The European debt crisis has put the banking system in peril and is threatening to end the grand European experiment. It is a test of whether European governments can find enough political common ground to find a solution to the problems created by sovereign fiscal policies in the periphery countries. Severe as the fiscal issues are, there are other problems that are likely to divide Europe into prosperous and stagnant zones for a very long time to come. The periphery countries have underinvested in human capital since the Euro was created and this will continue to exacerbate the economic division of Europe. Persistent inequality cannot be good for the stability of the union.
For all of the Eurozone countries faced with unsustainable fiscal policies the solution will involve considerable pain in the form of budget cuts, shrinking public sectors and increases in tax collections. Because draconian fiscal remedies impose a substantial drag on the economies concerned there is now the worry that Europe will become a two-speed continent with the healthier economies like German, France, and the Nordic countries experiencing strong growth and the periphery countries like Portugal, Greece, Italy and Spain growing more slowly.
Fiscal drag is not the only problem facing the periphery economies. These countries struggled to get their inflation rates in line before joining the EMU but when they did they surrendered the ability to alter the terms of trade for their exports. In many of these countries it meant surrendering a weak currency for a strong one.
For some countries this was a deathblow for domestic industry. A good example is the textile industry in Portugal. In 2001 it was the largest industrial sector accounting for nearly 25 percent of manufacturing employment and 19 percent of exports. But the strength of the Euro made Portuguese textiles uncompetitive and those jobs left for lower wage countries never to return. Similar transitions took place in Greece (the maritime industry), Spain and Italy. It may be that those jobs would have left in any event, but the ability to adjust exchange rates might have dampened the rate at which they left.
The usual solution for countries faced with the loss of lower-wage, lower-skilled jobs is to move up the value-added chain. That is, to replace lower skilled employment with jobs requiring more human capital. This is what Japan did in the post WWII era, what South Korea has done and what China is doing now.
The key to being able to make this transition is to have the necessary human capital. The challenge for many countries (including the U.S.) is to have the foresight and make the commitment to invest in that human capital. Unfortunately, the more typical reaction in the face of budgetary stress caused by a loss of competitiveness is to cut spending where it is easiest to do so and that all too often means cutting education spending. This is like a farmer eating his seed corn.
How well have the periphery countries of Europe responded in terms of building their human capital? Eric Hanushek of the Hoover Institution, who has done some of the boldest, most impressive work on the economic consequences of educational achievement, has compared the relative achievements of OECD countries as measured by standardized (PISA) scores.
The results for the EMU periphery countries tell an interesting if not surprising story. Using Finland (whose students have the highest PISA scores) as the standard, the crisis countries rank as follows: Greece and Portugal are the worst, falling 15 percent or more below Finland. Italy and Spain are next 13 percent and 11 percent behind respectively while Ireland is only 7 percent behind. The U.S. also lags behind by about 10 percent.
The economic consequences of these educational shortfalls are staggering. At the level of the individual there is a well-established empirical link between teacher quality and school achievement and between achievement and subsequent economic success. Additionally, there are established links between aggregate or country-wide measures of educational achievement and economic growth. Hanushek estimates that eliminating the gap between low achieving countries and the high achievers could add as much as 1.5 percent to the long run growth rates of the worst laggards. The compelling thing about the Hanushek analysis is that it relies on measured outputs of the educational process, however imperfect they may be.
The Global Competitiveness Report published by the World Economic Forum also looks at the effectiveness of educational systems. Education is one of its 12 pillars of competitiveness. Most of the measures reported look at inputs – secondary and tertiary education enrollment rates for example. But they also rate the quality of the educational systems based on surveys of the business community that assess the extent to which the system produces students with the math, science and other skills needed in a competitive economy. The conclusion that comes out of this is much the same. Greece ranked 120th out of 145 countries, Spain ranked 98th, Italy ranked 88th,, Portugal 76th, Ireland 11th , the U.S. 26th. This accords well with the output measures and with what many economists would regard as these countries trend growth prospects.
Given this state of affairs it seems inevitable that the European crisis countries (with the possible exception of Ireland) will be doomed to lower levels of income and years of slower growth whatever they do about their fiscal affairs. This is made even worse by the fact that German exports to the periphery countries — a huge share of their total exports — have boomed. This was helped by the fact that the Germans managed to keep their unit labor costs essentially flat for ten years while the periphery did not.
Unfortunately, simply spending more on education in countries where it is entirely captive to the inefficient public sector may not be much of a solution either. These countries must both devote more resources and find ways to deliver them more effectively. Whether the European experiment can survive a long period of growing inequality between the strong economies and the periphery countries remains to be seen. There is no quick fix to the human capital disparities that have been created and the longer they are neglected the greater the stress on the union.