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Speech - Cohesion and convergence in Europe

Met dank overgenomen van Europese Commissie (EC), gepubliceerd op vrijdag 24 oktober 2014.

European Commission

[Check Against Delivery]

László Andor

European Commissioner for Employment, Social Affairs and Inclusion

Cohesion and convergence in Europe

Lecture at the Warsaw School of Economics

Warsaw, 24 October 2014

Dear Rector, Professor Sapiro,

Ladies and Gentlemen,

It is an honour for me to speak to you today on a topic which has been central to my work as European Commissioner for Employment, Social Affairs and Inclusion over the past five years.

This happens to be my last public lecture in my capacity as Commissioner, since - as you know - a new College of Commissioners was approved by the European Parliament on Wednesday and will take office as of 1 November.

I have very much enjoyed coming to Poland over the past five years, first mainly to participate in various meetings under Poland's Presidency of the Council in 2011 and then in bilateral meetings or various economic conferences.

Earlier today I had the pleasure to participate in a major conference organised by the National Bank of Poland in cooperation with the International Monetary Fund. We discussed the lessons of the 25 years of transition towards a market economy in Central and Eastern Europe and the main economic challenges facing our region in the years ahead.

The topic of my session was 'economic convergence', mainly in the sense of catching up with Western Europe in terms of economic productivity and living standards. But we have also discussed the differences between individual countries of Central and Eastern Europe, both in terms of their transition experience and the challenges ahead.

In this lecture, I would like to go into greater detail and elaborate on the meaning of the words cohesion and convergence in today's Europe, re-shaped by a long economic crisis.

I will take a longer-term perspective, though, looking at how the European Union has been transformed not just by the crisis but by the two major political projects of the past 25 years.

The first of these projects was the establishment of a Single Market and a single currency. The second major project has been the eastward enlargement of 2004, 2007 and 2013.

I will point out what these processes have brought in terms of socio-economic convergence or divergence, and I will remind you what tools the European Union has in order to promote cohesion and convergence.

I will then conclude by highlighting the main challenges which Central and Eastern Europe faces in terms of cohesion and convergence over the coming decade or so.

Cohesion and convergence in the EU Treaties

The European Union is committed to economic, social and territorial cohesion, balanced economic growth and upward economic convergence. These objectives are also set out in its two basic Treaties.

The preamble of the Treaty on European Union (TEU) speaks about the resolve “to achieve the strengthening and the convergence of the [Member States’] economies” and links such convergence to the establishment of an economic and monetary union including “a single and stable currency”.

Article 3 of the Treaty on European Union says that “The Union shall … work for the sustainable development of Europe based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment … It shall combat social exclusion and discrimination, and shall promote social justice and protection, equality between women and men, solidarity between generations and protection of the rights of the child. It shall promote economic, social and territorial cohesion, and solidarity among Member States.”

The means to promote economic, social and territorial cohesion are then described in more detail in the Treaty on the Functioning of the European Union (TFEU), which contains a title on economic, social and territorial cohesion. This title speaks about “overall harmonious development” of the union, and in particular about “reducing disparities between the levels of development of the various regions and the backwardness of the least favoured regions”.

Such cohesion should be achieved through the coordination of economic policies as well as through budgetary instruments. These provisions represent the legal basis for EU cohesion policy, which operates mainly through the European Regional Development Fund, the European Social Fund and the Cohesion Fund.

These funds are the main resources which the EU has to support investments in infrastructure, human capital, innovation, resource efficiency and business development. They cover the whole EU28, but the intensity of support is highest in the ‘less developed regions’, whose GDP is below 75% of the EU average.

In addition, the objective of convergence is repeated in the important Article 121 TFEU, which (together with Article 148) represents the legal basis for economic policy coordination within the Union. The whole system of reinforced EU economic governance, which we developed over the past years is therefore supposed to have convergence at its heart.

Finally, ‘convergence’ is also the word used to describe the five criteria agreed as pre-conditions for Member States to advance to the third stage of Economic and Monetary Union, namely to join the single currency.

There have been plenty of debates about these 'Maastricht criteria' and especially their focus on nominal variables as opposed to the real economic situation. However, it is clear that Member States of the monetary union are supposed to achieve some economic convergence before adopting the euro, and further economic convergence once they are inside the euro zone.

Cohesion and convergence within the Single Market and the EMU

I would like to highlight at this point the difference between the concepts of cohesion and convergence within the Single Market on the one hand, and cohesion and convergence within the Economic and Monetary Union (EMU) on the other hand.

