Michael Dauderstädt
Cohesive Growth in the Enlarging Euroland: Patterns, Problems and Policies. A Summarising Essay

• Patterns of Growth and Cohesion during Europe’s integration since 1957
• Country cases
• Nominal convergence of income
• Real convergence of output
• Policies for Cohesive Growth
• Bibliography

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Michael Dauderstädt ^*
Cohesive Growth in the Enlarging Euroland: Patterns, Problems and Policies. A Summarising Essay

^*[Friedrich Ebert Stiftung, International Policy Analysis Unit]

Two major changes will affect the future pattern of growth and cohesion in Europe:

1. The introduction of the Euro
   In 2002, Europe will visibly enter a new stage of integration with the introduction of the Euro coins and bills as legal tender. With the introduction of the common currency, information and transaction costs in Europe will further decline (after the last step towards monetary integration in 1992). This applies to all markets: goods and services, labour and capital. The mobility of capital will probably increase within Europe. Goods and services (with the possible exception of information services) will still be subject to, albeit possibly decreasing, transport costs and local tastes, and the mobility of labour will continue to suffer from language, housing and many other socio-cultural barriers.

2. The integration of Central and Eastern Europe
   This will add a large pool of low-wage labour and low-wage locations to the present EU economy. Although the effects on growth and distribution within the EU have been rather weak up to now [See Wolfgang Quaisser et.al.(2000), „Wirtschaftliche Konsequenzen der Osterweiterung für die Euro päische Union".] it remains to be seen how fast Central and Eastern Europe will catch up with the current EU-15. Another risk lies in the growing disparities within Central and Eastern Europe which might grow wider after accession within the new member states as well as between the new members and those kept out. The Luxemburg and Helsinki candidates will become more and more integrated as they prepare for accession. Beyond that group, more countries (Turkey, the western Balkans, CIS and Mediterranean countries) will intensify their links with the European Union (EU). Thus, unity and diversity [To use a wording from a book edited by Christopher Bliss and Braga de Macedo (1990) "Unity with Diversity in the European Economy".] will intensify simultaneously.

The success of this on-going unification of Europe will depend crucially on a more equitable distribution of prosperity. Continued underdevelopment and poverty in the regions of the periphery would not only threaten the stability of the local society and polity but would spill over into the core regions of Europe through migration and the supply of badly regulated locations for economic and extra-economic activities including organised crime. A sustained and large supply of cheap and even desperate labour within an integrated Europe requires adjustments within the core societies that might endanger the social cohesion not only of the EU as such but within the national welfare states. In the end, integration itself will look increasingly undesirable.

Such threats might lead to demands for limiting the unification of Europe. The spill-over process could be controlled by tighter borders towards poorer countries and stricter

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requirements for accession. But such an approach could weaken the processes of reform and development in the periphery, too. Promoting or, at least, enhancing the chances for rapid growth in the periphery would obviously be a much better solution. The EU has committed itself to this goal (Art. 158-162 TEU). The examples of non-performing regions and countries, however, suggest some reservations regarding the feasibility of deliberate growth-promoting policies.

These dangers should not be over dramatised. On the one hand, parts of the "old" periphery have done well. Ireland (since 1993) and Portugal (since 1985) have experienced high growth. Some countries of Central and Eastern Europe have recovered from the shocks of transition (notably Poland and Hungary) but they still have to catch up much more in order to bridge the income gap. On the other hand, Greece and the former GDR as well as some regions (e.g. Mezzogiorno) provide examples of relative stagnation in spite of large assistance (between 5% and 50% of GNP).

The following essay focuses first on the historical record within the EU so far. It then analyses the causes of the nominal convergence of income. As income growth can only be sustained by increasing productivity the next section deals with the major factors contributing to productivity growth such as investment and trade. Finally, possible policies to enhance growth in the periphery like trade liberalisation, aid and integration in general will be discussed.

Patterns of Growth and Cohesion during Europe’s integration since 1957

If we take a brief look at the history of European integration and the development and distribution of growth during that time we can discern different periods:

Table 1: Integration, convergence and divergence in Europe

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The first period (1957-73) belongs to the „glorious years" of Europe’s post-war prosperity. Southern Europe experienced catch-up growth. Average per capita income increased from about 55% of the EU-15 average to around 71%, while Central and Eastern Europe remained at around 47-50%. [See David L. Ellison 2001.]. The high growth in the core countries provided jobs for migrant labour from the periphery (Southern Italy, Spain, Portugal, Greece, Yugoslavia, Turkey), too. This fordist growth model was not fully extended into the European periphery when the crisis of 1973/74 (end of the Bretton Woods system, oil price shock) struck. Since then, the rates of productivity growth halved, and unemployment picked up. This crisis of fordism affected poor countries more than rich ones (they were oil importers and experienced political upheavals) though the relative position of Central and Eastern Europe did not change much.

