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European Affairs
The European Economy
A More United Europe is Growing Economically Stronger
Arnout H.E.M. Wellink
President, De Nederlandsche Bank NV
With U.S. economic growth declining from the extraordinary peaks of recent years, the key question asked by international economists is this: will Europe be the white knight that rescues the world economy from a slowdown?
The background is certainly encouraging. Real Gross Domestic Product (GDP) in the euro area grew by 3.4 percent last year, the highest rate of the past ten years. The European Central Bank (ECB) has succeeded in keeping inflation low and stable, and in each of
the last three years employment has grown faster than in the United States. As a result, euro area unemployment fell from 11.6 percent in 1996 to 8.4 percent in March 2001. High fiscal deficits have been eradicated.
In at least two respects, the euro area is currently less vulnerable than the United States. First, Europe has a positive personal savings rate, which serves as a buffer against unexpected contingencies, such as a sharp fall in share prices. With a negative personal savings rate, as in the United States, shocks in equity prices may have relatively large effects on consumer expenditure and hence on economic activity.
This is all the more so in that shares are more widely held in the United States than in Europe. In 1999, the average American family owned equity worth 174 percent of its disposable income, roughly twice the German figure.
Second, and connected to the first point, Europe's current account position is stronger than that of the United States. The U.S. current account deficit has reached a record four percent of GDP, reflecting the increasing dependence of U.S. business investment on foreign sources of finance.
As a result, a switch in international investor confidence away from the United States is likely to cause a further slowdown in economic activity and lead to a downward spiral in the value of the dollar. We do not see this right now, but it has happened before.
This is not to deny that the current U.S. slowdown will affect Europe. It is still true that Europe catches a cold when the United States sneezes. Although direct trade links are limited, other channels are more important.
In today's global economy, disturbances on U.S. financial markets have a significant impact on their European counterparts.
A decline in U.S. economic prospects will also undermine European producer and consumer confidence.
All in all, euro area GDP is expected to grow roughly in line with potential in 2001. Nevertheless, since imports of goods and services count for only about 16 percent of euro area GDP, it would be misguided to think that Europe could be the sole power engine for the world economy. A buoyant global economy requires healthy growth in both Europe and the United States.
The euro area, which now includes 12 of the European Union's 15 members, is in many ways comparable to the United States. The euro area, with 300 million people, has a larger population than the United States, with 270 million. But the U.S. share of world GDP, at 22 percent, is bigger than the euro area's 16 percent. On the other hand, the share of the euro area in world exports is 19 percent, against only 15 percent for the United States
In spite of monetary union, economic diversity across the euro area has not disappeared completely. Growth differentials between countries have been more or less stable over the last decade; inflation rates have converged in the run-up to monetary union, but have diverged somewhat since.
Divergences in Europe attract much more public attention than do regional differences in the United States. This is striking, since in fact economic differences across the United States do not vary greatly from those across Europe. Admittedly, the dominant position of large member states in Europe has no parallel in the United States.
Germany accounts for 32 percent of euro-area GDP, France for 22 percent. Taken together, the three biggest states, California, New York and Texas, account for only a modest 28 percent of U.S. output. On the other hand, the euro area's smallest member, Luxembourg, accounts for roughly the same of total GDP as small states like Vermont, South Dakota or Maine.
Consider another example. In Europe, the Finnish economy relies largely on only one sector, telecommunications, while Texas is heavily dependent on oil. Such differences in economic structure can cause differences in cyclical patterns among regions, both in Europe and in the United States. They also explain differences in exposure between regions to economic shocks, a phenomenon well known in the United States.
Perhaps economic divergences in Europe attract more public attention than in the United States because the euro area has such a short history. Or maybe divergences in Europe catch the eye because we are used to thinking about economic divergences in terms of sovereign countries. Both answers probably contain elements of truth.
But there is another reason why regional divergences in the United States are less noticed - they tend to cancel each other out in the medium term. It is common for a U.S. state to have inflation and economic growth above the federal average in some years and below it in others. Only two years after the establishment of monetary union, we do not yet know whether this will also be the usual pattern in the euro area.
One reason why U.S. states do not diverge persistently from federal trends is that equilibrium is restored by economic mechanisms, such as labor market flexibility. If there are lay-offs in one part of the United States, people tend to move to other, more buoyant regions. Every year, more than two percent of the American population moves to another state to find a job. Another such mechanism is income transfers by the federal government.
In Europe, redistribution mechanisms that might absorb shocks on an interregional basis are less developed. Labor mobility is limited, even within countries. Fiscal transfers between countries would be politically difficult to implement and lack public support.
In addition, the current European Commission budget is very small in comparison to the U.S. federal budget, and certainly too small for significant fiscal transfers. Instead, the European system relies much more on the absorption of shocks within individual countries. This works through automatic stabilizers in national budgets, which are large in comparison with U.S. state budgets.
According to the European Stability and Growth Pact, member states must keep deficits below three percent of GDP. They should run fiscal surpluses in boom years in order to allow for possible deficits during economic downturns - over the cycle, budgets are required to be in equilibrium or in surplus. In the European context, the pact is a much better mechanism for smoothing divergences than income transfers between countries.
An important consequence of monetary union is that varying national monetary policies and national exchange rates can no longer cause divergent business cycles or inflation differentials. Until the early 1990s, interest differentials and, more importantly, exchange rate disturbances often caused economic divergence.
