The acronym ‘ESM’ stood for a long time for a set of common European social values, goals, illusions even, to express a certain common identity for the EU especially when compared to other regions of the world, notably the US. For a few years now, ESM is the leading acronym in the media for the Eurozone’s main crisis management tool, the European Stability Mechanism. Just a coincidence, one may say, but there is a deeper layer behind this shift of focus. Mario Draghi even declared the European Social Model as dead and indeed it has an uncertain future given the current state of the Eurozone and the entire EU.
Beyond the coincidence with the acronyms, there is a fundamental clash between Europe’s social ambitions and the way adjustment is under way. The conditionality of any bailout or support from the Stability Mechanism is geared clearly in one direction: austerity, cost cutting and undermining of social standards, this all means ‘rebalancing’ downward. Greece has lost 25% of its GDP during this process up till now.
The idea of the European Social Model has always taken the back seat in the process of European integration. A bunch of political science literature (Streeck, W 2000; Scharpf, F 2002; Martin, A-Ross,G 2006) argued that while the single market project has always been the hard core of integration backed by hard law and its flagship project the EMU, albeit on base of an incomprehensive architecture as we bitterly learned during the crisis, the social dimension has always been based on declarations, wish lists and well, the Open Method of Coordination. More than that was just based on ad hoc ideas, as. e.g. some sort of tax harmonisation, or even corridors of budget redistribution ratios, although the latter should not be seen as a totally unrealistic idea. While the EMU has clearly been a new stage of integration and much of the underlying regulatory framework was based on fiscal rules (by far not satisfactory as we again learned during the recent crisis), it is hard to imagine seriously that one can have a common fiscal platform among member states that have public expenditure ratios of GDP in the range between 34% and 57% of GDP. And indeed, some elements of social spending get under scrutiny during the rebalancing act: pension systems and social spending is under huge pressure, but again the direction is downwards.
Besides debt consolidation and fiscal austerity, the other main dimension of crisis management focuses on the adjustment of the divergence of competitive positions among EMU members. The therapy here is also biased into one direction: downwards. On the one hand, adjustment policies are asymmetrical with the whole burden of correction put on deficit countries, while surplus countries are not involved seriously. On the other hand the correction in the competitiveness gap (gap in unit labour cost developments) is forced out through the price channel (dominantly through a cut in labour costs, ie. wages) while non-price aspects of competitiveness (economic and export structure, productivity, quality) are ignored. This again results in a downward bias.
All this leads to asymmetric and downward adjustment, where mostly peripheral, lower income countries are affected. The result of this crisis management strategy is a persistently growing gap between surplus and deficit countries that manifests itself in a diverging Europe (a detailed analysis is given in ETUC/ETUI 2013). Where has the big European dream about convergence been lost?
From convergence to divergence – where is the EU heading for?
Beside the historical founding principle of the EU as a peace-keeping project, it was the prospect of convergence that gave true substance to the European idea for millions of people. This also seemed to work for several decades. Now that Europe’s flagship project, the single currency, is in trouble to respond to the external shock posed by the financial crisis and adjustment therapy forces its member states into a diverging downward spiral, this essential and fundamental mission seems to be evaporating.
The promise of income convergence – between poorer and richer member states and among the poorer and richer regions within them – has been an underpinning feature of European integration from the outset. In this respect, a glance back over fifty years of EU history up to the crisis provides confirmation of an unprecedented feat. As stated in a recent World Bank (2012) report: ‘The European convergence in consumption levels in the last four decades is unmatched. Except for East Asia, the rest of the world has seen little or no convergence’. Indeed, already by the early 1990s the incomes of more than one hundred million people in the poor south – Greece, southern Italy, Portugal, and Spain – had grown and moved closer to those of the more prosperous areas of Europe. Similarly, between the late 1990s and the mid-2000s, the income levels of one hundred million people in Central Eastern Europe were dynamically converging towards levels in the richer part of the continent. Figure 1 offers a historical glance at the economic divide in Europe, showing that Central Eastern European countries still have substantially lower per capita GDP levels (at PPS) than the EU27 average. The data also indicate milestones in the last fifteen years, showing the varying convergence dynamic of individual countries in the different periods.
