EU10 February 2009 Special Topic: Reshaping Economic Geography 25

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1 EU10 February 2009 Special Topic: Reshaping Economic Geography 25 This special topic is based on the World Development Report 2009, Reshaping Economic Geography, and spotlights the implications of the report for the EU Taking a long-term view which utilizes insights from economic geography and history, it recommends continued efforts to: Make economic borders thinner. In the EU10, economic divisions to the mobility of people and products remain considerable, and reforms to reduce these divisions should remain high on the agenda even during the financial crisis. In the EU15, as governments deliberate economic stimulus programs, they should resist the temptation of nationalism and make their borders thicker. Welcome rising economic density. The lesson of history is that greater international convergence is accompanied by a concentration of production in leading areas and cities. The EU10 should not resist the domestic concentration of economic activities: they are a necessary part of strategies for growth and competitiveness. Deepen institutional convergence. While infrastructure and place-based investments are often seen as most needed policy measures, the mainstay of a strategy for economic integration in Europe are common institutions that facilitate the mobility of goods, services, capital and labor. New member states should continue their efforts to harmonize trade, financial and employment regulations. Some Economic History The formation of the North Atlantic Treaty Organization (NATO) in April 1949 marked the beginning of the Cold War. With much of Eastern Europe under Soviet control, the continent was divided by an iron curtain, impermeable to flows of goods, services, people and ideas. Western Europe flourished while the East floundered. While GDP per capita in 14 Western European economies grew more than threefold between the 1950s and the 1990s, the economies of Eastern Europe progressed more slowly. Regional integration in the West would help former laggards such as Italy, first, then Ireland, Portugal, Spain, and Greece leave the ranks of poor Europeans nations and converge to West European averages (Figure 47). The driver of West European growth was a combination of market economies, a philosophy of rising regional cooperation, and the push of global economic integration. Spurred by the political will to avoid repeated conflict, the agreement on cooperation in the coal and steel industries in 1951 grew into a more ambitious project. In 1957, the six members of the European Coal and Steel Community signed the Treaty of Rome, creating the European Economic Community (EEC). By 1970, the EEC had adopted its first full plan for economic and monetary integration. Though this plan was to fail and integration to stall, the years that followed saw the broadening of the EEC, as another six countries joined between 1973 and also marked the signing of the Single European Act, which emphasized the free mobility of capital and put Western Europe back onto the road to full monetary integration. 27 Fast forward two decades. The chain of events that began with the fall of the Berlin Wall in November 1989 and the collapse of the former Soviet Union in 1991 is complete. The Iron Curtain was removed and Bulgaria, the Czech Republic, Hungary, Poland, Romania, the Slovak Republic, and Slovenia, and the three Baltic states of Estonia, Latvia and Lithuania, became members of an 25 Contributed by Indermit Gill, Chorching Goh, and Mark Roberts, with special thanks to Siobhan Murray for her superb cartographic assistance. For questions, please contact Chorching Goh (cgoh@worldbank.org). The World Development Report 2009, Reshaping Economic Geography is available at 26 The EU10 refers to Bulgaria, the Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, the Slovak Republic, and Slovenia. 27 Based on Geography in Motion: Overcoming Division in Western Europe in World Development Report

