An earlier version of this paper was presented at the Annual Meeting of the American Economic Association in Boston in January 2015. I thank Barry Eichengreen, Martin Feldstein and Dale Jorgenson for helpful comments, but I alone am responsible for any remaining shortcomings.
This paper analyses Europe's growth problem. Recovery from the recent global financial crisis and ‘great recession’ has been slower than after previous recessions in most advanced countries and areas, especially Europe. But the European growth problem is structural in character and it started much earlier. This paper analyses the structural causes of the European growth problem, evaluates the policies that Europe adopted to overcome it, and concludes that even with the appropriate policies, the prospects for accelerating growth in Europe will be difficult, especially in the context of Brexit and the slowdown of world growth in general.
Recovery from the recent global financial crisis and ‘great recession’ has been slower than after previous recessions in most advanced countries and areas, especially Europe. But Europe's growth problem is structural in character and started much earlier. This paper analyses the structural causes of the European growth problem, evaluates the policies that Europe adopted to overcome it and concludes that even with the appropriate policies, the prospects for accelerating growth in Europe will be difficult, especially in the context of Brexit and the slowdown of world growth generally.
2 Slow Recovery and Growth After the Global Financial Crisis
The recent global financial crisis and ‘great recession’ started in the US housing sector in 2007 and quickly spread across the Atlantic. Deep recession in advanced countries then greatly reduced their imports and financial flows to emerging markets, thereby spreading the crisis to the rest of the world. Most emerging market economies (such as Russia, Mexico and Turkey) fell into a deep recession, while China faced a sharp slowdown in its record-breaking growth. Only in India growth held up.
Table 1 shows that at the depth of the recession in 2009, the fall of real GDP ranged from 5.6 per cent in Germany to 2.8 per cent in the United States among the largest advanced nations (it was 4.5 per cent for the Euro Area of 17 at the time). Table 2 shows that among the largest emerging market economies, real GDP fell by 7.8 per cent in Russia, 4.8 per cent in Turkey and 4.7 in Mexico, while China faced only a sharp growth slowdown starting in 2012 (Salvatore, 2010).
Table 1. Average Growth (%) of Real GDP in Major Advanced Countries in 2009–15 and Forecast for 2016–17
3 Policies to Overcome the Crisis and Stimulate Growth
The United States and other advanced nations responded to the great recession by rescuing banks and other financial institutions from bankruptcy, slashing interest rates, introducing huge economic stimulus packages and undertaking huge injections of liquidity (quantitative easing or QE). These efforts, however, only succeeded in preventing the economic recession from being deeper than otherwise and the subsequent recovery being even slower than it has been.
To overcome the crisis, the Fed and the ECB (as well the Bank of England, Japan and Canada) drastically cut their fund rate starting in 2008, so much so that by early 2014 they were close to zero in nominal terms and negative in real terms (and subsequently negative even in nominal terms in the Euro Area and Japan, and also in Switzerland, Sweden and Denmark). They also conducted non-traditional expansionary monetary policy (QE) that sharply increased their holdings of private long-term assets so as to further lower long-term rates to stimulate growth.
Tables 3 and 4 show that powerful expansionary fiscal policy was also used, first to fight the recession, and then to stimulate growth. This led to huge budget deficits and very large increases in government debts.1
Table 3. Budget Deficits as Percentage of GDP in Major Advanced Countries, 2007–15 and Forecast for 2016
But Europe's growth problem is structural and started long before the recent global financial crisis. The recent crisis only exacerbated the problem, by making it worse. The left panel of Figure 1 shows that real GDP fell much more in the Euro Area than in the United States at the height of the crisis in 2009 and that it took until 2015 (not shown in the figure) to return to its pre-crisis level of 2007, while in the United States real GDP returned to its pre-crisis level in 2011 and it was almost 10 higher by 2015. The right panel of Figure 1 shows that the difference in the per capita GDP (labour productivity) performance between the Euro Area and the United States was only a little smaller than it was in terms of total real GDP.
But the Euro Area's growth problem started in the early 1980s and that the recent global financial crisis only made it worse when compared with the US growth. Figure 2 shows that starting at about the same level in 1983, the GDP, in purchasing power parity (PPP) terms at 2014 dollars, grew much more slowly in the Euro Area than in the United States and that the divergence widened significantly from the start of the global financial crisis in 2008 until 2015.
