Eastern front

Enlargement of the EU to the east is economically feasible, with sufficient flexibility in the west. But it is geopolitically risky. The historic fault line in Europe is between Germany and Russia, not Germany and France. Russia must not be isolated from Europe's mainstream
August 19, 1997

The people and countries of central and eastern Europe have been an integral part of Europe's common civilisation for 2,000 years; certainly since Charlemagne created the Holy Roman Empire. Prague, Warsaw, Budapest and the Hanseatic cities such as Riga and Tallinn have been centres of culture as significant in their contribution to European culture and history as Brussels, Berlin or Milan. You have only to think of Copernicus and Kepler, or Haydn and Chopin, to realise that the distinctions between western, central and eastern Europe are an artificial phenomenon related partly to the long decay of the Austro-Hungarian empire but, above all, to the iron curtain. Russia and Ukraine, too, were drawn into the European mainstream from the reign of Peter the Great until the 1917 revolution. The influence of Mendeleev, Tolstoy and, indeed, Lenin was pan-European. In the 19th century it was even more natural for the Russian and central European intelligentsia to speak to each other in French than it is for Swedish, German and Italian businessmen to communicate in English today. In the 50 years of European peace before 1914, the aristocratic elite and the professional classes of Europe travelled almost as easily from Moscow to Rome via Warsaw (without passports) as we do today from Madrid to Berlin.

To recreate in western Europe this sense of unity was the great achievement of the last generation and the institutions it created-Nato and the EU. To extend this homeland to embrace the whole of Europe, after the catastrophes of the first half of the 20th century, would be an achievement to crown the millennium which has seen European civilisation-its languages, its economic, scientific and cultural ideas, if not yet its human and political values-take over the globe. But, inspiring as it is to hope that the tide of history is now pushing the whole of Europe towards peace, prosperity and unity, there are great dangers in losing sight of the daunting obstacles.

the ten countries of central and eastern Europe (CEE) which have formally applied for membership of the EU can be divided into three groups: Poland, Hungary, the Czech Republic, Slovakia and Slovenia (the Visegrad-5); Romania and Bulgaria (the Balkan countries); Latvia, Estonia and Lithuania (the three Baltic states). Apart from Poland and Romania these are all relatively small countries in terms of population, economic output and purchasing power. Nevertheless, taken together, the ten CEE countries would add substantially to the size of the European market and, even more, to its longterm growth potential.

The CEE countries would add 105m people to the EU's population of 370m. At purchasing power parity exchange rates, their average per capita GNP in 1994 was about $5,600: half the level of the EU's poorest country, Greece; and about one third of the EU average of $16,164. To gauge their effect on European trade, however, we must consider market exchange rates. These show the total GDP of the ten CEE countries as only $252 billion, less than 4 per cent of the EU. The Visegrad-5-the candidates for the first wave of admissions-have a total GDP of $170 billion. Thus, in a static framework, enlargement would have little impact on the EU economy, either for good or ill. The effects of integration into the EU market for the CEE countries would, on the other hand, be huge-and almost entirely beneficial.

How long might it take for the CEE countries to converge towards the EU's average standard of living? The Visegrad countries could plausibly achieve longterm annual growth rates of 5 to 7 per cent once their financial stabilisation and institutional reforms are completed. This stage has already been reached in Poland and Slovenia. But Hungary is still encumbered by a huge foreign debt burden, while the Czech Republic and Slovakia have not yet moved far enough in industrial restructuring. Assuming 6 per cent annual growth rates in the CEE and 2.5 per cent annual growth in the EU, it would take about 30 years for the Visegrad countries to close the gap in living standards, while Romania and Bulgaria would take about 40 years. These estimates seem plausible in light of the experience of western Europe in the postwar decades as well as the more recent performances of Ireland, Portugal and Spain.

Most of the catching up in the CEE countries would occur even without joining the EU-as long as they follow sensible policies of market liberalisation. Agreements already signed with the EU provide tariff-free access for most goods, with the exceptions of agriculture, which remains a closed market, and textiles and steel, where anti-dumping restrictions have created high protection barriers. It could be argued that formal admission to the EU would make little difference, because agriculture and other sensitive industries will be subjected to long transition periods before full integration of the CEE is allowed.

Against this, supporters of early enlargement contend that sound policy choices in the CEE countries are conditioned by their hopes of admission to the EU. They also point out that full membership of the EU brings benefits beyond those of a free trade zone. A recent paper from the Centre for Economic Policy Research suggested that the benefit to the CEE countries' resulting from EU accession could be as high as 18.8 per cent of GDP, on the assumption of a big reduction in investment risk premiums.