The EMU, and especially its final stage, i.e. currency union, represents a significantly more advanced form of economic integration. It limits the autonomy of Member States’ economic decision-making in a much stronger way than participation in a Single Market does.

Once they have joined the euro zone, Member States are subject to monetary policy decided by the European Central Bank and they are no longer able to respond to economic developments through tailor-made monetary policies.

In other words, if their economy performs particularly strongly and inflation is a higher risk than unemployment, Member States of the euro zone are not able to unilaterally increase the interest rate.

Conversely, if they experience an economic downturn, euro zone Member States can no longer unilaterally decrease interest rates and they cannot rely on currency devaluation to regain competitiveness.

Monetary policy in the euro zone is one-size-fits-all, and this poses problems in terms of dealing with the economic cycle, especially if asymmetries or divergences develop inside the euro zone. In such cases some countries would prefer a tighter monetary policy while others would need a more expansionary monetary policy at the same time.

If such divergence gets out of control, the whole idea of a single monetary policy may stop making sense.

In the theory of currency unions, asymmetries are supposed to be managed through fiscal policy, so that countries in a downturn can stimulate their economies through tax cuts and increased public expenditure, while countries experiencing economic overheating or financial bubbles increase taxation and reduce public expenditure.

However, in today’s euro zone, the key problem is that many national governments have practically lost any margin for manoeuvre in fiscal policy because their sovereign debt has reached relatively high levels compared to GDP.

Basic interest rates in the euro zone are expected to remain very low for the foreseeable future, but there is a risk that further increases in sovereign debt of some countries might trigger panic in financial markets and an increase in the risk premia, meaning that the overall burden of debt and interest could get out of control.

Such things would not happen in other major currency unions in the world, such as in the United States of America, where the central bank can and does buy government bonds and a large federal budget helps to counter asymmetric economic developments within the dollar zone.

Here we come to the specificities, or rather design flaws, of Europe’s Economic and Monetary Union, whose rules prevent the ECB from acting as a full-fledged lender of last resort and which has no fiscal capacity at the euro zone level.

This means that the euro zone is substantially more vulnerable to the sentiments of the financial markets and less able to manage cyclical developments, especially if they are asymmetric.

This brings me back to the differences in the level of development of our Single Market and our Economic and Monetary Union.

The European Union has a very small budget of 1% of GDP. Within that budget, EU cohesion policy amounts to only 0.4% of EU GDP. Crucially, this is a budget for the Single Market of the EU28, and cohesion policy aims at promoting long-term convergence (or at least preventing long-term divergence) between countries and regions forming this Single Market.

By comparison, no budget exists at the level of the euro area, even though the bond of common currency is much stronger and reduces national autonomy much more than the Single Market.

Our Economic and Monetary Union certainly does not have a budget to compensate for disparities in economic performance, a budget that would enable to maintain similar levels of prosperity based on large-scale redistribution between euro zone countries.

Income equalisation across the EMU would of course not be possible without a strong political union and without strong democratic legitimation of redistributive decisions taken at the EMU level.

But what I find highly damaging is that the EMU does not even have a modest fiscal capacity that would serve as insurance for the Member States and enable temporary fiscal stimulus to countries experiencing an economic downturn.

This lack of a euro zone budget today significantly reduces the ability of euro zone economies to recover from recession, and it has negative implications even for the economic performance of the strongest euro zone economies, as we can observe in recent data.

To sum up the comparison of instruments for cohesion and convergence in the Single Market and the EMU, we can say that the deepening of the Single Market since the mid-1980s has been underpinned by social legislation to prevent a competitive race-to-the-bottom as well as by financial instruments serving economic, social and territorial cohesion.

However, the social dimension of the EMU and its ability to deal with the problems of cyclicality and asymmetry have not been developed.

Consequently, the financial crisis since 2007 has undone much of the previous convergence between the periphery and the core of the euro zone.

Socio-economic problems of the euro zone are centred today mainly in its Southern and peripheral countries (marked in this graph by the solid blue line). As you can see, the GDP of these countries essentially copied the EU28 average since the mid-1990s, until it started to fall significantly behind during the global financial crisis of 2008-9 and especially during the second euro zone recession since 2011.

But perhaps the most striking illustration of recent socio-economic divergence within Europe is this comparison of unemployment rates. (Again, the Southern and peripheral countries of the euro zone are marked by the solid blue line, while the solid red line denotes the Visegrad countries plus Slovenia.)

