Western Europe`s Eastern Challenge

Hans-Werner Sinn
Daily Times (ref. Project Syndicate), March 3rd, 2007

In January, the European Union expanded eastward once again. Following the "Big Bang" enlargement of 2004, which added 75 million new EU citizens, the accession of Romania and Bulgaria has added 30 million more. What does this mean for the labour markets of Western Europe? Politicians tend to argue that, although some plumbers migrate to the West and companies relocate to the East, the West will enjoy more jobs in net terms due to the likely expansion of its exports. That reasoning is familiar, but is it correct?

One thing is certain: enlargement has confronted Western Europe with extremely stiff wage competition. Whereas an employee in the old EU's manufacturing sector on average earns €26.09 per hour, in Romania the average is €1.60 and in Bulgaria a mere €1.39.

The view that eastward enlargement will create jobs in the West assumes that East European low-wage workers will complement, and boost demand for, West European workers. In fact, this is partly the case. West European engineers are needed to design world-class products to be manufactured by East European workers, while people with managerial skills can be sure that their abilities will be needed to integrate the EU's newest workers into the European economy.

But for the great majority of workers who have only their normal labor to sell, East European employees are actually substitutes, not complements. They find themselves confronted by low-wage competition from people who have similar skills and ambitions, and are consequently likely to lose ground from enlargement. According to empirical studies, the group of losers ranges from low-skilled to skilled workers with a completed educational training..

The implications for the labor market are clear: for the highly qualified in the West European workforce, eastern enlargement will lead to an increase in labor demand; for all others, it will mean a decrease. Due to a fundamental asymmetry in the flexibility of wages this will lead to a net decline of employment. Since unemployment is low among the more highly qualified, higher demand for their services will lead to an increase in wages rather than an increase in employment. For the less qualified in Western Europe, a decrease in employment will be inevitable, because the scope for wage fluctuation is limited by collective agreements and by the minimum-wage levels that the welfare state sets through wage-replacement benefits and legal minimum wages. Wage inflexibility, combined with the substitution effect exerted on the great majority of West European workers implies that eastern enlargement will cause a net loss of jobs in Western Europe, if the labor market remains as inflexible as it now is.

To be sure, eastern enlargement is leading to an increase in West European exports, because more markets have been opened in which western firms can sell their products. However, if exports increase, the factors of production - namely capital, qualified workers, and unskilled workers - must be diverted from other sectors of the economy, and this leads to a loss of jobs there. Since export goods are considerably more capital and knowledge-intensive in their production than other goods, the structural change will even reduce the net demand for unskilled labour: capital and talents that move away from the other sectors will not take all the unskilled workers with them. The shrinking sectors include the labour-intensive upstream stages of the production process, And, because production of export goods is considerably more capital-intensive than output of other goods, this structural change reduces the demand for simple labor. The shrinking sectors include the labor-intensive upstream stages of thel production process, where jobs have been outsourced to other countries - a phenomenon that is neither apparent to customers nor reflected in statistics on foreign direct investment.

Moreover, while it is often conceded that jobs can be lost via foreign direct investment, much more important are financial capital exports, that is, the loans that enable foreign firms to create jobs on their own turf. Consider Germany, which in 2006 exported capital worth €108 billion, only €25 billion of which was for direct investments, whereas net domestic investment in all sectors combined was only €75 billion. Part of this capital export flowed to the new EU members in Eastern Europe, which enjoyed, relative to their size, gigantic capital imports.

Considering all these factors, the assertion that the EU's eastward enlargement will lead to net job creation in Western Europe appears to be nothing more than empty politically correct rhetoric. Western European wages are far too rigid for the benefits of competition and sectoral change to be shared by a majority of workers.

Hans-Werner Sinn is Professor of Economics and Finance, University of Munich, and President of the Ifo Institute.

Copyright: Project Syndicate, 2007.

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