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Restoring the lustre of the European economic model
INDERMIT S GILL
ANDREA MARIO DALL’OLIO, TRUMAN PACKARD,
KASPAR RICHTER, NAOTAKA SUGAWARA,
REINHILDE VEUGELERS, JUAN ZALDUENDO
© 2012 International Bank for
Reconstruction and Development
/ International Development
The World Bank
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Washington DC 20433
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OVERVIEW: RESTORING EUROPE’S LUSTRE
A DISTINCTIVE MODEL
THE CONVERGENCE MACHINE
“EUROPE”A GLOBAL BRAND
THE LIFESTYLE SUPERPOWER
FROM DISTINCT TO DISTINGUISHED
SPOTLIGHT ONE: EUROPECONVERGENCE MACHINE
SPOTLIGHT TWO: GREENING EUROPE’S GROWTH
RESTORING EUROPE’S LUSTRE
1. The unmet precondition of
the common currency—
labor mobility ....................................... 29
1. In Europe, a rapid convergence
in living standards—not much
2. Almost half of the global goods trade
involves Europe ......................................6
3. More trade in services in Europe,
but apparently in more
traditional activities ...............................8
4. In Europe, foreign capital has boosted
growth in emerging economies ..........8
5. European enterprises have
delivered jobs, productivity,
and exports ........................................... 12
6. Much of Europe is becoming
more productive, but the south
has fallen behind .................................. 12
7. Smaller ﬁrms contribute half of
value added in the EU15 South,
but just a third elsewhere .................. 14
8. Western European investors
have been looking east,
not south ................................................14
9. Southern and Eastern Europe
must make it easier to
do business ............................................ 15
10. Productivity growth in Europe’s
larger economies has slowed
down since the mid-1990s ................. 15
11. The United States specializes
in younger, more R&D
intensive products .............................16
12. Outspending the rest of
the world ..............................................18
13. Europe’s pension systems have
to support people for many
more years .......................................... 19
14. Europe’s labor force will shrink,
while North America’s will grow
by a quarter .........................................20
15. Europeans are less mobile, even
within their own countries ...............20
16. Governments in Europe are big ......22
17. Social protection explains the
difference in government size
between Europe and its peers ....... 24
18. Small differences in annual pensions
per beneﬁciary, big in overall
public pension spending .................. 24
19. Western Europe has to reduce
ﬁscal deﬁcits by 6 percent of
GDP, emerging Europe by less.........26
20. Greening production but not
S1.1. Europe—the lifestyle
S1.2. Decomposing the growth in
worker productivity .......................... 40
S1.3. Europeans work fewer hours
while Americans work more .......... 40
S1.4. Convergence until the 1980s,
divergence since ................................41
S1.5. Big increases in productivity
during the transition, especially
in the former Soviet Union ............... 41
S1.6. Productivity got a big boost
from ICT in the United States,
not so much in Europe ..................... 42
S1.7. Policy affects the pace and
composition of productivity
growth ................................................. 44
S1.8. Information technology played
a bigger role in Eastern Europe ...... 44
S1.9. Growth has been greater in
Europe’s southern states ..................45
S2.1. Europe is the world’s largest
importer of carbon dioxide ..............50
S2.2. Advanced Europe has cut air
pollution in half since 1990 ..............52
S2.3. Europe’s north is leading the
push for cleaner energy ...................53
S2.4. Western imports,
Eastern emissions ............................. 54
S2.5. Germany, France, Sweden, and
Italy have helped business by
encouraging renewable energy ......57
S2.6. China now emits the most
carbon dioxide ...................................60
S2.7. But China’s per capita carbon
dioxide emissions may not
signiﬁcantly grow beyond the
European Union’s ...............................61
1. Relentless growth in the United
States, revival in Asia, and a
postwar miracle in Europe .................5
2. 30 questions, 30 answers .................31
S1.1. Relentless growth in the United
States, a miracle in Europe, and
resurgence in Asia, 1820–2008 ........38
“Now grows together what belongs together,” former West German Chancellor
Willy Brandt famously remarked in Berlin in November 1989. He was talking
about German reuniﬁcation, but his statement might well apply to European
integration. Over the last 20 years, the European Union has grown by 12 Central
European members and has helped millions get to high incomes. The single
market now stretches from Lisbon to Łódź and from the North Cap to Nikosia.
Trade and capital ﬂows unrivaled in economic history have fueled the European
convergence machine. Shared aspirations of Europeans in the east and the
west, the north and the south, for prosperity that is both sustainable and
socially inclusive have brought the continent together.
This economic integration makes it difﬁcult to view one part of the continent in
isolation. So this report looks at Europe as a whole — from the Atlantic Ocean to
the Azov Sea. It is unusual for a development institution like the World Bank to
be writing about countries in Western Europe that reached high-income status
many years ago. But the geographical scope of this report is appropriate, and
not just because what happens in the west affects prospects in the east. It is
appropriate because the European Union’s new member states in the east have
undergone an unprecedented transformation over the past two decades — and
their experiences have lessons for their western peers struggling with the
structural exigencies of an integrated continent. It is also appropriate because
the experience of Southern Europe with economic integration — and common
monetary policy in particular — can help Central and Eastern Europe.
The Polish authorities, who inspired the work on this report in preparation for
their Presidency of the European Union in the second half of 2011, understood
from the outset that a report on European growth had to be about European
integration. But it was also clear that it had to be about the lessons that
Europeans can learn from each other and from successful countries in other
parts of the world, to adjust better to an integrated Europe and a changing
world. The Polish Presidency’s report to the European Council in October
2011, Towards a New Consensus on Economic Growth, previews some of this
report’s conclusions. These in turn are informed by the successes of countries
in Europe and around in the world in the policy areas that are pertinent today.
The subjects range from regulating banks to reducing public debt; the countries
range from the Czech Republic to Canada, and from Turkey to New Zealand.
When work on this report started, the world was recovering from the global
economic crisis. Growth had returned to Europe too, but it was fragile. As the
report went to print, Europe was again in crisis. Poland is not a member of the
eurozone, and this report is not about the euro. It is about the future of the
European economic model. But as Radek Sikorski, the Polish foreign minister,
said in Berlin in November 2011: “The biggest threat to the security and
prosperity of Poland would be the collapse of the eurozone.”
RESTORING EUROPE’S LUSTRE
Philippe Le Houérou
Vice President, Europe and Central Asia
The World Bank
President, National Bank of Poland
Chairman, World Bank/IMF Development Committee
Equally serious, trouble in the eurozone prompted questions about the
achievements of European integration. It should not. The message of this
report for Europe is this: in reacting to the debt crisis, do not abandon the
attractive features of the European model. The report distinguishes three main
attributes of the European economic and social model. The ﬁrst is economic
and political enlargement. The second is the combination of enterprise and
social responsibility. The third is a focus on social inclusion and solidarity. These
attributes have produced a prosperity that has been shared between people
and countries in a manner not seen before or elsewhere. They should be
To be sure, though, some policies and institutions that have shaped Europe’s
progress need to be changed. The analysis in this report unveils a graduated
reform agenda. Some parts of the European model require smaller adjustments:
these include trade and ﬁnance, the two main drivers of the European
convergence machine. Other parts require deep reform, such as labor and
government. In between are enterprise and innovation, whose organization
across the continent ranges from world class to mediocre.
Three objectives should guide policymakers. First, the single market should
be strengthened to unleash new drivers of productivity growth. Second,
enlargement should continue, and fully integrate the 100 million people in
Southeastern Europe, and help another 75 million in the eastern partnership
beneﬁt from the same European aspirations and institutions. Third, Europe’s
global economic inﬂuence, which has been enabled and shaped by the values
of inclusion and enterprise, should be preserved.
But this report is not just for Europe. It is also for people and policymakers
outside the continent who follow Europe’s progress and are interested in its
prospects. Its message for them: don’t count Europe out. There are countries —
both advanced and emerging — where the European model has been made to
work, and the results are gratifying. Europe’s trials must not intimidate those
working toward progressive goals; its successes should inspire them.
The report draws inspiration and its title from the golden rule of economic
growth, which requires that today’s decisions are viewed by later generations
neither with regret nor resentment. The shared aspirations of Europeans
for inclusive development have led to decades of success, and Europe’s
development has been distinct. If they can learn the right lessons from the
reforms in and outside Europe, its development will be distinguished. This
would be good not just for Europe but for the world.
This report was written by a team led by Indermit Gill, Chief Economist, Europe
and Central Asia Region, and Martin Raiser, Country Director for Turkey at the
World Bank. The core team members were Andrea Dall’Olio, Truman Packard,
Kaspar Richter, Naotaka Sugawara, Reinhilde Veugelers, and Juan Zalduendo.
The work was carried out under the overall supervision of Philippe Le Houérou,
Vice President, Europe and Central Asia Region.
Marek Belka, President, National Bank of Poland, and Chairman, World Bank–
International Monetary Fund Development Committee, and Jean Pisani-Ferry,
Director of Bruegel, provided their insights, encouragement, and guidance at all
stages of this project.
Many people participated in the writing of the report. The main authors and
·The Overview was written by Indermit Gill, with inputs from Naotaka
·Chapter 1 (The European Growth Model) was written by Indermit Gill and
Martin Raiser, with contributions from Naotaka Sugawara and Marc Teignier-
·Chapter 2 (Trade) was written by Indermit Gill and Yue Li, with contributions
from Alberto Behar, Ileana Cristina Constantinescu, Caroline Freund, Susanna
Gable Lundstrom, and Saurabh Mishra.
·Chapter 3 (Finance) was written by Juan Zalduendo, with contributions from
Zsolt Darvas and Naotaka Sugawara.
·Chapter 4 (Enterprise) was written by Andrea Dall’Olio, with contributions
from Mariana Iootty De Paiva Dias, Naoto Kanehira, Federica Saliola, Minh
Cong Nguyen, Raian Divanbeigi, Louise Grogan, and Miriam Bruhn.
·Chapter 5 (Innovation) was written by Martin Raiser and Reinhilde Veugelers,
with contributions from William Maloney and Naotaka Sugawara.
·Chapter 6 (Labor) was written by Truman Packard and Johannes Koettl, with
contributions from Indhira Santos, Basab Dasgupta, Claudio Montenegro, Isil
Oral, and Lazar Sestovic.
·Chapter 7 (Government) was written by Kaspar Richter, Ewa Korczyc, and Paul
Walsh, with contributions from Bartosz Witkowski, Maciej Bukowski, Kamil
Wierus, Hans Pitlik, Margit Schratzenstaller, Igor Kheyfets, and Martin Cumpa.