With the brief exception of 1985-1990, Europe did not re-enter a prolonged growth path. This five-year period ended with the crisis in the wake of German unification and the collapse of the European Monetary System (EMS). In the late 1980ies, the poorer new member states Portugal and Spain, however, experienced relatively strong growth which was partially due to the Single Market. Central and Eastern Europe stagnated and thus fell back comparatively (to 41% of the EU average). The 1990ies were a period of weak and volatile growth in most of Europe, yet Portugal and above all Ireland continued to catch up with the rich core. Central and Eastern Europe experienced a dramatic decline of income in relative and absolute terms which was only slightly reversed in the second half of the past decade.

The causes for the fluctuations of European growth are subject to a long, intense and inconclusive debate. [See Nicholas Crafts and Gianni Toniolo „Postwar growth: an overview" in Nicholas Crafts and Gianni Toniolo (1996), "Economic Growth in Europe since 1945", pp.1-37, and the contributions by Barry Eichengreen (Institutions and economic growth: Europe after World War II), Mancur Olson (The varieties of Eurosclerosis: the rise and decline of nations after 1982) and Andrea Boltho (Convergence, competitiveness and the exchange rate) to that volume.]
To begin with, the causes of the successful growth period after WWII are not completely clear. It was probably due to catching-up with the USA while imitating its fordist growth model which allowed for co-operative industrial relations, high productivity growth, regulated demand and full employment. When the fordist mass production lost ground, service and knowledge industries expanded, accompanied by a spread of flexible specialisation and globalisation. This structural change reduced the number of low-skill high-productivity jobs in manufacturing which were the Industrial fundament of mass prosperity in the 1950ies and 1960ies. New jobs for low-skill workers became available but in relatively low-productivity service industries. It is that segment of the labour market which absorbs most migrant labour, mostly from the new European periphery (Central and Eastern Europe, North Africa).

The following table gives a first impression of the processes of convergence and divergence that could be observed.

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Table 2: GDP in ECU and PPP* in selected EU member states (EU=100)

* PPP = Purchasing Power Parity
Source: Eurostat

At present, growth in the periphery seems to confirm the free market assumptions. Locations in the EU periphery now combine their higher capital productivity (caused by relative underdevelopment and less capital available) with lower Euro interest rates. This combination allows higher growth, theoretically until the marginal productivity of capital in the periphery has reached core levels (a point which might be not too far away in Ireland). The other scenario would be increasing disparity due to agglomeration advantages in the core regions. [As supposed in a seminal way by Paul Krugman and Anthony Venables "Integration and the Com pe titiveness of Peripheral Industry" in Bliss/Macedo 1990, pp. 56-75]
Some regions (the „Euro-banana") tend to go from strength to strength while others (former GDR, Mezzogiorno, Alentejo, Estremadura) remain apparently mired in vicious circles of underdevelopment. The ambiguous relationship between economic integration and development has been the subject of a long academic debate. [See David L. Ellison 2001.]

The overall picture is rather mixed. The EU Commission itself admits in its Second Cohesion Report [See EU-Kommission 2001, p.4] (published in January 2001) that

• Average income per capita between member states converged

• Disparities between regions remained high

• Disparities within countries increased

Other authors [See Robert Leonardi 1995, "Convergence, Cohesion and Integration in the European Union", p.96 and 109.], possibly using different forms of measure, did observe income convergence between regions between 1979 and 1991 though that does not exclude stronger disparities within countries.

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Country cases

The various records of different countries indicate that national circumstances and policies should be analysed in greater detail:

• Ireland [See Denis O’Hearn 2001 as well as Michael Dauderstädt "Irland, der "keltische Tiger": Vorbild oder Warnung für ein wachsendes Europa?" in: ifo-Schnelldienst 6/2001 and „Über holen ohne einzuholen. Irland, ein Modell für Mittel- und Osteuropa?" Politikinformation Ost europa Nr.90, FES Bonn 2001.]:
  The superstar of catch-up growth is Ireland. The "Celtic Tiger" grew very strongly during the 1990ies, though not immediately after joining the EC in 1973. It has been approaching and even rapidly overtaking the average EU per capita income. Irish growth depended heavily on foreign direct investment (FDI), mostly from EU member states, but also from the US and Japan. This has led to a substantial decline in unemployment in Ireland, which has started to import cheap labour. It is now a capital exporting country and its public debt is declining thanks to increasing tax revenues.
  But the Irish case is very special. If one compares its GNP per capita with its GDP per capita, an enormous difference appears. Irish GNP is about 20% lower than its GDP. In GNP terms, Irish income is still below the EU average. The difference is caused by the huge income earned in Ireland by foreign firms and transferred abroad. The profits of foreign owned enterprises make up a substantial part of the Irish GDP. The share of wages in Irish GDP has correspondingly declined from about 77% twenty years ago to 58%. The high level of profitability and productivity of foreign firms reflects, to a large extent, transfer pricing that shifts profits within multinational corporations to their Irish affiliates in order to benefit from the very low corporate tax rates in the country. Ultimately, the prosperity of the Irish people has increased far less than one would think given its GDP figures. Income distribution has actually worsened; also in regional terms.

