European Growth: Myth, Reality and Necessity (Part I)

European Growth: Myth, Reality and Necessity (Part I)


While the perception that the US economy has left Europe far behind is exaggerated and distorted, it is true that Europe has not closed the per capita income gap with the US over the last three decades.


Liberals and neoconservatives concur that the idea of a distinctive European model is an anachronism. Yet their common view that the European economy is chronically sick is exaggerated and distorted for ideological reasons. Contrasting the liberal view that Europe lags far behind the US because it is inherently unproductive, the reality is that Europe has experienced far more productivity gains than the US over the last 30 years. With respect to the neoconservative vision that Europe’s ‘Kantian’ delusion is relegating it to geopolitical irrelevance, this would only be true if the trajectory of Europe stopped dead in its tracks and Europeans united to collectively place their heads in the sand. Priorities in Europe have indeed been different than in the US over the past decades; European priorities for the future should be modified. Until now, Europeans have not closed the per capita income gap with the US. However, the disaster diagnosis of Europe is far off the mark. Europe may well begin to converge with the US in the future.


The Liberal-Neoconservative Consensus on Stagnant, Recalcitrant Europe
It has almost become a cliché to refer to the growing economic divergence between the EU and the US. In Spain, Guillermo de la Dehesa’s PowerPoint presentation (Relative Economic Performance: The US versus the EU) analysing the income and productivity gap, has done the rounds several times over, while the recent Timbro report (EU Versus USA, by Fredrik Bergström and Robert Gidehag) has flooded the press with the apparently unacceptable, if not particularly relevant, fact that Germany and France are roughly on par with the poorest states in the US in per capita terms. The principal reason for this divergence, according to the view of liberal economists, is that the European economies are plagued by overly rigid and inflexible product and labour markets, suffer from excessive tax burdens and state intervention, and labour under the weight of unsustainable health and pension systems and the self-interesting tyranny of special interests, particularly those of the labour unions. This liberal argument also typically insinuates that there has been no meaningful reform in the distant or recent past, and –given the self-serving and hypocritical nature of European elites and the naïve obstinacy of the European middle classes– nor is there ever likely to be.

It has also become commonplace to argue that the old Cold War European immunity to the guns and butter trade-off is no longer to be financed by the US –leaving Europe increasingly vulnerable to growing security threats– while the pressures of post-Cold War globalization continue to undermine Europe’s former immunity to the trade-off between growth and social benefits. Indeed, with demographic trends pushing up the average age in Europe, the dilemmas for the ‘European model’ have become acute. In short, according to the liberals, the European model has become unsustainable in economic terms. The welfare state even appears to have replaced the communist centrally-planned economies and the Third World state-dominated models as the principal object of liberal polemics in the post-Cold War era.

The arguments of such liberal economists tend to converge with those of neoconservative strategists in the common claim that the idea of an increasingly integrated Europe with meaningful influence in the world and an economy based on anything approaching the ‘European model’ is an unsustainable –even dangerous– delusion. The convergence goes further in the common conclusion that if Europe does not drastically change, its economies and societies will be overtaken by rapidly emerging markets and relegated to an increasingly irrelevant status in the world.

Robert Kagan’s provocative article, ‘On Power and Weakness’ (Policy Review, June 2002), argued that the European model –in a broad sense defined as the welfare state together with the European accent on soft power– was only allowed to take shape as a result of the artificial context provided by the US strategic umbrella. In the late 1940s and early 1950s, European reconstruction and growth was a strategic imperative for the US. Only rapid growth and extended prosperity could undermine the historical class loyalties to communist and socialist parties which, once ensconced in parliamentary governments, might easily sympathise with the Soviet Union.

Allowing –even encouraging– economic policies in Europe which the US would never have tolerated at home (the social market, national healthcare, generous pensions and unemployment schemes, prominence for labour unions in corporatist national dialogues, to say nothing of the Marshall Plan foreign aid, etc) was viewed by the US foreign policy establishment as a necessary evil in the effort to consolidate European loyalty in the Cold War and the position of Europe within the Atlantic security apparatus. Even the first great exception to the US’s multilateral free trade project, embodied in the General Agreement on Tariffs and Trade, to allow preferential treatment among Europeans in their nascent single market, was considered a small price to pay. So, the neoconservative argument goes, the US tacitly agreed to underwrite the project of European integration and the construction of the European welfare state model as a critical part of its strategic project to contain the Soviet Union. The insinuation here is that not only does Europe owe its relative success since WWII to the US –even its very existence as a prosperous and integrated economic bloc, the economic equivalent of the oft-repeated argument that the US ‘saved’ Europe twice– but also that Europeans should be ready to cash in the US’s accumulated chips (and engage in wholesale liberal reform) now that the US itself feels threatened by international terrorism.