We can see that Central European countries, and especially Poland, experienced high unemployment around the year 2000, linked to the economic restructuring process and to tight monetary and fiscal policies. This was well before EU accession and certainly long before euro zone entry. Most of the countries in question in fact still have floating currencies.

By contrast, the rise in unemployment rates which we have observed in Southern Europe since 2008, and especially since 2011, is really dramatic and we can see little sign of any significant improvement so far.

Inside the incomplete monetary union, it is much more difficult for these countries to regain competitiveness and restore economic growth and job creation.

The lack of a rapid recovery also hinders the necessary structural reforms that would be able to boost productivity and the long-term growth potential of the more peripheral regions.

Once again, this problem is linked to the fact that the EMU in its current form lacks a fiscal capacity that would mitigate asymmetric developments in the economic cycle.

The EMU actually even lacks a coordinated approach to aggregate demand, and it has not been capable of agreeing a symmetrical adjustment by both deficit and surplus countries whereby cost-cutting on the periphery would be offset by a demand stimulus in the core.

The only available mechanism of economic adjustment inside the EMU has therefore turned out to be so-called ‘internal devaluation’.

Internal devaluation is a substitute for currency devaluation - but a very bad substitute what concerns the social impact.

Internal devaluation basically means cutting labour costs, also through higher unemployment and lower expenditure on social benefits and public sector salaries. It has very negative implications for people’s well-being and for economic, social and territorial cohesion.

Internal devaluation has weakened the peripheral Member States' human capital and has caused a dangerous polarisation within the euro zone in terms of welfare and industrial relations.

Reliance on internal devaluation has fuelled popular resentment against ‘Europe’ and it is in my view the primary threat to the sustainability of the EMU and stability of the European Union as such.

Central and Eastern Europe

Ladies and Gentlemen,

Let us now look closer at socio-economic convergence between Central and Eastern Europe and the ‘older’ Member States of the European Union.

As promised, I will look at the period of roughly 25 years since economic transition in Central and Eastern Europe started, the Single Market was deepened, the EMU was formed and the long process of eastern enlargement was launched.

The ten years of EU membership have indeed resulted in economic convergence for most of the 'new' EU Member States in Central and Eastern Europe.

Poland has been the most remarkable example in terms of sustainable GDP growth, higher than EU average. It was the only EU country that avoided economic recession during the global financial crisis, partly also thanks to the floating exchange rate of the złoty.

However, let us look at this trend of recent convergence in a historical perspective and from more angles than just GDP.

First of all, the dynamic periods of economic growth in Central and Eastern Europe since late 1990s can be to a large extent seen as a compensation for the major income loss in the early 1990s, when these transition countries lost one fifth or even one quarter of their GDP in cumulative terms.

The early 1990s were an era of abrupt economic restructuring and complicated political transition, with traditional export markets shrinking and many economic assets in Central and Eastern Europe getting mismanaged.

This graph is taken from a report presented by the IMF just today, on the occasion of the conference on 25 years of transition. It shows very well the dramatic period of the early 1990s and how it gradually stabilised into a decade of solid economic recovery across the region since the late 1990s till 2008. It also shows the impact of the global financial crisis and the more modest recovery since then.

(The Visegrad countries plus Slovenia are marked by the green line. The thick black line refers to the whole group of post-Communist countries, including the Balkans, Ukraine and Russia, but excluding the Caucasus and Central Asia.)

You can see that some Central-Eastern European countries experienced much deeper busts and booms during these 25 years than others. The Baltic countries were the most dramatic cases both in the early 1990s and during the global financial crisis. In their case, the decade from the mid-1990s and the current period can really be called ‘reconstruction’ periods.

In this comparison, the Visegrad countries were hit relatively less during the bad periods, and their growth in the good years has also been less buoyant.

Overall, we can clearly see the good and bad periods during the past 25 years when it comes to GDP. We can also see that the most recent growth dynamics are less strong than during the ‘convergence decade’ before the global financial crisis.

Let us now look ‘beyond GDP’ when assessing convergence in the Central and Eastern European Member States of the EU. The three most important in this respect are the employment rate, the unemployment rate and poverty, or - to be more precise - the rate of people at risk of poverty or social exclusion.

From this graph we can see that despite the good GDP dynamics during the ‘convergence decade’, employment levels in Central and Eastern Europe are basically at the level of the mid-1990s.

This means that the employment rate in the ‘new’ Member States of the EU remains well below the EU average, although it has fortunately held up better than in the troubled countries in the south of the euro zone.