• Greece: Other countries have fared less well than Ireland after entering the EU. In particular, Greece, which experienced much slower growth after joining the EU in 1981 than in the decades before. In the 1950ies and 1960ies, Greece had been a high performer with growth rates substantially exceeding the OECD average. Even during the 1970ies , while suffering from the oil price shock, it still grew faster than the EU average. After accession, however, it experienced a prolonged phase of slow growth. Accession coincided with an expansionary shift in domestic policies towards higher consumption (higher wages and public deficit spending) and the second oil shock which accentuated a crisis of over-investment.
  The country was badly prepared for accession. It was, in spite of some tariff reductions due to EU association, still a strongly protected economy with highly subsidised exports. EU membership led to a marked deterioration of the trade balance. Big amounts of EU funds became available but were used not very productively, at least in the short term. It was only after 1995 that Greece started to experience higher growth again and managed to join the European Monetary Union (EMU) thanks to the more restrictive fiscal and monetary policies it adopted.

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• Spain: Spain’s growth rate was not much affected by EU membership. Most of its catching-up with the EU core was achieved before accession. Contrary to Greece, it did not experience major problems after joining the EU in 1986 although its trade balance turned negative. Spain received a substantial amount of FDI but its growth remained weak and its unemployment rate has been the highest in the EU. However, regional disparities within the country have declined. It has also been a major recipient of EU regional and structural funds.

• Portugal: Portugal’s income had converged with the EU until 1974 when its growth was disrupted by the democratic revolution at home and the world economic crisis abroad. After 12 years of stop-and-go-development including two debt crises with IMF-induced austerity programs, the year 1985/6 became a turning point. Portugal got its first stable government based on a sound centre-right majority, growth in Europe picked up and the oil price declined. In the following years, Portugal experienced relatively high growth in spite of big deficits in the trade balance that could be financed by huge capital inflows (FDI as well as EU funds).
  It seems to have used this capital productively; improving its infrastructure and human capital. Unemployment decreased substantially. Portugal managed to join the EMU after reducing inflation and budget deficits substantially. However, in the late 1990ies, budget deficits and foreign debt increased again. Some critics see a dangerous tendency to over-invest in public projects such as Expo and other grand schemes as well as a generally too loose fiscal policy. [See Abel Mateus 2001.]

In Euroland, Member States, including future ones from CEE, will be much more like regions within countries lacking the possibility to control the exchange rate and trade and capital flows. As a rule, poor regions have performed less well than poor Member States. Two major cases should be briefly discussed [See Andrea Boltho, Wendy Carlin and Pasquale Scaramozzino "Will East Germany Become a New Mezzogiorno?" in Journal of Comparative Economics 24 (1997), pp. 241-264.]:

• Mezzogiorno [See Andrea Boltho 2001.]:
  Southern Italy is a classical periphery that has been part of the EU since its foundation as the EEC. In spite of major efforts on the part of the Italian state as well as the EU, its income level has remained much below the Italian and EU average while unemployment has been much higher. Early development efforts focused on the location of heavy industry that depended on big subsidies and a high growth environment which both became unavailable after 1974. It achieved a limited success until 1974 by increasing Southern GDP per capita from around 55% to about 65% of the Northern value.
  After 1974 the gap widened again. Among other things, the following causes can be identified: Wages increased beyond productivity growth and eliminated the wage differential to the North, investment declined, public policies switched from investment to income maintenance, and public expenditure became increasingly under local control and thus became subject to rent-seeking and corruption in the South. In recent years, increasing disparities within the South may be explained by different levels of efficiency and probity of local and regional administrations.

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• East Germany [See Joachim Ragnitz 2001.]:
  The worrying parallels with the Mezzogiorno include a lack of competitiveness due to an unrealistic real exchange rate and wage increases that have outpaced productivity as well as massive transfers to maintain income and finance public service employment. Productivity increases have been based largely on employment reduction. After an initial phase of convergence between 1990 and 1995, productivity and GDP have been stagnating relative to that of West Germany. The construction sector had to shrink while productivity in the manufacturing Industry continued to grow. The size structure of East Germany’s economy is dominated by small and medium enterprises. It has too few big enterprises. Transfers continue on a large scale.

