What to do about divergence between EU countries? The problem of structural polarization

The economic upswing over the years 2017/2018 has masked continued underlying challenges; ensuring long-term convergence and stability will require coordinated fiscal, wage and industrial policies.

 By Philipp Heimberger and Jakob Kapeller

 

  • EU countries are stuck on different trajectories in their economic development. Core countries, periphery countries, Eastern European countries and financialized countries have responded differently to increasing European integration.
  • This leaves Europe mired in structural polarization, where political tension relates to diverging economic developments and increasing gaps in the evolution of technological capabilities.
  • As a consequence, counteracting polarization and promoting convergence requires a coordinated strategy including fiscal, wage and industrial policies.

 

Dangerous upswing optimism in Europe

Over the last two years, the public debate on the economic development of EU countries has been characterized by a spirit of relief: finally, after several years of crisis, large parts of the European economy had experienced solid and stable growth over the years 2017/2018. Even the American Nobel-prize laureate Paul Krugman, who is well-known to be a critical observer of economic developments in Europe, has joined the chorus of upswing optimism: “Europe 2018 looks very different from Europe 2013. For now, at least, Europe is back as a functioning economic system.”

Although the economic upswing in large parts of the EU was certainly to be welcomed, it should not be seen as a reason to ignore underlying tendencies towards structural polarization in Europe. In structural terms, Europe in 2018 does not look much different from Europe in 2013: under given political and institutional constraints, the technological capabilities of a given country are still the most important determinant of its long-term development. Technological capabilities in EU countries, however, are distributed rather unequally. EU countries remain structurally polarized, i.e. they are stuck on different developmental trajectories, which contradict the political goal of ensuring convergence and stability in the EU. Notwithstanding short- and medium-term cyclical developments, existing differences in technological capabilities will continue to fuel a process of economic disintegration in the bloc if policy-makers fail to counteract the polarization trend by introducing a coordinated policy strategy that should include fiscal, wage and industrial policies.

Path dependent developmental models in the EU

In a recent study, we highlight the relationship between the process of European integration and existing economic polarization tendencies in the EU. For member states, European integration has brought an increase in trade and financial openness.

We show that macroeconomic developments (measured in terms of common indicators such as GDP growth, unemployment and the current account balances) have not responded uniformly to the increase in economic openness that is associated with deepened European integration. Based on our empirical analysis, we are able to identify four different developmental trajectories, which allow for an analytical separation of core countries (like Germany or Austria), periphery countries (like Italy or Greece), catchup countries (mainly in Eastern Europe) and financialized countries. The latter group is represented by countries that either serve as a hub for the financial sector (e.g. Luxemburg) or try to attract investments by multinational firms (like Ireland or the Netherlands). Both types of financialized countries draw on designing specific regulatory environments to the benefit of international investors or the financial sector.

Figure 1 summarizes our findings and shows distinguishing characteristics of those economies that follow a certain developmental trajectory.

Figure 1: A country taxonomy for the EU

Heimberger Kapeller Graphik 1(Source: see below)

Technological capabilities and structural change: How the strong get stronger

 In the four country groups described above, developmental trajectories are related to changes in industrial structures across Europe. The defining characteristic is that technological capabilities (proxied by data on the complexity of exported goods) are distributed unequally among European countries.

Figure 2 shows that those European countries with higher levels of technological capabilities in 1999 have, on average, accumulated further structural advantages, while countries with weaker initial technological endowments have further lost ground in terms of their capabilities. This result suggests that self-reinforcing processes, which favour countries that can be considered economic powerhouses, characterize the current European economic regime, while relative laggards (which are mainly to be found in the periphery and in Eastern Europe) are unable to keep pace in terms of their technological capabilities. Notably, some countries have indeed managed to catch-up in terms of technological capabilities in relation to the core (e.g. the Czech Republic or Ireland). Nonetheless, the path dependency of the European integration process has on average favoured those with a more favourable initial starting position (represented in terms of the x-axis value of the respective countries on product complexity in Figure 2).

From Figure 2, it can bee seen that there are still considerable differences within the four country groups proposed above. First, core countries differ in their structural development, which reflects the fact that some of these countries are struggling to hold on to their position (e.g. Finland and Belgium), while others have managed to expand their technological dominance (mostly Germany, but to a smaller extent also Austria). Second, Figure 2 does not show a single periphery country which has undergone decisively positive technological development over the period covered. Third, while some of the Eastern catch-up countries have managed to improve their technological capabilities (e.g. Czech Republic, Hungary, Slovakia, Poland), others have not. What the countries in Eastern Europe that have gained in terms of technological capabilities have in common is their geographical proximity to Germany and a successive integration into the supply chain of Europe’s manufacturing core. This finding indicates that the economic catch-up process of Eastern European countries is not necessarily tied to a technological catch-up process, as evidenced most forcefully by the outliers Bulgaria and Lithuania. Fourth, the differences among financialized countries that can be seen in Figure 2 are particularly large, but can arguably be explained by their different financialization strategies: Ireland’s role as a corporate tax haven manifests itself in a massive technological upgrading, while the more asset-based strategies of the Netherlands and Malta are associated with a tendency for deindustrialization. Finally, while the empirical analysis in our study on how macroeconomic developments in EU countries have responded to increased European integration suggests that although France is currently part of the periphery, the country remains on the edge and might also be loosely considered as part of the core.