In the run-up to monetary union during the second half of the 1990s, more uniformity emerged. In 1999, a single monetary policy was established that took away these potential causes of regional divergence. From 1999 onwards, the ECB has aimed at low and stable inflation in the euro area as a whole.
The single monetary policy is not in a position to influence the dispersion of inflation rates across the euro area. The ECB, however, is aware of inflation and growth differentials. Large economic divergences could undermine public support for a single monetary policy, as they would make a "one-size-fits-all" policy less appropriate for some parts of the area.
Again, as in the United States, a second reason for our interest in regional divergences is that they can provide early signals of area-wide developments. In this respect, there is no major difference between the ECB and the Fed. The Fed reports regularly on U.S. regional developments in its Beige Book.
The fundamental difference between the euro area and the United States concerns market flexibility and economic stability. The European model has benefits associated with greater economic stability for economic agents than in the more dynamic U.S. economy, as a result, for instance, of the more generous European social safety net.
The European way, however, comes at the price of less flexibility. The American model, for example, is better adapted to integrating new technologies. The major challenge for Europe is to increase market flexibility without risking the benefits of its current system.
European economic structures are improving. On January 1, 1993, Europe created a single market. A common monetary policy came only six years later. Budgetary discipline has improved considerably over these years.
More recently, Europe has abolished most barriers to competition in the telecommunications and energy sectors. Reforms are under way on a broad front. For example, at the Stockholm summit of EU heads of government in March, new steps were announced to make Europe more competitive and knowledge-based.
Several initiatives relate to removing obstacles to labor mobility between European countries. The most practical step forward was the agreement on proposals prepared under the chairmanship of Alexandre Lamfalussy aimed at removing the last hurdles to a fully integrated European capital market.
Subject to the energetic implementation of structural reforms, especially in the field of labor markets and social security, Europe will be able to benefit more from new technologies, and trend economic growth will increase.
Many countries in Europe are showing encouraging signs that progress on structural issues is under way. In France, for example, flexible work schedules have recently been introduced on a broad scale. The government has reduced the state's stake in banking, air transport and telecommunications. France has also taken a first step in lowering the fiscal burden with a reduction of one percentage point in Value Added Tax last year.
There are also developments that point in another direction, for example recent government plans to double redundancy pay by employers. But, on the whole, France has moved from a vicious cycle of high unemployment and welfare charges to a virtuous growth cycle.
Taking a broader view, one can say that the EU's coming enlargement to include Central and Eastern Europe bolsters prospects for structural reform. It is difficult to imagine that enlargement can occur without reforms leading to lower agricultural subsidies, fewer transfers from so-called cohesion funds and more efficient social security systems.
This is all the more true in that our policies, in contrast to U.S. policies toward Latin America, are aimed at full integration of our neighbors into the EU. The new member states, however, must realize they have to bear the main burden of adjustment.
In order to enter the EU, they will have to adopt European legislation and to implement EU environmental standards and so forth. When they subsequently prepare to join the monetary union, they will have to continue the adjustment process in order to converge with the standards of the euro area. This could take several years after EU entry. Nevertheless, the potential for structural reform and, therefore, for additional growth is immense.
Monetary union in general is working as a catalyst for more cooperation on economic policies. Tax structures are moving closer together across the euro area, and the euro area Council of Ministers of Finance has an unprecedented power to fine member states with excessive budget deficits. This Council can also make recommendations to member states with economic policies that are inconsistent with broad policy guidelines, as they did recently to Ireland.
With closer European cooperation on monetary and economic issues, it is natural that cooperation on other policies will increase, too. There is no ultimate goal, however, for closer political integration. Some dream of a United States of Europe, even though Europe will not be ready for this within the foreseeable future. Others talk of a United Europe of States.In any case, there is a growing understanding among European political leaders that Europe cannot develop faster than the people want. As I see it, from time to time this can mean that there is a pause at the current level of integration. But there is no moving backward.
As things stand, we have to be realistic and focus on issues that have to be resolved at relatively short notice. The main issue now is how to deal with the implications of enlargement for our decision-making processes.
If we want to have both enlargement and closer cooperation on particular issues, we will need pioneering groups of member states that move closer together on those issues. That is unavoidable, whether you call these groups "centers of gravity" or "avant-gardes," as former Commission President Jacques Delors proposed in the spring issue of European Affairs. Last December's Nice summit cleared the ground for this flexible approach.
My conclusion is that European economic growth prospects are favorable. Euro area economic diversity is a fact of life, and not very different from the situation in the United States. Admittedly, the European economy still has considerable progress to make in structural reform. But the improvements so far are genuine and likely to last.
Closer European cooperation on economic and political issues is underway. To quote the American economist Lester Thurow in his 1992 bestseller, Head to Head, "future historians will record that the 21st century belonged to the House of Europe."
In this environment, a common European culture is emerging. From January 1, 2002, euro notes and coins will give European citizens a concrete sign of their common identity. Nonetheless, some cultural differences will remain, just as in the United States. I am sure that someone from New Jersey is very different from someone who was raised in Texas.
In Europe, too, we will keep our national traditions. I was born Dutch. Now I feel European, but a Dutch European. That is the way ahead for all of us.