Europe’s Economic Future: The Silver Lining in the Cloud

During the past few weeks new reports from the Organization for Economic Cooperation and Development (OECD) and the International Monetary Fund (IMF) have focused increased attention on the Eurozone’s relatively poor economic performance and the structural problems that continue to impede growth.  While the IMF raised its forecast for Eurozone growth in 2004 to two percent (up from 1.75 percent), it noted that this reflected the spillover effect of the recovery in East Asia and the United States (US) rather than higher domestic demand in Europe. The Fund also reduced its estimate of the Eurozone’s long-term annual growth potential to just two percent.

The Eurozone does face a long list of daunting economic challenges, from sustaining the current recovery to implementing politically difficult labor market reforms and managing the fiscal impact of aging populations. But there are compelling reasons to believe that the current mood of gloom and doom about Europe’s future economic prospects is overblown.  Many of Europe’s economic problems are the result of social and economic policies that have restrained the supply of labor and discouraged productive work in favor of leisure. These policies are already in the process of being reversed, setting the stage for faster growth in the future.

At the beginning of the 1990s, conventional opinion expected the United States to finish a distant third behind Japan and Europe in the growth sweepstakes.  It would be hard to find a single respected expert who predicted then that the United States would outperform the rest of the industrialized world by almost any economic measure. A revitalized European economy could well prove the surprise story of the next decade.  Europe still has enormous economic strengths, including a skilled labor force, world-class companies, and an increasingly integrated internal market. 

It’s worth putting the current debate about Europe’s economic performance in some historical perspective. Following the devastation of the Second World War, Western Europe’s per capita income and labor productivity were at just half of US levels. The Marshall Plan and the removal of internal trade barriers in Europe helped spark a spectacular economic recovery that lasted for a quarter century until the first oil crisis.  Despite strong economic growth in the United States during the same period, per capita income and labor productivity in Western Europe converged to about 70 percent of US levels.

With the end of the postwar “economic miracle,” Europe entered a new era (1973-1995) during which per capita GDP growth slowed, but Europeans began to work far fewer hours and to enjoy the benefits of the European welfare state. Labor productivity continued to converge with the United States, reaching 95 percent of US levels by 1995, but per capita income remained 30 percent lower.

Since 1995, the trends of the previous 50 years have been reversed, as labor productivity and per capita income have risen faster in the United States than in Eurozone countries. The reasons for this shift remain hotly debated, but most economists attribute it to the greater success of the United States in taking advantage of the revolution in information technology. This in turn reflects the greater flexibility of the US economy and more positive US attitudes toward risk-taking.

But these types of cultural, institutional and technological advantages can prove fleeting as other countries adapt. The success of the United States, for example, in taking advantage of electricity and the internal combustion engine during the 1920s gave it a dramatic productivity lead over Europe, but Europe closed the productivity gap as it made more effective use of these technologies in later decades. The same is likely to happen with information technology—and sooner rather than later.

To succeed, Europe does not necessarily have to match economic growth in the United States. Given different societal preferences across the Atlantic, Europeans might well accept slower growth and lower material standards of living than Americans aim for, in exchange for more leisure time and greater social security. The problem for the Eurozone countries is that the present mix of policies is not sustainable. Without higher growth (and the corresponding increase in working hours), European governments will not be able to finance pensions and health care for baby boomers at the levels their parents enjoyed.

While tough reforms are unpopular with European voters, they have already begun and are likely to develop momentum in the next two to three years. There are several reasons for guarded optimism:

• Greater Policy Realism. European political elites understand the dimensions of the economic problems Europe faces, and there is a rough “Brussels Consensus” on the types of structural reforms that are needed. European Union governments may attempt to shift the onus for reform to Brussels, but they will press ahead with incremental but steady reforms. These have already begun in many smaller countries, and the current debates in Germany and France over the 35-hour week suggest the bigger countries will follow suit.

• EU Expansion. The addition of ten new member states has created intense competitive pressures within the European Union. Siemens and Daimler have already used the threat of plant relocations to force unions to accept longer workweeks for no extra pay.  This is just the beginning of a powerful trend.

• European and Transatlantic Integration. The European Commission has been a tremendously positive factor in creating a truly European market. This is expected to continue under the incoming Commission taking office in November 2004, under the pro-market leadership of President Manuel Barroso. We can expect Europe to benefit in coming years from the lagged effect of the European Community’s 1992 single internal market initiative (EC-1992) and the Financial Services Action plan. Deeper economic integration, including with the United States, will increase competition in Europe and lead to a more efficient use of capital, raising Europe’s growth potential.

The United States has a tremendous stake in Europe’s economic success. Faster European growth would ease the cost of adjusting our current account deficit and provide important commercial opportunities for US firms. The economic futures of Europe and the United States are deeply interconnected. The good news for the United States is that the economic obituaries for Europe are vastly premature. We can expect to benefit in coming decades from increasingly close commercial and financial ties with a prosperous and stable Europe.