What about unemployment? One of the previous graphs showed that unemployment rates in the EU-13 countries have basically converged towards the average of the EU28 during the recent years. This means that unemployment in Central and Eastern Europe is higher than in Northern and Western Europe, but lower than in Southern Europe.

However, as the present graph shows, the rate of poverty and social exclusion has remained very high in some of the ‘new’ Member States, despite the fact that unemployment is now comparable to the ‘older’ Member States.

There has been good improvement on the poverty front in most of the Visegrad countries, but not in Romania, Bulgaria and the Baltic countries, where poverty and social exclusion remain at very high levels. This comparison reveals in particular the weak and ineffective welfare states in Romania, Bulgaria and the Baltics - an issue which has also been subject to EU country-specific recommendations during the recent years. Developments in Hungary over the last 8 years are also of major concern from this point of view.

Looking ahead, an obvious question arises: Should we expect further east-west convergence over the next decade?

To answer this question, let us look at the absolute gap in terms of output between Central and Eastern Europe and the older EU Member States.

These graphs express the gap in GDP per capita, adjusted for inflation. They also show to what extent the gap is due to labour productivity, employment or the size of the active population.

The figures are not adjusted in terms of relative prices, so they represent more a comparison in terms of output than in terms of purchasing power.

What we can see is that the east-west gap in terms of output per capita has diminished only very little since the mid-1990s.

The gap is smaller in the case of the Visegrad countries than for the other 'new' Member States, but if we take the ‘new’ Member States as a whole, GDP per capita in real euros is still nearly 70% lower than the EU average. For example, Poland’s real GDP per capita was €8,700 in 2013, while the EU28 average was €23,200.

We can also see that most of this difference is linked to lower labour productivity, explained by the level of technological development, quality of the business environment and the skills of the workforce.

This shows that there is still a strong potential and need for investment in human capital and productive assets in Central and Eastern Europe, so that labour productivity can continue to catch up.

The wide income gap between ‘older’ and ‘newer’ Member States means that the dominant pattern remains as follows: capital moves from West to East, while labour moves from East to West.

It is understandable and efficient that Central-Eastern European workers move to other EU countries to apply their skills there. It is a natural feature of the convergence process.

East-West labour mobility increases GDP in the receiving countries, but also benefits the countries of origin in terms of knowledge transfer and financial remittances.

However, over the longer term, sustained outflows of working-age people (often the most qualified) present a clear risk to Central and Eastern European countries in terms of a growing economic dependency ratio. This would have major adverse implications on social security systems.

To put it simply, many regions and entire countries of Central-Eastern Europe are risk experiencing shrinkage of their workforce, with older people and sometimes also young children being left behind.

On this graph you can see that some Central-Eastern European countries have experienced much stronger population decline since the 1990s than the EU average. This is the combined result of lower fertility rates, shorter lives as well as emigration.

Continued outflows of working-age population from Central-Eastern Europe would of course make it more difficult to maintain good standards of living for those left behind, even if financial remittances continue to flow back.

How should this risk be tackled? Quite clearly, the answer consists mainly in continued investment in labour productivity in Central and Eastern Europe. This would enable to further reduce the gap in terms of output and income. It would thus help to ensure a sufficient material base to provide for the needs of all members of the society.

As the last step in our analysis of convergence in Central and Eastern Europe, I would like to draw your attention to some qualitative aspects of the economic and social models in this region, which show a continuing divide between the EU’s ‘older’ and ‘newer’ member states:

  • Firstly, there has been a lot of negative development in terms of industrial relations, especially during the crisis years. Social dialogue continues to be weak in many Central-European countries, which is not a good thing either for economic productivity or for social cohesion.
  • Secondly, in terms of gender balance, some new member states perform well and others not so well. Gender gaps in terms of employment and pay continue to be significant in the Czech Republic, Slovakia, Hungary as well as other countries. Poland is doing relatively well in terms of a small pay gap, but it has a large gap between the employment rates of men and women.
  • Last but not least, Roma integration is a specific challenge for both cohesion and competitiveness in Central and South-East Europe. A growing share of the working-age population in these countries comes from the Roma minority and it is therefore in the clear economic interest of these countries and the whole EU to significantly improve their education and support their integration into employment. At the same time, if we are serious about reducing poverty, access to decent housing and healthcare for the Roma population needs to be ensured.

All of this requires an active fight against discrimination and strong employment and social policies which view Roma integration as an investment, because that is what it is.

