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LATE last month was a dismal one for the European Union. As my colleague, Wolfgang Munchau, argued in the Financial Times, the European leaders reduced the stability and growth pact to a scrap of paper, removed the liberalising thrust of the services directive and failed to focus the Lisbon agenda on priorities. Though not alone, Jacques Chirac, the French president, was the leader of these naysayers.
Behind all this lies something even more disturbing: a desperate desire for integration shorn of inconvenience. Few, if any, leaders are prepared to recognise a simple truth: neither European enlargement nor monetary union, for that matter, can succeed without far more flexible labour markets. Chirac condemned such "ultra-liberalism" as the new communism. But his response to modest reforms also shows how far Chirac is from recognising today's realities.
This is not the first time in the recent past that forces of economic integration have come up against profound resistance to change.
Back in 1990, we should remember, the then West Germany absorbed the former East Germany. United Germany's population was roughly a third bigger than that of the old West Germany. The impact of last year's EU enlargement was an increase in population of only 20 per cent. Yet, in relation to the old EU of 15, these economies are at least as poor as the former East Germany was in relation to West. So what can be learnt from that experience?
Let us start with the theory. Consider the integration of two economies, one much richer than the other, that were previously separated by tight restrictions on the movement of goods, services, labour and capital. What should happen when the barriers are lifted? Wages, returns on capital and prices of goods and tradeable services should come much closer together, is the answer. How powerful convergence turns out to be also depends on the height of the residual barriers. In the case of Germany, those barriers were small: the language was the same, the two regions were next door and the institutions of the west were transplanted lock, stock and barrel into the east.
So what happened? In a nutshell, the western powers-that-were blocked the forces for convergence through growth by imposing excessive costs on the east. William Page, a Scottish economist, suggests plausibly that "the intention of West German unions and employers' associations (who represented East German workers during the crucial negotiations of 1991) [was] to price East German labour out of the market and to ... prevent them from threatening their (western) markets".
It was not, as often argued, the initial currency conversion that had this effect but the subsequent push for wage convergence, itself supported by the introduction of inappropriately high unemployment benefits in the east. The result has been convergence of output per worker (albeit still incomplete) via shrinking employment and emigration rather than higher investment and output.
Many outsiders (including the FT) warned at the time that precisely such a German mezzogiorno (after Italy's long-lagging south) might emerge. Western policymakers did achieve their overriding aim: they combined unification with minimal change in the west. But they had to pay a price: a permanent subsidy bill of roughly 4.0 per cent of gross domestic product (GDP). That helps explain why Germany's fiscal position remains so difficult. This, in turn, explains why the country that created the stability and growth pact has now been a leader in weakening it.
Now turn to today's Europe. The EU also guarantees freedom of movement of goods, services, labour and capital, which are fundamental pillars of the EU's single market. The EU, too, has a currency union that the new members are expected to join. In principle, therefore, integration should generate strong pressures for wage and price convergence inside the enlarged EU, even though language, distance and differing qualities of institutions will be far bigger obstacles than they were in the cage of Germany.
Yet there are also huge differences between the two cases. There is no mechanism to impose the panoply of western European costs on the new entrants and no possibility of subsidising the consequences of misguided attempts to do. On the contrary, the principal contributors to the EU budget are adamantly opposed to raising their support.
Yet, it is also clear that neither Gerhard Schroder, Germany's chancellor, nor Chirac, to name but two, is willing to accept another possible outcome of integration: still greater downward pressure on real wages at home. That is why the services directive, with its proposal that service providers resident in the EU be entitled to operate freely, has been so contentious. This idea, we are now told, is "social dumping", a malign form of behaviour incompatible with the vaunted "European social model".
The recent enlargement is modest in scale. Bulgaria, Romania, the Balkans, Turkey and perhaps Ukraine are also in the wings. Inclusion of all these countries would add more than 60 per cent of the population of the EU of 15. Moreover, these economies are very poor. Turkey's GDP per head, at purchasing power parity, is a quarter of that of the richer member states. Ukraine's is even lower. The economies of "old Europe", particularly those with structurally high rates of unemployment, are ill equipped to adjust to deep integration with such large and poor countries.
The response, in France at least, will be to say "too bad for enlargement". Such resistance is understandable. The US, after all, shows even less enthusiasm for free immigration of Mexican workers. For the EU, however, the ability to adjust to the economic consequences of integration is a necessary condition for its future political success. Good economics are, as always, a condition for good politics. At the moment, however, the EU suffers from bad politics and worse economics. The needed reforms will be painful. But the EU's choice is between accepting more flexibility now and failing later.
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FT Syndication Service
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