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EU membership has worked magic in central Europe

BY CULTURE and language, by history and landscape, the countries that joined the European Union last year offered more of a complement than a contrast to the existing membership. Slovakia, the Czech Republic, Hungary and Slovenia were recognisably still the Habsburg cousins of Austria, if a little countrified by separation. Poland and the Balts echoed an older Hanseatic order.

It was only when you asked people what they earned that the real division between the West and the rest became clear. When you crossed the border from Germany into Poland in 2003, average income per head fell by four-fifths, from $27,600 in Germany to $5,400 in Poland. When Romania and Bulgaria join the EU in 2007 or 2008, they will be poorer even than the central Europeans. According to Deutsche Bank, Romania's average income per head in 2005 will be $4,084 and Bulgaria's only $3,735, roughly half Poland's current level.

Figures like this help to explain why the EU has lost so much of its enthusiasm for enlargement, despite the relative success of the 2004 round. It has grown panicky about competition for jobs and investment from the countries it has just embraced. It is reluctant to add to that competition by promising to admit even more low-wage countries later. “The Polish border is 1,800km (1,120 miles) from London but 80km from Berlin,” says one German official, asked why Britain has opened its labour market to the eastern newcomers but Germany has not. Germany fears a free flow of Polish workers, and even more of Turkish ones. Turkey's population of almost 70m is about the same as the combined total of all ten countries that joined the EU last year, and it is poorer than any of them. Ukraine, another would-be member, has 47m people, with an income per head of around $1,000 in 2003.

Western Europe's fears are understandable but counterproductive. Low-wage countries next door should be seen more as a resource than a threat: they attract business that would otherwise go to low-wage countries on the other side of the world. But can Europe come to see it that way? The would-be members among the EU's neighbours can only hope so. They have seen their friends and neighbours in central Europe transformed by EU accession. Having failed to catch that first wave of enlargement themselves, they are now praying for a second chance.

The EU's newest members, though much poorer than France or Germany, are already a lot richer than they were immediately after communism's collapse. In 1991, Poland's GDP per head was just $1,998. The EU led the way in central Europe's rehabilitation, helped by America's USAID and other international agencies, giving or lending $18 billion to central Europe in the 1990s. Just as valuable was the work of multinational companies that bought or built operations in central Europe. They set new standards for wages, training, workplace safety and technology transfer, creating a “meritocracy in which hard work, ethical behaviour and a desire to learn” were properly valued locally for the first time in decades, says Charles Paul Lewis, author of a study on these companies' role in post-communist Europe.

But even this intervention brought deep change only because the central Europeans really wanted to anchor their democracies and raise their long-term living standards, even at the cost of short-term disruption. The accession process gave politicians an alibi for unpopular reform. Civil servants spent so much time in Brussels that they felt as accountable to the European institutions as to their governments at home. Voters wanted the West, if not for themselves then for their children.

Soon they will have it. From the viewpoint of the western European countries, the transition in central Europe has worked almost embarrassingly well. By the end of the 1990s, the countries there had reached a level of political and institutional development that made it impossible to refuse them membership of the Union, even though their incomes and wages were still only a small fraction of those in the older member states. Now their economies are continuing to grow at rates shaming the ones that used to be their models. This year even the laggard of central Europe, Hungary, is likely to grow more than twice as fast as the euro zone. The Baltic countries look set to grow at more than four times the euro zone's pace.

Watch them grow

Extrapolate from that, and the implications are startling. Latvian incomes are currently the lowest in the EU, but if the Latvian and the German economies were to go on growing at last year's rates of 8% and 1.6% respectively, then, all other things being equal, Latvian incomes would overtake German ones in 2032 - which is to say, within the working lifetime of a young adult. That should be a thrilling thought for Latvians. It should be a thrilling thought for Germans too, since they would then no longer have to worry about low-wage competition. In reality, however, the thought of becoming poorer than a former Soviet republic is likely to make Germans unhappier still.

