policy insight 67

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Whats wrong with Europe?Paolo Manasse and Isabella Rota BaldiniUniversity of Bologna; Link Tank

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November 2013

The economic recovery is well underway in theUS growth back to 2.5% and unemploymentfalling. The Eurozone economy, by contrast,

is still struggling (IMF 2013). Why is this?

This Policy Insight argues that major structuraland institutional differences go a long way inexplaining this transatlantic divergence. Unlikethe US, the Eurozone consists of a heterogeneousfederation of independent states, an economicarea where goods, labour and nancial markets aresegmented by national boundaries. Consequently,competition across states is often scarce (comparedto the US), and European institutions are farfrom adequate to address the fragmented and

diverse economic dif culties facing its constituenteconomies.

We document in this paper that the crisis has slowedthe process of convergence between EZ countries,bringing to light the unresolved structural problemsthat hamper growth in many countries. Price andwage rigidities have exacerbated the recessionaryeffects of demand shocks, the credit crunch andbudget consolidations. Moreover, the crisis hasexposed the underlying fragility of both new andold European institutions, revealing serious faultsin the overall design of the European monetaryunion.

Per-capita GDPIt is informative to compare the trend of per-capitareal GDP in the US (the blue line in Figure 1) withthat of the Eurozone (the yellow line in Figure 1).Real average incomes have declined since 2007-2008 in both areas. The impact of the crisis inthe US was larger, with a reduction of $2,459 atconstant prices (-6%), compared to the Eurozone,where incomes fell by 1200 (-4.7%). However,

while average income in the US had returned toits pre-crisis level by 2012, that of the Eurozoneremains 2.5% below its 2007 level.

In order to understand why this is the case, it isuseful to compare the level of average incomesacross the individual US states and EZ member

states. Figure 1 shows two bands, blue for the USand yellow for the Eurozone, whose upper andlower limits consist of the per-capita income in therichest and poorest intra-union states. 1 The graphclearly shows that internal differences are muchgreater in the Eurozone than in the US: between2000 and 2012, the real per-capita income of therichest US state was ve times that of the pooreststate, while in the Eurozone the ratio was 8.6:1.

Figure 1 Real per-capita GDP

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Figure 2 clari es how these differences have changedover time. The yellow and blue lines represent, forthe Eurozone and the US respectively, an indexthat measures the average distance of individualstate per-capita income from the mean in thetwo areas. 2 A negative slope indicates a reductionin income differences across states. The gureshows that until 2008 income differences amongEuropean countries fell, but that this process hasslowed since the beginning of the crisis. In theUS, the crisis increased the degree of inequalitybetween states on impact, but this increase wasreversed beginning in 2009.

1 These are the District of Columbia and Mississippi for theUS, and Luxembourg and Estonia for the Eurozone.

2 More precisely, the lines measure the ratio of the standarddeviation of per capita income and the mean.

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Figure 2 Dispersion in per-capita GDP

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120.3

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0.6Coefficient of variation

CV_Euro CV_USA

A closer look at convergence/divergence

According to the standard model of economic

growth, poor countries should grow faster thanrich ones. This is because poor countries tend tohave less capital, compared to labour, implying thatthe marginal product of capital and the return toinvestment should be greater. Europe experienceda signi cant process of convergence between2000 and 2007, as documented by the reductionin the dispersion of per-capita incomes across EUmembers, but the speed of this convergence hasbeen halved in the most recent period followingthe crisis.

Figure 3 EZ convergence and US divergence

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3.1 Convergence in Eurozone

2007-2000 2012-2007

In Figure 3.1, each dot represents a country in theperiod 2000-2007 (in blue) and 2007-2012 (in red).The gure shows the relationship between theinitial level of real per-capita income on the x-axis,and the average increase in income in subsequentyears on the y -axis. When the data points lie on adownward line, this means that the countries thatinitially had the lowest per capita incomes havegrown faster on average. The greater this (negative)slope, the higher the speed of convergence. Thegure shows that the European convergence ratealmost halved in the post-crisis period comparedto the previous period (the slope of the red lineis about half the slope of the blue one). In the US(see Figure 3.2) the relationship between growthand initial income is less clear and statisticallyinsigni cant. In fact, the graph suggests that therecent period has increased income divergencebetween US states.

