Ending Europe's Economic Underperformance

In recent decades, economic performance in Europe has been disappointing, with particularly pronounced weakness in the core European nations--Germany, Italy, and France. Estimates of potential growth in Europe have been revised down significantly. In the 1980s, average annualized economic growth in the EU15 was 2.5 percent, nearly 1 percentage point lower than in the United States, and in the 1990s--as European nations converged toward the Maastricht Treaty's criteria and entered into the European Union--the gap widened: Europe's 2.2 percent growth was 1.4 percentage points behind the United States. Since the European Monetary Union was established, eurozone growth has averaged 1.9 percent annualized (1.6 percent in core Europe), while growth in the United States has averaged 2.6 percent. Europe's persistent growth shortfall has been reflected in very high unemployment rates. It does not appear that the establishment of the EMU and the euro have had a significant effect on overall economic performance. In 1998, I stated that the EMU would not resolve Europe's economic problems, only reveal them, and that assessment still seems valid. Misguided Fiscal and Regulatory Policies The economic underperformance in Europe has been a direct result of misguided fiscal and regulatory policies. The European Central Bank is frequently blamed for Europe's slow growth but in fact it has consistently and successfully pursued its monetary policy mandate of maintaining low inflation. Excessive government spending, burdensome taxes and regulations in European nations misallocate resources, raise the costs of production, inhibit labor supply and distort labor mobility, and dull entrepreneurship and risk taking (Nicoletti and Scarpetta 2003). The startling gap between employers' costs of employment and workers' take-home pay in most European nations highlights the problem (Heitger 2000). Low potential growth, particularly in core European nations, points to constrained increases in future standards of living. Improving economic performance in the EU requires the smooth functioning of the EMU and the euro, but it hinges critically on whether the EU establishes an environment conducive to fiscal, regulatory, and labor market reforms that improve efficiencies and lift growth (OECD 2003). In the last decade, initiatives have selectively deregulated labor, goods, and capital markets, creating positive efficiencies. However, fiscal policy reform has lagged behind. Fiscal policy reform in Europe is constrained and distorted by the Stability and Growth Pact, specifically its requirement that limits deficits to 3 percent of GDP. By limiting countercyclical fiscal policy and tax reform, the SGP does not enhance stability or encourage growth. Nor does it set the best standard for new EU entrants. It has led to budget gimmickry (earlier asset sales to reduce deficits) and heightened diplomatic discord. It has led key EU nations to explicitly violate the law. It has not materially reduced government spending and has constrained recent efforts to cut taxes. At the same time, it has failed to materially reduce the debt burdens of high-debt nations. Such heavy reliance on cash flow budget deficits as a guideline for conducting fiscal policy--and coordinating fiscal policy across nations--is misguided. Established as part of the Maastricht Treaty in 1992, the deficit limitation clearly contributed to lower deficits among EU member nations. But the deficit/GDP ratio is an inadequate and potentially misleading representation of fiscal responsibility. It does not reflect the level of government spending or taxes, and it provides limited understanding of how the government allocates national resources. In Europe, it has not fostered a successful coordinated effort toward reduced spending or reduced taxes, and it has not contributed materially toward reduced indebtedness of high-debt nations. Continuing to rely on a deficit guideline for fiscal policy is allowing the tail to wag the dog. …