The fear of workers flooding in from Poland or Estonia has caused all but three countries in western Europe to close their labour markets to the new members for up to seven years. This year France and Germany blocked an EU law opening up national markets to services from anywhere in the Union, for fear that self-employed workers would arrive by this route. This French-led move was inexplicable to anybody from a more consumerist society. French trade lobbies gave warning that Polish plumbers would swamp the country, yet they also agreed that France was desperately short of plumbers. The arrival of Polish plumbers, even by the thousand, could only have been a blessing.

The new members have also upset the old with their taste for flat and often low rates of personal income tax and corporate tax, chosen mainly for ease of collection. Other payroll taxes and indirect taxes mean that the overall tax burden in the new member states is still similar to that in the old. But France, Germany and Belgium have accused the newcomers of unfair tax competition, and called for minimum rates for corporate taxes across the Union. Nicolas Sarkozy, when French finance minister last year, suggested cutting EU budget payments to new members that insisted on setting low tax rates.

Investors, by contrast, love the new members for their low wages, high productivity and simple taxes. Build a factory there, and you get EU market access at far less than average EU costs. According to the Boston Consulting Group, if you want to sell refrigerators or cars in western Europe, it can be cheaper to make them in Poland than in China. A.T. Kearney, another consulting firm, reckons that the acceptance of Ukraine as an EU candidate could quickly triple the recent rate of foreign direct investment there.

But it was not only EU market access, granted progressively to the central European countries through the 1990s, that attracted investors to the region then and continues to attract them today. It was also the expectation that the rule of law and the quality of government would rise towards EU levels as the accession process continued. Firms will build factories in difficult places if they have to, but they much prefer places where contracts can be enforced, property rights are secure, taxes are predictable, executives feel safe, and workers get basic social services from the state. Conditions like that help to mobilise domestic investment too.

In our back yard

If Ukraine and Turkey are brought inside the EU, they will create, together with Romania and Bulgaria, a low-wage industrial powerhouse in Europe's back yard, a zone of 150m people able to compete even with China or India. That thought might frighten highly paid workers in Germany or France. But it is better for all of Europe if new investment goes to eastern Europe and not to faraway China or Brazil. More investment and more growth in low-wage Europe generates more demand for goods and services from high-wage Europe. That helped Germany to run a trade surplus with Poland last year, for example.

The EU countries with more to fear from further enlargement should be those in central Europe which are the Union's lowest-cost producers right now. Slovakia has had spectacular success in attracting foreign direct investment, especially from the car industry. Soon it will produce more cars per head of population than any other country in the world. But in five or ten years, says Ivan Miklos, the Slovak finance minister, the country's competitive advantage in mass production will slowly but permanently decline as Romania, Turkey and Ukraine catch up. Slovakia wants to encourage more high-tech and service industries by improving the education system and the business climate.

The Slovaks have it right. Enlargement is globalisation in miniature. If the EU holds its neighbours at bay, it is putting off a shock of adjustment that will get bigger and bigger the longer it is delayed. Germany has 5m unemployed, not so much because old jobs in old industries are vanishing there (though they are) but because an inflexible German labour market deters firms and individuals from creating new jobs in new industries in which German companies are still world-beaters.

All the same, tactically it may be a good idea to accept that free movement of labour is incompatible with further EU enlargement, not for economic reasons but for political ones. If rich countries want to block cheap labour, let them do so. Europe has capital mobility to compensate. If workers cannot come looking for the jobs, the jobs will go looking for the workers. The central Europeans' experience suggests that the more assured Turkey and Ukraine can be of EU membership, the more foreign investment they will get.

If, on the other hand, these countries are kept outside the EU, investors will expect political and economic reform there to be slower and less secure. Investment will be lower, and growth with it. Something of the sort has been visible in Turkey where, despite a customs union with the EU, foreign direct investment has been much lower than in most central European countries relative to the size of the economy - a fifth of the Czech Republic's level and a third of Poland's between 1994 and 2003. Less investment means fewer jobs at home, lower incomes, less trade and more pressure on workers to find jobs elsewhere. Everyone loses.

EU membership has worked magic for the countries of eastern and central Europe. Article forms part of a survey 'Meet the neighbours. A survey of the EU's eastern borders'.