Income inequality in the EU

You have done research on the disparity between incomes in Europe. The results are surprising, as social cohesion in Europe is less strong than assumed.
Let me say at the outset that, surprisingly, there are no reliable official EU figures on income distribution in the 27-member EU. The statistics available are based on methods which obviously produce incorrect results, because they fail to take into account the income differentials between the member states. The EU only formed averages of the distribution data within the individual states, so that it does not take into account the income gap between Belgium and Romania, for example, but instead only that inside a country, such as between the Flemish and the Walloons in Belgium or between rich and poor Romanians.

So how did you measure the income gap?
The normal method is to compare the income of the richest 20 % with that of the poorest 20 %. The technical term for such groups is “quintile”. There are about 500 million people in the EU, so each quintile has about 100 million people, and the poorest quintile lives predominantly in the poorest countries. According to my calculations, the total income of the richest 20 % of the EU population is higher than that of the poorest 20 % by a factor of 9.8. The comparable figures for the USA and Russia are 8.5 and 7.6 respectively.

Is this comparison meaningful? Both the USA and Russia are countries which have one currency throughout, but the EU is not.
From an economic perspective, the EU is a single market due to its deep integration. Therefore, it does make sense to make the comparison. But the issue of exchange rates does matter when making such comparisons. If we use recent purchasing-power estimates instead of exchange rates, the EU data look more favourable, with the wealthiest quintile only disposing of 5.5 times as much as the poorest. The reason is that rents or visits to a hairdresser are cheaper in Sofia or Bratislava than they are in Paris or Hamburg.

Nevertheless, purchasing power cannot be exactly determined – and rents are also more expensive in important urban agglomerations like Paris and Hamburg than in the remote Breton region of Finistère or the district of Greiz in East Germany, despite the fact that they have the same currency. Likewise, the cost of living is higher in New York than in Walla Walla, Washington.
Yes, we do face this methodological problem. We do not have any meaningful international data for comparing purchasing powers within single-currency areas. And of course, all purchasing-power parities are based on estimates. It is revealing, in my view, that the World Bank carried out a major review of its purchasing-power calculations late last year. After it did so, it made a dramatic downwards correction to China’s gross domestic product based on purchasing-power parities – from $ 8.9 trillion to $ 5.2 trillion. ­According to the official exchange rate, it is only $ 2.2 trillion.

D+C/E+Z addressed the matter in a comment on China in the February edition, but aren’t such technical statistics only a matter for experts?
No, I don’t think so. If we want to realistically assess the performance of different national economies, then it matters quite a bit what people are able to purchase, even if measuring that is difficult from a methodological viewpoint. Nonetheless, the comparison based on exchange rates is also economically significant, as this is the basis on which Nokia and other multilateral companies decide. Wages paid to workers in Romania are much lower than in Bochum. Employers are not primarily interested in whether their Romanian staff are able to afford reasonably acceptable housing nonetheless. However, that their workers can do so, serves them well. They have a comparatively satisfied and efficient workforce despite low costs.

But if you say that actual poverty in Romania is not as bad as the exchange rates suggest, than social cohesion in Europe must be better than you say accordingly.
You can look at it that way. On the other hand, the discrepancy between purchasing power and exchange rate means that there are greater incentives for companies to move to cheap locations. It follows that cohesion is declining in the individual member states in which jobs are abolished. While exchange-rate differences exaggerate social inequality, they also reflect actual competition. Moreover, the prices of some important goods are uniform even at exchange rates. Goods that are traded on the world market such as petroleum products, cars or computers, are not noticeably cheaper in Eastern Europe than in the Euro area.

What does that mean for social cohesion in ­Europe?
In theory, we should be witnessing a healthy structural change, with advanced nations focusing increasingly on premium products, and those still needing to catch up capitalising on their wage advantages. According to the model, all national economies would grow and so would general prosperity. In reality, however, this will only happen if there is demand for sophisticated goods in poor countries and, currently, there is not enough demand in Europe. The result is that people in rich nations are becoming unemployed without new high-tech jobs being created.

