how do you evaluate this time inconsistency, in particular in terms of monetary, fiscal and labor market policies? Also, if an integrated political or legal framework is implemented, which might increase, for example, the fiscal burden, how do you think these countries will solve such time inconsistencies?

A: On the monetary union, one thing the new countries have to face is that they do not have the opt-out; so they need to start the conversion process to the euro as soon as possible because they are still very far behind in terms of the Maastricht Treaty criteria due to high inflation and large budget deficits. No date has been set yet and EMU membership is not likely to happen before the end of this decade. But we have to start thinking about it reasonably soon or risk losing momentum.

The focus thus far in the policy mix has been on structural and labor market reforms. One thing we are researching at Chatham House is whether we should move to a different mix, leaving aside the budgetary problems of many European countries, and move toward a more relaxed fiscal policy and a tighter monetary policy. A more relaxed fiscal policy should stimulate domestic demand

The legal framework to be implemented in areas such as environment, I am not able to comment on. It is certainly a big burden under the current budgetary situation and adjustments have to be made. This will take a while because there are political issues involved. It is not clear how countries will cope with that. On the other hand, there will not be strong pressure to implement a legal framework.

Q: You stressed the importance of size, but thinking about Siberia in Russia, or other large countries, is there not a big risk or cost associated with a big enlarged region?

A: The fact that you have a big country does not mean that all your territory is very useful. When I say that size matters, I am thinking in particular of integrated regions as the important variable for Europe as a region in terms of economic integration. It seems to me that the trend now, even in Asia, is toward more integration of regions and areas, without necessarily moving toward political integration. This is something that is strongly resisted in Europe. As was obvious from the debate about whether or not to support the U.S. military intervention in Iraq, Europe does not have a common foreign or defense policy.

Q: In economics, you say "economic power" to mean the goal of your policy or its motivation, rather than economic welfare of the people. Can you comment on this?

A: I do not think it is the goal, but rather a scenario. What I want to suggest is that if Europe means to remain influential in the global scenario, the main goal, of course, is to close this income gap. However, as a sort of provocation, because things are changing faster than policy-makers realize, Europe is still inward-looking at the moment. Therefore, the world has become a much more open place and the risk is for Europe to lose ground at the expense of the welfare of its people. Europe, as a group of countries that shares common goals and objectives, has to reform and think ahead boldly about long-term scenarios.

Q: I suppose that in order to achieve common goals and objectives, as was done with the common customs and agricultural markets in 1968, it will take some time. There must be some provisions in the accession agreement of those countries to the EU about how to make their economic rules and regulations compatible with those of the EU?

A: I think we have to consider that it takes considerably longer than a lot of people think, and the reasons are mainly political. It has become very clear that the old EU is not prepared to put the same amount of funds into these countries as they did before.

Also, the big question is about what the advantages of joining are in the end. The EU 10 got into the EU with pretty unfair and tough conditions. At the time of the accession of Greece, it was very easy and the country almost set its own conditions. The requirements now set for new member states are really tough and will continue to get tougher. Even Bulgaria and Romania are experiencing tougher requirements than the countries that joined this year. If we ever come to the point that Turkey is eligible, the requirements will be absolutely massive. For example, Hungary benefited quite a lot from FDI, but one of the requirements set by the European Commission was for Hungary to get rid of all tax advantages not in line with those of the EU. The flow of FDI in Hungary decelerated because of this. So at the end of the day, benefits must be weighed against the costs. Furthermore, citizens of these countries do not enjoy full labor mobility, as was permitted for citizens of old EU member states, because of strong pressure from public opinion in several countries against the poorer people from Eastern Europe.

Q (from Subacchi): How do you see Japan in the decades to come? Does it still have the capability to compete on the global scene, on its own or as part of an integrated region?

A: Based on the history and discussion of the EU, here in Japan we have also been discussing among economists, industry and finance people, how to implement such experience in Asian economic integration, especially with discussions between Japan, China and Korea, for example, to create some artificial basket of currencies. From my point of view, because of the differences in economic development in these countries compared to the old EU member states, I think that such efforts on a micro basis will improve integration.

A: I think Japan will maintain a certain level of influence in the economic and technology areas because it has always been a developed economy, even before it opened its market to the West in the 1960s. However, the challenge is the declining birthrate and aging population. In the area of security or defense, how to keep a check on the U.S. as a superpower and make China a friendly member of the international community are the common challenges of developed countries. I think Japan can share the leadership in Asia since it has its own strengths, though not necessarily in terms of population or military, but to what extent I do not know.

