The EU Economy after Enlargement: Convergence with Growth

Speech by Chris Huhne MEP delivered to the Institute of International Finance and Financial Stability Institute, Bled, Slovenia on Fri 27th Jun 2003

It is a particular pleasure to talk to you here this evening in one of the most successful of the transition economies. I had the honour of leading one of the teams of economists that rated Slovenia - along with so many other transition economies - when you first came to the international capital markets in the nineties. Indeed, I led the teams in every one of the eight accession countries in central and eastern europe except Latvia. It is therefore with some sense of pride in parenthood that I look at the progress that central and eastern europe has made. I have always believed that the political completion of the european family of democracies was crucial, but also that it would be accompanied by economic success.

Economic success, of course, crucially depends on the effectiveness of the machinery for allocating scarce capital towards sound investment, namely the financial system. Bankers are never popular. As Wilhelm Roepke pointed out in 1936: 'Whereas in Russia the coercive machinery is represented by the G.P.U. with its rifles and dungeons, in capitalism it is represented by the banking system with its cheques and overdrafts'. Banks are the nerve centre of the market system. It is therefore a double honour to be asked to address this conference of central and eastern european bankers.

I am an optimist about the economic effects of EU enlargement. Economics is never a zero sum game where one person loses what someone else wins. It is usually a positive sum game where everyone can win (and, if the policies are bad, everyone can lose). Both enlargement and the euro are two large structural changes that tend to increase competition in the european economy, and therefore tend also to increase productivity. And in time, once all the structural changes that this extra competition brings about have worked through, these underlying rises in productivity will mean higher living standards.

I believe that the economic advantages of enlargement have been seriously underestimated. There is a seductive view that enlargement does not really matter for the ten new member states, because they have all the benefits of industrial free trade already. And I am the last person to denigrate the importance of free trade, or to suggest that the growing economic integration between the fifteen and the ten is unimportant.

But free trade alone does not encapsulate what is happening. Many investors invest in central and eastern europe because of access to the single market, and that would not be affected. But they also invest because they believe that the candidate countries - these low income countries - are fundamentally different to the low income countries of Latin America or Asia: they are committed to the Copenhagen criteria and hence to the rule of law. That commitment to due process and property rights is the first condition that any foreign investor insists upon.

So politics and economics inevitably overlap: I always preferred the old description of the subject in English as 'political economy'. Political economy matters. As the historian E.H.Carr pointed out: 'Economic forces are in fact political forces. The science of economics presupposes a given political order, and cannot profitably be studied in isolation from politics'. The stability of economics therefore depends substantially on the stability of the political system, which is why EU membership can be such an unalloyed benefit.

Just remember what happened in Slovakia when the government of Vladimir Meciar undermined the civil rights of the Hungarian-speaking minority. It was EU pressure - and most importantly the threat that membership would not proceed - that protected that minority. It was EU pressure that put Slovakia back on the right track. Without that pressure, Slovakia could easily have tumbled into the ethnic strife that was such a disastrous feature of Bosnia and Kosovo. And foreign investors would have run a mile.

Without EU membership and all the political guarantees that it brings - with only free industrial trade - the candidate countries would be substantially less attractive to investors. They would lose foreign direct investment, and the cost of borrowing on the financial markets would increase sharply. As it is, the interest rate spreads over bunds for the candidate countries to borrow are far lower than the spreads for similar countries in other regions. And those lower interest rates feed through into easier access to domestic capital, and to more assured capital flows. Astonishingly, the Czech government has recently been able to borrow long term money in korunas at an even lower interest rate than the German government can borrow in euros.

It may be that some of this reflects an asset price bubble fed by relative scarcity, and that it may unwind as the Technology Media Telecoms bubble unwound. Indeed, there are the first signs of that over the last month in the Hungarian markets. However, I think there are sound fundamental reasons to expect interest rates to be lower in central and eastern europe than in similar countries, and the EU's guarantees are essential to that case. After all, look at the impact of EU membership on the now thriving democracies of Spain, Portugal and Greece, and think that the last attempted coup d'etat in Spain was as recently as the eighties. Look too at the subsiding support for Jorg Haider in Austria, certainly partly self-inflicted but perhaps accelerated by the clear collective disapproval of the European democratic family.

If the ten can join the euro soon after EU membership, the possibilities of locking in a very rapid catch-up would be great. The Euro removes the exchange rate risks of investment and therefore increases cross border investment dramatically: so far cross border direct investment is up nearly fourfold in the euro-area countries since 1998 against a rise of just a half in the EU countries that have not participated in the Euro-area. In other words, the euro effect is to boost cross border investment by a factor of eight.