Figure 4 Aggregate supply and demand

Two factors explain these divergent patternsacross countries. The rst is the extent to whichnational economies were subject to large demandshocks (in particular related to the credit crunchand scal austerity). The second is the role ofstructural rigidities in product and labour markets.The negative effects of demand shocks on GDPand employment are larger when prices are rigid,as rms use their market power to prevent pricesfrom falling, thereby exacerbating the declinein consumption and output. The same holds forwage rigidities, as the unemployed are not easilyreabsorbed into the labour market. These demandand supply effects are depicted in Figure 4. Aleftward shift in the aggregate demand curve, fromAD to AD, has a large negative effect on outputwhen the aggregate supply curve (ASr) is atbecause prices are sticky. On the contrary, demandshocks have no effect on output when the supplycurve is vertical (ASf) as prices are completelyexible and absorb the full effect of the shock.

ProductivityIt turns out that countries that had larger labourmarket rigidities and lower (incentives for)productivity growth before 2008 have suffered moreduring the crisis. Figure 5 shows the relationship



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between the cumulative growth of total factorproductivity in Europe during the pre-crisis period(2000-08), and the subsequent change in real GDPper-capita from 2008-2012. The countries whoseproductivity had risen by less before the crisiswitnessed a greater fall (or smaller rise) in per-capita GDP during the crisis. However, there areexceptions: Greece (the lowest point in the chart)experienced a meltdown of GDP per-capita duringthe crisis (-17%) despite having experience amodest rise in productivity (+1.5%) in the previousyears. Slovakia (the rightmost point in the chart)also experienced a decline in capital income(-2.8%) despite a spectacular cumulative growth inproductivity of 30% between 2000 and 2008. TheGreek experience is certainly tied to the sovereigndefault and the harsh austerity measures; that ofSlovakia is largely due to the sharp contraction inexports. 3 Both cases highlight the important roleplayed by aggregate demand factors in addition to

supply rigidities (see below).

Figure 5 TFP and crisis in the Eurozone

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Source: European Commission, Eurostat

The labour market

The recessionary impact of the crisis has beenworse in countries where unemployment (and thuslabour market rigidities) was already high before thecrisis. Each dot in Figure 6 represents a state. Thehorizontal axis shows the average unemploymentrate before the crisis, and the vertical axis measuresthe change in the unemployment rate after 2007.The positive slope of the trend line implies thaton average unemployment has risen more inthose countries where it was already high beforethe crisis. Interestingly, this process of divergenceis much stronger in Europe than in the UnitedStates.

Figure 7 shows the average unemployment ratein the Eurozone (yellow) and the US (blue). Thebands around the lines describe the maximum andminimum levels in both economic areas. In 2007,

the largest difference in unemployment ratesbetween US states was 4.6%. This gap widened

3 For a discussion of the role of productivity and unit laborcosts in Italy see Manasse (2013).

to 10% in 2010, but has since declined. TheEuropean experience was very different. Already inthe pre-crisis period, the European labour marketwas much more segmented: different cultures,languages and institutions limit the internationalmobility of labour so that unemployment ratesare not equalised across countries. After the crisis,the gap widened to reach 20.7% in 2012, withunemployment equal to 25% in Spain and 4.3%in Austria. While aggregate unemployment inthe US has been declining since 2010, aggregateunemployment in the Eurozone continues to grow.

Figure 6 Unemployment in the Eurozone and the US

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6.2 Divergence of unemployment in US

Figure 7 Unemployment rate

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Source: Bureau of Labor Statistics, Eurostat

Budget defcitsFiscal policy is another important element thatexplains the dif culties in Europe. In the US, thefederal de cit as a percentage of GDP (see Figure 8)



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increased from 0.7% in 2006 to over 13% in 2009,remaining above 8% until 2012. This re ects inpart the expansionary policies put in place by theObama administration, in addition to the effectsof "automatic stabilisers" (the tendency of transfersto rise and revenues to fall during a recession)and the dramatic fall in GDP. Europe, contrary tothe US, does not have a real "federal budget" in amacroeconomic sense. 4 Moreover, the EU cannotissue common debt.

The yellow line in Figure 8 thus represents theaverage budget/GDP ratio of Eurozone countries,and not a federal budget. The rise in the averagede cit in the Eurozone between 2007 and 2009(5.7% of GDP) is largely due to the collapse inGDP and the automatic stabilisers. The two solidlines show the maximum and minimum level ofbalance/GDP ratio in the US states and EU memberstates. From Figure 8, it is clear that it is the federal

budget that is responsible for stabilisation, whilestates do not stray too far from a balanced budget(the blue stripe). 5 In Europe, the opposite occurs:given the absence of a federal budget, economicstabilisation can only be implemented at themember state level. Fiscal rules designed to insurescal discipline (e.g the Stability and GrowthPact and the Fiscal Compact) are imposed fromthe center, but these rules are (unsurprisingly)systematically violated, particularly when theeconomic situation deteriorates (e.g. Manasse,2007) Figure 8 also shows that since 2008 the gap

between budget positions has increased in Europe(the yellow band). However, as early as 2009-10almost all Eurozone countries put in place policiesto cut budget de cits, and this has led to a reductionin budget differences across member states.

