The European integration plan amounts to the creation of a giant economy out of thin air. It is analytically comparable to the reemergence of China as an economic power in the past decade – millions of people, previously locked in an economic model that rendered them almost completely unproductive, gradually being unleashed and producing goods for the world. The last event on a similar scale was the transformation of the U.S. economy from colony to global power between 1870-1900, after the Civil War. This view of Europe’s great project is greeted skeptically in many corners of the world, not least because of concerns that the latest 10 accession countries – Poland, Hungary, Czech Republic, Slovakia, Slovenia, Estonia, Latvia, Lithuania, Malta and Cyprus – may not be up to the rigors of full euro membership. Of course, such skepticism has been proven wrong before. In the past, it was argued that Italy could never qualify for membership in the European monetary union, yet it did; that Spain and Portugal would be left to a much later stage, but they were not; and that the monetary union would break apart soon after creation – but that did not happen either. Indeed, the euro has earned its stripes among global investors and is now worth more than it was at its inception.

Waiting in the wings

Both economic theory and history suggest that EU membership will be good for these countries, and that the process of preparation for future membership will be good for other countries waiting in the wings. The theory is simple: consider two countries, one rich and one poor, historically separated by political and economic barriers. If they adopt free trade and the poor country replicates the rich country’s legal and regulatory framework, the poor country begins to attract investment, for it has identical business conditions but lower costs. The result is that the poor country grows faster than the rich country and its living standards catch up. Historical examples of such convergence include Japan during 1945-85, Ireland during the 1990s, South Korea and Finland. Statistically, if one looks at total income per person, the convergence process looks like a giant V-formation, like Canada geese, with income per person in the poor country gradually catching up to living standards in the rich country. The rich country does not stop progressing, but like old geese at the head of the formation, they face the headwinds of pure investment and innovation, things that are then passed on to the younger geese at much lower cost.

Solid performance

Importantly, the key ingredient in this process of convergence is not outright membership in the European Union, but alignment of elements of the business environment with that of the leaders – harmonization of legal and regulatory environments, strengthening of democratic institutions, and the modernization of banking systems. The solid performance of the recent 10 accession countries in the past two years, while the world economy was struggling, is testament to the inherent resilience of the Canada geese formation – when geese are buffeted by strong headwinds, they immediately fall back into formation.

The leaders can benefit from the Canada geese formation too, because the persistence of the young, eager geese following from behind causes the older birds to pick up their performance. In Europe, this competition from below is helping to motivate pension and labor market reform in France (Agenda 2006) and Germany (Agenda 2010). And recent developments in European labor markets, where workers have accepted various workplace concessions in order to prevent the relocation of production to points eastward, is further evidence of this force operating from below. What this means is that, over time, the absorption of the new economies is likely to boost Europe’s economic performance overall.

Global expansion set to return

If euro-convergence can take place during such periods of global economic and financial stress, and the massive exchange rate fluctuations experienced during the past five years, imagine what can happen when the geese catch a global tailwind. Such a situation is emerging in 2004, with the first synchronized global expansion since 1996. The expansion will broaden in 2004 and become more entrenched, and therefore more robust, with global growth averaging more than 4 percent. As global interest rates move back up to more normal levels, world economic growth will gear back to a more sustainable pace of 3.7 percent in 2005. This moderation will prove essential to the sustainability of the expansion.

Growth is being led by developing Asia at 6-7 percent, and this is projected to continue into 2005. China will gear back from its recent torrid pace of 10 percent growth to around 8 percent this year and next, and India’s growth will moderate as well. Likewise, the U.S. economy will slow from around 4.5 percent to 3.3 percent, Japan from 3.7 percent to around 2 percent, and South America from 4.5 percent to 3.6 percent. In short, global conditions are ideal for the process of European convergence, for new members and prospective members alike. Growth in Europe as a whole will gather momentum into 2005, reaching above 2 percent. European companies throughout the region are still adjusting to the recovery of the euro to more normal levels, but this stressor is being outweighed by a much healthier global economy.

Intra-firm trade a cushion

Importantly, the recent stability of the euro is probably a good indication of its longerterm trading level, in contrast with many forecasts that it has a lot of upside. These forecasts of further euro strength are based on concerns about the un-sustainability of the U.S. trade deficit, which many think will cause the U.S. dollar to depreciate substantially against most other currencies. But this view ignores the incredible ramp-up of intra-firm trade that has come with globalization: today, nearly half of U.S. imports are by U.S. companies importing from their own subsidiaries. Most of the U.S. trade deficit is therefore inside of American companies, and accordingly, is likely to persist without contributing to a significant weakening of the dollar.

With that global and European backdrop, Central and Eastern Europe will see economic growth rates in the 4-5 percent range in 2004-05, or more than double the rate for the euro-zone itself, which is exactly what the Canada geese formation would predict. This is not to argue that Europe’s convergence process cannot stumble, for it surely can, as Korea’s was interrupted by the Asian crisis of 1997. Convergence requires an absence of impediments, and there is a very long list of potential roadblocks or headwinds that need to be borne in mind.

For one thing, several countries in the region, notably Hungary and Poland, face major fiscal adjustments to meet their EU entry criteria, and some believe that their economies might falter as a result. Foreign investors are more wary of this risk today, because of the possibility that there may be unforeseen changes in tax laws that will impact their investments in accession countries. But this problem is being widely recognized, and is helping motivate governments to put together credible fiscal plans. Furthermore, government spending cuts and privatization will create even more opportunities for private sector expansion in those countries – filling the void left behind, or the opposite of government crowding out – so any interruption in convergence due to fiscal cutbacks is likely to be short-lived.

Economic convergence

A second challenge that comes along with economic convergence is rising property prices. This is a basic characteristic of the convergence process, as Ireland and Hungary have discovered. It happens because the underlying rise in productivity and living standards puts upward pressure on the converging country’s exchange rate. In an economy that is attempting to minimize exchange rate fluctuations, this underlying force must find another outlet. Over time, the costs of production in the following countries will rise to match those in the leading countries. Labor costs will rise along with worker productivity, and the other costs of setting up a business will converge as well. Most important among these is the cost of land, and as many accession-hopefuls have discovered, this trend can emerge very early in the game. It can make the objective of controlling inflation a bit more difficult for the central bank. And it means that new companies in the converging economies must be very cost conscious if they are to maintain their competitive edge along the way.

The bottom line? The expansion of Europe is creating a new integrated economy that will be bigger than and as diverse as the United States. It offers a wide range of very exciting sales and supply chain partnership opportunities for global companies, regardless of where they are situated. There will be massive investments in infrastructure and a substantial increase in consumer purchasing power along the way. The risks associated with the convergence process are mainly political in nature – the possibility that well-meaning governments might unintentionally interrupt convergence when it would occur all by itself, were they simply to stand back and allow it to happen.