The picture emerging from these country cases is somewhat confusing. Integration does not seem to promote catch -up growth. The only country where convergence and integration coincided has been Portugal. However, neither does integration prevent convergence as the Irish and Portuguese cases prove. Even the extreme cases of Greece, Mezzogiorno and East Germany suffered less from integration as such than from a lack of preparation and/or bad domestic policies.

On the one hand, overvalued currencies or wages outpacing productivity (two sides of the same coin) and thus consumption beyond their own means facilitated by huge revenues from transfers destroyed jobs and deterred investors. On the other hand, less integration could have allowed for a selective protectionism orienting import demand towards investment goods and given domestic producers a better chance to compete with foreign enterprises. These problems will be discussed in more detail below where the focus will be on the implications for the accession countries of CEE. In particular, we will analyse two problems for catching-up countries of the periphery: the nominal convergence of income and the real convergence of output.

Nominal convergence of income

The average per capita income of a catching-up country can be increased in two ways: first, by receiving additional transfer income from abroad or, second, by producing greater value added. The first option is seldom attainable, at least over a longer period of time. East Germany and Southern Italy can to some extent rely on it as they belong to national communities where higher standards of solidarity apply. In the second case, when the growth of income depends on the market (i.e. wages and profits), either the quantity or the average price of the output has to increase.

For some people who can hardly increase their output per hour (e.g. hair dressers) price increases may even be the only way to increase their income. A whole country can theoretically catch up by increasing its level of prices, wages and profits, i.e. by a higher rate of inflation than the EU average as long as this real appreciation is not corrected by a nominal devaluation of its currency. Such a correction will usually take place as imports rise, exports fall and the trade deficit widens. It can only be avoided by rising productivity in the tradables sector.

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The catch-up growth of countries within the EU periphery actually depended on real domestic growth and currency appreciation with the latter accounting for the bulk of convergence. Real growth (i.e. nominal growth measured in local currency and deflated by the inflation rate) has been only marginally (to less than 25%) responsible for reducing the disparity between national per-capita incomes measured in ECU (or Euro). [See Annamaria Artner and Andras Inotai „Chances of Closing the Development Gap. A Statistical Approach" Institute for World Economics Working Papers Nr. 80, Budapest 1997]
Within a currency union, an appreciation of the local currency is no longer feasible. Continuing convergence would thus require different inflation rates between core and periphery. In reality such a higher rate of inflation in poorer countries has occurred and will continue to occur thanks to stronger increases of the prices of non-tradables. The Balassa-Samuelson effect explains these inflation differentials. [Prices of non-tradables rise more rapidly because the productivity in the non-tradables sector increases more slowly while wages have to increase at a more or less uniform rate in order to keep workers from moving from low productivity to high productivity sectors. See Europäische Zentralbank, Monatsbericht Oktober 1999 "Inflationsunterschied in einer Währungsunion", pp. 39-49, and, more recently, UN-ECE „Economic Survey of Europe 2001, No. 1, pp.227-241.]

Nominal wage growth implies higher real wages only if consumer prices increase less than wages. The more integrated Europe has become, the more prices for tradables should have been equalised throughout the Common (and later Single) Market. The more the law of one price holds, the more differences in nominal wages imply differences in real wages. [See Hubert Gabrisch and Rüdiger Pohl (eds.) "EU Enlargement and its Macroeconomic Effects in Eastern Europe. Currencies, Prices, Investment and Competitiveness" Basingstoke and London 1999.]
However prices are not yet uniform in Europe. Even prices of identical products vary substantially (e.g. cars). [See Europäische Zentralbank, op.cit.] More important is probably the fact that similar products are available at very different prices due to differences in quality and to specific local market conditions. The prices of non-tradables can differ even more as they reflect lower levels of income in the local economy. Tourism and capital mobility can contribute to the equalisation of prices of non-tradables as tourists compete for goods and services in the domestic market of poorer countries and foreign investors bid up prices for property and housing.

Central and Eastern Europe (CEE) will hardly avoid higher inflation than the EU as prices for tradables will approach the EU-level and prices for non-tradables, notably services, will increase even faster. Devaluations also tend to reinforce inflationary tendencies which in turn require further devaluation to maintain external competitiveness. Restrictive wage policies could prevent this vicious circle but at the price of lower domestic demand, at least in nominal terms. Allowing the nominal catching-up with its implied higher than EU average inflation rate (Balassa-Samuelson-effect) while at the same time avoiding a too strong loss of international competitiveness requires a careful monetary and exchange rate policy. [See the article by the Hungarian central banker György Szapáry "Transition Countries’ Choice of Exchange Rate Regime in the Run-UP to EMU Membership" in Finance and Development June 2001 pp.26-29.]

