Mega Europe

Soon, 10 states and millions of people in the old Soviet bloc will join the EU to form a new super-Europe. The question now: Is bigger better?

The construction of Europe has often seemed more like the building of a great medieval cathedral--a painstaking process that takes generations, and whose final majestic shape can only be dimly imagined by a farsighted few. True, there were always visionary European leaders who saw the citizens of Germany, France, and Sweden someday swearing double allegiance--to a flag of 12 gold stars on a field of blue as well as to their own nation's colors. But over the decades, the gap between the European Union's vision of itself and the gritty business of uniting a whole continent of cultures often felt as unbridgeable as in those first dark days after World War II, when a few policymakers dared dream of a Greater Europe. To keep the faith alive, Brussels technocrats, like clerics of old writing out their psalters, produced binders full of plans and rules for a new Europe to pass on to the next generation. Believe, the acolytes said, and one day it shall happen.

Now, in the course of one short decade, it is happening. In 1992, Europeans got a single market and a standardized European passport, a pocket-size badge of unity. It was the first hard evidence that Brussels might do more than run a subsidy machine for the continent's farmers. Then last Jan. 1, Europeans woke up to a new money, the euro. In place of their faded marks, guilders, and francs, they got packets of green-, red-, and blue-tinted euro bills and weighty brass-rimmed coins. Germans, French, Italians, and others could feel the reality of Europe jingling in their pockets.

Monetary union, monumental as it is, is only a prelude. In a move so audacious that no one knows whether it will work or not, the West is now set to make most of the citizens of the old Soviet bloc Europeans. Over the next two years, nations from Estonia in the north to Slovenia in the south will be admitted into the EU after a few final rounds of negotiation. The island states of Malta and Cyprus will join, too. Enlargement--a prosaic word for such an epochal event--marks a true inflection point in modern human history. Proud and ancient states from Portugal to Latvia are voluntarily giving up huge swaths of sovereignty on a scale not seen since Charlemagne tried to unify the continent 1,200 years ago.

Brussels' embrace will add 23% to the EU's land mass and bring in 75 million additional citizens, making a new Mega Europe of more than 450 million people. Its economy of $9.3 trillion will approach that of the U.S. The new entity could easily eclipse America if Europe rediscovers growth. "This is the dawn of a new era," says Lithuanian President Valdas Adamkus.

Always primarily a political project, expansion is intended to underpin democracy and free markets in the once-centrally planned dictatorships of Central and Eastern Europe, and create a zone of stability on the EU's eastern flank. Yet what Europeans have really wrought will not be known for years. The current leader of this effort, Romano Prodi, head of the European Commission in Brussels, recently told associates it "is like the Allied invasion of Normandy--you just have to go ahead and have faith it's going to work."

That's because expansion is far more politically charged than anything Europe's builders have attempted before. True, the distribution of a common European passport aroused some rump nationalism from folks who hated giving up the passports of the French Republic or Her Brittanic Majesty. And the backlash against a European money seemed serious, especially among Germans. Half said they were reluctant to give up the mark--until Jan. 1, when most pocketed the currency with enthusiasm.

But grafting on 10 new European states suggests a much rougher ride ahead. For one thing, unlike monetary union, which was heavily marketed to voters, there has been no selling of enlargement to the masses. Except for the Irish, whose constitution compelled a referendum, no Western Europeans have gotten to vote on it. Now ordinary citizens are wondering what's up. "Deep, basic questions are being asked, and French public opinion polls for one are extremely worrying," says John Kerr, secretary general of the European convention, which is coming up with a working constitution for the EU. "Would we be in that state had we had a public debate from the start?"

Politicians may still get their day. Many Dutch legislators want the Netherlands to schedule a vote on the issue early next year. That's an ideal setup for Western European populists, who can bash faceless Eurocrats for shifting jobs and money to the East. Grants and subsidies from the EU to the Eastern countries will run to $40 billion between 2004 and 2006, a big chunk of the annual $97 billion Brussels budget. "The cost is considerable," says Jules Maarten, a Dutch member of the European Parliament. "I don't think we can deal with a big-bang expansion."

Then there are the raised expectations on both sides. Western Europeans have been led to believe that their new neighbors will make them more competitive and provide a sizable dose of prosperity. Perhaps. But don't expect a return to Europe's wonder years of growth. "Expansion is important for many individual Western companies, but not necessarily for the Western economy as a whole," says Robin Marshall, an economist who follows the region for J.P. Morgan Chase & Co. in London. Still, the existing EU economy will grow by an additional 0.2% a year as a result of enlargement, says Prodi. Not bad. But Eurostat statistics show that adding 10 countries will only expand the EU's overall economy by 4.4% or so.

