Productivity is Europe’s ultimate problem

By Nemat Shafik

It is now widely accepted that managing the eurozone crisis requires “more Europe”. Greater integration is needed not just for the sake of the single currency, but also across the single market of the EU to improve competitiveness and revive economic growth. 

Last year saw policy makers take important decisions to manage the crisis. The decision-making process was not always elegant and the architecture is not yet fully in place, but ultimately “just in time integration” appears to have averted a currency crisis. As Jean Monnet, one of the EU’s founding fathers, said: “People only accept change when they are faced with necessity, and only recognise necessity when a crisis is upon them.”

While the primary symptom of the crisis was financial disintegration, the primary cause was the lack of convergence in productivity. Many economic analysts mistakenly believed that the common currency and narrowing of bond yield spreads would mean that capital would flow where it could be used most efficiently – and convergence would occur. In fact, those eurozone countries with the lowest per capita incomes in 1999 did not have the highest per capita growth rates. Interestingly, many countries in eastern Europe did better than those in the south – their per capita incomes converged faster because their economies were more competitive and were able to integrate into worldwide supply chains, particularly through strong links with Germany. 

The period of current stability must be made durable. This requires fixing the eurozone financial sector, high debt levels – and solving the problem of low convergence in productivity by improving competitiveness. Unfortunately, it all has to happen against the backdrop of a still-weak economic outlook – the International Monetary Fund’s latest forecast is for a slight contraction in the eurozone in 2013. 

Consider product and labour market reforms. Research from the IMF suggests closing half of the eurozone’s gap with OECD best practice in employment market and pension policies could boost gross domestic product by almost 1.5 per cent on average after five years – and by another 2¼ per cent if more competition is introduced into markets for products and services. 

Gains from such structural reforms accrue gradually, which makes them difficult for politicians to implement. Substantial progress has been made, most notably in the hard-hit southern periphery. But such reforms, often implemented at high social and political cost, have for the most part yet to translate into tangible gains in the form of growth and jobs.

In Greece, for example, the government has taken bold steps to reform the labour market. But these gains have not yet translated into lower prices. The reason is that many markets remain protected. Take baby formula, for example. Until recently, only pharmacies had the right to sell it. Last year, the government liberalised sales and prices promptly dropped by at least 20 per cent. But then the measure was reversed after opposition from those who had benefited from the restriction. Baby formula is now back on the shelves of Greek supermarkets, but this illustrates what an uphill battle it is to inject more competition into economies that have grown accustomed to high levels of protection. Many of the required reforms will have to be done at the national level. But many, such as fixing troubled banks and implementing banking union, needs to happen at the eurozone level while others, such as labour mobility or service sector liberalisation, would benefit from collective action by the EU.

What is economically necessary is, however, politically difficult. Public support for the European project has fallen in most countries of the union. Eurozone and EU members will need to hammer out compromises that focus on the medium-term gains for the union from reform rather than getting bogged down at the national levels by the costs of adjusting.

The financial symptoms of the crisis are thankfully receding with a new sense of optimism in markets. But a key underlying problem – the lack of convergence of productivity – remains to be addressed. Further integration will have to be part of the solution to restoring growth and making it last. Europe’s leaders should continue their long and arduous climb, and avoid the temptation to look down until they reach the top. Copyright The Financial Times Limited 2013