5 Low Productivity and Slow Growth in Europe
Table 5 shows that the slower growth of real GDP in the Euro Area and the European Union as a whole in relation to the United States reflects Europe's slower growth of labour productivity and total factor productivity. The table shows that from 1999 to 2006, the average yearly growth of real GDP was 3.0 per cent in the United States as compared with 2.3 per cent in the Euro Area and 2.6 per cent in the European Union of 28 (EU-28). From 2007 to 2015, comparable figures in percentages were, respectively, 1.3, 0.4 and 0.7.2 Thus, the growth of real GDP declined sharply in the United States, the Euro Area and EU-28 after 2007, but it remained lower in the Euro Area and EU-28 than in the United States. Comparable figures (in percentages) for labour productivity growth were, respectively, 2.4, 1.5 and 1.9 for 1999–2006 and 0.9, 0.6 and 0.7 for 2007–15.
Table 5. Average Growth (%) of Real GDP, Labour Productivity and Total Factor Productivity in the United States, Euro Area and Europe Union of 28, 1999–2015
Source: Conference Board (2016) and World Bank (2016a).
Total factor productivity
For the even more important growth of total factor productivity (TFP – the increase in output over and above the increase in labour and capital used in production), the figures were, respectively, 1.0, 0.4 and 0.6 for 1999–2006, and 0.2, −0.5 and −0.4 for 2007–15.
To be sure, there were major differences in the growth of labour productivity and total factor productivity among the major Euro Area countries, Japan and the United States, but as Figures 3 and 4 show, even Germany, the best performer of the Euro Area, did not perform as well as the United States (especially in the growth of total factor productivity).3
6 Reasons for the Slow Growth of Productivity, International Competitiveness And Real GDP in the Euro Area
The slow growth of labour productivity and total factor productivity in the Euro Area led to its low international competitiveness and growth of real GDP in relation to the United States. Most of the Euro Area's loss of international competitiveness has been attributed to over-regulation and overtaxation, which discouraged innovations and reduced efficiency (Salvatore, 1998, 2004, 2007).
An overview of the competitiveness problem that the Euro Area faces vis-à-vis the United States is summarised by the much lower ranking of the Euro Area than the United States on the important World Bank (2016b) index on ‘Ease of Doing Business’. The 2016 index includes the 13 specific measurements or indicators shown in Table 6. Figure 5 shows that it is more than seven times easier to do business in the United States than in the Euro Area and about four times easier to do business in the United Kingdom than in the Euro Area. Figure 6 then shows that there is a high positive correlation between the ease of doing business in a nation and its international competitiveness, while Figure 7 shows that there is a positive exponential correlation between the international competitiveness of a nation and its per capita GDP.
Table 6. Factors in the ‘Ease of Doing Business’ in 2016
1. Procedures, time, cost and paid-in minimum capital to start a business
2. Procedures, time and cost to complete all formalities to build a warehouse
3. Procedures, time and cost to get connected to the electrical grid
4. Procedures, time and cost to transfer a property
5. Movable collateral laws and credit information systems
6. Minority shareholders’ rights in related-party transactions and in corporate governance
7. Payments, time and total tax rate for a firm to comply with all tax regulations
8. Time and cost to resolve a commercial dispute
9. Time, cost, outcome and recovery rate for a commercial insolvency and strength of the legal framework for insolvency
10. Quality of building regulation and its implementation
11. Reliability of electricity supply, transparency of tariffs and price of electricity
12. Quality of the land administration system
13. Quality of judicial processes
In other words, the easier it is to do business in a nation, the greater its international competiveness, and the greater the nation's international competitiveness, and the higher is its per capita income. Since the Euro Area ranks much lower than the United States in the ease of doing business, its international competitiveness is much lower than that of the United States, and so it is its real per capita income. Thus, the way for nations of the Euro Area and the European Union (EU-28) to increase their growth is by deregulating economic activities (i.e. making it easier to do business). This would increase their international competitiveness and lead to higher per capita income or GDP.