That task is further complicated as, in the course of catching-up, successful periphery countries tend to receive massive capital inflows that bid up the exchange rate. While this may contribute to convergence, financial markets often tend to overshoot and

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provoke inverse reactions later. Thus, those countries have to carefully choose their monetary and exchange rate policy in order to smooth appreciation processes while keeping inflation under control and protecting their international competitiveness. [See also Lucjan Orlowski 2001.]

As long as the exchange rate deviates from the purchasing power parity (PPP), these disparities allow nominal wage differentials between core and periphery without entailing differences in living conditions of the same magnitude. Often, poor households get access to important parts of their income and consumption in non-markets or regulated markets (e.g. family income pooling, subsistence production, regulated housing). The more the societies of the European periphery are modernised, the less those niches survive and the more nominal wages have to increase if massive poverty and migration are to be avoided. If workers in periphery countries whose competitiveness depends on relatively low wages will have to pay higher prices for non-tradable, local goods and services, the difference between income measured at the current exchange rate and at PPP will disappear or at least be reduced. This would imply that the workers traditional living standards could no longer be maintained. As table 2 shows, convergence of income per capita has been much stronger if incomes are compared at purchasing power parity (PPP) rather than in ECU (Euro).

Nominal growth of GDP per capita might not tell the whole story. The actual average income of workers and/or citizens, i.e. GNP/capita, might be different from the GDP/capita when there are big flows of factor income across borders. In the Portuguese case, GNP/capita has been higher than GDP/capita until the mid-1970ies thanks to remittances from Portuguese workers abroad. In the Irish case, the GNP/capita has been substantially lower probably because a big part (between 20% and 25%) of its gross domestic income is earned by those foreign investors. That fact indicates a possible scenario for catching-up growth. After a period of FDI inflows and import surpluses, the country must enter a phase of export surpluses and outflows of factor income. This might have to be accompanied by a declining share of wages in GDP (in the Irish case from 78% in 1980 to 68% in 1990 and 58% in 2000).

In Central and Eastern Europe (CEE), these phenomena can be observed, too. [For the following analysis see Leon Podkaminer 2001.] Productivity increased in all countries (though often because of labour shedding), but did not lead to higher wages everywhere. Unit labour costs declined substantially in Hungary while they increased strongly in Poland and Slovakia. In the remaining considered applicant countries, unit labour costs changed less substantially. Thus the share of wages in GDP declined in Hungary indicating that Hungary is following the Irish model.

Real convergence of output

Economic growth can be achieved by using more labour and capital and/or by increasing their productivity. The availability of more labour depends on participation rates, working time customs or regulation, the duration of schooling, the retirement age, unemployment rates and migration. The readiness of potential workers to work (more)

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depends further on the wages offered which they compare to alternative types of income (welfare, activities in the black market or in the subsistence sector). More capital results from savings, either domestic or foreign. As long as the savings of the private sector are relatively constant, higher savings can only be achieved by a restrictive fiscal policy leading to public savings. Conversely, state budget deficits and the subsequent borrowing can crowd out private investment though public investment is necessary to accompany economic growth or even a precondition for it. Keynesian economics suggest that in the case of surplus saving (i.e. less private investment than savings) public expenditure should close that gap.

Poor countries tend to export labour and import capital. Wages earned abroad increase GNP, though not GDP, at least not directly. The remittances of those migrants can be a substantial source of savings, as in the case of Portugal. Capital imports take various forms from foreign aid (grants) to credits and direct investment. But savings need to be invested to produce growth. Often, for example, in Greece, the capital made available has been consumed rather than invested.

Portugal, Spain and Ireland attracted large amounts of FDI. Poland showed good growth after 1994 with relatively little FDI, too. The later surge of FDI in Poland has been a consequence of strong Polish growth rather than its cause. Some countries – - mostly bigger - in other regions of the world (e.g. Japan, Korea, Taiwan) also achieved high growth without strong inflows of FDI though even these countries used foreign capital to finance prolonged current account deficits. To sum up, FDI is not a necessary condition for rapid development but it certainly helps, in particular if it is not footloose capital but investing into the long-term conditions of growth (R&D, training etc.). FDI is no free lunch, however. Ireland, as mentioned above, shows the price in terms of lower GNP than GDP that has to be paid.

Most of Central and Eastern Europe is presently following that pattern of labour exports and capital imports. The transition crisis after 1989 has reduced the use of labour by lowering participation rates and increasing unemployment. Although traditional high savers during communist times, some countries imported capital even then to finance heavy, but often unproductive investment, and thus began the transition already burdened with foreign debt (e.g. Hungary and Poland). Additional capital was made available by western assistance including debt relief, new credits and FDI. One of the most important obstacles to growth was the balance-of-payments constraint. Hungary and the Czech Republic experienced debt and currency crises in the mid-1990ies that spoiled their growth performance. [See also Lucjan Orlowski 2001.]

