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Economic Models: from theory to application n.3
The diversity of European Union member states gives rise to many challenges. The EU needs to ensure integration as well as cohesion between member states in order to optimise and ease the realisation of its goals, whether economic or social. In its early days, the European Union counted only 6 countries, and had a narrowed scope of action, which limited its need for homogeneity. However, as it enlarged and countries with diverse backgrounds and institutional settings gained admission, disparities arose which threatened the vision of a united, strong and homogeneous block. While such diversity can be a driving force for some aspects of the EU, it may also represent barriers to its functioning, such as for the European Monetary Union.
However, the initial diversity among its members need not be preventative to the EU reaching its aim. Perhaps the union itself is a vector to greater uniformity within its members.
The Solow growth model is a crucial economic model that assesses economic growth depending on productivity, capital, labour and the demographics of a country. Among the important predictions of this model, its analysis of growth rates depending on initial capital may be used in the context of the European Union to study convergence and integration among the member states. In particular, the discrepancy between GDP levels of recently admitted countries and more established members gives us a framework to observe the potential effects of European integration on growth rate.
The Solow Growth
The Solow Economic Growth model studies economic growth and output in an economy based on several factors such as saving, population and technological advancement. This model makes valuable predictions, as it predicts that countries eventually reach their steady state, that is a level where there is no growth in output per worker, with said level determined by the factors mentioned above. More importantly, what this model predicts is that countries with lower output will end up experiencing faster economic growth in order to catch up with the more advanced economies to eventually reach this steady state as well.
In the case of the EU, this is captured by two types of convergence rate; the β-convergence and the σ-convergence. The first type of convergence corresponds to the difference in GDP levels between countries; over time and after admission to the Union, members should eventually converge to similar levels of GDP per capita. The second type of convergence deals with the catch-up process that allows for similar levels of GDP per capita, that is that countries with lower levels of income have to grow faster than high-income countries. Therefore, β-convergence is necessary in order to reach σ-convergence; indeed, if countries with different levels of output were to grow at the same pace, countries with lower levels of GDP would never be able to catch-up with more advanced economies, therefore sustaining – if not worsening – the gap existing between these countries. Hence, faster growth rates among low-income countries is an essential part of the cohesion process.
Convergence in the EU
Is the theory actually in action in the EU? Research on the adequacy of the Solow growth model for the EU case appears inconclusive; although convergence has been observed in some countries, the growth rate was lower than was predicted by the theory (Diaz del Hoyo et al., 2017). Yet, although levels were lower than expected, it appears that a catch-up process was indeed taking place.
In particular, one recurring question in the European Union is the convergence within members and policymaking in the European Monetary Union. As a monetary union, policies are implemented for the union as a whole, which can be challenging when there are large economic disparities between its members. In particular, countries with different income levels, or different debt levels, may be affected differently by the same external shock, and hence require different types of responses. Hence, economic convergence may be a first step towards more homogeneity in the union, and potentially more efficient policymaking.
Data on the economic convergence in the EU is rather mixed. The following graph plots EU member states’ growth in the past 20 years depending on their GDP levels per capita. As we move right on the x-axis, countries benefit from larger GDP levels. On the other hand, going up on the y-axis is associated with a larger cumulative change in GDP; as this change is measured over the same period of time for every country, economies with higher levels of cumulative change grow faster. Hence, β-convergence can be perceived as a negative relationship between GDP levels and GDP cumulative change, as countries with lower income levels would grow faster.
Source: European Central Bank
The graph suggests some β-convergence among countries that joined the Eurozone after 2002, as we can see a clear negative relationship between GDP growth and GDP levels. However, this does not seem to be the case for countries that joined the Eurozone before 2002. While discrepancies in income are present among these countries, it does not appear to be negatively associated with higher growth rate. Such observations hold for the three different periods represented on the graphs.
Yet, this does not seem to capture the full picture. Perhaps focussing on the past 20 years is not enough to fully grasp the convergence among member states, especially considering that the 2008 financial crisis unevenly hit countries in the Eurozone.
The following graph captures the difference between countries’ GDP levels and the EU GDP average across time, measured by the standard deviation. An overall decline of the standard deviation would be concordant with the σ-convergence, as countries would become more similar income-wise with time. Looking as far as the 1960s, we can distinguish 5 phases, with alternating periods of convergence and non-convergence among countries, and finally a period of divergence following the 2008 financial crisis.
Source: European Central Bank
This longer time frame allows us to grasp some of the β-convergence as well, as shown on the following graphs. Using the same axes as before and focusing on the 12 countries that joined the Euro in its early days, a β-convergence seems more visible, especially before the crisis. Therefore, focusing on a longer-term vision may allow us to better capture a convergence movement among European countries, though such a process may have been affected by the 2008 crisis.
Source: European Central Bank
In all, Convergence is an important concept for the Union, as it allows a decrease in discrepancies among member states and eases policymaking for the EU. While countries joining the Union appear very different at first sight, it seems that a phenomenon of convergence is present among member states. Many mechanisms may be behind such observations, such as the promised stability brought by European membership. However, countries remain very diverse and most importantly sovereign in many aspects. As institutional convergence may be one of the most important drivers for economic convergence, simple European membership may be not enough to ensure the full process of catching-up between European countries.
Diaz del Hoyo, J., Dorrucci, E., Heinz, F., & Muzikarova, S. (2017). Real convergence in the euro area: a long-term perspective. ECB Occasional Paper, 203.