Figure 1: Income gaps and convergence: GDP/capita as percentage of EU27 total for selected years and countries (based on market prices at PPS)
Source: Eurostat (2012), Note: data for BG and RO: latest year 2010
Most of the convergence took place between 2000 and 2007, after which it lost momentum or even went into reverse. It is apparent also from the graph that Greece and Portugal stand out as having displayed no convergence whatsoever over the whole fifteen-year period. The year 2008, with the onset of crisis, marked a halt in these processes of convergence achieved via a catching up of the less prosperous countries and regions, placing a question mark over the continuing sustainability of some of the progress achieved in the earlier phases of European integration.
Although 2008 was a common point of fracture for both East and South, the experience of these two regions has been significantly different. While convergence ground to a definite standstill in southern Europe, in the Central Eastern European (CEE) countries the much stronger impetus towards convergence came to a more abrupt halt which, in some cases, nonetheless proved no more than temporary. Indeed, in most CEE countries – and particularly those with the lowest per capita GDP levels – a rapid process of catching up had been observable in the years before the crisis. In southern Europe, however, the picture had been more mixed, even during the boom period, with Spain having achieved significant convergence, while Greece and Portugal had tended to stagnate. Latvia and Lithuania, the two countries which suffered the most dramatic falls in output in 2009 (17.7% and 14.8% respectively), nonetheless showed still impressive overall convergence for the 1995-2011 period as a whole, with per capita GDP levels relative to the EU27 rising from 31% to 59% for Latvia and from 35% to 66% for Lithuania.
The picture for southern Europe is much bleaker: between 1995 and 2011 the region showed no convergence – in the case of Greece and Portugal – or, in Spain, only limited convergence to EU27 levels. Thus, while Spain still achieved some convergence over these 16 years, from 91% to 98%, Portugal saw none over the entire period (77% in 1995 and still in 2011), while Greece actually suffered a loss of convergence (from 80% in 1995 to 77% in 2011). All three countries suffered significant setbacks in the wake of the crisis, most particularly Greece with a 14%-point drop in its relative income level between 2008 and 2011.
What matters is economic structure, not costs
The different pattern in the catching-up process in the East and the South is the result of a number of underlying structural differences among European countries that have affected their respective paths in economic integration. We take a look at four important drivers of economic integration that played a key role in convergence: exports; the balance-of-payments situation and its structure; foreign direct investment (FDI); and the role of credit flows.
Currently, the most pronounced division in Europe appears between ‘surplus’ and ‘deficit’ countries, as determined by their balance-of-payments position within the Euro Area, with the core ‘surplus countries’ clustered around Germany and the ‘deficit’ ones around the Mediterranean. A similar distinction applies beyond the Euro Area, with a number of CEE countries belonging to the ‘surplus’ core (e.g. the Czech Republic and Poland) and the more peripheral CEE crisis-ridden countries (e.g. the Baltic states) falling into the ‘deficit’ group. This division between surplus and deficit countries thus cuts across the historical divisions between the East and the West of the continent.
The Czech Republic, Hungary and Slovakia had broadly balanced trade even before the crisis, whereas Latvia, Bulgaria, Greece, Romania and Portugal were, during this period, used to have persistent and double-digit trade deficits.
The key distinction to be considered here is the one we see between countries that experienced credit bubbles in terms of huge credit expansion that was followed by credit crunch and recession and those with a more balanced development. The credit expansion underpinned the current account deficits in the South and in the deficit countries in the East. With the credit crunch and the accumulated high debt, short-term growth and convergence effects achieved through credit expansion evaporated all of a sudden and turned into their reverse.
When looking at key features of ‘deficit’ and ‘surplus’ countries on the periphery, we see important structural differences in their economies. While ‘surplus’ countries in the East had large scale foreign direct investment into their productive sectors and have a high export share in their GDP, this is not the case for the deficit countries in the South. For illustration Figure 2 shows export shares for this group of countries.
Figure 2: Exports of goods and services (% GDP)
Source: Eurostat (2013)
Moreover some figures also indicate that even if wage and unit labour cost developments showed a high grade of divergence in the decade up to the crisis when the competitive positions of periphery countries (both in the East and the South) deteriorated substantially in comparison to Germany, there is no fundamental cost competitiveness problem if we look at the levels of productivity and wage costs in their tradable (manufacturing) sector. Figure 3 shows that based on the manufacturing sector, periphery countries would not have a cost competitiveness problem with Germany. The problem some have is more of structural nature: the share of manufacturing and exports in general is very low in their economy.