Enlargement will also create a host of new opportunities-for both sides-based on the very different labour costs, consumption patterns and investment requirements of the east. Eastern Europeans have a huge appetite for low-priced consumption and investment goods and for infrastructure projects-all markets which are nearing saturation in the present EU. Germany, which accounts for 40 per cent of the EU's total exports to the CEE, has been the main beneficiary, but the CEE is also an important market for Austria, Greece and Italy. (Britain, too, has benefited through "invisible" exports of financial and consultancy services.) The CEE accounted for 8 per cent of Germany's exports in 1993, the last date for which figures are available, but anecdotal evidence suggests that this share has grown rapidly and that CEE countries have been responsible for a large part of Germany's recent export boom-helping to prevent the unemployment crisis becoming a disaster. Furthermore, because many German exports to the CEE are capital goods connected with production outsourcing, they represent something of a captive market, partly protected from the loss of international competitiveness which German industry has suffered as a result of the appreciation of the Deutschmark since 1989.

Central and eastern Europe could play the same role in reducing Europe's production costs as Mexico has for the US and southeast Asia for Japan. The significance of the CEE as a production base will not become apparent until the full institutional infrastructure to support greater flows of investment is in place. But in the past three years there has been an acceleration of foreign direct investment and portfolio investment in Poland and the Czech Republic, comparing well with levels in Asia's developing countries.

in principle, the opportunity to increase outsourcing and shift activities to lower cost locations in the east should be a benign influence, increasing western Europe's competitiveness and boosting European manufacturers (which have lost out to Japan and the US, both because of overvalued exchange rates and because of the locational advantages of low cost production centres in the Asian and American regions). But it could also lead to severe social dislocation. The EU's dominant social partnership model will be strained, perhaps to breaking point, by the low wage competition and industrial restructuring which must result from the eastward expansion of the European economy. These strains will develop, however, whether or not the EU is enlarged. The eastern boundary of the EU now has the steepest economic gradient in the world. Germany, which is the world's highest cost production area, is imme-diately adjacent to the very low cost areas of Hungary and the Czech Republic. This gradient between Germany and eastern Europe is steeper than that between Mexico and California, and far steeper than the gradient between Japan and other parts of southeast Asia.

Full insulation from low wage competition is not possible. But what could be achieved by the negotiations on EU enlargement would be to bring the restructuring into a more predictable framework. It cannot, however, be taken for granted-as it usually is in the public policy circles of western Europe-that any such effort to control the effects of competitive markets would produce a favourable outcome.

Perhaps the most serious danger of enlargement is that the EU will try to impose on the candidate members a set of social and monetary restraints which are premature for the CEE countries' stage of economic development, lowering their rates of growth and investment towards the levels typical in the mature economies of the west and thereby extending their phase of technological catch-up from several decades to several generations. Such constraints-for example on labour market flexibility or environmental standards-would be presented as symbols of the CEE countries' maturity and their readiness to undertake the full obligations of EU membership. In reality, however, their effect and purpose would be to undermine eastern Europe's competitive advantage and to prolong the lifetimes of the doomed high cost industrial structures of the west. If the price of EU membership for the CEE countries was the acceptance of over-regulation they would do far better to stay out, relying instead on existing free trade agreements and membership of the World Trade Organisation to ensure adequate access to the EU market. The huge costs to west German taxpayers of stunting east Germany's development by prematurely imposing western regulatory practices and cost structures should deter governments of both east and west from making similar mistakes in the negotiations over EU enlargement.

But while it is easy to accept in principle that relatively low income countries need different social institutions and standards of regulation, the practical implications of this distinction are harder to swallow. Workers, trade unions and many businesses in the high cost areas of Europe will not easily accept the social implications of open competition against producers who benefit from low wages and a light burden of regulations. For western policymakers a key challenge of Europe's expansion to the east is first to explain to their peoples that low cost competition, whether from eastern Europe or from developing countries, is not only morally legitimate but also inevitable and economically beneficial.

That free trade and low wage competition can be combined with full employment and rising wages is demonstrated not just by economic theory but also by the recent performance of the US and, to a lesser extent, Britain, the Netherlands, Portugal and Ireland. To achieve such a happy conjuncture throughout western Europe will require a combination of microeconomic policies to promote flexibility with far more aggressive macroeconomic policies to eliminate cyclical unemployment by expanding demand.