2 expanded European Union, an economic zone based on the principles of democracy, markets and the free mobility of goods, capital and labor. Together, the 27 countries of the EU have a combined population of almost 500 million people 28 and account for more than 30 percent of the world's GDP. 29 But the legacy of division has meant that the EU10 countries lag considerably behind. While these economies have brought 123 million people into the EU, they have reduced its average level of GDP per capita by an estimated 15.6 percent. Figure 48. A Politically Divided Europe Saw Economic Divergence GDP per capita in selected Western and Eastern European economies, GDP per capita (1990 international dollars) 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Year ( ) Denmark United Kingdom Sweden Netherlands Belgium France Finland Germany Austria Italy Ireland Spain Portugal Greece Bulgaria Czechoslovakia Hungary Poland Romania Yugoslavia Source: Based on data from Maddison (2008), "Statistics on World Population, GDP and per capita GDP, AD", downloaded from Economic Division Thick Borders Impede Specialization East European poverty relative to western prosperity is indeed a legacy of division for over half a century. In the west, market forces operating within restored democratic frameworks enabled people and firms to gravitate towards the areas of maximum opportunity. This facilitated the buildup of economic density in a core area which now stretches across Western Europe from London to Paris, through Brussels and Frankfurt and down to Milan. The density built in this core area has propelled the western economies forward. But while geographic distance to density in the west was not long, Eastern European economies were denied access by division. Eastern European economies still remain, relatively speaking at least, divided from the density of Europe's core economic area. 28 Eurostat figures for International Monetary Fund, World Economic Outlook Database, October

3 Figure 49 shows the thickness of economic borders, which has contributed to a discrepancy between market potential in west and central Europe (Figure 50). Real market access which measures the size of nearby markets including the home economy in the EU10 falls short of that in Europe's leading economies. Good access to foreign markets should facilitate the building of domestic density which promotes real market potential through the growth of the domestic economy. In turn, enhanced real market access should lead to a further improvement in foreign market potential because growth of the domestic economy enlarges the markets which neighboring countries can themselves access. 30 Figure 49. EU10 Countries Need to Make Their Borders Thinner, and EU15 Should Not Thicken Its Economic Borders as It Deliberates Fiscal Stimulus Source: Based on Map 3.2, chapter 3 of the World Development Report 2009 Reshaping Economic Geography. The width of borders is proportional to a summary measure of each country s restrictions to the flow of goods, capital, people, and ideas with all other countries. 30 See Mayer (2008), "Market Potential and Development", background paper prepared for the World Development Report

4 Figure 50. Higher Divisions, Greater Economic Distance, and Lower Density Mean Poorer Market Access in the EU10 Real market potential relative to the US, 2005 Source: Based on estimates in Mayer (2008), "Market Potential and Development", background paper prepared for World Development Report 2009 Reshaping Economic Geography. 43

5 Economic Density Agglomeration Should Be Facilitated Density refers to the intensity of economic activity per unit of land area and can be measured by, for example, the level of GDP generated per square kilometer of land. Figure 51 shows Eastern Europe s economic topography. It portrays a landscape which is spiky rather than flat, reflecting the fact that market forces generate a tendency for economic activity to concentrate in some areas rather than others. While the spikes in Germany, Austria and Italy resemble part of a vast mountain range which spreads westward into the other established members of the EU, those in Eastern Europe show up as small foothills. This reflects the great difference in density which separates the EU's newest members from the rest. In particular, economic density across the EU s subnational areas shows a strong association with GDP per capita. This correlation is no accident. Econometric evidence demonstrates that economic density facilitates higher productivity and well-being. 31 Economically dense settlements of activity and people have production advantages. These include "thick" markets which help to improve the variety of goods available for final consumption and a vibrant base of suppliers for industries of local importance. They also include the existence of a pool of labor, which improves the efficiency of the local labor market, and leads to beneficial spillovers of knowledge both within and between local industries. Figure 51. Mountains in the West, Hills in the East The Economic Topography of Central Europe and the Baltics Source: Geographic Information Systems Laboratory in the World Bank's Development Economics Research Group. 31 See Ciccone, Antonio (2002), "Agglomeration Effects in Europe", European Economic Review, vol. 46, pp In particular, Ciccone derives the prediction of a positive relationship between GDP per capita and the natural log of economic density from an explicit theoretical urban economics model which has microfoundations for agglomeration economies. He verifies the existence of this relationship using a much more restricted sample of EU NUTS1 regions than was used to construct figure 50. Ciccone demonstrates, through the use of an instrumental variable identification strategy, that the correlation which he finds is not driven by reverse causation from GDP per capita to density. 44