·Chapter 8 (Golden Growth) was written by Indermit Gill and Martin Raiser,
with contributions from Aleksandra Iwulska and Bryce Quillin.
·Spotlight One (Europe—Convergence Machine) was written by Bryce Quillin.
·Spotlight Two (Greening Europe’s Growth) was written by Uwe Deichmann.
·The Selected Indicators tables were compiled by Naotaka Sugawara, who was
also responsible for verifying the accuracy of statistics used or cited in the
·The Country Benchmarks summarizing global good practice were written by
Aleksandra Iwulska, with contributions from Bryce Quillin.
RESTORING EUROPE’S LUSTRE
Elena Kantarovich oversaw the production of the entire report. Aleksandra
Iwulska and Rhodora Mendoza-Paynor provided support. Santiago Pombo
Bejarano and Paola Scalabrin generously made resources at the Ofﬁce of the
Publisher available to the production team.
Bruce Ross-Larson was the principal editor, leading a team at Communications
Development Incorporated, with Jonathan Aspin, Rob Elson, Gary von Euer, Jack
Harlow, Abigail Heald, Emily Schabacker, and Christopher Trott.
Zephyr designed and typeset the report. Fidel Prokopovich created the graphics.
This task received ﬁnancial and technical assistance from the Research Support
Budget of the World Bank and the Europe and Central Asia Regional Studies
Program, for which the team is grateful to Jean-Jacques Dethier and Willem
van Eeghen. The many background papers made possible by this ﬁnancial
support were written by Alberto Behar, Caroline Freund, Susanna Lundstrom
Gable, Saurabh Mishra, Kamila Fialova, Mihails Hazans, Benno Torgler, Martin
Brown, Zsolt Darvas, Philip Lane, Swati Ghosh, Naotaka Sugawara, Juan
Zalduendo, Steen Byskov, Roumeen Islam, Gary Schinasi, Aleksandar Stojkov,
and Holger Wolf. Staff of the central banks and banking supervision agencies
in eight countries contributed excellent accounts of monetary and ﬁnancial
sector policies: Tomislav Galac, and Evan Kraft (Croatia); Jan Frait, Adam
Geršl, and Jakub Seidler (Czech Republic); Andres Sutt, Helen Korju, and Kadri
Siibak (Estonia); Adám Banai, Júlia Király, and Márton Nagy (Hungary); Frosina
Celeska, Viktorija Gligorova, and Aneta Krstevska (Former Yugoslav Republic
of Macedonia); Michał Kruszka and Michał Kowalczyk (Poland); Cristian Popa
(Romania); and Turalay Kenc, Ibrahim Turhan, and Onur Yildirim (Turkey). All the
background papers written for the report are available in the World Bank Policy
Research Working Paper Series.
A panel of advisers chaired by Marek Belka provided guidance to the team
at all stages of the project. For their interest, encouragement, and advice,
the team is especially grateful to Irina Akimova, Antonio Borges, Ibrahim
Çanacki, Božidar Đeli ´c, Vitor Gaspar, Danuta Hübner, Adam Jasser, Michael John
Hofmann, Jean-Pierre Landau, Jean Pisani-Ferry, Helga Maria Schmid, and Zoran
Stavreski. Naturally, they are not responsible for any errors in the report, and its
conclusions do not necessarily reﬂect their views.
The work of the team would not have been timely or relevant without the
sponsorship and discipline provided by the Polish Presidency of the European
Union Council. Paweł Samecki, Andrzej Raczko, and Agata Łagowska at
the National Bank of Poland, and Mikołaj Dowgielewicz, Paweł Karbownik,
Małgorzata Kału˙zy ´nska, and others at the Ministry of Foreign Affairs have been
the report team’s strongest allies. The authors owe a special debt of gratitude
to Michał Krupi ´nski for fostering a most fruitful relationship between the Polish
Presidency and the World Bank.
Bruegel has been a valuable partner in this exercise from its very inception.
The World Bank owes Zsolt Darvas, Jean Pisani-Ferry, André Sapir, Reinhilde
Veugelers, and other colleagues at Bruegel an enormous debt.
Colleagues at the European Commission generously gave their support and
suggestions. The team would especially like to thank Marco Buti, Jean Claude
Thébault, Michel Servoz, Vasco Cal, Philippe Legrain, and Margaritis Schinas.
Reiner Martin and many colleagues at the European Central Bank’s Convergence
and Structural Analysis Section provided useful feedback. Eurostat staff
overseeing the Structural Business Statistics promptly and patiently responded
to the team’s requests for information.
Charles Roxburgh and Jan Mischke of McKinsey Global Institute provided advice
at an early stage of the work and useful comments on a draft of the report. The
team gratefully acknowledges their help.
Many people at the World Bank have helped. Peter Harrold, Dirk Reinermann,
Sebastian Stolorz, Mart Kivine, Thomas Laursen, Satu Kahkonen, Sophie Sirtaine,
Lucio Vinhas de Souza, Lilia Burunciuc, Xavier Devictor, Kseniya Lvovsky, Markus
Repnik, and Zeljko Bogetic have helped make the report better and engage
policymakers more effectively. Bernard Hoekman, William Maloney, Aaditya
Mattoo, Brian Pinto, and Michał Rutkowski provided constructive criticism and
Others who have helped in various ways include Theodore Ahlers, Pedro
Alba, Richard Baldwin, Bruno Bonansea, Carlos Braga, Otaviano Canuto, Rinku
Chandra, Gerrardo Corochano, Uwe Deichmann, Michael Emerson, Marianne
Fay, Ana Margarida Fernandes, Chorching Goh, Daniel Gros, Stephane Guimbert,
Borko Handjiski, Bridget Harrison-Dowd, Jesko Hentschel, Stella Ilieva, Roumeen
Islam, Gregory Jedrzejczak, Elena Karaban, Katarina Mathernova, Shigeo Katsu,
Andrew Kircher, Michael Klein, Dorota Kowalska, Jerzy Kwieci ´nski, Jeffrey
Lecksell, Laszlo Lovei, Marco Mantovanelli, Martin Melecky, Marialisa Motta,
Mamta Murthi, Evgenij Nadjov, Julia Nielsen, Ngozi Okonjo-Iweala, John Pollner,
Jean Louis Racine, Ana Revenga, Alexander Rowland, Pablo Saavedra, Luis
Servén, Kristyn Schrader, Maria Shkaratan, Emily Sinnott, Sándor Sipos, Emilia
Skrok, Mark Thomas, Michael Toman, Mehrnaz Teymourian, Volker Treichel,
Marina Wes, and Sally Zeijlon. Finally, the team is grateful to members of the
Regional Management Team of the Europe and Central Asia Region for their
feedback on earlier drafts of this report.
The team thanks others who have helped in preparing and writing the
report and wishes to apologize to anyone inadvertently overlooked in these
RESTORING EUROPE’S LUSTRE
Restoring Europe’s lustre
Fifty years ago, the American Economic Review published a
short article titled “The Golden Rule of Accumulation.”1
In it, Edmund Phelps, an American economist, proposed a
simple rule for a nation’s wealth to grow and provide the
highest standard of living for its citizens — present and future.
The rule essentially speciﬁed how much people had to work,
save, and invest today so that future generations could be at
least as well off as they were. The golden rule had European
origins as well. The paper used the insights of economists from
France, Hungary, the Netherlands, and the United Kingdom.2
And just a few months before Phelps’ article was published, a
German economist, Christian von Weizsäcker had submitted a
dissertation that proposed the same rule.3 In 2006, the Nobel
Committee awarded the prize to Phelps for “his analysis of
intertemporal tradeoffs in macroeconomic policy.”
RESTORING EUROPE’S LUSTRE
Many economists still consider the golden rule the most basic proposition of
optimum growth theory. It is the inspiration for the title of this report, and
forms the roots of its policy prescriptions. Following the golden rule means that
today’s Europeans work and consume just so much that future generations
do not resent them for consuming too much, nor pity them for consuming too
little. Keeping to the rule is perhaps the most telling sign of a country’s — or a
continent’s — economic maturity.
Europe’s growth is already different from other economies’ in two aspects,
reﬂecting its cultural and demographic maturity. Perhaps more than others
around the world, Europeans want economic growth to be smarter, kinder, and
cleaner, and they are willing to accept less for “better” growth. The single word
that summarizes these ideals might be “golden.”
Europe’s growth will have to be golden in yet another sense. Economic
prosperity has brought to Europeans the gift of longer lives, and the continent’s
population has aged a lot over the last ﬁve decades. Over the next ﬁve, it
will age even more: by 2060, almost a third of Europeans will be older than
65 years. Europe will have to rebuild its structures to make fuller use of the
energies and experience of its more mature populations — people in their golden
These desires and developments already make the European growth
model distinct. Keeping to the discipline of the golden rule would make it
distinguished. This report shows how Europeans have organized the six
principal economic activities — trade, ﬁnance, enterprise, innovation, labor, and
government — in unique ways. But policies in parts of Europe do not recognize
the imperatives of demographic maturity and clash with growth’s golden rule.
Conforming growth across the continent to Europe’s ideals and the iron laws
of economics will require difﬁcult decisions. This report was written to inform
them. Its ﬁndings: the changes needed to make trade and ﬁnance will not
be as hard as those to improve enterprise and innovation; these in turn are
not as arduous and urgent as the changes needed to restructure labor and
government. Its message: the remedies are not out of reach for a part of the
world that has proven itself both intrepid and inclusive.
A distinctive model
It is common these days to hear Europeans calling for a “new growth model.”
The public debt crisis has shaken conﬁdence not just in the euro but in
Europe.4 Aging Europeans are being squeezed between innovative Americans
and efﬁcient Asians, it is said. With debt and demographics weighing down
European economies, the argument runs that they will not grow much unless
they discover radically new ways.
The end of complacency among Europeans is good, because developments in
and outside the continent have made changes necessary. But loss of conﬁdence
could be dangerous. The danger is that in rushing to restructure and restart
growth, Europe may throw out the attractive attributes of its development
model with the weak ones. In fact, the European growth model has many
strong points and enviable accomplishments.
Between 1950 and 1973, Western European incomes converged quickly toward
those in the United States. Then, until the early 1990s, the incomes of more
than 100 million people in the poorer southern periphery — Greece, southern
Italy, Portugal, and Spain — grew closer to those in advanced Europe. With the
ﬁrst association agreements with Hungary and Poland in 1994, another 100
million people in Central and Eastern Europe were absorbed into the European
Union, and their incomes increased quickly. Another 100 million in the candidate
countries in Southeastern Europe are already beneﬁting from the same
aspirations and similar institutions that have helped almost half a billion people
achieve the highest standards of living on the planet. If European integration
continues, the 75 million people in the eastern partnership will proﬁt in ways
that are similar in scope and speed.