There is actually only one big industry that is certain to suffer irreparable damage from Europe's expansion to the east. This is agriculture, at least on the heavily protected and subsidised model that prevails in the EU. A few figures indicate the scale of this potential problem. Agriculture accounts for 8 per cent of GDP and 27 per cent of employment in the ten CEE countries. This compares with 2 per cent of GDP and 5 per cent of employment in the EU. Agricultural prices in the CEE are, on average, about half those in the EU. Levels of protection are much lower, ranging from about 20 per cent in the Visegrad countries down to 1 per cent in Latvia. Thus, if the common agricultural policy (Cap) were extended to the CEE with anything like the level of European farm prices, output would rise dramatically, leading to huge surpluses and unsustainable subsidies.

But the present Cap is doomed even if the CEE countries are not admitted to the EU, or are offered only a second class membership which excluded them from the agricultural market (and therefore required the permanent preservation of border controls). Beyond the CEE countries lie the far greater threats, on the one hand, of Russia and Ukraine, and, on the other, the pressure from American free trade. The huge amount of land Russia and Ukraine will eventually bring under efficient cultivation is likely to lead to a collapse of world prices for the northern agricultural products most heavily subsidised by the Cap. To impede or delay EU expansion for the sake of a Cap which is heading for collapse is the height of folly. Yet this is what seems to be happening.

What is the overall budgetary implication of eastern enlargement for the EU? The two main programmes affected would be the structural funds, which account for 32 per cent of the EU's total budget, and the Cap, which absorbs 49 per cent. The cost of enlargement to an unreformed Cap depends on what happens to CEE farm productivity as well as to world prices. Estimates vary from 4 billion ecu to 37 billion ecu for the Visegrad countries and from 9 billion ecu to 55 billion ecu for the ten CEE countries. The high estimates, which assume that CEE productivity gradually rises towards western levels, seem the more plausible (although only on the implausible assumption that the Cap is continued in its present form). Most of the structural fund spending is available to regions with per capita incomes of less than 75 per cent of the EU average and countries whose incomes are below 90 per cent of the EU average. All CEE countries would qualify under these criteria. Because structural spending has been the EU's most rapidly growing budget item since the late 1980s, there have been fears that admitting the CEE would impose intolerable financial demands. A recent estimate has suggested a total cost for the Visegrad countries of between 13 billion ecu and 27 billion ecu.

Against these costs-to Cap and the structural funds-must be set the contributions (VAT and other levies) which would be paid by the new entrants. These should amount to about 6 billion ecu by the Visegrad countries and 9 billion ecu by the ten CEE countries. So the net budgetary cost of enlargement for the Visegrad countries could be anything from about 16 billion ecu up to 56 billion ecu. These figures compare with the EU's present annual budget of about 89 billion ecu and a total budget of about 100 billion ecu expected, without enlargement, after 1999. Even the lower figure is daunting. The upper one is beyond imaginable bounds.

But little significance should be attached to any of these figures. They are all based on highly uncertain assumptions. More important, they abstract from the essentially political nature of budgetary negotiations. EU budgets are determined by horsetrading among pragmatic politicians with strong national self-interest, not by objective criteria or quasi-judicial rules and precedents. The fact is that the CEE countries are anxious to join the EU and believe they would benefit from membership even without additional subsidies. It is hard to see, therefore, why they should be offered additional financial inducements by way of structural funds-unless it is believed that joining the EU will actually hurt their economies, in which case they should not apply to join in the first place. It seems bizarre to exclude the CEE countries because the EU cannot afford the regional subsidies to which these countries might feel entitled. Offering membership without any regional subsidies would surely be more rational. The question of Cap costs is not so easily dealt with. If the Cap is to be preserved, and a single market in farm products established across Europe, huge costs will be unavoidable. The only real solution is to reform the Cap and move to a system of income support for poor farmers, and away from the present system of subsiding production.

In sum, it is hard to believe that budgetary costs to the EU will be the binding constraint on enlargement. The nervousness among many EU governments in contemplating enlargement has more to do with the challenges presented by a single market that included the low cost countries to the east. To the extent that budgetary costs are a potential problem, it is only because of the prevalent view in Brussels, Paris and Bonn that the eastern countries will have to accept the constraints of the EU acquis on their ability to exploit lower costs for competitive advantage. In essence, what is proposed is a modified version of German unification, albeit with a much lower level of subsidy, and with a long period of transition when free movement of labour would continue to be restricted. If this is the kind of formula on offer from the EU, the CEE countries would be wise to say "no, thank you." If, on the other hand, the EU were to accept eastern Europe's right to compete on cost, and were to offer long transition periods for the competitive burdens imposed by the acquis, then CEE countries should be happy to accept membership with no subsidies at all.