6 Since its inception, the European Union has had a strong commitment to tackling disparities in productivity and well-being across its member states and regions. The expansion to incorporate former COMECON countries from Eastern Europe has reinforced this commitment, given that their relative poverty implies that disparities within the Union are now wider than ever. The EU has designated three objectives for its new "Cohesion Policy" in the period , to which it has allocated total funding of 348 billion. By far the most important of these is the "convergence objective", under which almost 82 percent of cohesion policy spending falls. In turn, some 71 percent of spending under the convergence objective is earmarked for NUTS2 regions which have GDP per capita levels of less than 75 percent of the EU average. Inevitably, the majority of these regions are in new member states. 23 percent of convergence objective spending is reserved for member states which have a level of gross national income (GNI) per capita less than 90 percent of the EU average, again primarily the new Eastern European members. The aim of all of this spending is to "reduce structural disparities between EU regions, foster balanced development throughout the EU and promote real equal opportunities for all." 32 This is often equated with spatial equality and the desire to "smooth out" the economic landscape. The World Development Report suggests that such an approach may be misguided, at least at the stage of development of much of the EU10. Economic growth, by its nature, is spatially unbalanced. The convergence of Eastern with Western Europe requires policies that facilitate the building of economic density in the leading areas of the EU10. Some of the hills in the new member states will grow into mountains, making the topography of density spikier: a more prosperous central Europe will not be flat. The experience of Western European and other advanced countries suggests that increased spatial concentration will initially lead to rising spatial disparities in productivity and perhaps initially in living standards. Cities and leading regions will pull away from the more remote and rural areas. Over time, with migration, redistributive tax systems and a commitment to the universal provision of health, education, security and other basic amenities, spatial disparities in living standards diminish. So while economic density continues to increase, its benefits are shared more widely. Economic density is higher in the most prosperous and largest EU countries France, the UK, and Germany. But the six most unequal countries in terms of the spatial dispersion of GDP per capita levels are Latvia, Estonia, Hungary, the Slovak Republic, Bulgaria and Romania (Figure 53). Clearly, a smoother economic landscape is not synonymous with a reduction in spatial inequalities in wellbeing. Further, the economies which have grown fastest in the EU over the period , i.e. the most successful of the Eastern European economies, are also those which have experienced the largest increases in spatial inequality (see Figure 52). (For Ireland s experience with rapid convergence, see Box 4.) While many of the EU10 nations are building density and fostering international catch-up, rising spatial inequality may have to be temporarily tolerated. However, although faster national growth will mean larger disparities between subnational areas, it may bring forward the day when the living standards of even the poorest regions will have converged to EU average levels. 32 Activities of the European Union: Summary of Regional Policy Legislation website ( 45

7 Figure 53. Higher Economic Density, Higher Standards of Living NUTS2 regions in the EU GDP per capita (EUR, PPS) y = x R 2 = ln(density - millions of GDP per sq km, EUR, PPS) Note: This is based on data for 2005 for 48 NUTS2 regions in Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland and Slovenia. Source: Eurostat ( ,1090_ &_dad=portal&_schema=PORTAL). Figure 54. Initially, Prosperity in Leading Areas Exacerbates Spatial Inequality Faster growing EU countries have seen larger increases in spatial disparities Growth rate (% pa), y = x R 2 = Absolute increase in concentration, Notes: For a given country, the dispersion of regional GDP is defined as the sum of the absolute differences between regional and national GDP per inhabitant (measured at current market prices), at NUTS level 3, weighted with the regional share of population. The value of the dispersion of GDP per inhabitant is zero, if the values of regional GDP are identical in all regions of the country or economic area (such as EU27), and it will show, ceteris paribus, an increase, if the differences between the values of regional GDP per inhabitant among regions are rising. Source: generated using online tools supplied by Eurostat. 46

