Sunday, May 02, 2004
Will new blood revive Europe?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

Were it not for the carve-up of eastern Europe after the first world war, the people of Transylvania would this weekend be marking their membership of the EU as part of Hungary. But the region was given to Romania in that deal, so they will have to wait until 2007.

I mention Transylvania partly because this may be the only chance I get to refer to its most famous figure, Vlad the Impaler, in an economics column. Mainly, though, it is because of a misspent youth watching Hammer horror films and the fictitious Transylvanian, loosely based on Vlad, Count Dracula. He was usually pale and decrepit but magically revitalised by feasting on blood, usually that of young women.

I wouldnít want to take the analogy too far but the topic is highly relevant after this weekendís big enlargement. Will new blood from eastern Europe revitalise a pale and decrepit EU?

This is the fifth EU enlargement in nearly half a century of existence (slightly longer if you start from the European Coal and Steel Community of the early 1950s). Europeís original six ó Belgium, France, Germany, Italy, Luxembourg and the Netherlands ó were joined by Britain, Denmark and Ireland in 1973, Greece in 1981, Spain and Portugal in 1986, and Austria, Finland and Sweden in 1995.

The entry of 10 new members ó Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia ó is thus the biggest enlargement in the number of countries.

It is also the biggest in terms of extra population, just pipping the 1973 enlargement. Figures from Eurostat show that the EU is adding 74m people to its existing population of more than 380m. Just over half of the EUís new citizens come from one country: Poland.

What about the economic impact? Here the numbers are less impressive. While the EUís population will rise by nearly 20%, the boost to gross domestic product will be a mere 5%.

In GDP terms, this enlargement is the smallest apart from the entry of Greece 23 years ago. The 10 new members have a combined GDP no bigger than that of the Netherlands (population 16m), and under a third of the size of Britainís economy.

With the exception of Cyprus, and to a lesser extent Slovenia and Malta, these are very poor countries. Per capita GDP in the 10 is just over 20% of the EU average. Even adjusting for relative prices, so-called purchasing power parity, per capita incomes are under half of EU levels. The new members do not have much economic weight to throw around.

They will, however, have an economic impact; indeed, they already have. Charles Robertson, emerging-markets economist at ING, points out that EU firms have been enjoying cost savings for years by investing in the accession countries in anticipation of this weekend.

The flood of foreign direct investment to the new members, bigger in per capita terms than to China, and with 85% coming from the EU, has been one of the big stories of recent years. German companies have been investing in Britain for decades but have been determinedly looking east lately. The BDI, Germanyís CBI, estimates that 8,000 German firms have investments in Poland, compared with 2,000 in Britain.

The advantage these countries have is low labour costs. Wages have been rising strongly in recent years, up by more than 40% in the Czech Republic and more than 70% in Hungary since 2000. But that is a well-known economic effect, the so-called Balassa-Samuelson effect, as rising export productivity, driven by large-scale investment, pushes pay higher generally. However, a huge wage advantage remains: Polish pay is just 18% of the EU average.

Even allowing that workers in the new members are not yet as productive as those in western Europe, the advantage in labour costs is decisive. Bulgaria and Romania, which should join in 2007, have wages less than 10% of the EU average.

One thing the accession countries will bring to the party is rapid economic growth. This is partly catch- up, as their economies converge on the rest of the EU. But there is also a ďsmall countryĒ effect. With Britain as the main large-country exception, the EUís small economies have outperformed their bigger brothers. Finland, which comes near the top of many of the competitiveness league tables, is a good example.

The new members have been growing rapidly and, according to projections by Lehman Brothers, will continue to do so. It predicts annual average growth of 4%-6% between now and 2013. Even Poland, as the biggest of the new boys, is expected to show annual growth of 5%.

The entry of these fast-growing economies will raise EU growth, if only fractionally. The big question is whether by example, and by asking questions of competitiveness, they will raise the game of the existing EU members. They could ó but only if Europe grasps the nettle of economic reform.

Lehmanís report, Building the New Europe (available in summary from globalec@lehman.com), sets out three scenarios. In its baseline scenario, there is some reform along the lines set out in the Lisbon agenda but progress is slow. Despite enlargement, the EUís share of the world economy slips from 35% now to 33% by 2020. It could be worse. In their pessimistic scenario, enlargement raises tensions, reform grinds to a halt, and the EUís share of the world economy slides to 28%.

Only in its optimistic scenario does the new blood really revitalise the EU. Enlargement gives Europe new political confidence and a determination to tackle longstanding inflexibility. A dynamic new EU lifts its share of the world economy from 35% to 44%.

Which will it be? Recent history would suggest that optimism about Europe is misplaced. The dynamic new boys will make a lot of noise, but the EUís old codgers will draw the curtains and carry on as before.

PS: Some clear messages have emerged from the Bank of Englandís monetary policy committee (MPC), the clearest being that it does not target house prices (up 2.1% last month and 18.9% on a year earlier, according to Nationwide). Paul Tucker, Marian Bell and Kate Barker have all said this. Tucker and Bell have signalled that rates need to rise, while Barker was more guarded.

It is an unwritten rule of Bank independence that MPC members will not say before a meeting how they intend to vote. Professionalism and etiquette require that they assess all the evidence and listen to the arguments of their colleagues before committing themselves.

That said, things have rarely been as well-positioned for a rate rise. The City, having half expected it in April, would be thrown into confusion if the MPC passed up the chance again this week. Business is reconciled to a rise. Even Gordon Brown has given his blessing, though that is something the Bank could do without. A ďno changeĒ announcement on Thursday would raise questions about whether further increases were likely at all.

That is why the Bank should, and surely will, act. The basis will not be house prices but the strength of the economy. A rise this week from 4% to 4.25%, following the November and February hikes, would maintain a pattern. Each time the Bank has a new inflation report (they come out in February, May, August and November), it raises rates.

These things are never, of course, set in stone. If MPC members havenít finally decided how they will vote this week, they havenít thought about future months. Even so, August 5 and November 4 might be worth putting in the diary.

From The Sunday Times, May 2 2004