As the dismal growth record of communism proves, rising productivity is in the long run more important than rising factor inputs. In order to become sustainable, all nominal increases of income (however measured) have to be based on higher productivity. This requires structural change with the shifting of capital and labour into activities that add more value either within the same enterprise by up-grading the quality and effectiveness or by reallocation between enterprises and industries. In this context, the local economy has to find its place within the ever-changing global division of labour by specialising in those more productive activities. Foreign trade and foreign direct investment (FDI) can

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contribute to this process by forcing domestic enterprises to innovate, and by providing markets, capital, know-how, technology etc.

In Europe, vertically differentiated intra-industry trade, where different qualities of the same sector are exchanged, is the principal trade pattern. Within the EU, Ireland, Germany and France excel in high quality, while Spain, Greece, Italy and Portugal show strengths in low quality. The remaining countries are specialised in medium quality. [See Lionel Fontagné et al. „Trade patterns inside the Single Market" Paris, CEPII Document de Travail no. 97 1997] This trade reflects to a large extent growing European production networks. EU integration has strengthened these networks by attracting more FDI into new member countries. Both Spain and Portugal benefited from surges of FDI after accession in 1986. Ireland’s growth is largely based on locating parts of international value chains on its territory.

The new division of labour within Central and Eastern Europe shows a similar differentiation. [See Michael Landesmann "Structural Change in the Transition Countries 1989-1999" in: UN-ECE "Economic Survey of Europe 2000 2/3", Chapter 4, pp. 95-117.]
Structural change has led to a relative decline of agriculture (except in Bulgaria and Romania) and manufacturing industry while the tertiary sector expanded. Productivity increases were particularly strong in medium and higher-tech industries. In foreign trade, CEE exports had specialised first in labour and energy intensive industries. After ten years of liberalisation and integration, intra-industry trade has become much more important than inter-industry trade. But within the former, vertically differentiated trade is predominant with Central and Eastern Europe supplying cheap low-quality products and the EU exporting more expensive high-quality products. [See Michael Freudenberg und Françoise Lemoine, „Central and Eastern European Countries in the International Division of Labour in Europe", Paris, CEPII, document de travail, 1999 - 05, april, p. 13.]
The less advanced the economies of Central and Eastern Europe are, the more they focus on exports of products incorporating unskilled low-wage labour.

Policies for Cohesive Growth

Cohesive growth depends first and foremost on the appropriate policies of the catching-up countries. Short term and long term measures should be discerned.

• In the short run, policies influencing the business cycle are most important. Loose fiscal and monetary policies stimulate domestic demand and, as a rule, the depreciation of the currency, foreign demand. A devaluation of the exchange rate increases the international competitiveness of domestic producers and widens the gap between PPP and the exchange rate. Such policies can help to close the output gap between potential GDP (capacity) and actual production. At the same time they will probably reduce unemployment.

• In the long run, supply-side policies that enlarge and upgrade capacity dominate. In this context, investment is the key element including "investment" in human capital. Low wages increase profitability and often induce or attract investment. Trade, regional and industrial policies can orient investment towards higher value added activities. Public policies promoting research and development, education and training can enhance productivity growth.

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Some trade-offs between the short and the long run exist. Productivity growth might be enhanced by foreign private investment and EU assistance for public investment in infrastructure and training. That inflow of capital can, however, lead to the appreciation of local currency and a "Dutch disease" making local production less competitive. In order to achieve price competitiveness of their exports, periphery countries usually try to keep inflation under control or compensate inflationary processes by a devaluation of the national currency. They have usually adopted fixed exchange rate regimes with an undervalued exchange rate as it is easier to permit some inflation than to regain market share, production and employment lost due to an overvalued exchange rate. [See Lucjan Orlowski 2001 as well as William H. Branson "Financial market integration, macroeconomic policy and the EMS" in Bliss/Macedo 1996, pp. 104-130, and Paul R. Krugman 1990, "Macroeconomic adjustment and entry into the EC: a note", pp. 131-140.]
It is arguably even possible to achieve long-term growth advantages by starting the catch-up process with an undervalued currency, as most Western European countries did vis-à-vis the USA after WWII. [See Andrea Boltho "Convergence, competitiveness and the exchange rate" in Nicholas Crafts and Gianni Toniolo "Economic Growth in Europe since 1945" Cambridge 1996, pp.107-130.]

Deliberate undervaluation might be difficult to achieve in the face of liberalised global financial markets, which expect an appreciation of the national currency. Thus, entering the EMU could be helpful as it can protect the exchange rate against speculative attacks. However, in the case of real overvaluation due to high domestic inflation, potential responses become limited to policies of disinflation such as wage restraint and austerity measures which usually are politically sensitive.