Kagan also suggested that the European vision of the world (stressing the superior effectiveness of transnational cooperation and sovereignty sharing, multilateralism, negotiation and soft power), which developed through the experience of decades of European Union construction, was in fact a perspective that developed within an artificial bubble. Neoconservatives now claim that this bubble always was, and continues to be, cut off from the real world. Therefore, Kagan’s argument suggests, the Kantian paradise which the Europeans imagine they have approximated in Europe, and which they believe can be achieved one day in the (perhaps distant) future in the broader international community –with the European model serving as inspiration for the construction of an efficient and prosperous multilateral order– is nothing more than the child’s fantasy that his naïve pursuits might be sustainable once he leaves the sheltered (and financed) home of his parents.

In short, the European model –even the EU itself– was allowed to exist only because of the peculiar configuration of the world during the Cold War. In the new configuration of the post-Cold War world of globalization and international terrorism, the European model cannot continue to exist, according to the liberals, while further political integration of the EU is a dangerous obstacle for neoconservatives who believe that, with the global threat now being defined by Islamist terrorism, European countries should be united directly with the US on issues of international security. The option of a unified Europe with its own foreign and security policies is viewed simply as an attempt to create the EU as a rival to the US, with no chance of constructively contributing to a better world.

This confluence of opinion on Europe between liberal economists and neoconservative analysts does contain a grain of truth. It does appear that Europe must change if it wishes to wield more meaningful influence in the world and if it desires to avoid a total collapse of its welfare states. Nevertheless, the liberal-neoconservative confluence should be challenged.

First, why does Europe need a growth transformation? It is not because of the inevitable decadence of the past or the present, as the liberals might claim, but rather because of the challenges of the future. Second, what should be changed and how? The welfare state which lies at the heart of the European model should not be eliminated (again, as many liberals would suggest), but rather maintained, if rearticulated: product and labour markets should be further reformed, and pan-European economic governance should be deepened and strengthened. Third, what would be the real implications if Europe does successfully rise to the challenge of transformation? The answer is likely to be much more than that of the liberals and neoconservatives: that perhaps Europe might become more vibrant economically and therefore capable of contributing to military and security efforts which would assist the US in a more efficient management of a Hobbesian world. Simply put, the conclusion of this analysis is that if Europe does manage to rearticulate the European model –to say nothing of actually converging with the US in per capita GDP terms– it will have generated the necessary traction to realize its potential as a world superpower and stand with the US as a transatlantic partner on at least a very complementary, if not exactly equal, footing. This is what would be best for the world.

The Question of European Growth and the Myth of Stagnant Europe
Before addressing the challenges facing Europe, and the necessity of a strong, transformed EU to realize its potential role in the world, the vision of the liberals must be examined more closely. The issue of a growing economic divergence between the US and Europe is the centrepiece of the liberal/US demand for economic reform in Europe. Nevertheless, the claim that the US economy is leaving Europe behind is typically exaggerated and even distorted. The myth of the US as a dynamic powerhouse and Europe as a stagnant ‘sick man’ stems from long-standing ideological positions that continue to rely unreflectively on superficial headline data. While an exhaustive treatment of this issue lies beyond the possibilities of this short analysis, we will focus on some of the key points.

Much of this debate fixates on recent economic and productivity growth. GDP growth in the US for the year ending in March came in at 5% compared with only 1.3% in the euro zone, fuelling the short-term media emphasis on US dynamism and European paralysis. In the three years to the end of 2004, the US will have experienced growth of 2.2% (2002), 3.1% (2003) and 4.1% (2004), while the euro zone will have lagged significantly behind (0.9%, 0.4%, and 1.7%, respectively). In the ten years to 2003, the US averaged annual growth of 3.3% compared with a more modest 2.1% in euro zone.

Nevertheless, a closer look reveals that headline GDP figures exaggerate the US’s relative performance. A recent report in The Economist (‘Mirror, Mirror on the Wall’ June 19, 2004) demonstrates that, in per capita terms, the divergence is not nearly as large: per capita GDP grew at an average annual rate of 2.1% in the US during the ten years to 2003, and at 1.8% in the euro zone. Furthermore, all of this adjusted underperformance can be explained by Germany. Stripping Germany from the numbers yields an average annual per capita GDP growth for the other two-thirds of the euro zone of 2.1% –exactly in line with the US–. If the UK were a member of EMU, The Economist argues, the picture would look even more positive for the euro zone.

Moreover, during the last three years, at least, much of this growth difference can be accounted for by the diverging macroeconomic policy stances in the US and the euro zone. According to OECD data cited by Martin Wolf in a recent analysis in the Financial Times (‘It’s the Economy, Stupid’, June 15, 2004), since 2000 the US’s structural budget deficit has increased by nearly six percentage points of GDP. Meanwhile, the euro zone has experienced no net fiscal stimulus, with its structural deficit remaining below 2% of GDP, compared with a structural deficit of nearly 5% in the US. Monetary policy has also been relaxed much more rapidly and significantly in the US than in Europe during the last three years.

None of this is to suggest that the US economic managers did the wrong thing in 2001 when confronted with the end of the stock market boom and the recession –after all, their understandable objective was to minimise the impact and length of the downturn and avoid the deflationary fate of post-bubble Japan–. Nor is it meant to absolve European leaders from their historic responsibility to transform their welfare states into a more streamlined and sustainable version of the European model (see Part II, The Challenges Facing the European Model and The Necessity of Europe).