It is no exaggeration to say that Europe invented a “convergence machine,”
taking in poor countries and helping them become high-income economies. Over
the last four decades, the countries in Europe experienced a convergence in
consumption levels that is unmatched (ﬁgure1). Annual per capita consumption
in the poorer parts of Europe grew by 4 percent while in the wealthier countries
it increased at a still- impressive 2 percent. The rest of the world — except for East
Asia — has seen little or no convergence. That is why the European model was so
attractive. That is why European growth is unique.
Given Europe’s diversity, it is not easy to identify a single “European growth
model.” There are big differences in how Italy and Ireland regulate work and
enterprise, and how Greece and Germany balance ﬁscal policies and social
objectives. There are big differences in what Spain and Sweden export, and
how they regulate commerce. There are differences in how Portugal and Poland
have regulated their banks, and not just because one of them shares a common
currency while the other has one of its own. And there are differences in how
Finland and France provide government services such as education and health.
But these differences in speciﬁcs do not rule out the existence of a common
approach to economic growth and social progress. This approach consists of
policies and institutions that govern trade and ﬁnance, enterprise and innovation,
and labor and government that have common elements. Together, these elements
deﬁne an economic and social model distinctly European (chapter1).
These elements have been associated with Europe’s biggest successes since
World WarII: unprecedented regional integration, global economic power, and
the attainment of the highest quality of life in human history.
·Trade, ﬁnance, and unprecedented regional integration. Europe’s rich and
poorer economies are more integrated through trade in goods and services
than in any other part of the world, resulting in quicker convergence in
incomes and living standards. Private capital in all its forms — foreign direct
investment (FDI), ﬁnancial FDI, and portfolio funds — has ﬂowed from richer to
poorer countries, and from low- to high-growth economies. Trade and ﬁnance
— facilitated by the single market instituted by the European Union and its
forebears — have fueled convergence in incomes and living standards.
RESTORING EUROPE’S LUSTRE
·Enterprise, innovation, and global economic inﬂuence. Private enterprises
are held accountable for proﬁts by shareholders, but are also more socially
and environmentally responsible than companies in most other parts of the
world. Research and development and tertiary education, recognized around
the globe for their economic spillovers, are seen as a responsibility not just
of ﬁrms but also the state. Enterprise and innovation — aided by deep and
comprehensive regional economic integration — enable Europe to account for
about a third of world gross domestic product (GDP) with less than one-tenth
of its population.
·Labor, government, and high living standards. Workers in Europe
are accorded strong protection against abuse by employers, and have
unprecedented income security after job loss and in old age. European
governments are the most decentralized and representative of local interests,
Figure 1: In Europe, a rapid
convergence in living standards—
not much elsewhere
(annual growth of consumption per
capita between 1970 and 2009, by
level of consumption in 1970)
*** Statistically signiﬁcant at 1 percent.
Note: n = number of countries.
Source: World Bank staff calculations,
based on Penn World Table 7.0 (Heston,
Summers, and Aten 2011); see chapter 1.
Corr. = −0.80***
n = 26
Corr. = −0.21
n = 15
Corr. = −0.25
n = 22
0 3 6 9 12 15
Annual per capita consumption growth, 1970−2009, percent
Initial level of consumption per capita, 1970
PPP, thousands of 2005 international dollars
and Europe has developed the most effective institutions for regional
coordination in human history. Europe’s model of labor and government —
facilitated by the growing consensus for continental cohesion and made
affordable by its economic heft — has made the European lifestyle admired
and envied around the world.
What has Europe accomplished that other parts of the world could not? Which
aspects of the model are no longer sustainable, either because of unanticipated
changes in Europe and elsewhere or because some European countries have
transformed themselves too fast? Which changes are needed now, and which
can wait? These are the questions that this report asks.
The short answers: Europe has achieved economic growth and convergence
that is unprecedented (table 1 and spotlight one). Most countries in Europe
are doing well in trade and ﬁnance, many in enterprise and innovation, but far
fewer are doing well in labor and government. So Europe needs many changes
to make its governments and labor markets work better, fewer to foster
innovation and productivity growth in enterprises, and fewer still to reform
ﬁnance and trade. These deﬁciencies are rooted in how some activities are
organized — and they will need to be reorganized. Stalled productivity, declining
populations, and growing ﬁscal imbalances have made some changes urgent.
But in addressing these shortcomings, Europeans should not forget the singular
successes of their growth model. By fostering a regional economic integration
unique in both depth and scope, Europe has become a “convergence machine.”
Table 1: Relentless growth in the United States, revival in Asia, and a postwar miracle in Europe
(average annual compound growth rates, GDP per capita, 1820–2008, US$ 1990 Geary-Khamis PPP estimates)
States Japan East Asia Latin
1820–1870 1.0 0.6 0.6 0.6 1.3 0.2 –0.1 0.0
1870–1913 1.3 1.0 1.4 1.0 1.8 1.4 0.8 1.8
1913–1950 0.8 0.4 0.6 1.7 1.6 0.9 –0.2 1.4
1950–1973 3.8 4.5 3.6 3.2 2.3 7.7 2.3 2.5
1973–1994 1.7 1.9 –0.2 –1.6 1.7 2.5 0.3 0.9
1994–2008 1.6 2.7 4.0 4.2 1.7 1.0 3.9 1.6
Note: Regional aggregates are population-weighted; see spotlight one for details.
Source: Maddison 1996; Conference Board 2011.
RESTORING EUROPE’S LUSTRE
By engineering entrepreneurial dynamism in the countries that balanced market
forces and social responsibility, it has made “brand Europe” globally recognized
and valued. And by allowing a balance between life and work, it has made
Europe the world’s “lifestyle superpower.” To continue the progress of the last
ﬁve decades, Europeans now have to do three progressively tougher tasks:
restart the convergence machine, rebuild Europe’s global brand, and recalibrate
the balance between work and leisure to make their lifestyles affordable.
The convergence machine
An increasingly vigorous ﬂow of goods, services, and ﬁnance over the last ﬁve
decades has fueled European growth. Europe’s economies are the most open in
the world. Before the global crisis of 2008–09, half of the world’s approximately
$15trillion trade in goods involved Europe (ﬁgure2). Two-thirds of it was among
the 45 countries discussed in this report. Financial ﬂows have been equally
vigorous. In 2007, for example, annual FDI in Europe exceeded $1trillion. Big
and growing trade and ﬁnancial links facilitated by the single market form the
core of the European convergence machine.
Increasingly sophisticated trade
During the last two decades, the new member states of the European Union
have done especially well at taking advantage of the opportunities offered to
them, integrating westward by trading goods and modern business services.
Figure 2: Almost half of the global
goods trade involves Europe
in 2008, US$ billion)
Source: World Bank staff, based on
WTO (2009); see chapter 2.
During the last decade, the candidate countries of Southeastern Europe have
been doing it through trade in merchandise and more traditional services such
as travel and transport. This has helped enterprises in Western Europe too. With
FDI and offshoring, enterprises in Western Europe such as Fiat, Renault, and
Volkswagen have made themselves and eastern enterprises like Yugo, Dacia,
and Škoda more efﬁcient and sophisticated. Simpler tasks are being given to
countries outside Europe; advanced Europe is getting emerging Europe to do
more difﬁcult things, and both regions are beneﬁting (chapter2).
The goods trade between advanced and emerging Europe has grown rapidly
since the mid-1990s — when the European Union signed its ﬁrst association
agreements with Hungary and Poland — and this does not appear to be injuring
trade with other parts of the world. Europe does a brisk goods trade with North
America, Asia, the former Soviet Union, and Africa (ﬁgure2). But trade within
the region has grown much more sophisticated over the last decade, aiding
quick convergence in productive capacity and living standards. It is helping
to create a bigger and stronger economic union between the European Free
Trade Association (EFTA), the EU15, the new member states, the EU candidate
countries, and even the eastern partnership economies.
Factory Europe may not be expanding as fast as Factory Asia, but it has become
smarter. And it could expand a lot too. With economic recovery and better
trade facilities — especially information and communications infrastructure in the
European Union’s new member states and the candidate countries — regional
goods trade could double over the next decade.
The trade in modern services in Europe is increasing too, but not fast enough
for many Europeans. The benchmark for merchandise trade is East Asia, a
developing region, but the European Union gauges the Single Market for
Services against the United States, a developed country. Trading services
is not easy: it often requires movement of people across borders, ease in
establishing a local presence, and harmonious home–host regulations. Given all
this, Europe’s trade in services does not seem stunted (ﬁgure3). But progress
is mixed: travel and ﬁnancial services have done well but transport and other
business services — especially those involving new technologies and the Internet
— have not. With reforms that make adopting newer technologies easier, better
regulations, and greater mobility of workers, Europe’s trade in services could
triple in size over the next decade. More important, productivity in the general
services sector — which is about 70 percent of GDP in Europe — would increase.
The opportunity that Europe might really be missing involves regional trade
in agriculture. The European Union pays for its agricultural trade policies not
just with the roughly €50billion a year the European Commission spends on
agriculture and rural development and their large indirect efﬁciency costs, but
also through missed opportunities for closer economic integration with eastern
partnership countries. In Georgia and Ukraine, a third of all workers still depend
on agriculture for a living. Allowing better access to European farm markets
would aid their development, win friends, and inﬂuence policies in the countries
of the eastern partnership.
Despite these weaknesses, the overall assessment of European trade is
positive. In 2009, Europe’s merchandise trade was worth about $4.5 trillion,
RESTORING EUROPE’S LUSTRE
more than East Asia’s and North America’s combined. Its trade in services was
worth $2.25 trillion, more than that of the rest of the world combined. Trade is
the mainstay of the European economic model and its most attractive attribute.
Finance that ﬂows downhill
Financial integration is the second part of the convergence machine. Finance
has served Europe well. This may come as a surprise to those who blame
the current crisis in the eurozone on banks that lent money to spendthrift
governments. But European ﬁnance has a desirable attribute: capital of all
Figure 3: More trade in services
in Europe, but apparently in
more traditional activities
(services exports in the European Union,
United States, and Japan, 2008)
Note: The numbers in parentheses refer
to the sum of traditional and modern
service exports as a percentage of GDP.
Source: World Bank staff calculations,
based on IMF BOPS; see chapter2.
Figure 4: In Europe, foreign
capital has boosted growth
in emerging economies
(current account deﬁcits and
per capita growth, 1997-08, by
groups of countries, percent)
Note: Average growth rates calculated
using 3 four-year periods in 1997–2008.
