Reducing European Inequality: Cohesion Through Convergence

Michael Dauderstädt

When founded in 1957, the then European Economic Community comprised six relative prosperous countries, albeit including a very poor region, the Italian Mezzogiorno. With the first enlargement in 1972, poor Ireland joined the Community, bringing a start to its regional policy to promote growth in its poorer regions. The EU publishes regularly cohesion reports that assess the progress. This effort had to be strengthened substantially after the Southern enlargements (Greece in 1981, Spain and Portugal in 1986). But these challenges pale in comparison with the impact of the Eastern enlargements in 2004, 2007 and 2013, when much poorer post-communist countries joined the EU.

Convergence: the record so far

When Ireland and the Mediterranean countries joined, their Gross Domestic Product (GDP) per capita was about 60 to 70 percent of the EU average at purchasing power parities (PPP). Measured at exchange rates, they reached about 30 to 60 percent with Portugal being by far the poorest and Ireland the relatively richest country of the periphery. Joining the EU did not trigger a rapid catching-up process. Indeed, Greece and Ireland even fell back after their entry. Portugal and Spain performed better thanks to more favorable global economic circumstances in the late 1980s. The only true success has been Ireland after 1990 when it turned into the famous “Celtic tiger” overtaking all other EU countries except super-rich Luxemburg by the end of that decade.

The GDP/capita of the post-communist countries of Central and Eastern Europe (CEE) has been even lower than that of the Southern peripherals. Measured at exchange rates, their income in 2004 ranged from about 10 percent of the Euro area average to about 30 percent with Bulgaria and the Baltics being the poorest. At purchasing power parities the picture improves, reaching between 30 and 50 percent of the Eurozone average.

Table 1 presents the development of the GDP/capita in three subsets of member states since 1998, differentiated in the period before and after the crisis: The rich North West (NW) of the EU provides the benchmark; the Southern periphery (SP) comprises the poorer Mediterranean countries that have been subject to austerity programs, and the CEE plus Cyprus and Malta (CEE+) are the new member states that joined after 2004.

Table 1: Convergence and divergence in Euro (PPP) 1998-2015

Source: Eurostat; author’s calculations (unweighted averages of the country groups)

NW = Sweden, Finland, UK, Ireland, Belgium, Netherlands, Luxemburg, France, Germany, Austria, Italy

SP = Greece, Portugal, Spain

CEE+ = Baltics, Poland, Czech Republic, Slovakia, Hungary, Slovenia, Bulgaria, Romania, Croatia, Cyprus, Malta

As table 1 shows, growth in both poorer regions was stronger than in the rich core until 2007. But, while the three Southern countries fell back afterwards due to austerity, CEE growth continued to outpace the core’s. Economists call this kind of convergence “beta convergence”. It leads to a better relative quotient, improving the relation between the GDP/capita in CEE+ and NW from 2.14 to 1.7. Perhaps surprisingly, this does not imply “sigma convergence”, i.e. a decline in the absolute inequality measured by the standard deviation (last line in table 1) or the absolute difference between the GDP/capita (NW-CEE+ or NW-SP in table 1). These absolute measures are still increasing in spite of higher growth in the poorer member states. The most shocking fact is the divergence between the core and the Southern periphery, reversing decades of convergence.

Causes: real and nominal convergence

The major cause of the gap between different countries’ GDP/capita is the different level of labour productivity (per hour or per employee). Employees in poorer member states tend, in fact, to work more hours (often more than 2000 hours per year) than those in rich countries (mostly less than 1500 hours). Still much lower productivity (at about 20% of the more advance countries) leads to a big gap in income levels (Dauderstädt).

Labour productivity depends primarily on the amount of capital used, the technologies employed and the speed of innovation. Thus, capital flows into poorer member states, in particular when they incorporate better technologies, should accelerate productivity growth. Structural reforms are supposed to alleviate adjustment and change from less productive companies and industries to more productive ones. Securing the poor countries’ access to capital remains crucial. The regional funds and cohesion policies are not sufficient to counteract private flows, driven by volatile market sentiments.

Successful catching-up growth processes (as in most countries of the European periphery until the crisis) depend on these structural changes leading to real convergence. But catching-up requires nominal convergence, too. Nominal incomes must appreciate in comparison to richer countries by the way of currency appreciation or higher inflation. The latter is a necessary feature of catching up as incomes and prices in industries with slower or no productivity growth must increase in step with the average productivity growth of the whole economy. Thus, the request for low inflation and stable exchange rates is a recipe to stop or slow down cohesion.

The consequences of high inequality

Persistent high inequality between member states leads to migration from poorer into richer countries. Indeed, some countries in CEE such as Romania, Latvia and Lithuania have lost more than ten percent of their labour force due to emigration. Often, this implies a serious brain drain when the most qualified people (doctors, engineers) leave for better-paid jobs in the core regions of the EU. The low wages in the poorer countries attract foreign investment in labour-intensive, low-skill industries at the same time. Both processes are likely to increase the gross national income, which includes the earnings of national citizens abroad, although only the latter has a direct positive impact on GDP.

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In the richer member states, these developments will probably increase inequality as wages of low-skilled workers are under pressure from job-seeking immigrants and the threat of offshoring, i.e. the relocation of parts of the production to low-wage locations. The best remedies are statutory minimum wages and social investment in education and training.

The second in a series on inequality co-sponsored by SE, the Hans Böckler Foundation and the Friedrich Ebert Foundation