Figure 8 Budget/GDP in the Eurozone and US

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Source: Eurostat, IMF World Economic Outlook April, 2013, ourcalculations based on data www.usgovernmentspending.com

Public debtsThe implications for public debt levels are shownin Figure 9. The US federal debt has increased from60.4% to 106.5% of GDP between 2006 and 2010,

while the debt of individual states (blue band)

4 The budge of the EU represents about 1% of GDP and isalways balanced.

5 In the US, states adhere to (explicit or implicit) self-imposedrules of budget discipline.

never exceeded 20%. In Europe, the average debt/GDP ratio of countries (there is no federal debt)increased from 70 to 90.6%. While the increase inaverage debt levels has been much less than in theUS, contrary to the US, the differences betweenEuropean member states have exploded: in 2012,Estonia had a debt/GDP ratio of 10% while inGreece it was 157%.

Figure 9 Debt/GDP at state and federal level

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Source: Eurostat, IMF World Economic Outlook April 2013 www.usgovernmentspending.com.

Fiscal austerityExplaining the heterogeneous impact of the crisison Eurozone countries cannot abstract from thedemand effects of scal consolidations. Figure 10shows the relationship between the extent of scaltightening in the period 2009-12, measured by theimprovement in the budget balance as a percentage

of GDP on the x-axis and the growth of GDP percapita over the same period on the y -axis.

Figure 10 Fiscal adjustment and Eurozone per capitaGDP

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On average, each percentage point of reductionin the de cit/GDP ratio is associated with a fallof 0.84 points of GDP per capita. 6 The gure alsoshows signi cant heterogeneity in the response ofEuropean countries to the budgetary tightening,which suggests that scal austerity alone is notenough to explain the differential impact of thecrisis. The most notable cases are Greece and

Ireland, two countries that have lost access to

6 Note however that this number is likely to overestimatethe negative impact of domestic austerity on demand forsmaller countries, which are more exposed to the negativespillover effects from other countries consolidations.



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international capital markets and were forced torely on conditional loans offered by the "Troika"(EU, IMF, ECB). In Greece (bottom right of thegraph), GDP per capital fell by nearly 20%, whilethe budget position improved by about 5.6 pointsof GDP. In contrast, in Ireland (right of the graph),per-capita income has remained largely unchangeddespite a scal tightening of over 6% of GDP. Thedifference between these two countries exempli esthe difference between a rigid and exibleeconomy, as described above.

Redistribution in Europe and the USThe lack of an adequate EU federal budget notonly prevents Eurozone countries to implementstabilisation policies in the face of global economicshocks, but also prevents the implementation ofan effective risk-sharing system based on inter-state transfers that would insure countries against

country speci c shocks (such as the bankingcrises in Ireland or Spain). The Netherlands, thelargest net contributor to the European budgetrelative to its GDP, pays to the EU budget 0.31% ofGDP per year (see Table 1).

Table 1 Net contributions to EU budget

CountryNet contributions

( million)% GDP

Belgium -1369 -0.36

Bulgaria 725 1.94

Czech Republic 1455 1.01

Denmark -836 -0.34

Germany -9002 -0.34

Estonia 350 2.31

Ireland 383 0.31

Greece 4622 2.22

Spain 2994 0.29

France -6405 -0.31

Italy -5933 -0.38

Cyprus 6.8 0.04

Latvia 731 3.62

Lithuania 1368 4.63Luxembourg -75 -0.24

Hungary 4418 4.67

Malta 67 1.15

The Netherlands -2213 -0.36

Austria -805 -0.27

Poland 10975 3.10

Portugal 2983 1.81

Romania 1451 1.08

Slovenia 490 1.40

Slovak Republic 1160 1.71

Finland -652 -0.34

Sweden -1325 -0.33

UK -5565 -0.32

Source: European Commission 2011 data

Hungary, the country that most bene ts from theEU budget, receives transfers equal to 4.76% ofGDP. The size of the equalisation scheme in theUS is at least one order of magnitude larger (seeTable 2). The poorest states (such as West Virginia,Mississippi, New Mexico and Puerto Rico) havereceived between 1990-2009 total transfers totallingbetween 224% and 291% of their GDP, while therichest states (such as New Jersey, Delaware andMinnesota) have contributed between 150% and206% of their income.

Table 2 US scal transfers



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Conclusions

We have documented that:

The crisis slow convergence process amongEuropean economies.