Even under these benign circumstances, however, there is cause for concern for proponents of an ever more integrated Europe. The CEE countries could not accept the Maastricht requirements, designed for mature economies at similar stages of development. With several EU countries already opting out of Emu, enlargement would add to the critical mass of non-Emu countries and could endanger the programme of irreversible integration which monetary union was supposed to produce. Admission of the CEE countries would also shift the EU's centre of gravity. Geographically the centre would shift towards Germany, but politically it could move southwards. The poorer countries of the east and the south would be in a near majority and could form a blocking minority. This might be particularly troubling to the high cost northern economies trying to preserve their social and industrial structures in the face of intense competition from outside and within the EU.

A final question is what enlargement will do to the geopolitical balance of Europe. Helmut Kohl has called the future of monetary union "a question of war and peace in Europe." How much more worrying, then, is the issue posed by expanding the borders of Europe eastwards while leaving the continent's biggest and most troubled country, Russia, perennially on the outside? Chancellor Kohl's famous comment was based, like the construction of the EU itself, on the assumption that the great fault line which has created the earthquakes of European history lies between Germany and France. If the Franco-German relationship can be secured forever, the danger of war in Europe will be a thing of the past. But this preoccupation with the Franco-German relationship could be an historic error. There is another fault line which has caused even more tragedy. This is the unstable zone between Germany or Austria and Russia. The EU's enlargement could aggravate this fault line by appearing to isolate Russia forever from the European mainstream. If Russia is left behind, its isolation could turn to paranoia and eventually to violence. The situation would be greatly exacerbated if former Soviet republics such as Lithuania, Moldova, Ukraine and even Belarus were to apply for membership of the EU and Nato. Step by step this process would bring the EU's boundaries on to territory still inhabited by Russians and perceived by many of their countrymen as their own soil.

The geopolitical danger of enlargement is far greater today than it seemed a year ago, because of the way that EU enlargement is now interacting with the eastward extension of Nato. Nato's extension was unthinkable a few years ago, and the permanence of Nato's borders offered reassurance that the enlargement of Europe was a purely economic phenomenon. Now simultaneous EU and Nato enlargement threatens to send a very different message, which is sharpened by the EU's efforts to create its own defence identity under the Amsterdam treaty.

In the next five to ten years the EU and Nato are almost certain to include Poland, a country which for the past 500 years has been the main locus of power struggles between Russia and the west. Worse, the EU and Nato have both made it clear that Poland's eastern borders do not define a limit on the possibilities of enlargement. There is already talk of the Baltic states as potential candidates for Nato and the EU. Beyond that, Ukraine, a country with strong support in the US Congress, could eventually be brought in. If Ukraine, a country whose capital Kiev was the cradle of Russian civilisation and is still regarded as part of the Russian homeland, were ever absorbed into the European sphere of influence, this could easily be viewed in Russia as a hostile act.

It may be, of course, that Europe in the future will be so powerful and Russia will remain so feeble that sharing a 3,000-kilometre border with this aggrieved neighbour will present no problem for an enlarged EU. There is, nevertheless, a possibility that this assumption will prove as wrong as France's belief that Germany had been permanently paralysed by its defeat in 1918. Even if Russia's recovery to great power status is unlikely, the consequences of a revanchist, nationalistic, and authoritarian Russia re-emerging on Europe's eastern borders are so horrendous that even the small probability of this happening must be accorded great weight.

The best way to reassure Russia and guarantee its still fragile transition to democracy and peace would be to devise a longterm enlargement strategy that would bring it into the single market and all the commercial, agricultural and economic policies of the EU. To do this, however, would mean abandoning the Maastricht objective of an ever deeper political union of Europe and require a return to the earlier idea of an essentially economic EU, with the single market as its only acquis.

Europe must make up its mind between two alternative visions. Does it want to remain a primarily economic entity-an integrated single market made up of co-operative but independent countries with their own social systems, macroeconomic policies and geopolitical identities? Or will it become a single country with a single set of social institutions and a single foreign policy-the third biggest country in the world in terms of population (after China and India) and by far the most powerful in its economic capacity and force of arms? This second option seems the grander and more exciting. But the strategy of expanding an integrated EU superstate relentlessly eastwards is fraught with perils.