A: I do not know whether Japan has an interest in the future toward regionalization, because it may benefit most from an enmeshed globalized world. For Japanese companies, the European market is the hardest region to penetrate and even if Japan becomes part of an integrated Asian region, I do not know whether Japanese companies will benefit from that. The worst scenario would be to form three regions, Europe, Asia and America, but I do not think that will be the case.

Q: With regard to the legitimacy of the European monetary union, up until now, the growth rate of the euro area has been lower than that of the non-euro area. As a founder of the euro [being Italian] how do you convince people inside or outside about its benefits?

A: I am a national of a founder country, but I work in a euro-skeptic country. Even europhiles are critical. But the difference in growth is explained by the strong growth of the UK economy, partly because it is on a different cycle compared to the rest of Europe and the U.S. This was one of the main arguments that the chancellor of the exchequer in the UK used last year to explain why the UK should stay outside the euro area and, for the time being, should continue to stay out. The UK has a very well-developed financial market and financial services, while continental Europe is different.

This is why one of the requirements and features of the monetary union is its centralized monetary policy, which is run by the European Central Bank. A big difference between the UK and continental Europe is that in the UK, changes in monetary policy or interest rates quickly affect the economy. If consumption demand is overheated and there are inflationary pressures, you can use interest rates to calm things down. Europe is different because changing interest rate levels at the ECB does not have the same impact. Until the economy in the UK is more in sync with the rest of Europe, it is better to stay out. In the long term, I personally believe that, assuming the monetary union goes ahead, the UK will have to consider its position.

In terms of advantages, the monetary union was much better for Southern Europe than for Northern Europe because the monetary union imposed a very strong discipline. And for countries such as Italy, Spain, Portugal and Greece, with a long tradition of double-digit inflation and huge public debts, the situation improved. There were also some obvious costs. .

Q: How do you maintain discipline while the big founders of the euro are talking about relaxing the Stability Pact?

A: This is a big issue, and one thing to bear in mind is that the monetary union is still in its early days. We have to allow for adjustment and changing of policies. Germany strongly wanted the Stability Pact as a way to put a straightjacket on Italy at the time. Then Germany realized that it was not in the right position to be in the monetary union itself, because the rules did not allow scope for cyclical downturns or take into account the underlying budgetary position. Only a couple of years ago it became clear that a country such as Italy with a deficit below 3% but a debt of over 100% of GDP should be treated differently from Germany, which has a higher deficit but a much smaller debt. The view that the Stability Pact is not a one-size-fits-all policy is now common. That is why policies have to be made compatible with the state of each nation's economy, as well as with that of the whole union.

For example, Portugal became the first country to overshoot the deficit level of the Stability Pact in 2002. The Portuguese government was keen to comply with the Stability Pact's rules and tightened its fiscal policy. As a result, the economy went into a recession. But Portugal is a small country and its economic weight in the monetary union is marginal, so there was no effective cost for the union as a whole. However, when the time came for France and Germany, these governments said they were not going to comply with the rules. This was a sensible decision in economic terms because the tighter fiscal measures needed to adjust the budget deficit to the 3% level of GDP as required by the Stability Pact would have jeopardized the economic recovery and triggered a recession in Europe as a whole. It was, however, badly handled politically as they gave the impression that they could disregard the rules, being the EU's biggest countries. Through this, the realization arose that you need more flexibility.

Q: I do not think that the monetary union fulfills the conditions of an optimal currency area because it lacks labor mobility. The euro, rather than uniting countries, lays the basis for arguments and dispute. As an ideology it is good, but how about the reality?

A: As I said in my conclusion, now is the time to move on and do something different. There is too much conflict and dispute because while the political cycle by definition is short, reform is difficult because the benefits it brings come mostly in the long term. No politician can bear the cost of something which will only start to deliver results in the next decade.

It is not a perfect currency area; it is still an experiment and it is still developing. However, in terms of labor mobility, with the high unemployment rate in Europe, especially among the younger generation, they are, out of necessity, more mobile. In time, we will increasingly see a well-educated young labor force speaking a common language and working together. Therefore, we have to look at the EU as a long-term project.