Source: World Bank staff calculations,
based on IMF WEO; see chapter 3.
Distribution of services exports, 2008,
Real per capita GDP growth,
EU12 EU candidates Eastern partnership Non−European EME
types ﬂows from richer to poorer countries, from low- to high-growth countries.
Financial FDI — big investments by Austrian, French, Italian, and Swedish banks
in Central and Eastern Europe — is a unique feature of Europe. In the east, it has
Figure 4 shows the relationship between economic growth and current account
deﬁcits in the new member states of the European Union, its candidates, the
eastern partnership countries, and other emerging economies. An upward
sloping arrow means that countries that ran smaller deﬁcits or larger external
account surpluses grew faster. In other words, a country grew faster if it lent
rather than borrowed abroad. And for emerging economies outside Europe,
this is indeed what we see: capital ﬂows from poorer, high-growth countries to
richer, low-growth countries (green arrow). Call this the “China syndrome.”
In Europe, capital behaves the way it should: it ﬂows from richer to poorer
economies, and countries receiving more capital grow faster. The laws of
economics have held in Europe. They hold more ﬁrmly the more institutionally
integrated the economies have become with Western Europe — by membership
in the European Union or by signaling the intention to join. Belarus and Ukraine,
for example, have done neither, and they look a lot like emerging market
economies outside Europe, growing faster when they have external account
surpluses (capital outﬂows) or smaller current account deﬁcits.
In 2008, when the ﬁnancial crisis hit, people who were familiar with earlier
crises in Asia and Latin America expected a massive pullout by western banks.
It did not happen: foreign banks stayed, renewing 90 percent of the loans they
had made, a much higher proportion than in previous crises. Of course, during
the preceding boom some governments, enterprises, banks, and households
abused the opportunities provided by this model of ﬁnancial integration. And
today, as western banks face pressures to offset losses in Southern Europe,
they may have to sell their proﬁtable businesses in Eastern Europe. But the
beneﬁts have been greater than the excesses, and some reforms can make the
ﬂows more stable and their beneﬁts even greater: better management of public
ﬁnance during booms in both advanced and emerging Europe, and more adept
regulatory structures to crisis-proof private ﬁnance. To grow at high and steady
rates, economies in emerging Europe have not had to “become Asian.” Nor
should they have to now.
Restarting the convergence machine
In the early 2000s, an important debate took place. For two decades,
economists had been puzzled by the ﬁnding that a country was able to invest
only as much as what it could itself save. In theory, capital ﬂows should allow
savers in wealthier, or low-growth, countries to ﬁnance investment in poorer, or
high-growth, economies. They would get a higher return on their money, and
these ﬁnancial ﬂows would allow the people in developing nations to save less
and consume more, and invest more and grow faster. Unfortunately, it did not
seem to happen; instead, there was a strong correlation between saving and
investment across countries (Feldstein and Horioka 1980). But in the European
Union between 1992 and 2001, especially the eurozone, research showed that
something had changed. Greece and Portugal had run large current account
RESTORING EUROPE’S LUSTRE
deﬁcits ﬁnanced by foreign capital inﬂows; their savings had fallen, investment
had increased, and their economies had grown (Blanchard and Giavazzi 2002).
The question was whether policymakers — national governments, the European
Union, and the European Central Bank — should welcome these growing
imbalances, or worry about them.
With the beneﬁt of hindsight the answer is, of course, both. The capital inﬂows
were the result of trade and ﬁnancial integration, and they were supposed to
make Greece and Portugal more productive and richer economies. Until about
2001, they did, and their living standards converged to those of more advanced
European economies. But since 2002, labor productivity in Europe’s southern
countries has been falling. The sheer volume of ﬂows meant that inﬂows
replaced domestic saving. Increasingly, though, they did not fund productive
investment. Obviously, the borrowed money had not always been used well. It
had ﬂowed in on the belief that Greek and Portuguese debts would be serviced
or repaid. By 2009, it was clear that this was going to be difﬁcult.
In the new member states, the same story was being played out, but with
many more happy endings than sad. In countries such as the Czech Republic
and Poland, foreign savings ﬂowed into productive uses, and both Western
European savers and Eastern European investors beneﬁted. In some others,
ever larger ﬂows began to ﬁnance consumption, sometimes by the government
but more often by households. In these countries, economic growth went into
reverse during the global ﬁnancial crisis.
Restarting the convergence machine will not be difﬁcult. The Single Market for
Services is becoming more efﬁcient, and national governments can accelerate
the process by fully implementing the European Union’s Services Directive. For
many services, measures to increase mobility of labor among countries will help
greatly. For other more modern services that can be sold digitally, harmonious
regulations may be much of what is needed. New member states of the
European Union and the candidate countries in Southeastern Europe will have to
continue easing the bottlenecks in transport and communication infrastructure
and modern services, so that trade in manufactures can facilitate the production
networks that have been growing in size and sophistication. The European
Union can also help millions of people in the eastern partnership countries —
whose combined GDP is less than $0.5 trillion — by giving better access to its $1
trillion market for food and other farm products.
A lot of this is happening. It is ﬁnance, the fuel for the machine, which needs
more attention. Europe’s convergence machine needs a better regulator of
ﬁnancial ﬂows. Finance ﬂows in the right direction in Europe — proof positive of
the soundness of the system. But the ﬂows are erratic, ﬂooding Europe’s less
advanced economies when ﬁnance is plentiful, and starving them of ﬁnance
when savers and investors in advanced countries become skittish. Financial
ﬂows could be made steadier through conservative ﬁscal policies and prudential
regulations, so that they do not suddenly stop when growth slows. Canada,
the Czech Republic, Croatia, and Poland showed what can be done during good
times, and Sweden and the Republic of Korea have shown ways to quickly
get ﬁrms and households out from under a debt overhang when boom-time
ﬁnances fuel excesses and cause busts (Iwulska 2011).
“Europe” — a global brand
As convergence has slowed and even gone into reverse in parts of Europe, the
entire region is getting a bad press. Europe’s best days are behind it, it is now
said. High unemployment among young people, stagnant worker productivity,
unsustainable public ﬁnances, and archaic social protection and innovation
systems that are unsuited for a globalized economy are all presented as
symptoms of economic decay. But the heart of an economy is neither labor nor
government — it is enterprise. Since the mid-1990s, during a period when Asia
had a huge ﬁnancial crisis and bigger recovery, and the United States had a
spectacular technology boom and a massive ﬁnancial crisis, European enterprise
has quietly ﬂourished.
This is no mean achievement, because Europe expects much from its
enterprises. Their shareholders expect them to add value and turn a proﬁt,
workers expect them to create jobs, and governments want them to bring
in export earnings. Remarkably, over the last decade and a half, European
enterprises have delivered all three (ﬁgure5). Between 1995 and 2009, job
growth in advanced Europe outstripped that in the United States. The new
member states of the European Union and the candidate countries engineered
productivity increases that outstripped those in East Asia and Latin America.
Exports of goods and services in advanced and emerging Europe rose faster
than output, and exceeded the growth rates even of the heralded BRIC
economies (chapter4). German and Swedish manufactures, produce from
France and the Netherlands, and British and Italian banks have global reach and
reputation; Czech engineering, Estonian information technology, and Turkish
construction companies are quickly acquiring them. These are not the signs of a
region in decay.
With Asian enterprises becoming more active globally, the next few decades
might well require European enterprises to make changes in how and where they
do business. For now, the numbers show that in aggregate, European enterprise
has been a reliable component of the economic model.
Southern enterprise falters
But not all is well. Employment growth in the EU12 could have been quicker,
productivity growth in the EU15 should have been faster, and EU candidate
and eastern partnership countries should raise exports to levels seen in the
rest of Europe (see top ﬁve bars in ﬁgure5). Perhaps most worrisome are the
productivity patterns since 2002, which show that parts of Europe have been
faltering (ﬁgure6). Northern countries such as Finland, Sweden, and the United
Kingdom — and later the Baltic economies — have done well, and continental
economies such as Austria, France, Luxembourg, and Germany — and later the
Czech Republic, Poland, and others — have been doing well too. But Southern
Europe — Greece, Italy, Portugal, and Spain — have not. From 2002 to 2008,
they created jobs, but mainly in cyclical activities like construction or in less
productive enterprises (like micro and family ﬁrms). And the productivity of
their workers has been falling.
RESTORING EUROPE’S LUSTRE
Figure 5: European enterprises
have delivered jobs,
productivity, and exports
(performance of European subregions
and benchmark countries, 1995–2009)
Figure 6: Much of
Europe is becoming
but the south has
(labor productivity levels
in 2002, thousands
of 2005 US$)
Note: For Belgium, Greece, and Norway, productivity levels refer to 2003 (top panel). In the bottom panel, the period considered
varies: Belgium and Norway (2003–08); Greece (2003–07); and the Czech Republic, France, Latvia, Romania, and the United Kingdom
(2002–07). The three lines in each panel show average values for countries covered by each line. Expected growth for EU15 South is
obtained by computing gaps in productivity levels between EU15 South and each of the other two groups and then applying these
shares to the difference in growth between the ﬁrst (that is, EFTA, EU15 North, and EU15 Continental) and the third (EU12) groups.
Source: World Bank staff calculations, based on Eurostat; see chapter 4.
growth, 2002–08, annual
Note: Growth rates in employment and productivity are compound annual growth rates. Average values by group
are shown. China and Japan are also included in the calculation of East Asia’s regional average.
Source: World Bank staff calculations, based on WDI and ILO (2010b); see chapter 4.
0 1 2 3 0 2 4 6 8 0 20 40 60
Employment growth, 1995−2009,
Productivity growth, 1995−2009,
Exports, 2009, percent of GDP
63 61 61 60
26 22 16 16 16 15 14 10 9
NOR IRL DNK FIN GBR SWE LUX BEL AUT NLD DEU FRA ITA ESP GRC PRT SVN HUN SVK CZE POL EST LVA LTU ROM BGR
thousands of 2005 US$
Labor productivity, 2002,
0.7 0.6 1.4
NOR IRL DNK FIN GBR SWE LUX BEL AUT NLD DEU FRA ITA ESP GRC PRT SVN HUN SVK CZE POL EST LVA LTU ROM BGR
Labor productivity growth,
A premature adoption of the euro by southern economies is sometimes blamed
for this reversal of fortune. Others say that letting the formerly communist
countries into the European Union so soon did not give the south enough time
to become competitive. But perhaps the most likely explanation is that of all the
economies in Europe, the entrepreneurial structures of Greece, Italy, Portugal,
and Spain were least suited for the wider European economy. For one thing,
a sizable part of net output in southern economies is generated in small ﬁrms
— almost a third of it in tiny enterprises (with fewer than 10 workers; ﬁgure7).