Considering the problems of Germany’s internal monetary union from 1990 on, wouldn’t it be tough for the accession countries to expand the Euro area to the entire EU?
Yes, that is so, and this is why the European Central Bank and the European Commission are also taking a very conservative approach in this matter. If the monetary union is extended, and wages are raised without regard to productivity, the competitiveness of the weaker partners is destroyed. The income level of a country must correspond to its level of productivity.

That is easier said than done.
Wage growth should in any event track progress in productivity, because this ensures demand, which then results in continuing growth and greater prosperity. One problem, however, is that productivity in the internationalised sectors grows much faster than wages do. Manufacturing mobile phones is hardly less productive in the long term in Romania than in Bochum. In principle, companies use the same technology, but workplaces are much cheaper in Romania.

So what must be done?
There must be real currency appreciation when incomes are brought in line in the enlarged EU. This can take one of two forms – either inflation in the accession country is greater than in the core Euro area, or the exchange rate for the accession country’s currency appreciates. However, this is only possible so long as the accession country is not part of the Euro area. As soon as it joins, only inflation will have a regulating effect. However, the EU, as it is designed today, prohibits real appreciation. The accession treaties define price stability and fixed exchange rates as the key objectives. This approach cannot be sustained in the long run, and in practice we do see real appreciation through both methods.

The drifting apart of highly productive and more traditional sectors also has social impacts domestically. EU integration seems to aggravate such trends inside nation states.
Per se, advances in productivity are desirable. They lay the base for greater prosperity. The problem is how advances in productivity are passed on. Social progress must of course also benefit people whose productivity cannot simply be increased, such as teachers, hairdressers or piano virtuosos. There are a couple of basic mechanisms for that to happen. First of all, prices: premium goods become less expensive, and this benefits consumers. Examples were mobile telephones and computers in recent years. Second, higher productivity results in higher incomes. Now we must distinguish between whether we are dealing with profits or wages. In the EU, tough competition in the low-wage sectors of the various member countries has clearly led to the income shares from capital and corporate profits increasing.

Whether this state of affairs is good or bad, however, depends on one’s political viewpoint.
Neo-classical, liberal economists do not consider the trend problematic, arguing that investments will go up and further boost productivity. The counter-argument is that investments do not happen as fast as they should unless demand keeps in step. Investment decisions depend less on productivity calculations than on sales opportunities. If demand is too weak, investments in higher productivity mean fewer jobs rather than greater social prosperity.

What do you predict for the coming years?
I believe that we will experience more acute inequality in income distribution over a longer phase of inner-EU adjustment, associated with relatively low growth and persistent unemployment. It is not enough to liberalise markets and thereby put pressure on productivity. Mass demand must also be secured through increasing incomes for employees. We need a Europe-wide productivity-oriented wage system, but we do not have that yet.

Are the social gulfs in Europe nationalistically politicised?
It is significant that wherever there are fairly major social problems, populist parties gain power and influence. Poland and Slovakia are the two countries in Eastern Europe with the greatest unemployment, and populist forces are also particularly strong there.

There seems to be a paradox: the belief prevails among the core EU countries that the Union exists to safeguard Europe’s social model. On the other hand, free trade in the single market is exacerbating social differences.
What is happening in Europe is in fact the most radical example of free-trade policy worldwide. A single market of countries with very different income levels is being established. In comparison, supporting social measures are relatively underdeveloped. Certainly there is a wide range of social provisions, including Europe’s Social Charter and rules about safety and health in the workplace. But these are minimum standards which do not describe what is possible and desirable in highly developed welfare states. It is not as if these issues were completely ignored, but this area is not fully developed. It is particularly regrettable that the macro-economic management of this huge economic area has not reached its full potential. The EU budget makes up only about one percent of the EU’s gross domestic product, which is far too little to make any difference at this level.

Questions by Hans Dembowski.