What’s wrong with Europe?

Nov 07 2013, 02:08 IST
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SummaryUnlike the US, Europe is struggling to recover from the crisis. European institutions should now cope with the structural problems—with individual country-level reforms and a federal budget. Else, the alternative could be a disintegration of the eurozone

While the recovery is well under way in the US, with growth back to 2.5% and falling unemployment, the eurozone economy is struggling to recover. Why? And why did some European countries suffer much more than others during the crisis? In CEPR Policy Insight No 67, we argue that the answers to these questions are intertwined. The crisis has slowed down the process of convergence between European countries, shedding light on unresolved structural problems. In some peripheral countries, price and wage rigidities have amplified the recessionary impact of demand shocks, the credit crunch and budget consolidations. As a consequence, the crisis has exposed the inadequacy of the (new and old) European institutions to cope with aggregate, as well as idiosyncratic shocks.

It is useful to compare the trend of per capita real GDP in the US and in the eurozone (figure 1). The graph shows a decline in real average incomes since 2007-08 in both areas. The impact of the crisis on the US is larger, the decrease in per capita income is of minus $2,459 at constant prices (minus 6%), compared a fall of minus 1,200 euro (minus 4.7%) in the eurozone. However, in 2012, the average US income has recovered to pre-crisis levels, whilst Europe’s is still 2.5 points below.

In order to understand why, it is useful to look at the state-level data. Figure 1 shows two bands for the US and the eurozone, respectively, whose upper and lower limits describe the per capita income in the richest and poorest state: the District of Columbia and Mississippi in the US; Luxembourg and Estonia in the eurozone. From the graph it is clear that internal differences are much greater in the eurozone than in the US. Between 2000 and 2012, real per capita income of the richest US state is five times that of the poorest state. In the eurozone this ratio is 8.6 to 1.

The data on unemployment confirms this pattern—both countries experience a sharp rise during the crisis years; however, aggregate unemployment rate in the US has been declining since 2010, whilst it is still increasing in Europe. In 2012 the gap between the lowest (4.3% in Austria) and the highest (25% in Spain) rate skyrocketed.

A closer look at convergence/divergence

According to the standard model of economic growth, poor countries should grow faster than rich ones. This is because in such countries capital, compared to labour, is relatively scarce,

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