Figure 3: Wage-adjusted productivity in manufacturing in selected countries, 2009
Source: Eurostat 2012 (http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/Manufacturing_statistics_-_NACE_Rev._2); *apparent labour productivity is defined as value added at factor costs divided by the number of persons employed.
The case of the two peripheries in Europe demonstrates that the competitiveness problem of some of the Mediterranean countries is much more due to deeply rooted structural problems than just price and costs levels. Since the therapy is focused almost exclusively on cost and wage cuts, not addressing their structural problems, it is not only that their previous achievements in convergence are wiped out but their future perspectives are also put at stake.
Although tackling these structural problems through cost adjustment (wage and spending cuts) can deliver temporary results in cost competitiveness at the price of a dramatic increase in poverty and unemployment, in the end these inevitable ‘side effects’ also jeopardize the success of the entire adjustment. Cost adjustment is simply not an adequate way of addressing the longer-term structural problems (such as the share of manufacturing in the whole economy, export shares, qualitative composition of exports, place in the international division of labour, etc.). The problem, to put it bluntly, was not that consumers in the surplus countries had been buying less olive oil and port wine due to rising unit labour costs in Greece or Portugal. In other words, the cure chosen to date is one that tackles the symptoms but not the causes of the problem.
Even if part of the achieved convergence before the crisis can be deemed as not sustainable, this also points to a policy failure. European institutions in a series of reports and communications were proud to give account of growing employment and income convergence in many of the periphery countries up to 2007. This progress was also seen as partial achievement of the Lisbon targets. If much of this was not based a real performance it is also a strong criticism of EU policies. European leaders cannot just shrug their shoulders and say, sorry, what we believed and welcomed as achievement turned out to be (partially) fake. It was just an illusion, we can wipe this out. It is a matter of fact that much of the unsustainable expansion was due to a huge capital allocation problem resulting also from irresponsible finance and lending practices (predominantly through banks in surplus countries). Now ordinary working people should pay the price and those who blew the bubble are safeguarded.
The crisis has highlighted the diversity of economic models and of their sustainability during hard times and external shocks in the European ‘peripheries’. Convergence of income levels between poorer regions in the South and the East towards the level of rich countries in the centre has been one of the big European objectives and seemed to function for several decades. This also strongly contributed to the legitimacy and public support for the European Union. Convergence, although mostly driven by economic processes, had also been a fundamental factor to maintain a European Social Model amid diversity at member state level.
While divergence in the economic catching-up processes, particularly after 2008, showed an East-South division, the multiple fault lines characterizing the diversity of political and economic structures can be shown to cut across historical and geographic country groups. The credit crunch of 2008 highlighted the division between the countries with current account surpluses, the European ‘core’ around Germany including also the eastern central European exporters, and the ‘deficit’ countries, including the Mediterranean countries, Ireland, and a number of countries in eastern Europe. Given the lack of effective adjustment mechanisms in the Euro Area, the surplus-deficit divide quickly turned into the difficult creditor-debtor relationship. The ‘debtor’ countries then experienced a prolonged agony of negotiated and imposed adjustments in the context of crisis-driven Euro Area institution building. Given the unequal power relations between debtors and creditors, the concerns of the latter inevitably came to dominate the nature of the adjustment efforts made.
What we clearly see now is that if convergence is driven by economic processes only, the result will not be enduring and balanced, more political and institutional integration is needed, the Single Market alone will not do the job. The paradox and most worrying phenomenon is that political integration in the form of the economic governance that has evolved through the crisis management practice of the EU is precisely doing the opposite: it drives diversity further up to the point that may tear the Eurozone and the EU apart.
ETUC/ETUI, 2013: Benchmarking Working Europe – 2013, ETUI, Brussels.
Andrew Martin and George Ross, 2004: “Introduction: EMU and the European Social Model”, in Andrew Martin and George Ross (eds.), Euros and Europeans. Monetary Integration and the European Social Model (Cambridge: Cambridge University Press, 2004).
Fritz Scharpf, 2002: “The European Social Model: Coping with the Challenges of Diversity”, Journal of Common Market Studies Vol 40, No 4 (2002), p. 665.
Wolfgang Streeck, 2000: Competitive Solidarity: Rethinking the” European Social Model, In: Karl Hinrichs, Claus Offe, Herbert Kitschelt, Helmut Wiesenthal (eds): Kontingenz und Krise, Campus, Frankfurt, New York, 2000.
World Bank, 2012: EU11 Regular Economic report: Coping with External Headwinds, World Bank Office, Zagreb