7 Policies Adopted in Europe to Increase International Competitiveness and Growth
Europe became very much aware of its competitiveness and growth problems early on, and so in the year 2000 the European Heads of States and Governments launched the Lisbon Strategy or Agenda (European Council, 2000), with the specific aim of making Europe ‘the most competitive and the most knowledge-based economy in the world by 2010’. The goal, however, was not achieved. To be sure, most nations of the world grew much more slowly in the 2000–10 decade than in the previous decade because of the global financial crisis, but, as we have seen before, Europe grew more slowly than the United States, and so its growth gap with the United States persisted and even grew.
Because of this, the European Commission (2014) introduced the Europe 2020 agenda (Horizon 2020). This is a seven-point programme with nearly €80 billion in funding for making Europe ‘the best place in the world to innovate’ and also to increase industry's share of GDP from the current 15 per cent to 20 per cent from 2014 to 2020. Specifically, Horizon 2020 involves:
completing the single market (particularly for digital business, telecoms and services);
making public innovation funding bold, experimental and open to all;
building twenty-first century infrastructures (including superfast broadband and smart grids);
educating a technology-savvy workforce;
embracing social innovation;
making innovation open for EU citizens and the world; and
reforming European institutions to better support innovation.
The EU subsequently introduced the Junker Investment Plan in December 2014, the Single Market Strategy in May 2015 and the Five Presidents’ Report in July 2015 – all aimed at increasing investments and innovations in the EU, so as to increase its international competitiveness and speed up its growth. All of these plans and proposals, however, seem more statements of intentions and often involve even more regulations to be implemented. In short, without reducing taxation and regulations and actually improving the ‘ease of doing business’, all of these efforts are not likely to significantly increase labour productivity, international competitiveness and growth in the European Union, especially in the present context of Brexit and the general slowdown in world growth as a whole.
8 Europe's Growth Challenge With Brexit
Tired of excessive EU regulations and immigration, the United Kingdom voted for Brexit on 23 June 2016 (Rose, 2016). This was unexpected by most economists in the United Kingdom and abroad because calculations just before the vote showed that Brexit would impose reasonably high economic burdens on the United Kingdom and also have negative effects on growth in the European Union and other areas and nations.
Immediately after the vote for Brexit the forecast of United Kingdom economic growth was sharply revised downward, financial markets exhibited large volatility and stock markets and the pound sterling fell sharply. These negative effects, however, soon subsided (except for the depreciation of the pound) and the Bank of England (BoE) lowered its benchmark rate from 0.5 to 0.25 per cent (the lowest level in the BoE's 322-year history) and also resumed QE to avoid a possible recession. But the forecasts remain of significant negative effects on the United Kingdom and the rest of Europe in the years to come.
An OECD study by Kierzenkowski et al. (2016) indicated that by 2030 the UK's real GDP would be lower with respect to the baseline, by 2.8, 5.3 and 7.8 per cent, respectively, according to an optimistic, central and pessimist scenario (the left panel of Figure 8). The right panel of Figure 8 shows that in 2018 the United Kingdom's real GDP would be about 1.4 per cent lower than the baseline and, by repercussion, the GDP of other nations and areas would be correspondingly lower with respect to the baseline. The estimated short run (by 2018) reductions in the United Kingdom's real GDP would arise primarily as a result of the increase in the risk premium and the reduction in business confidence and international trade in the United Kingdom, despite the expected depreciation of the pound. In the long run (by 2030), the United Kingdom's GDP would be lower primarily as a result of the reduction in the inflow of foreign direct investments, immigration and skills, and in the importance of London as Europe's premier financial centre. Factored in these estimates of loss of real GDP (with respect to the baseline) is the positive effect of the additional deregulation that the United Kingdom would be able to undertake with Brexit.4
The actual size of the negative effects on the United Kingdom and the rest of the world will depend, however, on how the United Kingdom manages Brexit and how the rest of the world (primarily the European Union) responds to it. Perhaps, the best deal that the United Kingdom can negotiate with the European Union is to remain part of the European Economic Area (EEA) upon exiting the European Union. This is often referred to as the Norway Case or ‘Brexit soft’, whereby the United Kingdom would retain full access to the European Union, while continuing its financial contribution to the European Union (but with no say in how EU rules are set) and continuing to uphold the EU's four freedoms (the free flow of trade, services, capital and labour). The European Union will accept no less as a condition for the United Kingdom to be a member of the EEA. Since one of the primary reasons for Brexit was to limit immigration, the United Kingdom may have second thoughts about leaving the European Union (despite Prime Minister Theresa May's statement that ‘Brexit means Brexit’) after carefully re-evaluating the benefits and costs of Brexit (BBC World Service 2016).5
With Brexit, it will also be more difficult for Europe to stimulate its growth. In the meantime, the growth of labour productivity, and hence the growth of the US economy, also has been falling as a result, among other things, of the rapid increase in US regulations in recent years (Salvatore, 2014, 2016). Thus, we can expect the US growth rate to converge, more or less, to the lower growth rate of the Euro Area and the EU-28 in the next few years.