The case of the former GDR is a particularly negative illustration of the opposite "strategy". It shows what harm an overvalued exchange rate and rapid increases in nominal wages can do to the competitiveness of the local industry. The convergence of incomes could no longer be achieved by domestic efforts but only by huge transfers that have to continue over a prolonged period. The migration that was to be avoided by the policies adopted in 1990 has actually continued until now.

A successful growth policy is also a matter of timing, i.e. to determine the point when a poor country can switch from relying on low costs (cheap currency, low wages etc. ) to relying on high productivity and quality which allow currency appreciation and high(er) wages without losing competitiveness. Obviously, the switch from macro-economic policy is closely linked to a structural change from enterprises and industries that rely on low costs to those relying on qualitative factors. The less competitive enterprises and branches will usually exert pressure on the government to keep wages low and the currency cheap. Actually, a too strong and/or too early rise of wages or nominal appreciation can be harmful in the longer run if it pushes enterprises out of the market which can later not be easily re-established even after a depreciation. But a continuous policy of wage moderation risks locking a country into low-tech, low-productivity activities.

Beyond the purely economic factors, growth depends on societal, political and cultural influences and structures [One could call this the "Meta"-dimension of economic development as opposed to the "Macro" of economic policies, the "Meso" of structural and regional policies and the "Micro"-level of activities by specific markets, enterprises and their networks. See Jörg Meyer-Stamer 2001, "Was ist Meso? Und wer ist Meta? Systemische Wettbewerbsfähigkeit: Analyseraster, Benchmarking-Tool und Handlung srahmen".].
Many authors point to industrial traditions in the more

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advanced CEE countries or to clientelistic obstacles to growth in countries such as Greece or Southern Italy. Basically, good policies to promote growth might not work when administered in a bad way or when there is a lack of, as it is called, "good governance". Conversely, changes in the political or administrative structure such as more responsibility and accountability at the local or regional level may improve local development. Industrial and trade policies have allowed Japanese and other South East Asian economies to grow rapidly while similar types of protectionism in other countries have led to rent-seeking and prevented adjustment and competitiveness. "Trust" has been identified as an ingredient of growth whose lack can increase transaction and information costs to a prohibitive extent. Similarly, a network of civil society and/or a democratic governance can lead to more sustainable development [See Putnam, Robert D., Nanetti, Raffaella and Leonardi, Robert "Making Democracy Work: Civic Traditions In Modern Italy" : Princeton 1994].
However, these structures can hardly be created or changed by deliberate policies (if at all).

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How can the growth of the countries of Central and Eastern Europe be promoted by the EU? [See also Michael Dauderstädt 1997, "The EU and its poor neighbours. How the centres could help those on their periphery".]

Although the policies of the periphery countries play the decisive role in promoting the catching-up process, the EU can support that process. As the major trading partner and investor, its policies and development affect the neighbouring countries to a large extent. EU-integration by association, pre-accession, accession and membership exerts also a strong influence on domestic policies of any candidate country. As an applicant country that wants to become a full member of the EU, it has to give up control over important economic policies such as subsidies, policies regulating foreign trade, cross-border capital flows, migration and even the exchange rate and fiscal policy within the EMU. Sometimes that will make it difficult to react adequately to certain external shocks or domestic problems. To avoid and prevent some of the problems mentioned in the first sections, it might be necessary

• to allow poorer member states more national room to manoeuvre and/or

• to strengthen common EU policies to promote growth and cohesion.

The right time to take these steps is during the accession process when the conditions for entry and the transitional period are defined.

For the EU to assist in the development of neighbouring countries, the following policy areas are obviously important:

1. Macro-economic policy
   One starting point of any catch-up growth strategy is high investment which needs either high domestic/local savings or imported foreign savings as FDI or portfolio investment or credits. Although the EU is a major source of foreign capital to CEE, it tends to neglect the macro-economic problems which might be triggered by its investors. Under these conditions, it might become increasingly difficult for the CEE countries to find the right balance between keeping wages competitive and allowing incomes to increase. The EU has to design policies that prevent or resolve current account crises of countries which have pegged their currencies to the Euro.
   A major decision to take concerns the relationship to the European Monetary Union (EMU) with the options ranging from early "Euroization" to maximum monetary autonomy (as far as possible) with managed floating, currency pegs and currency boards as some of the intermediate stages. Early membership in the EMU, on the one hand, imports stability with lower interest rates [For arguments in favour of joining the EMU early see Daniel Gros "EMU, the Euro and Enlargement" Ms. CEPS Brussels 2001 (chapter of forthcoming book)] but puts economic policy in a straight-jacket. Adjustments have to be made primarily by wage policy and to some extent by fiscal policy. The Maastricht inflation target prevents catching-up as it blocks the Balassa-Samuelson effect. That criterion should be modified regarding the applicant countries in order to avoid that dilemma. [As suggested by György Szapáry 2001.] Or the applicant countries could adopt the Euro unilaterally as national currency without joining the EMU and

