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Wednesday, September 01, 2004

Europe: Lack of Competitiveness or High Interest Rates?

This article in the US business press discusses Europe's economic problems, and concludes that Europe needs to cut corporate taxes, reduce social benefits such as health, pensions, and unemployment insurance, and deregulate. The article is allegedly news, not opinion, although why standard boilerplate that you can read any day of the week in the business press is news is a mystery to me.

Europe is slipping further behind the U.S. in competitiveness as the leaders of Germany, France and Italy, weakened by election setbacks, fail to take advantage of the economic recovery to reduce taxes and over-regulation.
Germany, the continent's largest economy, abounds with reasons why Western Europe is losing the competition for investment and jobs to the U.S., China and India -- and the low-tax Eastern European countries that, after entering the European Union in May, are competing right on Germany's doorstep.

German labor costs are six times the Eastern European level, according to a report published on August 24 by the Cologne-based IW research institute. A corporate tax rate of 37 percent is almost twice that of neighboring Slovakia, which now makes more cars per person than any other Eastern country.
Now, the weird thing is that this nonsense is believed not only by corporate executives, for whom it's welcome propaganda against the welfare state, but also by anti-globalizers. The article says that increased trade leads to increased competitiveness which leads to falling living standards. The anti-globalizers draw the natural conclusion that increased trade is a bad thing.

I'll confine myself to pointing out one obvious problem with the argument: yes Slovakia's wages are lower than Germany's, but their productivity is lower too. Germany's wages aren't about to fall by a factor of six. Even if one can make a theoretical argument that this should happen (and you can't, because of the productivity differential) it never has happened in the history of the world.

But the real problem with the article is that it makes no mention of monetary policy, and the strains caused by the Euro. Overregulation of the labor market may plan some role in raising Europe's unemployment rates (or it may not, some European countries have "rigid" labor markets and low unemployment). But monetary policy is at least as likely a cause of slow growth and high unemployment as a lack of "competitiveness," whatever that is.

Here's an excerpt from an interesting article in the conservative UK Daily Telegraph, which discusses how monetary union is very bad for the low inflation coutries of Europe: they end up with high real interest rates, because of tight monetary policies aimed at fighting inflation elsewhere. The Telegraph actually tries to inform its readers about their economy, rather than writing propaganda. Perhaps this is because European readers want good analysis of their own countries, while American readers of the business section are happy to settle for comforting lies about faraway places.

France and Germany have the same nominal interest rate, set by the European Central Bank. It stands at 2 per cent, having been gradually reduced from 4.75 per cent since May 2001.

It is widely appreciated that rates haven't been cut far or fast enough for Germany. High inflation elsewhere in the euro zone has discouraged the ECB from taking more radical action.

What is less well understood is that economic divergence makes these pressures of policy mismatch much worse. Faster growth in France, for instance, brings higher French inflation - an average of 2.5 per cent this year, compared with 1.5 per cent in Germany.

So Germany's inflation-adjusted interest rate (its real interest rate) is actually above that of France. Perversely, then, struggling euro members are landed with interest rates that are not only too high for their own purposes (given that the ECB sets rates with reference to all members) but slow-growth economies end up with real costs of capital that are even higher than other members who are already growing quite well.


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