European Economic Perspectives 26

Poles Apart?

As European integration deepens, will the clustering of people and firms lead to a polarized Europe, in which some regions buzz with activity while others decline? A new CEPR Report explains how the right policies can prevent polarization.

Further European integration will increase the incentives for regional specialization of economic activity. People and firms will increasingly cluster together with those that share their particular know-how and skills – which may be those within the same industry as conventionally defined, or simply those that share a functional specialization whatever the industry in which they are classified. But according to CEPR’s latest Monitoring European Integration Report, this specialization need not imply polarization of Europe into rich and poor regions, those with jobs and those without. Three main types of outcome are conceivable:

• The Dispersion Outcome. There could be a broad dispersion of activity and considerable regional equality: there will be specialization, but most regions will be able to specialize in something.

• The Concentration Outcome. There could be strong geographical concentration accompanied by high labour mobility, leading to depopulation of declining regions but not to great inequality of per capita income or access to jobs.

• The Regional Stagnation Outcome. There could be long-run polarization of Europe into advanced regions with high incomes and low unemployment, and depressed regions with low incomes and high unemployment.

Which outcome seems most likely? The Report considers the forces favouring agglomeration, and the contrary forces favouring dispersion. Certain forces – scale economies, learning effects and various pecuniary and non-pecuniary externalities – encourage firms to cluster, while others – factor immobility, congestion externalities and the intrinsic diversity of people’s preferences – tend to keep firms dispersed. Whether Europe becomes more concentrated or dispersed depends on the balance between these forces, as well as on the various barriers erected to prevent people and firms from acting under their influence.

The Report stresses that what matters is not just the mobility of the various factors of production – labour, capital and entrepreneurship – but also their relative mobility, since their location decisions depend on each other. It makes all the difference in the world whether jobs follow people or people follow jobs – or indeed, if neither follows the other.

The Report examines the mobility of firms and the mobility of labour in Europe. The evidence it uncovers strongly implies that the Concentration Outcome is very unlikely. Evidence from the investment behaviour of multinational firms suggests that agglomeration gains are significant but not overwhelming, and can be offset by the higher costs of operating in areas where labour and public goods are scarce. At the same time, labour mobility is low in Europe and has even declined in recent years.

So will Europe experience Dispersion or Regional Stagnation? This is still unclear. But it is clear that misguided regional policies, which try but fail to freeze existing patterns of economic activity, can paradoxically increase the likelihood of the very polarization they seek to prevent. Wage subsidies and discretionary state aids, for example, may discourage people and firms from seeking out the new opportunities that are central to generating innovation, employment and growth.

Nevertheless, both the Report’s evidence on the mobility of firms and the contrast it draws between the successful development policies of Ireland and the unsuccessful regional policies of the Italian Mezzogiorno suggest that government policy has an important role to play in preventing polarization. Firms locate not just according to comparative labour costs and other country endowments, but also in pursuit of skilled and educated labour, and clusters of know-how and technical ability, both features of a country that can be strongly influenced by policy.

The evidence on firm mobility and the experiences of Ireland and the Italian Mezzogiorno also strongly suggest that the process is not a zero-sum game: one region’s success does not have to be at the expense of another. This is particularly true because of the character of the policies that work: they are ones that build up a region’s productive skills rather than merely allow it to bid for business more cheaply. The essential components of a successful policy include:

• Public investment in a skilled and educated workforce – this is important not just because skilled workers are more productive, but also because better educated workers can benefit more from the transfer of know-how between firms that takes place in local agglomerations. They are also more mobile and hence more likely to shift from low to high yield activities.

• A tax and regulatory environment that encourages entrepreneurship – this does not necessarily mean very low profit taxes (though they may help) but it certainly requires a simple and predictable tax structure, and a clear link between the taxes firms pay and the benefits they perceive from locating where they do.

• Labour market policies that encourage wage flexibility in response to economic shocks – this is especially important within the euro zone, ensuring that wages will not fall out of line with productivity trends and undermine regional competitiveness.

• Redistributive policies that diminish workers’ fear of unemployment without acting as a disincentive for geographical mobility – this means using the tax system rather than public employment and subsidies to firms as a method of redistributing income.

• Acceptance and encouragement by policy-makers of geographical clustering by firms using related skills.

• Reduced reliance on policies to support existing firms in difficulty, or simply to compensate firms for operating in an adverse environment without making any attempt to improve that environment.

• Policy consistency over time.

These are all ingredients of a policy environment that is good for growth as well as for regional convergence. The Report’s most central message is that growth and cohesion are not enemies; unless misguided policies determine otherwise, they are allies.

This article summarizes ‘Integration and the Regions of Europe: How the Right Policies Can Prevent Polarization: Monitoring European Integration 10’ by Pontus Braunerhjelm, Riccardo Faini, Victor Norman, Frances Ruane and Paul Seabright (CEPR, 2000).

Recent MEI  Reports:

The Future of European Banking MEI 9
Jean-Pierre Danthine, Francesco Giavazzi, Ernst-Ludwig von Thadden and Xavier Vives

Social Europe: One for All? MEI 8
Charles Bean, Samuel Bentolila, Giuseppe Bertola and Juan J Dolado

EMU: Getting the Endgame Right MEI 7
David Begg, Francesco Giavazzi, Jürgen von Hagen and Charles Wyplosz

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