Chapter 7: Growth effects and factor market integration The Union has today set itself a new strategic goal for the next decade: to become the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion. Presidency Conclusions, Lisbon European Council, March 2000

The logic of growth Economic growth means producing more and more every year. European leaders have long emphasized the pro-growth aspects of European integration: it affects growth mainly via its effect on investment in human capital, physical capital and knowledge capital. Growth effects fall naturally into two categories: medium term, like ‘induced physical capital formation’; long term, involving a permanent change in the rate of accumulation, and thus a permanent change in the rate of growth.

The logic of growth Schematically: European integration (or any other policy) → allocation effect → improved efficiency → better investment climate → more investment in machines, skills and/or technology → higher output per person. Under medium-run growth effects, the rise in output per person eventually stops at a new, higher level. Under long-run growth effects, the rate of growth is forever higher.

The logic of growth: the evidence By historical standards, continuous economic growth is a relatively recent phenomenon. Before the Industrial Revolution, which started in Great Britain in the late 1700s, European incomes had stagnated for a millennium and a half. With industrialization incomes began to rise at a respectable rate of something like 2 per cent per year. Growth rates, however, were hardly constant from this date:

The logic of growth: the evidence

The logic of growth: the evidence Are growth and European integration related? Prima facie evidence:

The logic of growth: the evidence Are growth and European integration related? Statistical evidence shows sizeable medium-run effect of integration:

Medium-term growth effects For the analysis, we consider the whole EU as a single, closed economy with fully integrated capital and labour markets and the same technology everywhere. We study the link between growth and integration by focusing on the connection between GDP-per-worker and capital-per-worker: when a firm provides its workers with more and better equipment, output per worker rises. However, output per worker does not increase in proportion with equipment per worker: the GDP/L curve is concave. The equilibrium K/L ratio is where inflow and outflow of K/L are identical: the inflow is investment while the outflow is depreciation. Solow assumed that people save and invest a constant fraction of their income each year, so the inflow of capital is just a fraction of GDP/L.

Medium-term growth effects: the Solow diagram

Medium-term growth effects: the Solow diagram Integration improves the efficiency of the European economy by encouraging a more efficient allocation of European resources: this positive allocation effect shifts the GDP/L curve. The shift up in the GDP/L curve also shifts up the investment curve since the fixed investment rate now applies to higher output and so generates a higher inflow of investment for any given K/L ratio. Schematically: integration → improved efficiency → higher GDP/L → higher investment-per-worker → economy’s K/L ratio starts to rise towards new, higher equilibrium value → faster growth of output per worker during the transition from the old to the new K/L ratio. This is the so-called medium-term growth bonus from European integration.

Medium-term growth effects: the Solow diagram

Medium-term growth effects: the Solow diagram The Solow diagram assumes a constant investment rate. But it may not be constant: many people claim that the euro makes it easier, cheaper and safer to invest in Europe. If European integration raises the investment rate from, s(GDP/L), will rotate upwards, altering the K/L ratio.

Medium-term growth effects: EU accessions Accession countries provide a natural experiment to evaluate the medium-term growth effects of European integration since these countries experienced a rather sudden and well-defined increase in economic integration when they joined. The logic described above should lead to observe the following: stock market prices should increase; the aggregate investment to GDP ratio should rise; the net direct investment figures should improve.

Medium-term growth effects: EU accessions Spain and Portugal:

Medium-term growth effects: EU accessions The Baltic States:

Medium-term growth effects: EU accessions Greece (sharp contrast with other accessions):

Long-term growth effects Here, focus is on knowledge capital = technology. Is knowledge capital subject to diminishing returns? NO! So the GDP/L curve rises in a straight-line fashion with respect to the knowledge-per-worker ratio.

Long-term growth effects: the evidence The evidence on long-term growth effects of European integration is much harder to find. Also, the overarching fact is that long-term growth rates around the world, including those in Europe, returned to their pre-Golden Age levels. It is hard to explain how the long-run growth rate in Europe returned to its pre-integration average, if European integration strongly boosted long-run growth. For this reason, it is probably best to focus on medium-term growth effects. The experience of the new Member States will provide an important opportunity for testing the growth effects of EU membership, but as yet not have enough data to undertake serious statistical analysis.