8 Box 5. Economic Concentration Accompanied Faster Convergence in Western Europe Between 1977 and 2000, Ireland s per capita GDP grew from 72 percent of the EU average to 116 percent. What was behind Ireland s success? Since joining the EU in 1973, Ireland received about 17 billion in EU Structural and Cohesion Funds through In the first two rounds of EU funding, the entire country was classified as an Objective One area. Between 1993 and 2003, cohesion funds supported 120 infrastructure projects at a cost of about 2 billion. The choice of projects was based on a national development plan, focused on investments in infrastructure that stimulated long-term national economic growth. These included investments in leading areas and in connecting leading and lagging areas, such as the M50 (Dublin Ring Road), M1 (Dublin-Belfast), and improvements in the N4 (Dublin-Sligo), N7 (Dublin- Limerick), and N11 (Dublin-Rosslare). The Irish also invested in education and training to improve the business environment nationwide. With its skilled labor force and good logistics, it has become a popular destination for U.S. firms wishing to reach European markets. In 2004, Irish-based U.S. firms exported US$55 billion worth of goods and services, mostly destined for Europe. Ireland s rapid convergence toward the incomes of Europe s leaders was accompanied by a rising spatial concentration of economic activity. Compared with the other cohesion countries Greece, Portugal, and Spain Ireland s economic concentration rose much more (see Figure B4.1). But its per capita income grew much faster too. In 1977, Greece, Ireland, and Spain had per capita incomes of about US$9,000; Portugal s was about US$6,000. By 2002, Portugal had an income of US$11,000, and Greece and Spain close to US$15,000; Ireland s per capita income had risen to US$27,500. Today, almost all regions in the new member nations in Central Europe qualify for EU financial support. They should consider the Irish example of using the funds for international convergence and not until later stages for spreading out economic production domestically. Figure B4.1. As Ireland s Income Rapidly Grew, Economic Concentration Increased Evolution of regional incomes ln (variance) years Greece Portugal Ireland Spain Source: Based on Box 8.4 in World Development Report Promoting Prosperity in the EU10 Institutions That Unify All Places What is the best way for the EU10 states to build density, converge to Western European levels of prosperity and reduce disparities in living standards between places? How can the new member states achieve domestic integration and attain high-income levels? The World Development Report suggests that the most important integration instrument for economies close to major world markets is to strengthen their institutions. 47