This is not an entrepreneurial proﬁle suited for a big market. Unsurprisingly, with
the expansion of the single market in the 2000s, foreign capital from the richer
economies of Continental Europe quickly changed direction, going east instead
of south as it had done in the 1990s (ﬁgure8).
Did the south need more time to adjust, or did it squander opportunities?
The latter seems more plausible. Ireland has shown that EU institutions and
resources can be translated quickly into competitiveness. The Baltic economies
are now doing the same. The chief culprits for the south’s poor performance
were high taxes and too many regulations, often poorly administered. While
these mattered less when its eastern neighbors were communist and China and
India suffered the least business-friendly systems in the world, they are now
crippling southern enterprise (ﬁgure9).
But there are reasons to be optimistic. The sovereign debt crisis has led to a
resumption of regulatory reform in these countries, and the experience of
countries such as Latvia and Lithuania shows that the necessary improvements
can be done over years, not decades. And they need to be done quickly. From
2003 to 2006, Europeans who felt that globalization was an opportunity for their
enterprises fell from 56 to 37 percent (Morley and Ward 2008). By 2006, the share
of people who felt it was a threat to European enterprises and employment was
almost half. The Danes, Swedes, Dutch, and Estonians were the most positively
disposed to globalization; the French, Greeks, Belgians, and Cypriots the least. It is
not a coincidence that the countries where people are wary of competition have
the worst business climate in Europe.
Europe would get even more from its enterprises if it made doing business
easier. Southern Europe must start doing this now, and Central and Eastern
Europe should continue improving the investment climate. Otherwise,
enterprises will remain small and unproductive — increasingly unable to attract
foreign investors, incapable of taking advantage of a pan-European market that
will only get bigger and more competitive, and progressively uncompetitive
in global markets, where they have to contend with enterprises from East
Asia and North America. A better business climate will help to stem the
growth of imbalances within Europe, restart the convergence machine, and
make European enterprises globally competitive. Countries such as Denmark,
Germany, Finland, Ireland, Sweden, and the United Kingdom show how it can be
done (Iwulska 2011).
The north innovates
But making it easier to do business will not be enough on its own. When
productivity gaps were growing within Europe, the gap between the advanced
RESTORING EUROPE’S LUSTRE
economies of Europe and the United States started to widen after almost
disappearing in the mid-1990s. Indeed, the 2000s were a decade of declining
productivity in the EU15 relative to both the United States and Japan, the
world’s next two largest economies after the European Union during that time
(ﬁgure10). Between 1995 and 2009, labor productivity in the United States grew
at 1.6 percent annually, in Japan at 1.2 percent, and in the EU15 at just 1percent
Reassuringly, productivity in Northern Europe grew at 1.7 percent per year
during the same period. What has the north done to encourage enterprise and
innovation? Much of its success has come from creating a good climate for
doing business. All the northern economies are in the top 15 countries of 183
in the World Bank’s Doing Business rankings; at 14th, Sweden is the lowest-
ranked among them. They have given their enterprises considerable economic
Figure 7: Smaller ﬁrms contribute
half of value added in the EU15
South, but just a third elsewhere
(contributions to value added by
size of enterprises, 2009)
Note: The numbers in parentheses are the
total value added expressed in billions of
constant 2005 U.S. dollars. The EU15 comprises
Denmark, Finland, Sweden, and the United
Kingdom (North); Austria, Belgium, France,
Germany, and the Netherlands (Continental);
and Greece, Italy, Portugal, and Spain (South).
The EU12 comprises Estonia, Latvia, and
Lithuania (North); the Czech Republic, Hungary,
Poland, the Slovak Republic, and Slovenia
(Continental); and Bulgaria and Romania (South).
Source: World Bank staff calculations,
based on Eurostat; see chapter 4.
Figure 8: Western European investors
have been looking east, not south
(foreign direct investment
inﬂows in Europe, percent, 1985,
1995, 2005, and 2008)
Note: The numbers in parentheses
are the amount of inﬂows expressed
in billions of U.S. dollars.
Source: World Bank staff calculations,
based on UNCTAD (2010); see chapter 4.
Value added by ﬁrm size, 2009,
FDI inﬂow share in Europe,
FDI inﬂow share in Europe,
Figure 9: Southern and Eastern Europe
must make it easier to do business
(principal components index of the
ease of doing business in 2011, scaled
from 0 [poor] to 100 [excellent])
Note: Averages are computed using principal
component analysis. EFTA here comprises
Iceland, Norway, and Switzerland. The EU15
comprises Denmark, Finland, Ireland, Sweden,
and the United Kingdom (North); Austria,
Belgium, France, Germany, Luxembourg, and
the Netherlands (Continental); and Greece,
Italy, Portugal, and Spain (South). The EU12
comprises Estonia, Latvia, and Lithuania (North);
the Czech Republic, Hungary, Poland, the
Slovak Republic, and Slovenia (Continental);
and Bulgaria, Cyprus, and Romania (South).
Source: World Bank staff calculations,
based on Doing Business; see chapter 4.
Figure 10: Productivity growth in
Europe’s larger economies has
slowed down since the mid-1990s
(EU15 labor productivity, indexed
to the United States and Japan)
Source: World Bank staff calculations, based on
the OECD Productivity database; see chapter 5.
freedom. Their governments are doing a lot more. They have speeded up
innovation by downloading the “killer applications” that have made the
United States the global leader in technology: better incentives for enterprise-
sponsored research and development (R&D), public funding mechanisms and
intellectual property regimes to foster proﬁtable relations between universities
and ﬁrms, and a steady supply of workers with tertiary education. Tellingly,
Europe’s innovation leaders perform especially well in areas where Europe as
a whole lags the United States the most. These features make them global
leaders; combining them with generous government spending on R&D and
public education systems makes their innovation systems distinctively European
For Europe’s larger continental economies that have reached or exceeded U.S.
standards in physical, ﬁnancial, and human capital, R&D and other innovation
82.8 79.5 76.0
64.4 69.4 74.5
Quality of regulations, 2011,
0−100: higher, better
USA JPN EFTA EU15 North Conti−
nental South EU12 North Conti−
EU15 labor productivity
1970 1975 1980 1985 1990 1995 2000 2005 2010
RESTORING EUROPE’S LUSTRE
deﬁcits are likely to be growth inhibitors. In dynamic Eastern Europe, countries
need not invest much more in R&D and the production of knowledge. But they
must still innovate through osmosis: they have considerable scope for the
quick adoption of existing technologies, using FDI and trade links as conduits.
The south is becoming slower in importing new technologies: FDI inﬂows and
outﬂows have been falling since the economies in emerging Europe integrated
with Continental and Northern Europe. For these increasingly service-oriented
economies, reform of domestic regulations — not more R&D spending — may be
the best way to speed up innovation.
What has been more perplexing is Europe’s generally poor performance in
the most technology-intensive sectors — the Internet, biotechnology, computer
software, health care equipment, and semiconductors. Put another way, Korea;
Taiwan, China; and the United States have been doing well in sectors that are
huge now but barely existed in 1975. Europe has been doing better in the more
established sectors, especially industrial machinery, electrical equipment,
telecommunications, aerospace, automobiles, and personal goods. The
United States has young ﬁrms like Amazon, Amgen, Apple, Google, Intel, and
Microsoft; Europe has the older like Airbus, Mercedes, Nokia, and Volkswagen.
Europe’s young leading innovators (called “Yollies” for short) are as R&D-
intensive as those in the United States. Europe just has a lot fewer Yollies.
As a result, while more than a third of U.S. R&D spending is by Yollies, it is
less than one-ﬁfteenth in Europe. The United States focuses its R&D efforts
on innovation-based growth sectors (ﬁgure11). Europe specializes in sectors
with medium R&D intensity. Japan is showing other East Asian countries
how productivity growth can be maintained in established industries such as
automobiles and electronics, and Germany may be doing the same. With the
size and diversity of the European economy, productivity growth will likely
Figure 11: The United States
specializes in younger, more
(relative technological advantage
and R&D efforts by young and old
innovation leaders in the United States,
Europe, and the rest of the world)
Note: R&D intensity is measured as the
ratio of R&D spending to total sales,
for ﬁrms established after 1975 (young
leading innovators or “Yollies”) or before
1975 (“Ollies”). The relative technological
advantage is calculated as the share of each
region or country (say, Europe) in the R&D
of a particular sector (say, the Internet)
relative to the share of Europe in world R&D;
values greater than one indicate the region
is technology-specialized in the sector.
Source: Bruegel and World Bank
staff calculations, based on the
European Commission’s Institute for
Prospective Technological Studies
R&D Scoreboard; see chapter 5.
Relative technological advantage
in innovation−based growth sectors
0 2 4 6 8 10
(R&D to total sales ratio)
come both from doing what Japan has done and adopting parts of the American
innovation system. But to do either, the common market will have to become
more of a single economy.
All European countries should have the friendly business climate that Denmark,
Ireland, and Norway have. It is not a coincidence that the only large European
economies that rival the United States and Japan in innovation are Germany
and the United Kingdom, which were both ranked in the top 20 countries for
ease of doing business in 2011. Many more European countries should have
the universities like those in the United States and Japan, where more than one
out of two people ages 30–34 have completed college; in Europe, only Ireland,
Denmark, Norway, Luxembourg, and Finland exceed 45 percent. More countries
will have to improve their business–science links to rival those in the United
States and Japan; currently, only Switzerland and Scandinavia do as well.
Burnishing the brand
Perhaps the simplest and most reliable way to assess the innovation
performance of a country is to see how much more productive its enterprises
become every year — that is, how much better they are in buying, producing,
and selling. During the last decade, two things have happened that should
worry Europeans. The ﬁrst is that since the mid-1990s, labor productivity in
Europe’s advanced economies has been falling relative to that of the United
States (and Japan). The second is that productivity in Southern Europe has been
falling compared with that in both the advanced countries in Western Europe
and the less well-off countries in emerging Europe. How can these gaps be
It depends on the gap. For reducing that between the south and the north,
the most important steps involve improving business regulations. Countries in
the EU12 South — notably Bulgaria — and Georgia have been showing that this
can be done even in the poorest parts of Europe. For closing the transatlantic
productivity gap, more is necessary. Leading European economies such as
Switzerland, Sweden, Finland, Denmark, and Germany are showing what
works. Following their example would mean giving up the ﬁxation on public
R&D spending targets, and focusing instead on improving competition among
enterprises, increasing the private funding of universities, changing the way
research is funded so that business-university linkages become stronger, and
making the single market work for services so that Europe’s entrepreneurs view
the entire continent as their domestic economy.