However, one should not try to cover up the fact that the recent faster growth in the US has been substantially due to significantly looser –and probably unsustainable– macroeconomic policies which have generated a number of important imbalances in the US economy. While such imbalances have potential negative implications for the entire world economy (including Europe), it is striking to note that Europe remains much more sound on all counts, lending it more potential flexibility in the face of unexpected economic shocks in the short- or medium-term future. The list of US imbalances include the explosion of the structural budget deficit (5% versus less than 2% in the euro zone), the current account deficit (5% versus a small surplus in the euro zone), a low household savings rate (2%, which, after increasing slightly in the last few years, is now again on a downward trajectory; 12% in the euro zone), and high and rising total household debt (84% of GDP versus 50% in the euro zone). Indeed, according to a recent analysis by Alvaro Espina (Deflación y trampa de liquidez “revisitadas”: EEUU tras el cambio de política de la Fed, ARI, June 30, 2004), the spectre of deflation in the US has not only not vanished for good, but may even be more dangerous now after the long period of historically loose monetary policy.

But the messengers of European decline and irrelevance have insisted on downplaying US disequilibria, treating them as necessary evils –or even positive virtues– which the shortcomings of the rest of the world (and the myopic paralysis of Europe, in particular) have foisted upon the US economy. Instead, these critics continue to hammer on the idea that the US’s dynamic economic model has produced much higher potential GDP growth than has the euro zone’s unworkable currency area. According to the OECD, potential GDP growth between 1997 and 2005 will have been 2.1% in the euro zone (and only 1.9% between 2006 and 2009), while potential growth in the US will have been 3.4% (and 3.3% in 2006-09).

While potential output growth is also a function of additions of capital and labour to the productive process, we typically focus upon productivity gains as the fundamental driver of potential output growth. This is where the critique of Europe has recently been the most severe. The most frequent claim in this regard has been that US labour productivity growth, after having lagged behind Europe during the 1980s, has rocketed ahead of Europe in the last ten years, as the US economy has experienced a more profound IT revolution, presumably due to the US economy’s superior flexibility. This story, which finds fertile ground in US and liberal circles, at least appears to be supported by the numbers. The OECD forecasts US potential output per employee to grow 2.1% a year from 1997 to 2005, compared with only 1.3% in the euro zone, and 2.5% annually in 2006-09 (versus 1.5% in the euro zone).

Much criticism of European productivity performance focuses on this measure of output per worker. A more accurate reflection of labour productivity, however, is to be found in the measure of output per hour worked. In the US, this measure is only published for the non-farm business sector; during the last ten years, this has grown by an average annual 2.6% in the US. Applying the European measure of GDP per hour worked across the entire economy (including the public sector), one finds that US productivity has risen at an average annual rate of only 2.0%, only modestly faster than the euro zone’s 1.7% annual average over the last ten years. According to a study by Kevin Daly of Goldman Sachs (also cited in the above mentioned Economist analysis), adjusting still further for differences in the two zone’s economic cycles, trend productivity growth in the euro zone has even been slightly higher (1.8%) than in US over the last ten years (1.7%). Indeed, over the last 20-plus years, the euro zone’s productivity level, measured in terms of output per hour worked, has increased from less than 80% of the US level to just over 95%.

The claims of such critics of Europe only become credible at all if we concentrate on the most recent period since the early days of the US boom (which, incidentally, corresponded to an unprecedented period of macroeconomic stabilization and other challenges for the euro zone, including the final push to meet the Maastricht fiscal and inflation criteria, the launch of the euro and the creation of the ECB). Only taking 1997 as the base year does US trend productivity growth come in faster than that of the euro zone. It is quite telling that most of the major US macroeconomic imbalances more or less date from this period, and have not been corrected for even despite the recession and the rapid appearance of yet another major imbalance: the large US budget deficit. In essence, US economic managers used their accumulated macroeconomic flexibility to engineer a relatively shallow and short recession, but only at the price of further magnifying their economy’s macroeconomic disequilibria, thus making the international economy far more imbalanced than at any time since the mid-1980s. Again, this is not to say that Europe has been absolved of any responsibility; indeed, this situation has created a European imperative –that of faster growth (more on this in Part II, The Necessity of Europe)–.


Despite these reasonable adjustments to the headline figures, however, it is still impossible to deny that the average person in the euro zone remains about 30% poorer than the average person in US (measured in terms of GDP per capita on a PPP basis). Moreover, this gap has hardly changed in the last three decades. Therefore, even if it can be shown that there has been very little real divergence –if any– between the US and the euro zone, it cannot be denied that even the maintenance of similar per capita growth rates implies that euro zone inhabitants will remain with lower living standards than Americans. However, it should be stressed that this fact is not new –thus relieving the recent Timbro report of much of its intended drama of demonstrating that Germany is no richer than Arkansas, the US’s fourth poorest state–. Perhaps more drama would be provided by the data on Arkansas’s Gini coefficient, its poverty and crime rates –or for that matter, by the same data from the other 46 richer US states–.

Paul Isbell
Senior Analyst, Real Instituto Elcano