9 The key for countries close to world markets is to undertake institutional reforms and improve domestic governance to fully integrate with the large markets nearby. Free trade alone does not bring the full benefits of integration. Institutional reforms include moving to a sound macroeconomic environment that contains inflation and an efficient fiscal system that does not rely on distorted trade policies for budget revenues. They also include establishing a sound institutional framework that limits corruption and improves governance. Although Turkey has had a free trade agreement with the EU for many years, it did not receive significant foreign direct investment until it embarked on major institutional reforms associated with membership talks. The policies and governance standards in countries close to large world markets have to converge to those in the nearby high income region. Indeed, multinational firms are more likely to locate in a country if it has both institutional and physical connections to a larger market. The large market nearby also has a strong incentive to foster sound policy and governance frameworks in nearby small markets to ensure the stability of its neighborhood. These two factors make the coordination of national policies in neighborhoods close to large world markets both desirable and feasible. The prospect of joining the EU has accelerated the pace of reform in Central Europe. And the prospect of better access to the U.S. market triggered policy reforms in Mexico long before North American Free Trade Agreement took effect. 33 The Stabilization and Association Agreements between the EU and the Balkans specify the legal and regulatory reforms to be undertaken before joining the EU. The Balkans have also signed an intraregional free trade agreement, the CEFTA, to replace the patchwork of 32 bilateral agreements formerly governing their intraregional trade. The new agreement simplifies and harmonizes rules of origin and extends the trade and transport facilitation initiative launched in The region has also established a common power market and signed an open sky agreement with the EU that could boost tourism. The Balkan region is close enough to the EU to permit tight integration of its companies into pan-european production networks. Governments can facilitate regional production chains linking their supply capacity to that of the EU by signing mutual recognition agreements, conformity assessments, and other trade-related coordination initiatives. Despite their membership of the EU (and in the cases of The Slovak Republic and Slovenia, their being in the euro zone), EU10 states need to continue to reduce the thickness of their borders. Despite considerable progress (to fulfill the Copenhagen criteria to join the EU for example), continued domestic institutional reform is required. This is particularly the case for Hungary, Bulgaria, Romania, Slovenia, the Czech Republic and Poland, all of which lag behind the leading EU economies in the Ease of Doing Business rankings. 34 And Bulgaria lost 220 million of EU funding from the European Union due to unresolved concerns over governance. 35 Improvements in governance are needed to attract investment and facilitate the growth of density in Eastern European cities. Likewise, strengthening common institutions within each of these EU s new members will be the most important measure. Specifically, universal provision of basic and social services and improved land markets will increase labor mobility and land use convertibility. Historically, such mobility has been the primary mechanisms for both building density and spatial convergence of living standards within countries. The most striking example of the power of migration to affect convergence is the German unification (see Box 6). But though migration from Eastern European countries to other EU countries will play a role in promoting international convergence, it may end up being a relatively weak force. About 350,000 Polish workers may have migrated between May 2004 and December 2005 to fill jobs in the UK labor market, but many of these workers have since returned home. 36 And as unemployment once again rises across Europe, there is likely to be less demand in the UK and other rich European economies for migrant workers, at least for the next few years. For now, a more important policy priority may 33 International Monetary Fund (1998) for the EU enlargement; Schiff and Wang (2003) for NAFTA. 34 Admittedly, however, although the East European countries cited all lag the rankings of the UK, Ireland, Finland, Sweden, Belgium, Germany, the Netherlands, Austria and France, they do all have better rankings than Greece and also, except in the case of Poland, Italy. For the full list of rankings see 35 Article entitled "EU Strips Millions from Bulgaria", published on 25 th November 2008 on the BBC website ( 36 The Guardian, "345,000, migrants since EU expansion, figures show", Wed 1 st March,

10 be the facilitation of migration to density, including urban-rural migration, within individual EU10 nations. In any case, the aim should improve the flow of workers, goods and services between poor and more prosperous places, instead of trying to make every poor place prosperous. The willingness of Europeans to move has, historically, been low compared to Americans. This has been in part the result of artificially thicker borders. As borders thin, both domestic and EUwide policies can help as they facilitate the mobility of goods, money and people. During times of prosperity, there is the danger of pursuing the elusive goal of spatially balanced growth, which means fighting prosperity itself. During times of crisis, growing protectionism may be the greatest danger to economic recovery. Box 7. The German Integration: Convergence and Concentration with Mobile Labor With the fall of the Berlin Wall in 1989, direct migration from East to West Germany became possible. By 2007 more than 1.7 million people had left the east, of about 17 million East Germans at the time of the fall of the Berlin wall. (See Box Figure B.5.1). Box Figure B5.1. Migration from East To West Germany After the Fall of the Berlin Wall (net migration, , in thousands) Box Figure B5.2. Wages in the East and West Converged During This Period (black line=1992, red line=2005) Migration produced one desired outcome: incomes became more equal between the two areas (see Box Figure B5.2). While the cross-country distribution of income in 1992 was clearly bimodal, with the counties in the east forming the lower peak (black curve), this was smoothed by 2005 (red curve). Although the counties from the east are still located at the left of the distribution, their economic distance to western counties has shortened. Convergence in incomes has also produced a more surprising outcome. Almost all counties with more young women than men are in the economically dynamic areas of Germany, which also have better institutions of higher learning. In 2004, in the age group, there were only 90 women for every 100 men in East Germany (including Berlin). Why did East German women move to the economically dynamic areas, while men tend to stay behind? Two possible explanations: First, women are on average more successful in school and higher education, which makes it easier for them to study or to find a job in the economically more dynamic parts of Germany. Second, it is harder for women to find an attractive job locally in the lagging areas than it is for men, because these places are dominated by traditionally male jobs in agriculture, manufacturing, and construction. Source: Based on Box 8.2 in World Development Report