There are reasons to be optimistic. During the last two decades, countries in
the EFTA — Iceland, Norway, and Switzerland principally — have actually done
better in improving productivity than the United States. Northern parts of the
EU15 — especially Denmark, Finland, Ireland, and Sweden — have also been doing
well. The trouble is that their economies add up to less than $1.5 trillion in
purchasing power terms, roughly the GDP of Spain or Texas and just a tenth of
the European Union’s economy (see the Selected Indicators tables). If the rest
of Europe could beneﬁt from the dynamism of northern economies — by learning
from them or leaning on them — Europe’s innovation goals might quickly be
RESTORING EUROPE’S LUSTRE
Chapters 4 and 5 make it clear that preserving Europe’s global brand will be
more difﬁcult than restarting convergence. To stay competitive on world
markets, Europe will have to make trade even more vigorous and ﬁnance
more durable so that the region eventually becomes a single economy. To help
redress the continent’s growing productivity gaps, governments in Southern
Europe will have to quickly improve the climate for doing business. The more
dynamic countries in Eastern Europe will have to do all this as well as invest in
infrastructure. To close the growing transatlantic productivity divide, continental
countries must give their enterprises more economic freedom. Enterprises in the
northern and EFTA economies — already among the world’s most innovative — will
need fuller access to markets in the rest of Europe. Europe will have to become
the top destination for those seeking higher education and the opportunity
to become entrepreneurs. Only then can European enterprises stay globally
competitive, and Europe become the place of choice of entrepreneurs from
around the world.
The lifestyle superpower
In 2008, Europe was already the place of choice for tourists: of the busiest 20
international tourist destinations, more than half were in Europe. The United
States had the might and China the momentum, but Europeans had the highest
standard of living. Millions of people from around the world visited Europe
to see and experience it ﬁrsthand. In the 1990s, Japan’s Prime Minister Kiichi
Miyazawa had promised he would make his country the “lifestyle superpower.”
With average incomes still a quarter short of those in the United States, Europe
had become one.
Superpowers tend to spend a lot to protect their interests and project inﬂuence.
To remain the political superpower, the United States spends almost as much on
defense as the next 15 countries do together. To keep its status as the lifestyle
superpower, Europe spends more on social protection than the rest of the world
Figure 12: Outspending
the rest of the world
(general government spending on
defense [United States] and social
protection [Europe], 2004–09,
share of total world spending)
Note: For social protection spending, due
to the data availability, averages over
2004–09 by country are used. Data cover
general government but, if unavailable, refer
to central government only. n = the number
of countries included in the calculations.
Source: World Bank staff calculations,
based on Stockholm International Peace
Research Institute (2011); IMF GFS; WDI;
World Bank ECA Social Protection Database;
and Weigand and Grosh (2008).
Social protection (n=96)
percentage of world total
The decline of work
The hallmark of the European economic model is perhaps the balance between
work and life. With prosperity, Americans buy more goods and services,
Europeans more leisure. In the 1950s, Western Europeans worked the equivalent
of almost a month more than Americans. By the 1970s, they worked about the
same amount. Today, Americans work a month a year more than Dutch, French,
Germans, and Swedes, and work notably longer than the less well-off Greeks,
Hungarians, Poles, and Spaniards (chapter6).
Europeans have also cut the years they work during their (ever-lengthening)
lives. Today, men in France, Hungary, Poland, and Turkey effectively retire more
than eight years earlier than in the mid-1960s. The average European can also
expect to live four years longer. By 2007, Frenchmen expected to draw pensions
for 15 more years than in 1965, and Austrian, Polish, Spanish, Swiss, and Turkish
men for more than a dozen. In Organisation for Economic Co- operation and
Development countries, only Korean, German, and Czech men work more years
today than they did 50 years ago (ﬁgure13).
American, Australian, and Canadian men also retire about four years earlier
than they used to. But their countries have more favorable demographics than
the typical European country (ﬁgure14). On current immigration and work
participation trends, the 45 countries covered by this report will lose about 50
million workers over the next ﬁve decades, and have a workforce of about
275 million by 2060. In the 2030s alone, the labor force will fall by 15 million
Figure 13: Europe’s pension systems have to
support people for many more years
(changes in life expectancy at 60 and effective retirement age, 1965–2007)
Source: OECD (2011a); updated data from OECD (2006).
Change from 1965 to 2007, years
Life expectancy at age 60, men
Retirement age, men
RESTORING EUROPE’S LUSTRE
Figure 14: Europe’s labor force
will shrink, while North America’s
will grow by a quarter
(projected cumulative change
in working-age population,
Note: North America is Canada and
the United States and North-East Asia
includes China; Hong Kong SAR, China;
Japan; Macao SAR, China; the Republic
of Korea; and Taiwan, China.
Source: U.S. Census Bureau, International
Data Base; see chapter 6.
Figure 15: Europeans are less mobile,
even within their own countries
(labor mobility, share of working age
population that has moved, 2000-05)
Source: Bonin and others (2008); OECD
(2005 and 2007); see chapter 6.
people. The decline will be most severe for the European Union (countries such
as France, which have high fertility rates today, do better), but candidate and
neighborhood countries will also lose workers. The exception is Turkey, where
the labor force is projected to increase until 2060.
Only with radical changes can Europe counteract the shrinking of its labor
force. If participation rates in all countries were to converge with those seen in
Northern Europe, or if the retirement age were to increase by 10 years across
the board, the European labor force would increase marginally over the next 50
years. If female labor force participation converged with men’s, the labor force
would still decrease by 5 percent. But none of these changes would completely
offset the loss of young workers. For that, Europe will need to integrate Turks
into the European labor market and attract talented young workers from around
the world. In one plausible scenario, Turkey could contribute 40 percent of
the gains in the European labor force, and almost all of the increase in young
Fixing the European labor market will require a lot: increasing the competition
for jobs, improving labor mobility within Europe, ﬁxing how work and welfare
interact, and rethinking immigration policies. These changes will not happen
without a new social consensus, which has yet to be built.
Working−age population, 2010=0
2010 2015 2020 2025 2030 2035 2040 2045 2050
1.0 1.0 0.8
Cross−border labor mobility,
Perhaps the best way to start is to accelerate internal labor mobility in Europe.
Mobility in the European Union is the lowest in the developed world (ﬁgure15).
There are natural barriers to greater labor mobility associated with language
and cultural differences, but there are also policy-induced obstacles. In most of
the older EU member states, there are restrictions on the movement of workers
from the new member states. Housing markets in many European countries can
be inefﬁcient and make moving expensive: the transaction costs of buying or
selling a house can be high. Despite measures to ensure the portability of social
beneﬁts across the European Union, including pensions and unemployment
insurance, in practice it is limited because of cumbersome rules. Generous
unemployment beneﬁts discourage workers from seeking jobs. Labor market
signals can be muted by collective bargaining agreements that limit territorial
wage differentiation. To make the single market work better, making labor
more mobile should be a priority. For the countries that share the common
currency, it is a prerequisite (box 1).
Then, Europe has to make changes in how work is regulated and social security
provided. Many countries in Western Europe had started to reverse the decline
in work participation during the late 1990s and early 2000s; many in Central,
Eastern, and Southern Europe now must do the same. The main attribute of
the European economic model that needs to be reassessed is employment
protection legislation, which is lowering participation and reducing employment
in many countries. In countries such as Spain, it may be responsible for
youth unemployment rates as high as 40 percent. Paradoxically, Europe has
impending shortages of young workers and high joblessness among its youth.
Denmark and Germany have shown how this can be remedied (Iwulska 2011).
Other countries like Croatia, Moldova, Poland, Romania, and Turkey may
have to learn quickly and carefully implement the lessons. The countries in
emerging Europe will also have to decide — based on their cultural and political
antecedents — whether to move toward greater job security and join countries
such as Belgium and France, or toward greater ﬂexibility and become more like
the North Americans and East Asians. To have both as in Denmark, they will
have to consider the greater ﬁscal costs of “ﬂexicurity.” At the moment, most
countries have neither.
While all this is being done, Europe’s policymakers could get people to
appreciate the need for a new approach to immigration. Europe needs an
immigration policy that is more driven by economic need. Today the debate is
about how to best manage migration from North Africa. Tomorrow’s debate
should be about the policies and practices that will make Europe a global
magnet for talent. Countries like Sweden and the United Kingdom have been
doing this, but not quite as effectively as Canada and the United States (Iwulska
The precipitate promise of social protection
Europe will have to make big changes in how it organizes labor and
government. The reasons are becoming ever more obvious: the labor force
is shrinking, societies are aging, social security is already a large part of
government spending, and ﬁscal deﬁcits and public debt are often already
RESTORING EUROPE’S LUSTRE
In dealing with government spending, deﬁcits, and debt, it is sensible to start by
asking whether European governments are too big; that is, whether they spend
too much. They are obviously bigger than their peers. In the EU15, governments
spent 50 percent of GDP in 2009; in much of the rest of Europe, this share was
about 45 percent — versus less than 40 percent in the United States and Japan,
33 percent in Latin America, and about 25 percent in emerging East Asia. A map
of the world resized to reﬂect government spending instead of land area shows
how Europe might look to outsiders (ﬁgure16).
Figure 16: Governments
in Europe are big
(the world resized by
in dollars, 2009)
Source: World Bank
staff, using IMF WEO.
Governments in Europe spend between 7 and 10 percent of GDP more than
their peers elsewhere — that is, countries at similar levels of per capita income.
The difference is mostly the spending on social protection. For example,
Western European governments spend about 10 percent of GDP more than the
United States, Canada, Australia, and Japan. The difference in social protection
spending is 9 percent of GDP (ﬁgure17).
There can be good reasons for having bigger governments. If governments are
good at supplying essential social services, and if European society wants to
redistribute more to protect the welfare of the elderly, inﬁrm, or unfortunate,
they should provide these amenities. If European populations are older and
social security systems have to be bigger, that may be another good reason for
high-spending governments. European societies have been more redistributive
and to good effect — look at the impressive declines in poverty in Western
Europe since World WarII and in Eastern Europe since the end of the Cold War.
But social services, social welfare, and social security have to be ﬁnanced by
taxes, and tax rates in Europe are the highest in the world. For example, the
tax wedge in Korea — the amount that Korean employers pay besides wages
when hiring workers — is about a third of what Belgian enterprises pay and half
of the taxes paid by businesses in Greece and Turkey. The question that such
numbers provoke: is big government a drag on growth in Europe? It appears it
is. Over the last 15 years, a 10 percentage point increase in initial government
spending in Europe has lowered annual growth by 0.6–0.9 percentage points.