9 The World Growth Slowdown
Faster growth in the Euro Area and EU-28 for the rest of this decade and beyond may also be more difficult to achieve in the context of Brexit and the actual and expected slowdown in the growth trend of the entire world economy. OECD (2014a) estimates the average growth of potential output from 2014–30 to be 2.4 per cent for the United States but 1.7 per cent in the Euro Area. Figure 9 shows the decline in the long-run growth in advanced countries, emerging market economies, and the world as a whole expected by the OECD (2012) and Klein and Salvatore (2013). The reasons given for the slowdown in world growth range from the possible slowdown of innovations, ageing populations, increasing inequalities, and over-regulation and overtaxation in advanced countries (Salvatore, 2014) and also as a result of the operation of the convergence hypothesis and, possibly, of the related ‘middle income trap’ in emerging market economies (OECD, 2014b).
Recovery from the deep global financial crisis and great recession has been slow in advanced countries, especially in Europe, and with the weak countries of the periphery of the Euro Area (GIPSI) remaining in a deep crisis. But the European Union (EU-28) as a whole also faces the serious crisis of anaemic growth. The Lisbon Strategy or Agenda introduced in 2000 to overcome the European growth problem was not successful, and so in 2014 Europe launched ‘Horizon 2020’ to stimulate innovations and growth in the rest of this decade and increase the share of industrial production in the economy from 15 to 20 per cent by 2020.
Will ‘Horizon 2020’ (and the measures and policies introduced afterwards) succeed in stimulating innovations and growth in Europe, and eliminating or reducing its growth gap vis-à-vis the United States, in the face of Brexit and the generally declining growth or ‘new normal’ expected for the world as a whole during the rest of this decade and the next (OECD 2014b; Salvatore, 2014)? If the European growth divergence vis-à-vis the United States will diminish, this will more likely be the result of slower US growth than that of accelerating EU growth. An important reason (there are others) for slowing growth in the United States is the sharp increase in economic regulations during the past decade (Salvatore, 2016). The only way to increase growth on a sustainable level in the European Union is by improving its ‘ease of doing business’ and stimulating innovations and labour productivity.
To be noted is that Europe faces not only a general growth problem but also the additional specific problem of the periphery countries of the Euro Area or GIPSI (Greece, Ireland, Portugal, Spain and Italy). Not only is the growth of the GIPSI slower than that in the other European countries, but they also face unsustainable national debts and loss of international competitiveness in relation to other European countries, and they have no policy choice to overcome their specific problem, except very painful internal devaluation to keep up with the rest of Europe (Salvatore 1997, 2015). This does not mean that average real wages and per capita income have to be the same in the GIPSI as they are in the richer EU members (just as they are not the same in the various states of the United States). But it does mean that the workers and people in the GIPSI countries that choose not to migrate to other EU members with lower unemployment rates and higher average real wages and per capita incomes prefer to remain at home and enjoy more leisure time and amenities of life (such as a better weather, closer family connections) rather than migrate.
As indicated in Figure 5, the United Kingdom is already much less regulated than the other EU members, and so the benefit of further deregulation with Brexit may not be that much.
The United Kingdom would not be allowed to restrict immigration without having to accept some limitations on EU accessibility. But then an important aim of Brexit vote would not be met (even though Cameron had already negotiated with the European Union in February 2016 a compromise that allowed the United Kingdom to impose temporary limits on social benefits that encourage immigration). Facing the likely prospect of limitations on universal EU access, officials and representatives from the financial sector (The City) have been drawing up plans for negotiating for complete EU openness of at least the financial sector, similar to Switzerland's arrangement with the EU (The Financial Times, 2016).