Figure 2: Self-reinforcing effects in the development of technological capabilities in Europe

Heimberger Kapeller Graphik 2 -new

(Source: see below)

Macroeconomic divergence in Europe is fuelled by existing differences in technological capabilities, which seem to follow a path-dependent pattern, where past success breeds further success and fundamental changes can only be induced with more fundamental path-breaking policies (as, for instance, in the case of Ireland). Results from the economic complexity literature suggest that technological capabilities are of prime importance for assessing the future developmental trajectories within given political and institutional constraints. As a consequence, the lack of structural convergence in the existing European system raises prospects for increasing economic tensions in the future.

A coordinated economic policy strategy for Europe

Against this backdrop, it is highly likely that the differences in developmental trajectories that can be observed within the EU represent a ‘lock-in-effect’ in economic development. This situation can only by unlocked by large-scale policy interventions as current trends hardly provide any indication for the emergence of a ‘natural convergence process’. The country taxonomy, which we develop in our study, also proves useful in thinking systematically about what needs to be done to promote convergence and to counteract economic disintegration in Europe. Against the background of the long-run importance of technological capabilities for economic development, the core of such a policy plan must include targeted industrial policies.

Our proposals, which should be viewed as a starting point for more in-depth policy discussions, are summarized in Figure 3. In particular, the periphery countries need an investment initiative that serves to diversify and modernize their industrial structures. Targeted industrial policy should be geared towards improving non-price competitiveness to improve the prospect of sustainable development in the long-run. Such an investment initiative could be financed either by additional European taxes or by external funding sources. Additional tax revenues may come from a European corporate tax or a European wealth tax. In terms of external financing, the European Investment Bank could for example issue investment bonds that could be bought by the ECB.

In our view, a sustainable strategy also requires policies that allow for a continuation of the catching-up process in Eastern Europe. In this context, measures should be geared towards allowing for higher wage growth in the Eastern European countries relative to other EU countries. Furthermore, labour standards should gradually be adjusted to the higher levels in the core countries. Such an adjustment of wage and labour standards would not only provide a stimulus to aggregate demand; it could also help to reduce inner-European tensions related to migration and job displacement. To make sure that the respective countries retain and further improve their competitiveness, the strategy for Eastern Europe should be complemented by targeted (vertical) industrial policies.

The core countries (especially Germany) have been running significant current account surpluses for several years. This means that they possess considerable resources to improve the social cohesion of their societies by reducing unemployment and tackling social inequality as well as deficiencies in public infrastructure. Another possibility is to pursue policies that lead to higher wage growth for the low- and middle-class (e.g. by minimum wage laws, wage bargaining and labour union legislation).

Finally, in terms of moving towards more sustainability in Europe, we argue that it is necessary to push for re-regulation of the financial sector in the financialized country group. Particularly low corporate taxes in the financialized countries (which attract corporate profits through tax incentives) make it clear that a European initiative leading to a substantial increase in the corporate tax rate is required to counteract the existing race-to-the-bottom in regulatory standards. Increasing corporate taxes would also provide the public sector with the necessary resources to pursue targeted industrial and social policies.

Such policies would hopefully put us in a position to proactively address core future challenges, like climate change or increasing digitization, while striving for deepened integration and convergence in Europe at the same time.

Figure 3: A coordinated policy strategy for Europe

Heimberger Kapeller Graphik 3(Source: see below)

 

Sources

Figure 1: Gräbner et al. (2018), Structural change in times of increasing openness: assessing path dependency in European integration, wiiw Working Paper No. 143, p. 18.)

Figure 2: Gräbner et al. (2018), Structural change in times of increasing openness: assessing path dependency in European integration, wiiw Working Paper No. 143, p. 15. Product complexity of exported goods serves as a proxy for technological capabilities. The green line was derived from fitting a linear equation to the ten Eastern European countries. The grey line was derived from a linear regression for the remaining EU countries in the data set.

Figure 3: Gräbner et al. (2018), Structural change in times of increasing openness: assessing path dependency in European integration, wiiw Working Paper No. 143, p. 26

 

Comments

This article is based on the results of the following working paper:

Gräbner, C.; Heimberger, P.; Kapeller, J.; Schütz, B. (2018): Structural change in times of increasing openness: assessing path dependency in European integration, wiiw Working Paper No. 143.

More in-depth research results on structural polarization and macroeconomic development in the Eurozone are available from this study:

Gräbner, C.; Heimberger, P.; Kapeller, J.; Schütz, B. (2017): Is Europe disintegrating? Macroeconomic divergence, structural polarization, trade and fragility, wiiw Working Paper No. 136.

 

Philipp Heimberger is Economist at the Vienna Institute for International Economic Studies (wiiw) and the Institute for Comprehensive Analysis of the Economy at Johannes Kepler University Linz. His research focuses on macroeconomics, public economics and international economics.

Jakob Kapeller is Professor of Socio-Economics at the University of Duisburg-Essen and Head of the Institute for Comprehensive Analysis of the Economy at Johannes Kepler University Linz. He has published extensively in political economy and the philosophy of science.

 

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