Countries with government spending-to-GDP ratios above 40 percent grow by 2
percentage points of GDP less than those with lower ratios (chapter7).
Of course, size is not the only feature that matters. What government does and
how it ﬁnances its activities is as important. European governments regulate the
largest economic area in the world; encourage a vigorous exchange of goods,
services, and capital; promote voice and accountability; provide or enable the
provision of public goods; and redistribute wealth. Bigger governments are
often better at doing these things, especially when social trust ensures that
everybody plays by the same rules. As countries like Sweden show, such big
governments can go together with thriving, dynamic economies.
But it is not easy being like Sweden. What does it take? Make it so easy to
register property, trade across borders, and pay taxes that the World Bank
ranks the country one of the top 15 for doing business. Create the conditions
that get four out of every ﬁve people of working age into jobs, and get almost
everybody who works to pay taxes. Have an efﬁcient government that provides
high-quality social services, so taxpayers get their money’s worth. Institute
the pension rules that make it difﬁcult to retire before 65 and impossible until
you reach your 60s. Cultivate the social trust that allows both a generous social
safety net and a transparency in government so that abuse is minimal. The list
is long. If a country can do all this, big government will not hurt growth.
Europe’s governments will have to become more efﬁcient, or become smaller.
Fortunately, governments that have grown prematurely big have done so for
just one reason: social protection. Europe’s states are not big spenders on either
health or education. The variation among countries stems from a difference
in spending on pensions and social assistance. Europe’s countries also differ
in how they tax these beneﬁts; Northern European countries tax the social
security beneﬁts of people with high incomes more than others in Europe do.
After taxes are considered, the southern periphery is the biggest social spender
in Western Europe. But the reason why Europe spends more than its peers on
public pensions is the same in the north, center, and south. This is not because
Europe has the oldest population (Japan’s is much older) nor because of higher
pension beneﬁts (annual subsidies per pensioner are about the same in Greece
as in Japan). It spends more because of easier and earlier eligibility for pensions
Fiscal consolidation should be a top priority in Europe during the next decade,
and controlling the public expenses related to aging will remain the policy
imperative over the next 20 years. Calculations done for this report suggest that
Western Europe has to improve its primary balance — adjusted for the business
cycle — by about 6 percent of GDP during this decade to reduce public debt to 60
percent of GDP by 2030 (ﬁgure19). Among the countries of Western Europe, the
need for consolidating public spending is greatest in the south and lowest in the
north. Among Europe’s emerging economies, with a lower public debt target of
40 percent of GDP, the adjustment needs are about 5 percent of GDP. They are
lowest in the European Union’s new member states. Bigger adjustments will be
needed in candidate countries and the economies of the eastern partnership,
because many of them have not begun seriously reforming their social
protection systems — pensions, unemployment insurance, and social assistance.
Public spending related to aging includes the ever-increasing costs of providing
health care for the elderly. Without comprehensive reforms to pensions and
long-term health care, these costs could add more than 3 percent of GDP to
RESTORING EUROPE’S LUSTRE
the governments’ ﬁscal imbalance during the next two decades. Governments
in Europe that spend more than 10 percent of GDP on such beneﬁts may be
risking underinvestment in activities that help economic growth — education,
infrastructure, and innovation. Countries such as Serbia and Ukraine that
already spend 15 percent or more on social security alone may be jeopardizing
the welfare of generations.
Recalibrating the work–life balance
The European model of work provides income security more than any other,
and some countries such as Austria, Denmark, Ireland, and Switzerland have
adapted it to combine security with ﬂexibility in hiring and ﬁring to foster
both efﬁciency and equity in labor market outcomes. But for much of Europe,
Figure 17: Social protection explains
the difference in government size
between Europe and its peers
percentage of GDP, 2007–08)
Note: “Social protection” includes beneﬁts
related to sickness and disability, old age,
survivors, family and children, unemployment,
and housing. Western Europe comprises
Denmark, Finland, Iceland, Norway, and
Sweden (North); Austria, Belgium, France,
Germany, Ireland, Luxembourg, the Netherlands,
Switzerland, and the United Kingdom (Center);
Greece, Italy, Portugal, and Spain (South).
Source: World Bank staff calculations,
based on IMF GFS and IMF WEO.
Figure 18: Small differences in annual
pensions per beneﬁciary, big in
overall public pension spending
(public pension spending in 2007)
Note: Median values by group are shown.
Western Europe comprises Denmark, Finland,
Iceland, Norway, and Sweden (North); Austria,
Belgium, France, Germany, Ireland, Luxembourg,
the Netherlands, Switzerland, and the United
Kingdom (Center); Greece, Italy, Portugal, and
Spain (South). Anglo-Saxon comprises Australia,
Canada, New Zealand, and the United States.
Source: World Bank staff calculations,
based on Eurostat and the OECD
Pensions Statistics; see chapter 7.
Government spending, 2007−08,
percentage of GDP
South EU12 EU
Social protection Educatio n Health Nonsocial spending
Public pension spending,
percentage of GDP
0 3 6 9 12 15
Real public pensions per elderly, PPP
thousands of international dollars
the imbalances between work and life need to be mitigated, as do the ﬁscal
imbalances that have emerged as a result of public spending to protect societies
from the rougher facets of private enterprise.
Since the mid-1980s, a billion Asian workers have entered the global
marketplace. Over the same period, Europeans have been working fewer
hours per week, fewer weeks per year, and fewer years over their lifetimes. It
is worrisome that their productivity is not increasing as quickly as it should. In
the European Union’s southern states, for example, productivity during the last
decade fell by 1 percent each year, when — given productivity levels relative to
those in Continental and Northern Europe — it should have increased by about 4
percent annually. It is also worrisome that in many parts of Europe, taxes bring
in less than what governments spend. France and Germany, for example, have
not had a ﬁscal surplus since the 1970s; Greece expected a budget deﬁcit of
about 10 percent of GDP in 2011; and Hungary, Serbia, Ukraine, and many others
have been struggling to contain budgetary imbalances.
This will have to change. The reform of pensions and disability allowances will
have to be the highest priority now, with costs of long-term health care soon
becoming a pressing problem. Europe already spends twice as much on social
security as Japan and the United States. There are some countries in Europe
that are showing how to address these problems. Some such as Sweden
are well known; others like Iceland could be studied more (Iwulska 2011).
European societies will also have to modernize social welfare systems so that
the disincentives to work are minimized. Denmark, Germany, and Ireland may
inspire others how this can be done. But what needs to be done is not hard to
see: Europeans will have to work for more years.
From distinct to distinguished
In 2007 An East Asian Renaissance, a report by the World Bank, introduced the
notion of the “middle-income trap” (Gill and Kharas 2007). It was about why
countries seem to easily grow from low per capita income levels to middle
income, but ﬁnd it difﬁcult to become and remain high-income economies. Later
research identiﬁed about two dozen countries that have grown from middle
income to high income since 1987. Some had discovered oil, like Oman and
Trinidad and Tobago. But this can hardly be a development model for others
to emulate, because it is a matter more of providence than policy. Some, like
Hong Kong SAR, China; Singapore; and Republic of Korea, had translated peace
into prosperity through export-led strategies that involved working and saving
a lot and sometimes postponing political liberties for later. They had to be
aggressive, like tigers, looking out only for themselves.
But of the countries that have grown quickly from middle-income to high-
income, half — Croatia, Cyprus, the Czech Republic, Estonia, Greece, Hungary,
Latvia, Malta, Poland, Portugal, the Slovak Republic, and Slovenia — are in
Europe. If you can be a part of the formidable European convergence machine,
you do not need to be extraordinarily fortunate to become prosperous nor —
like the East Asian Tigers — do you have to be ferocious. You just have to be
RESTORING EUROPE’S LUSTRE
The inability of this convergence machine to continue to deliver rapid growth and
an improved quality of life in the advanced economies of Western Europe has
been recognized for some time. Europe’s policymakers have put together protocols
and commitments to encourage innovation and dynamism. Policies that were a
core component of Europe’s postwar growth model — or those that evolved from
it — are not giving European economies enough ﬂexibility to take advantage of new
technologies that have led to high productivity growth in Asia and North America
during the last 15 years. It is not that European product market regulation and
employment protection became more stringent over time; they just became more
The Western European model that so effectively enabled catch-up has created
“afterglow” institutions that are hindering growth in a different age — an era of
greater competition abroad and big demographic shifts at home. These institutions
now need updating. In the states aspiring to become part of the machine, notably
the candidates, potential candidates, and the Eastern Neighborhood, the afterglow
structures will probably not preclude the beneﬁts that come from greater
economic union. In the new member states too, these institutions may not yet
prevent productivity gains if their ties with advanced Europe become stronger and
sophisticated. In the western economies, the structures must quickly be made
more ﬂexible. Convergence to a rigid core may soon become unappealing.
The European Union has a growth strategy, Europe 2020, which recognizes this
imperative. Not all of the 45 countries covered by this report are in the European
Union, but most share the aspirations of Europe 2020: economic development
that is smart, sustainable, and inclusive. Europe’s way of life — and its growth
ambitions — put a premium on combining economic dynamism with environmental
sustainability and social cohesion.
Figure 19: Western Europe
has to reduce ﬁscal deﬁcits
by 6 percent of GDP,
emerging Europe by less
adjustment needs, 2010 –30,
percentage of GDP)
Note: The ﬁscal impacts of aging on pensions and health care systems are missing for EU candidate and eastern partnership countries.
For this exercise, the sum of adjustment in health care spending is assumed to be the same as for the new member states. The
adjustment in pension related spending is assumed to be the same as that for Southern Europe. Western Europe comprises Denmark,
Finland, Iceland, Norway, and Sweden (Nor th); Austria, Belgium, France, Germany, Ireland, Luxembourg, the Netherlands, Switzerland,
and the United Kingdom (Center); Greece, Italy, Portugal, and Spain (South). Overall Western Europe contains all the countries belonging
to these three groups. Overall emerging Europe includes all countries from EU12, EU candidates, and eastern par tnership.
Source: Calculations by staff of the Institute for Structural Research in Poland and the World Bank, based on IMF WEO; see chapter 7.