Conclusion: the second decade of EU membership should be about human capital investment

Ladies and Gentlemen,

EU policies and funds are supposed to help maintain and improve competitiveness and cohesion in Central-Eastern Europe. You will certainly agree with me that EU Structural and Investment Funds have played an important role in supporting Poland’s strong economic performance over the past decade. Indeed, Poland will be the biggest beneficiary of EU cohesion policy also in the 2014-20 period.

However, as I have shown, the process of socio-economic convergence between the ‘new’ and ‘old’ Member States is far from complete.

Major gaps still remain in terms of GDP, employment, poverty, social dialogue, and ability of public policies to effectively support the social inclusion of disadvantaged groups.

Moreover, new challenges to cohesion and convergence emerge as soon as countries enter the euro zone. The Single Market and the EMU are very different ball-games, and the still incomplete character of Europe’s monetary union actually makes cohesion and convergence more difficult.

At present, the euro zone unfortunately does not have adequate instruments to promote cohesion and convergence and is not well-equipped to deal with asymmetric economic shocks.

But the key conclusion which I draw from the analysis of socio-economic convergence in the enlarged European Union is that Central and Eastern European countries should focus more than ever before on investment in labour productivity, particularly through human capital.

In the long term, the quality of human capital is what competitiveness is really about; it is not about cheap labour.

If Central and Eastern Europe wants to reduce the gap to the EU average in terms of productivity and income, then investment in education, innovation, labour market integration, lifelong learning, social inclusion and good-quality social dialogue is fundamental.

And it is very important that these human capital investments are not just centred on a few elite institutions or large companies, but reach the wide population.

As you can see clearly on my last graph, the added value of labour to economic output in Central-Eastern Europe is well below EU average, and the share of wages in GDP is therefore also much lower.

If we want to increase prosperity and well-being in Central Europe, investment in people’s education and skills is crucial. It will also help to continue the transition from agricultural employment towards more productive industrial and service activities.

In the first decade of EU membership, it was understandable that Central and Eastern European governments focused on investment in physical infrastructure. However, in the second decade, more resources should be invested in human capital than in the past.

It is also for this reason that I campaigned throughout my mandate for a stronger budget for the European Social Fund (ESF) within the EU's Multiannual Financial Framework for 2014-20.

After long negotiations, the Council and Parliament agreed one year ago on a compromise ensuring that at least 23.1% of cohesion policy funding would be used for human capital investment through the European Social Fund.

And as more detailed plans for the use of cohesion funding have been developed over the past months, it turns out that many Member States want to invest in human capital even more.

The European Social Fund for 2014-20 will amount to about € 85 billion in current prices, which is about 25% of cohesion policy funding. This is exactly the share of cohesion funding which the Barroso II Commission proposed to devote to human capital back in 2011.

I am obviously happy to see this outcome, along with the agreement on an additional €3 billion under the Youth Employment Initiative and another more than €3 billion from the new Fund for European Aid to the Most Deprived (FEAD).

Greater investment in human capital in Central and Eastern Europe over the coming decade is crucial for sustained convergence with the West. The trend of GDP convergence can be expected to continue in any case. But if we care about the speed and quality of such convergence, then we need to focus on human capital.

Only by investing in education, well-functioning labour markets, good-quality public services and social inclusion can the 'newer' Member States of the EU hope to catch up with the 'older' ones in terms of labour productivity.

And only through human capital investment can Central and Eastern Europe achieve convergence with the West also in terms of employment, poverty and disposable income.

Finally, investment in human capital is particularly important for countries like Poland as they prepare for entering the euro zone.

Given the weakness of macroeconomic stabilisation instruments at the euro zone level, larger countries of Central and Eastern Europe would be well-advised to maximise prior convergence with the euro zone's core in terms of real economic fundamentals. When I say 'prior convergence', I mean catching up before they actually join the common currency.

Getting closer to the euro zone average in terms of labour productivity, resource efficiency and sector structure is important if countries like Poland want to avoid replicating the 'Baltic model', where adjustment to the economic crisis took place through sharp internal devaluation, leading to a major increase in unemployment, poverty and social inequalities.

Central and Eastern European countries should certainly support the on-going process of reforming the Economic and Monetary Union and equipping it with relevant budgetary tools to enable greater resilience and cohesion. Hopefully when Poland enters the euro zone, it will be a better-designed monetary union than at present.

But in parallel, Central and Eastern European countries should do their utmost to improve labour productivity and boost employment and social inclusion through smart investments in human capital.

There is a plenty of good examples elsewhere in the EU from which one can learn, and the European Social Fund is a significant source of financial support in this effort.

Thank you very much for your attention.

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