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2. its macroeconomic policy straight-jacket. [This proposal has been advocated by Bratkowsli / Rostowski 2001, "Unilateral adoption of the euro by EU applicant countries : the macroeconomic aspects", in: Lucjan T. Orlowski (ed.) "Transition and Growth in Post-Communist Countries. The Ten-year Experience".]
   Prolonged autonomy, on the other hand, allows adjustment to certain shocks by changing the exchange rate and smooth appreciation without provoking criticisms and sanctions by the EU.

3. Trade policy [See Patrick Messerlin 2001.]
   EU trade policy has been liberalised vis-à-vis CEE after 1989 but always with certain reservations. It continued to protect European agriculture and some sensitive industries where the neighbouring countries have been rather competitive. Continued petty protectionism (e.g. anti-dumping) have discouraged exports and FDI in export-oriented industries.
   The applicant countries have increased the economic costs to their economies by strengthening trade barriers against third countries and thus giving preferences to EU exporters. Upon accession the new members will have to apply the EU’s external trade policy including the Common Customs Tariff. As the EU has a different pattern of protection from the CEE countries, the adoption of the EU policy will give new incentives. Since the EU protects agriculture, the most that might lead to is a re-agrarisation or, at least, shifting resources into or keeping them in agriculture.

4. Cohesion policy [See Heinz-Jürgen Axt 2000.]
   Cohesion or a regionally equitable distribution of prosperity has been a goal of the EU since the 1970ies. EU regional policy expanded after the first enlargement and got an increasing share of the EU budget which reached around 40% in 2000. The distribution has largely followed a political logic. Eligibility for EU assistance has been diluted by adding ever new goals (unemployment, sectoral adjustment, low population density) though the central condition has been an income per capita below 75% of the EU average. The system does not provide net payments from rich to poor member states but redistributes budgetary funds collected from all member states to poor regions (some of those even in rich member states).
   The assistance does not provide income support but consists mainly of providing grants and credits from the regional and structural funds and the European Investment Bank (EIB), mostly for infrastructure investment. The basic idea is to raise the productivity in a region in order to support local or attract foreign investment. Ideally, public policies strengthen and flank favourable market processes such as the sophistication of demand, interaction between suppliers, and between public institutions (e.g. universities, research institutes etc.) and private enterprises in order to achieve competitiveness as defined by Porter or Esser et al. [See Michael Porter, „The competitive advantage of nations" New York 1990 or Klaus Esser et al. „Systemische Wettbewerbsfähigkeit. Internationale Wettbewerbsfähigkeit der Unternehmen und Anforderungen an die Politik" Berlin DIE 1994].
   The results of that approach have been mixed. [See Robert Leonardi 1995, "Convergence, Cohesion and Integration in the European Union".For success stories see the Irish case (e.g. O’Hearn 2001) or Adam Price, Kevin Morgan & Philip Cooke "The Welsh Renaissance: Inward Investment and Industrial Innovation" Cass Cardiff 1994]

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5. Reform proposals suggest different approaches such as switching to a system of net payments which would reduce contributions by rich Member States to the EU budget substantially, or eliminating the variety of different goals of EU regional policy and focusing on poverty, or stopping more rapidly support for regions that were no longer eligible for it.

6. Migration policy
   This would regulate the movement of labour between CEE and the EU. On the one hand, free movement would benefit the poorer countries by alleviating their unemployment and providing additional sources of income (remittances). On the other hand, it might take away qualified manpower needed for the growth process in the applicant countries. Remittances will decline anyway as workers continue to stay in the host country and reduce savings as they adapt to the consumption pattern and life style there.
   In the host country, the opposite effects occur: labour supply increases allowing higher growth, but domestic workers might be substituted, lose their jobs and become a burden to the welfare system.

Eventually, the distribution of income and growth within Central and Eastern Europe still needs to be considered. Even when average national incomes approach the average European level, huge disparities within these countries might still remain - in particular between regions and between wage earners and asset owners. The Irish case with its enormous decline of the share of wages in GDP is a strong warning signal regarding the latter. And the EU’s cohesion reports have to admit that in spite of a, albeit slow, convergence among Member States, there has been no convergence among regions but increasing disparities. Without cohesion on the national level many problems and threats to stability remain. National redistributive policies, however, suffer from the above mentioned constraints on fiscal and other policies imposed by the preparation for accession and EU membership.

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