Meanwhile, in the East, countries like Poland, the Czech Republic, Hungary, and the Baltic states envision a rush of investment similar to what some got in the 1990s. Investment will surely come, but multinationals have their pick of low-cost locales around the world. And productivity in the East lags badly. A German worker--the world's priciest at 55 euros an hour--can do the work of four Poles.

There is another danger. Expansion could reinforce structural weaknesses that have left Europe with high unemployment and anemic growth. Ideally, Europe would have already reformed rigid labor markets, freed pension systems, and cut corrosively high taxes before embarking on expansion. It hasn't. Instead, "the EU will unfortunately bring a lot of bureaucracy [to Central Europe]," says Volkswagen's former chairman, Carl H. Hahn. Adds former Czech Prime Minister Vaclav Klaus: "The European social economy is a tragic mistake, and there aren't strong forces trying to dismantle it."

Klaus has a point. But the bureaucrats are pressing on. "The window of opportunity is now open and has to be used," says EU Enlargement Commissioner Gunther Verheugen. "Any delay is extremely dangerous." The EU has been preparing for this Big Bang since that day in November, 1989, when the Berlin Wall came down. To qualify for membership, candidate countries have had to privatize state assets, deregulate markets, and restructure industries. The candidates have enshrined the acquis communautaire, 80,000 pages of complex EU law, in their own legal systems. Even the compilation of national statistics must be brought into line with EU practice.

For most East Europeans, Ireland and Spain are models for what can be achieved by joining the EU. When the Emerald Isle enlisted in 1973, its GDP per capita was less than 70% of the European average and unemployment was almost 17%. Now the country suffers from a labor shortage, and living standards are way above average. "It was joining the European Union that made Ireland rich," says Noreen Aher, an Irish dairy farmer enjoying a long weekend break in Kraków. Spain, once a backwater, is now one of Europe's most vibrant regions. "[EU membership] underpinned Spain's success," says Polish Finance Minister Grzegorz Kolodko. "We want it to do the same for Poland."

In the late 1990s, as the East started its run toward EU membership, it looked as though joining the club would indeed generate prosperity. In anticipation of their joining the common market, Western companies--most of them from the existing EU--invested more than $80 billion in the candidate countries. Attracted by the region's low costs, educated workforce, and proximity to core Europe, the likes of General Electric (GE ), Volkswagen (VLKAY ), and Allied Irish Bank (AIB ) bought privatized assets, built up strategic stakes in local companies, or set up new factories. "For the German economy and the euro economy, enlargement will bring a boost," says Heinrich von Pierer, CEO of Germany's Siemens (SI ). The result has been economic growth in the East of 4% to 5% a year, on average, since 1995, far higher than the 2% achieved in Western Europe. Labor productivity, though low, is increasing fast. Economists predict it will grow by more than 7% this year in Latvia, and 4.5% in Poland.

Trade with the EU now accounts for more than 60% of the GDP of each future member. Western companies, such as Siemens and French yogurt king Danone (DA ), have integrated their Eastern subsidiaries into global international supply chains. Sleep in a Berlin hotel, and the odds are the bed linen will be laundered in Poland. Eat in a Vienna restaurant, and many of the waiting staff will be commuters from Slovakia.

As a result, the candidate countries' economies have started to converge with the EU's. But it's a slow process. One indicator produced by Deutsche Bank (DB ) measures convergence based on GDP growth, productivity, and a range of other economic factors. It will take Slovenia, the most developed country, up to a decade to catch up with the EU average. The economic gap between most of the candidate countries and the EU average is far bigger than it was for previous newcomers. The problem is most acute for Poland, the largest country in the region, with a population of 38.8 million. After years of banner growth, Poland has slowed to a virtual standstill. Unemployment is 17%. "It could be 40 years before Poland reaches average EU living standards," predicts Willem H. Buiter, chief economist of the European Bank for Reconstruction & Development (EBRD) in London.

One problem is that the new members can expect far smaller handouts from Brussels than the likes of Spain and Ireland received. With Western economies slowing, existing EU members aren't in much of a mood to be generous. Sure, Western farmers will get their EU subsidies--but they'll only get 25% of the EU level in 2004, and won't reach parity until 2013. By that time, subsidies in the West will have been cut by some 20% in real terms. Other grants will be capped at 4% of a candidate country's GDP, compared with 8% for previous new members. European Commission officials say that at this stage of their development, the newcomers aren't capable of absorbing more than that. Maybe. But their economies will doubtless be held back for want of money. And the discrepancies in payments are generating backlash in some countries such as Poland, where radical farm leader Andrzej Lepper is building a big following.