Moreover, euro membership would bring another clear benefit for catch-up. Because rapidly growing economies tend to have higher inflation rates than slower growing ones - the famous Balassa-Samuelson effect - it also follows that a unique nominal interest rate is lower in real terms in the higher growth parts of a monetary union. That means that real interest rates would regularly be lower in the ten than the fifteen, providing a market means for the acceleration of the catch-up in living standards to which we all aspire and which of course would resolve any residual tensions between new and old members. High growth means high employment growth and a repeat of the experience of the southern member states when they joined: people stay at home to prosper rather than migrating.

These positive economic effects do not in any way depend on budgetary transfers, which is perhaps just as well. The existing members have been notably cautious about the budget as it affects the new members. There is a limit on structural and regional fund spending of 4 per cent of GDP in each new member - reasonable given the absorption capacity of any economy. There is also purely a phase in of the agricultural support policies and there will be a likely cap on total structural fund spending of 0.45 per cent of GDP of the EU as a whole.

There is even the possibility that some of the new members could, without special offsets, be net contributors to the budget which in my view would be an obscene outcome for countries at a much lower than average level of income. However, all these budgetary issues must be seen in the context of the relative size of the new members. In market price terms, the ten new members amount together to an economy the size of the Netherlands. If you add Romania, Bulgaria and Turkey, you have an economy the size of Spain. So these are manageable problems. We can ensure flows of finance to the new member states that are substantial for you, without being unduly burdensome for the richer and older member states.

I have said that economics is not a zero sum game whereby one person wins what another person loses. The increased prosperity that enlargement can bring to central and eastern europe will also create markets for us in the old member states: after all, almost all the accession countries now have balance of payments deficits with us. That means that they are buying more from us than we are buying from them. The faster your growth, the more attractive your investment opportunities, and the greater your balance of payments deficits and the larger the positive demand effects on the old member states.

However, these demand effects go side by side with a substantial increase in supply capacity and hence in competitive pressures, ensuring that they are benign and that the environment in the old member states remains non-inflationary. Enlargement, like the Euro, is another essential catalyst for economic change in our countries as well as in the east.

Enough now of the rosy spectacles. There are of course substantial challenges, not least in the high unemployment you and other candidate countries now suffer as growth is depressed in your main markets and structural problems prove to be persistent. Providing that sensible economic policies are maintained, however, that unemployment will come down, and probably much more quickly than many expect. Look at the experience of Spain which faced a peak unemployment rate of 19.8 per cent on average during 1994, but whose unemployment rate today, although still too high, is down to 11.4 per cent. Market economies are dynamic, and the best way to provide jobs is to make it easy for businesses to hire.

An obstacle to the prospects of early euro membership are also the widening fiscal deficits in so many of the new members, including in Poland and in Hungary. Hungary's deficit at 9.5 per cent of GDP last year was more than three times the Maastricht 3 per cent, although it is projected to fall back this year. Poland's deficit exceeded 6 per cent of GDP last year, and the International Monetary Fund projects that there will be a further widening this year. Both of these numbers, of course, are swollen by slow growth and its impact on tax revenues. But they do mean that Euro membership is some way off. In this period, policy-makers must not lose heart. The prize of free trade, political stability, currency union, low interest rates and investment is not one that policy makers in the new member states should ignore. As the recovery gets under way, fiscal tightening may prove an investment with great rewards.

The scale of these fiscal deficits at a time of sluggish growth would represent a substantial political challenge in any society, let alone one grappling with transition. At least, though, the referenda on EU membership have so far been triumphantly navigated even where - as again in Poland - hurdles included some difficult requirements on turnout. In general the political consensus among central and eastern european elites is impressive, but we know from my own country and elsewhere that elites are not always good at communicating their own enthusiasms.

Nor is it always easy in a country like Poland with vivid nightmares of past experience with foreigners - Russian and German tanks on the Vistula - to lay old ghosts. I remember being in Warsaw when a former prime minister, much to the shock of some foreign investors, disparagingly talked about the dangers of such investment turning Poland into a 'white colony'. If so, by the way, I have to say that my own country was colonised a long time ago: more than half of the assets of the British banking system are controlled by foreign banks mainly from our european partners. We welcome foreign investment as our experience suggests that foreign investors bring know-how and higher pay.

I am confident though, now that we are on the home straight with accession a done deal for May 2004, that a golden age beckons for central and eastern europe. You will surmount these new challenges in the same way that you have surmounted so many others in the deeply impressive reconstruction of a market economy since 1989. Together, we face an economic and political future that is free and liberal, and which offers a vision of stability and prosperity. That will benefit us as much as I am sure it will benefit you.