Courtesy Reuters

False Hope

By Adam S. Posen

To the Editor:

In "Mind the Gap" (March/April 2005), Robert Pozen augments popular fantasies about the integration of ten new members states into the European Union and the prospects for European growth. The hope that EU expansion represents an economic breakpoint for Europe's old ways is misguided. The ten additions may well grow at a faster rate than the rest of Europe for an extended period, but that is unlikely to have much if any transformative effect on EU growth overall -- in terms of increasing the growth of either productivity or the labor force. Moreover, Pozen's proposed reforms are the same ones that have been recommended for years but resisted for domestic political reasons; he offers no convincing political or economic explanation for how "new Europe" will bring about these reforms in "old Europe."

Most of his assertions about the eastern European economies are simply untrue. First, eastern European populations are not significantly younger than western European populations, and, more important, their fertility rates are low and declining, putting them on a par with those in Germany and France -- and well below the U.S. rate. So new Europe's demographics will not change in a positive way. Second, there is no evidence of greater labor flexibility or mobility in eastern Europe; in any event, the rest of Europe is creating long-term formal and informal barriers to labor mobility and entry from the east. Third, due to their lower skill and education levels, eastern European workers are not good substitutes for western European workers and will thus place limited competitive pressure on old Europe. Finally, a significant part of the GDP and GDP-growth differences between the United States and the EU is attributable to the fewer hours worked in old Europe, as Pozen acknowledges. There is nothing to suggest that new Europe will change that.

The only way for eastern Europe to truly accelerate its growth and productivity is with extensive investment from and integration with the west. Yet, foreign direct investment from western Europe to the region has already peaked, and barriers to labor mobility from east to west are going up. In fact, investment in eastern Europe from the EU has been on a steady decline for the last several years, while old Europe is treating eastern Europe as an excuse for protectionism.

There are other conceptual problems with the exaggerated faith in new Europe's economic impact. The first relates to the nature of "catching up" in growth -- what economists call "income convergence." It is true that stable lower-income populations with good property rights, openness to trade, and sufficient savings do tend to catch up over time to the income levels of countries or regions with which they are economically integrated. But this process generally takes decades, even if it progresses smoothly. The biggest positive jump usually occurs in the first few years, as an economy begins to liberalize. There are large initial gains to be had in adopting market incentives, bringing in new technology, upgrading infrastructure, and reallocating capital and labor that is obviously being used inefficiently. But most of this has already happened in the last 15 years in eastern Europe, and growth will be slower from here on out.

Another conceptual difficulty is the disregard Pozen and other benighted optimists show for the basic sizes involved. The recently added countries are just too small economically to have much impact on overall EU growth.

Pozen also claims that Europe will be able to catch up to the United States because he expects U.S. productivity growth to diminish, essentially because of excessive U.S. government debt leading to higher interest rates, crowding out productive investment. Washington truly should address this problem -- but it is hardly a cause for EU optimism, not least because rising U.S. interest rates would also harm European investment.

The observation that the EU could grow if it utilized female workers or information technology investment as the United States does, meanwhile, is simply another way of saying that Europe needs to reform, not that Europe will grow. By that false logic, U.S. deficiencies in education or savings would actually serve to increase the United States' advantage over Europe because they represent untapped opportunities for U.S. reform.

In the end, eastern Europeans will benefit most from their integration with the EU. Eastern Europe's entry into the EU is no substitute for necessary reforms in western Europe.

ADAM S. POSEN

Senior Fellow, Institute for International Economics

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