To be sure, many Eastern businesses will be given a new lease on life when the final trade barriers separating them from Western markets finally come down. One company confident of selling more is Kovinoplastika, a Slovenian manufacturer of sheet metal tool sets, hot-chamber casting machines, and cad-cam equipment. Its production costs are 10% to 15% below those of competitors in Germany or Austria. Managing Director Marjan Vampelj already has new distributors in the West. But selling to the existing EU will be even easier after 2006, when the first new members can start converting to the euro. Another company poised to do well is Media Menu, an Estonian information-technology company focusing on Internet-based solutions. Owned by Swedish and Norwegian investors, it can undercut prices of its EU competitors because labor costs in Estonia are one-sixth those in Finland.

But for every Eastern European winner, there could be a loser. Western manufacturers may have higher costs. But they also tend to have productivity levels twice as high as they are in the East, as well as savvier distribution skills. Many have already made inroads in Eastern markets and will doubtless increase their sales efforts after expansion. "We could be crushed by them," says Philips Gunnars, who runs a small meat processor on the outskirts of Riga.

The EU newcomers must attract a new wave of foreign direct investment to remain competitive. "Large-scale foreign investment acts as a catalyst for the creation of small and medium-size enterprises," points out Alain Pilloux, business group director for Central Europe at the EBRD in London. "That's vital because these countries need to develop a tier of mid-size business." Since Volkswagen acquired Czech car manufacturer Skoda in 1991, for example, a few local suppliers that made the grade gained a great deal of new business.

In theory, joining the EU should make countries even more attractive for investors, because it confirms them as stable democracies and functioning market economies with attractive costs. Von Pierer of Siemens, which employs 12,000 people in the Czech Republic, 6,000 in Slovakia, and 5,000 in Hungary, notes that the overall cost of employing a Czech worker is just a third the cost of a German. But whether the candidate countries can continue sucking in investment on the scale they need to plug yawning current account deficits--Latvia's will top 8% this year--and still fuel growth is an open question. Even privatization is not the gold mine it once was. "Most of the good assets have been sold," says the EBRD's Pilloux.

Workers in the East will not simply sit on their hands while these issues are resolved. Although free movement of labor between new and existing member states won't be allowed until 2007 at the earliest, there has already been an influx of cheap Eastern labor to the EU. That partly explains the rise of anti-immigrant sentiment in countries such as Austria. But it is helping to hold wages down in some hard-pressed industries like construction, and relieve skills shortages in others such as high tech. "Most of the workers here are Poles," says the manager of a building site in Frankfurt. "They work harder, and they cost less." Get on the No. 11 tram in Frankfurt's Gallus district, for example, and most of the passengers will be speaking an East European language.

The entrepreneurial zeal of workers is often matched by the liberalizing drive of governments. The Eastern newcomers have embraced deregulation, which is more than can be said for Germany and France. Poland's bank system, for example, is profitable, efficient, and almost wholly privatized. Germany's is burdened with rising bad debts, high costs, and the presence of large, state-owned banks that distort competition. "The hope is that the newcomers will act as a catalyst and spur reform," says the EBRD's Buiter.

Yet the opposite may happen. Talk with Swedish entrepreneur Arne Ostlin, who runs Ostlins, a fish smokehouse, with his family in Stugsund, a small village three hours north of Stockholm. He recalls that when Sweden joined the EU in 1995, Swedish food businesses had to be approved anew by Brussels. "'I already filled out all these forms here, then I had to fill them out again. If I do all of this, I won't have time for business," he says.

The problems, complaints, and fears are sure to mount as the deadline for expansion approaches. But the mandarins of Brussels are committed: They take the long view, and count the political gains of union as already won. Others must still struggle to win in the new Europe. Jerzy Bis, a 39-year-old Polish miner, spends his days pounding the pavement in Kracow, looking for any work. "What we need is more investment to get the economy moving," he says. "Joining the EU might give us that." Will the EU deliver that job to Bis and other hapless workers? Can Europe ultimately afford the great experiment? Those remain the final, essential questions.

Read a Letter to the Editor about this story.

By David Fairlamb in Brussels, with John Rossant in Paris and bureau reports

— With assistance by John Rossant

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