Western Europe Emerging Europe
Overall North Center South Overall EU12 EU
Cyclically adjusted primary balance, 2010−20
Changes in pensions and health care, 2010−30
Europe’s economic model is already more environment-friendly than most. It has
made production cleaner than any other part of the world except Japan, and will
become the lowest per capita emitter of carbon dioxide by 2020. But it is still
the largest importer of emissions (embedded in imported products — ﬁgure20),
polluting not as much through production as by proxy. Europeans will need to do
more on the consumption side to be considered truly green. It is a testament to
European ideals that Europe is willing to pay the most to avert global warming
while it is likely to be damaged least. There is reason to believe that Europe’s
economic model can become greener without unduly sacriﬁcing growth: Germany,
France, and Sweden may already be showing the way.
Social cohesion is the cornerstone of Europe’s economic model, but this aspiration
must be realized in ways consistent with sound economic principles. It can be,
because Europe has three priceless assets: the European Union’s single market,
a momentum for regional integration, and the global inﬂuence that comes
from being the generator of one-third of the world’s annual output. Inclusive
development will be a natural outcome of measures to deepen the single market,
expand the scope of regional economic integration, and preserve Europe’s global
This will require adjustments in all of the European economic model’s six
components. The rules to guide policymakers — adapted from Phelps (1966) — might
look something like the following:
·Extend the beneﬁts of freer trade to those outside the European Union.
Enlargement has made Europe stronger, and economic integration should be
continued toward the east. The single market can be made deeper and wider at
the same time.
·Borrow from abroad only for investment. In Europe, where foreign ﬁnance has
been used for private investment, it has fueled growth and convergence. But
relying on foreign capital to ﬁnance consumption makes economies everywhere
more vulnerable than dynamic.
·Provide enterprises with the freedom to start up, grow, and shut down. Efﬁcient
regulation of enterprise trusts but veriﬁes, makes compliance easy but punishes
violation, and assesses risks and concentrates resources where risks are highest.
·Use public money to catalyze private innovation, not substitute for it. Effective
innovation policy sets the table for innovators to thrive by supporting inventions,
mobilizing ﬁnance, and bringing the power of choice and the resources of business
into Europe’s universities.
·Design labor laws to treat insiders and outsiders more equally. Regulations
should not favor either those with jobs or those without. Seeing labor as a ﬁxed
lump to be divided among workers leads to poor rules for regulating work.
·Consider government debt mainly as a way to ﬁnance public investment.
With high debt levels and modest growth prospects, public ﬁnance should be
premised on the expectation that future generations will not be much wealthier
than today’s. Social protection, social services, and public administration should
be ﬁnanced with taxes and contributions, not sovereign debt.
RESTORING EUROPE’S LUSTRE
European economies do not have to become North American or East Asian to
keep to these rules. But Europe might learn a few lessons from them. From
North Americans, Europe could learn that economic liberty and social security
have to be balanced with care: nations that sacriﬁce too much economic
freedom for social security can end up with neither, impairing both enterprise
and government. To get this balance wrong could mean giving up Europe’s
way of life and its place in the world. From the Japanese, the Koreans, and the
Chinese, Europe might learn that while the gifts of prosperity and longevity
arrive together, they have to be unbundled: being wealthier means that
Europeans do not have to work as hard as before, but living longer means
having to work more years, not fewer. To do otherwise unjustly burdens future
generations, and violates growth’s golden rule.
Europeans can of course learn the easiest and most from each other. The
countries in Europe that have instituted policies manifesting both cultural
maturity and economic discipline have shown how a distinct growth model can
be made distinguished (table 2).
Figure 20: Greening
production but not
(net CO2 emission
Note: MtCO2 = million
tons of carbon dioxide.
Source: World Bank staff,
using data from Peters and
others (2011); see spotlight 2.
Box ﬁgure 1: More monetary and ﬁnancial than real integration in Europe during the last decade
(arrows begin in 1997 and end in 2008; the origin indicates complete nominal and real integration)
Note: The ﬁgure shows the extent of economic
integration, using the theor y of optimum currency
areas (Mundell 1961). The vertical axis combines
in one index of dissimilarity three indicators of
nominal integration—volatility of exchange rates,
convergence in inﬂation rates, and convergence in
interest rates. The horizontal axis does the same
with three indicators of real integration—extent of
synchronization in business cycles measured by
indices of industrial production, trade integration, and
per capita income. The origin in the ﬁgure represents
perfect economic integration, and the arrows show the
integration path of each country or group of countries
in 1997–2008. EU candidates are represented by Croatia
and Turkey; the eastern partnership countries by
Armenia, Azerbaijan, Belarus, Georgia, Moldova, and
Ukraine; and the EU’s new member states by Bulgaria,
the Czech Republic, Estonia, Hungary, Latvia, Lithuania,
Poland, Romania, the Slovak Republic, and Slovenia.
Source: Sugawara and Zalduendo 2010.
Nominal integration (0 = full integration)
0 1 2 3 4
Real integration (0 = full integration)
Box 1: The unmet precondition of the common currency—labor mobility
The September 1961 volume of the American
Economic Review might well be the most
inﬂuential issue of an economic journal
ever. A dozen or so pages after the article
on optimum growth paths by Phelps is a
short communication from Robert Mundell
that outlines a theory of “optimum currency
areas.” It states the conditions that the
countries in a monetary union had to have—
or quickly institute—to share a single currency
proﬁtably. In practical terms, it meant
ensuring that the single currency should not
lead to persistently high unemployment rates
in some parts of the monetary union, nor to
unacceptably high rates of inﬂation in others.
In 1999, Mundell was awarded the Nobel
Prize for “his analysis of monetary and ﬁscal
policy under different exchange rate regimes
and his analysis of optimum currency areas.”
The conditions for a successful monetary
union identiﬁed in the 1961 article can be
distilled to mobilit y of labor and capital
among the member states. To understand
why, imagine a fall in economic activity in
one par t of the union (say the south) and a
rise in another (say the north). This would
cause unemployment to rise in the south,
and inﬂationary pressures and balance-of-
payments surpluses to increase in the north.
If the central bank increases the money
supply, it might help the south but would
aggravate inﬂation in the north. If it does
not, high unemployment in the south would
cause suffering. But if capital and labor
were quick to move within the monetary
union, the dilemma would disappear.
For a practical application of his ideas,
Mundell chose Western Europe, presaging
today’s debates about the euro. “In Western
Europe the creation of the Common Market
is regarded by many as an important step
toward eventual political union, and the
subject of a common currency … has been
much discussed. One can cite the well-
known position of J. E. Meade, who argues
that the conditions for a common currency
in Western Europe do not exist, and that,
especially because of the lack of labor
mobility, a system of ﬂexible exchange
rates would be more effective in promoting
balance-of-payments equilibrium and internal
stability; and the apparently opposite view
of Tibor Scitovsky who favors a common
currency because he believes that it would
induce a greater degree of capital mobility,
but fur ther adds that steps must be taken
to make labor more mobile and to facilitate
supranational employment policies.”
The introduction of the euro undoubtedly
increased capital mobility in the eurozone;
one can reasonably expect a single currency
to greatly facilitate ﬁnancial integration.
The single currency undoubtedly also
facilitated the exchange of goods. But a
single currency cannot by itself increase
people’s mobility. This requires states to
harmonize labor regulations, education and
training arrangements, and social security
and welfare systems. Growing goods trade
in the eurozone may reduce the need
for labor mobility, but trade in services—
now three-quar ters of Western Europe’s
output—itself often requires movement
of people. So does keeping manageable
unemployment differences among countries.
In the decade before the global ﬁnancial
crisis, European economic integration
showed impressive progress. But for many
countries, the progress was unbalanced
(box ﬁgure 1)—more rapid in ﬁnancial areas
(interest rates and inﬂation) than in real
sectors (trade and incomes). It was more
balanced for the new member states. Poland,
for example, became more integrated in
ﬁnancial and real terms. The EU candidate
countries (represented here by Croatia and
Turkey) experienced just ﬁnancial integration.
But while integrating in monetary and
ﬁnancial aspects, Greece became less
integrated within the EU15 in real terms.
Labor mobility in Europe is the lowest
in the developed world. Mundell’s
communication 50 years ago suggests
that this will be a serious problem for
the eurozone. Increasing labor mobilit y
may be a privilege in Europe, but it is a
prerequisite in the eurozone. Countries that
integrate their labor markets will be able to
share a single currency proﬁtably. Others
will have to deal with stressful tradeoffs
between inﬂation and unemployment.
Source: Mundell 1961; Sugawara
and Zalduendo 2010.
RESTORING EUROPE’S LUSTRE
1 Phelps, Edmund. 1961. “The
Golden Rule of Accumulation:
A Fable for Growthmen,” The
American Economic Review,
Vol. 51, No. 4. (September,
1961), pp. 638-643.
2 Among the economists
were Maurice Allais, Tjalling
Koopmans, Joan Robinson,
John von Neumann, Robert
Solow, and Trevor Swan.
3 von Weizsäcker, Carl
Christian. 1962. Wachstum,
Zins und optimale
(Mohr-Siebeck), 96 pages.
4 The report covers 45 countries:
the 27 member states of the
European Union, 4 countries in the
European Free Trade Association
(Iceland, Liechtenstein, Norway,
and Switzerland), 8 candidate
and potential candidate
countries (Albania, Bosnia and
Herzegovina, Croatia, Kosovo,
the former Yugoslav Republic
of Macedonia, Montenegro,
Serbia, and Turkey), and 6
eastern partnership countries
(Armenia, Azerbaijan, Belarus,
Georgia, Moldova, and Ukraine).
Chapter 1: The European
What makes the European
economic model unique?
The principal components of
Europe’s growth model—trade,
ﬁnance, enterprise, innovation,
labor, and government—are
organized in unique ways.
Have changes in Europe and the
rest of the world made a new
economic model necessary?
Sluggish productivity growth, a
declining workforce, and growing
ﬁscal imbalances have revealed
weaknesses of the European
economic model, and the entry of a
billion Asian workers into the global
market is adding to the stress.
Which parts of the European
model should be preserved,
and which changed?
Many changes are needed in
how governments and labor
markets are organized. Fewer
changes are needed to foster
innovation, productivity growth,
and job creation by enterprises,
and fewer still to improve
ﬁnance and trade in Europe.
Table 2: 30 questions, 30 answers
Chapter 2: Trade
Is “Factory Europe” as dynamic
as “Factory Asia”?
Factory Asia is growing faster,
but goods trade in Europe
is more sophisticated.
Is the Single Market for Services
with the United States?
The single market is working
quite well for traditional services
such as travel and transport, but
it is underperforming in modern
services such as insurance,
information technology, and
other business services.
Is the Common Agricultural
Policy compromising Europe’s
The European Union’s agricultural
policies hobble th