This has ampli ed the differences in terms ofincome, unemployment, scal balance and publicdebt. This has happened because:

The countries have been subject to demandshocks, scal austerity and a credit crunch ofdifferent magnitudes.

These asymmetric shocks exacerbated pre-existingsupply-side structure problems in goods, labourand credit markets.

The crisis has also highlighted the inadequacy ofEuropean institutions, and exposed serious aws

in their design (Wyplosz, 2013).

In the US, the federal budget serves a dualpurpose: aggregate macroeconomic stabilisationand redistribution of income through inter-state transfers.

Moreover, the US states choose their own scalrules, and budget discipline is supported by anexplicit no-bailout commitment from the federalgovernment.

In the Eurozone, the federal budget is negligibleand always balanced, implying that the burdenof macroeconomic stabilisation falls on nationalbudgets.

Budgetary discipline rules are imposed from thecentre, and prevent effective implementationof stabilisation policies and insurance againstcountry-speci c shocks.

Unlike the US, the integrity of the Eurozoneultimately depends on the political will of eachmember. This makes the Eurozone intrinsicallyvulnerable to speculative attacks. In order to stem

the crisis, the ECB has intervened by providingcheap liquidity to banks, enabling them to buygovernment bonds and to use these as collateral forloans. The EFSF/ESM fund has contributed to therecapitalisation of banks in Spain, and should alsobe used to nance interventions in governmentbond markets. This tool, however, is likely tocreate moral hazard problems because, given therecent experience in Greece, Ireland and Portugal,it cannot be supported by a credible no bail-outcommitment.

The way to shelter the Eurozone from the risk ofdisintegration is long and fraught with politicalobstacles. It requires member states to undergodif cult structural reforms. It also requires Europeto gradually establish a federal budget and an inter-state risk-sharing mechanism. 7 Notwithstandingthese challenges, it is a path worth pursuing, sincethe alternative (the disintegration of the Eurozone)

would have unforeseeable consequences. Inaddition to the solvency risks for state and banks,a return to national currencies carries the risk oftaking the continent back to an era of competitivedevaluations and trade protectionism. In sucha scenario, the bene ts of the free movement ofgoods, persons and capital could be at stake.

ReferenceIMF (2013), World Economic Outlook , InternationalMonetary Fund, October ( www.imf.org/external/

pubs/ft/weo/2013/02/ ).Manasse, Paolo (2007), De cit Limits and Fiscal Rules for Dummies , IMF Staff Papers, 54(3).

Manasse, Paolo (2013), The Roots of the Italian Stagnations , CEPR Policy Insight No. 66.

Wyplosz, Charles (2013), Europes Quest for Fiscal Discipline , Economy, Economic Papers, No. 498,European Commission.

7 This could be achieved by devolving the proceeds and theadministration of part of the tax base (e.g the VAT) to thecentre.

Paolo Manasse is Professor of Macroeconomics and International Economic Policy at the University of Bologna. Healso taught at L. Bocconi (where he currently teaches Macro in the PhD program), at Sorbonne (Paris I), Johns Hopkins(Bologna Center) and other Italian universities. He worked as a Consultant for the OECD, the World Bank, the Inter-American Development Bank, and was a resident Consultant, Visiting Scholar and Technical Assistance Advisor for theIMF. He is a research fellow of IGIER-Bocconi in Milan, and of the Rimini Centre for Economic Analysis. His researchinterests are in international macroeconomics, including a wide range of issues such as monetary and scal policy incurrency unions, scal federalism and asymmetric information, international trade and the labour market, internationalpolicy coordination, sovereign debt and banking crises.

Isabella Rota Baldini is the editorial coordinator of Link Tank ( www.linkiesta.it/linktank ), a section dedicated toeconomic analysis, at Linkiesta.it, an Italian online newspaper. She holds a double degree in Economics and SocialSciences at Universit Bocconi and at HEC, Paris (2011). During her studies, she spent a semester at the Universityof California, Berkeley.
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The Centre for Economic Policy Research , founded in 1983, is a network of over 800 researchers based mainlyin universities throughout Europe, who collaborate through the Centre in research and its dissemination. The Centresgoal is to promote research excellence and policy relevance in European economics. Because it draws on such a largenetwork of researchers, CEPR is able to produce a wide range of research which not only addresses key policy issues,but also re ects a broad spectrum of individual viewpoints and perspectives. CEPR has made key contributions to awide range of European and global policy issues for almost three decades. CEPR research may include views on policy,but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes noinstitutional policy positions. The opinions expressed in this paper are those of the author and not necessarily those

of the Centre for Economic Policy Research.

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