This document discusses economic convergence and divergence in Europe before and after the financial crisis. It makes three main points: 1) Before the crisis, economic diversity within the EU was not seen as a problem, as the EU had successfully enabled convergence among lower-income countries. 2) The crisis highlighted problems with economic diversity within the eurozone, as core countries were less affected than peripheral countries. It exposed flaws in the growth models of some southern eurozone countries. 3) To address these issues, the document argues that Europe needs both "more Europe" in the form of fiscal and banking unions, as well as "better Europe" through structural reforms and strict rules to reduce economic differences between countries.

1. Europe and the Crisis
Convergence and Divergence
André Sapir
Professor of Economics, Université Libre de Bruxelles
Senior Fellow, Bruegel

2. Before the crisis
2
 Economic diversity, measured by the dispersion of income or consumption
per capita, has been an important feature of the EU, at least since the 1980s
 Before the crisis, diversity was not viewed as a major problem
 On the contrary , the capacity of the EU
» to enlarge to lower income countries, first from Southern Europe and then to
Central and Eastern Europe,
» and to create conditions for their convergence
was rightly regarded as one of its biggest achievements
 This success story has been widely acknowledged

3. The crisis has changed our view on convergence
3
 The crisis hit more the periphery than the core countries
 The crisis first hit the EU Eastern periphery
» Sudden stop in capital inflows
» But generally healthy fundamentals => Fairly speedy adjustment and recovery,
even in countries with fixed ER regimes
 The crisis then hit the EU Southern periphery
» Their economic model was flawed and EZ membership precluded ER change =>
Slow adjustment and recovery

4. The lesson from the crisis
4
 Economic diversity may not be a problem for the EU as a whole but it is
definitely a problem for those countries that belong to the eurozone
 The problem in the eurozone comes from a combination of three incompatible
features

5. The incompatible trio
5
 An EMU with
» Important economic and social differences between countries
» Financial integration
» Lack of common fiscal and banking policies and institutions
is what led to the current EZ sovereign debt and banking crisis

6. Heterogeneity at the start of EMU
6
Adaptability
Exposure
Source: Buti and Sapir (2002)
GIIPS
DM-zone
OCA line

7. 7
Economic differences and financial integration:
The effect of EMU on current accounts
6
4
2
0
-2
-4
-6
-8
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Data source: AMECO Nov 2013
Correlation (GIIPS,DM)
1960-1998: +0.28 1999-2007: -0.85 2008-2013: +0.82
CA-DM
CA-GIIPS

8. Public debts have gone in the opposite direction:
convergence before the crisis, then divergence
8
140
120
100
80
60
40
20
0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
B-DM
B-GIIPS
Data source: AMECO Nov 2013

9. The Southern eurozone countries have big problems
9
 Their growth model, is based on
» Small firms that don’t invest enough in human capital and R&D
» Low trade openness (small closed economies)
» High business regulation
» Inefficient and inequitable social systems,
 Their model was already flawed 10-15 years ago due to
» Increased global competition from emerging countries (EMEs)
» Increased competition within Europe from the NMS.
 But they managed to avoid the necessary adjustment thanks to their
adoption of the euro which permitted large net external debt positions,
whereas the euro should have been an impetus for reform.
 Now these countries have two problems
» A competitiveness problem, inside the eurozone and vis-à-vis the NMS and EMEs
» A (public and private) debt and a high unemployment problem

10. 10
The eurozone: United in diversity?
 Diversity among EZ countries is very large
 The EZ was not an OCA at the start of EMU
 Convergence has not taken place
 Now we have a double problem
 Competitiveness
 Debt overhang and high unemployment
 Diversity is not only economic but also social and political
 The main eurozone policy tool is inadequate/insufficient

11. Conventional ECB monetary policy cannot help much
11
 The ECB’s policy is about right for the eurozone aggregate…
 …but it’s not for many individual EZ members because of their diversity
Source: Darvas, April 2014

12. Conventional ECB monetary policy cannot help much
12
 In fact, divergences in macro (p, U) conditions in the eurozone were always
fairly large but have increased substantially with the crisis
Standard deviations of Taylor-rule recommendations for eurozone countries
Based on Darvas and Merler, Nov 2013

13. Implications
13
 Economic diversity may not be a problem for the EU as a whole but it is
definitely a problem for those countries that belong to the eurozone
 What to do? More or better Europe?

14. Two views about what went wrong and how to fix it
14
 Diagnosis. The system was fundamentally flawed: a monetary
union needs a political union
 Remedy: “more Europe”, with some centralized economic policies
besides monetary policy
 Diagnosis: The system was not fundamentally flawed: a monetary
union among sovereign states can work, provided each state
respects the rules and keeps its house in order
 Remedy: “better Europe”, with no centralized economic policies
except monetary policy and strict application of rules

15. My own view: more but also better Europe
15
 More Europe: banking union and (some) fiscal union
 Better Europe: concentrate on where Europe can really have an added
value and create the conditions to foster growth and convergence

16. The way forward: Two tracks
16
 Track 1: A European growth strategy to overcome the debt and
unemployment problems
 Track 2: Reforming the EU and EMU

17. Track 1: A European growth strategy
17
 The growth strategy must combine two elements, besides the
cleaning up of banks (SSM, AQR, SRM)
 Demand measures (to close the output gap)
» Fiscal policy
» Monetary policy
 Supply-side measures (to increase potential output)
» EU level: Single market
» National level: structural reforms which would also reduce EZ heterogeneity)

18. Too much heterogeneity in the EZ
18
Eurozone economies
Ease of Doing Business Rank
2014
Finland 12
Ireland 15
Germany 21
Estonia 22
Netherlands 28
Austria 30
Portugal 31
Slovenia 33
Belgium 36
France 38
Slovak Republic 49
Spain 52
Italy 65
Greece 72

19. Track 2: Reforming EMU and EU
19
 GEMU means a genuine banking union and (some) fiscal union
 GEMU can only be implemented after track 1 has succeeded in
reducing
» Debt and unemployment levels
» Structural disparities between EZ countries
 But that does not mean that designing GEMU can and should wait
 Finally, the EU also needs to be reformed: A review of exclusive,
shared and national competences is overdue