Unshackling the Giant

European Economic Advisory Group calls for reforming the Lisbon goals, liberalising job markets and putting an end to the glorification of national champions to shake the EU out of its economic inertia

If something can be said about economic growth in the EU in the past decade or so is that it has been quite uneven, both across countries and over time. While Ireland , Finland, Greece, UK, Spain and Sweden have spurted ahead, Germany, France and Italy have become laggards. The new EU member countries enjoy much higher growth rates than the EU-15, but the EU in general is falling further behind the US in terms of per-capita GDP growth.

Clearly, the goals put forth at the Lisbon Summit in 2000, to turn the EU into the most dynamic knowledge-based economy by 2010, seem unattainable by now. As Bavarian premier Edmund Stoiber recently put it, “ We promised ourselves a moon landing by 2010. Now, five years on, we do not even have a rocket yet.”

What is to be done? Many explanations have been put forth for Europe ’ s lacklustre economic performance. By far the most comprehensive is the analysis provided by the European Economic Advisory Group at CESifo in their Report on the European Economy 2006 *, just released in Brussels, London and Munich.

 The first observation of the report ’ s authors — eight prestigious economic scholars from eight European countries — is that slow growth is not a universal phenomenon among the EU-15. Some countries have performed well over the last decade, with some of the new EU members even boasting something akin to a “ growth miracle” . Second, a convergence in living standards between the EU-15 and the new member countries is taking place.

It pays, therefore, to examine what the more economically dynamic countries are doing right, and whether those measures are applicable to the laggards. After decomposing GDP growth into the contributions from labour input, IT capital input, non-IT capital input and technological progress, the authors found that the unsuccessful countries — France, Germany and Italy — have all been growing mostly through traditional capital accumulation and to a much smaller extent through general technological progress. Labour input often played a substantial negative role, particularly in Germany.

The successful countries, by contrast, have followed different roads to prosperity. In one group, consisting of Ireland, Finland, the UK and Sweden, there has been a large increase in the contribution by IT capital growth, dwarfing the positive contribution made by the remaining production factors: relatively rapid IT capital growth has been coupled with relatively high total factor productivity (TFP) growth. The best performer, Ireland, excelled in all counts. Spain and Greece make up a second group of successful cases, owing their growth primarily to conventional capital accumulation and labour input growth.

Other significant variations become quickly evident. Finland, the UK and Sweden already exhibited higher shares of IT capital relative to other capital, so the recent fast accumulation of IT capital resulted in larger contributions to growth. These countries are also at the top in terms of IT diffusion, an area where education and innovation play a big role. Still, the authors point out, there appears to be no systematic relationship between spending in education (relative to GDP) and GDP growth, as shown by the experiences of Finland and Sweden, which had the highest spending in this regard. What does play a major role is the amount of deregulation: a higher degree of competition among firms leads to more widespread innovation. In many, though not all cases, the successful countries have done well in terms of deregulation, venture financing and R&D spending.

The EEAG analysis leads to several policy conclusions. First, the authors recommend that the Lisbon strategy be modified, as that strategy argues for the creation of a uniform model of a high-tech information society for the EU, whereas the European experiences suggest that there are different routes to success. The EU should allow for a flexible strategy for growth, in which there is scope for high-tech-driven growth as well as growth based on more traditional means of capital accumulation, increased labour input and imitative adoption of new technologies from the leaders.

One key element is improvement of the educational systems, both at the national and EU levels. Education not only influences growth through the accumulation of human capital, but also eases the adoption of innovation and new technologies. An important question concerns the level of education on which improvements should be focused. Countries that are close to the cutting edge should focus specifically on improving their tertiary education system, as high-technology innovation requires more advanced skills than lower-level innovation. While the US does not stand out for the quality of its secondary education, it is well ahead of EU countries in university education. The best universities in the US compete strongly with each other for the best graduate students and researchers. In European countries, the university system is largely sheltered from strong competition, though the UK with its national research and teaching quality audits is partly an exception.

A third policy conclusion concerns the potential to increase labour input — i.e. increase the level of employment — to enhance economic growth. In most EU countries, labour input has grown little, and in some countries even decreased. Labour market reforms, such as lower unemployment benefits, employment tax credits, lower marginal tax rates on labour, and pension reforms that provide incentives to a longer working life, are long overdue. Decentralised collective agreements that allow lengthening working hours (as in Germany) and reversals of earlier legislated working time reductions ( France) are other desirable measures.

Let National Champions Go

Another policy conclusion concerns the removal of regulations that limit competition by restricting entrepreneurial activities and labour market adaptability. Technology policy should focus on the provision of opportunities for the creation of new firms and industries and less on glorifying national champions. Venture capital financing and R&D must be encouraged across the EU, one of the areas where Europe clearly lags behind the US.

The service sector makes up around 70 percent of both GDP and employment in the EU-15, and lower trade barriers for services would have potentially large growth effects: it is crucial that the new EU Services Directive under discussion is not watered down.

related, and potentially painful, issue is the imposition of national pay on workers from other EU member states. This means that the EU-15 forsake the welfare gains that could come from allowing service providers from the new member states to compete effectively by compensating for lower productivity through lower wages. Such competition is a natural exploitation of different comparative advantages, and definitely not “ unfair wage dumping” . Wage competition among countries in trade with services should be allowed in the same way as in trade with goods.

*Report on the European Economy 2006, Chapter 3, by the European Economic Advisory Group at CESifo. EEAG comprises eight renowned economists from eight European countries. Further info at www.cesifo-group.de/eeag