The Failure Of Regional Policy In Europe

Regional policy has been surprisingly unsuccessful in promoting the take-off of backward regions across Europe. Indeed, according to Dr Klaus Desmet, writing in the latest issue of the Economic Journal, regional policy has not only been misguided, it has actually contributed to perpetuating the dismal situation in places like southern Italy and post-reunification eastern Germany.

Creating government jobs or setting wages equal to the national level is not doing any good, Desmet concludes. Though such policies undoubtedly raise income, they do not improve productivity. As a result, the competitiveness of these backward regions suffers, making them less attractive for new i nvestment, and reducing their chance to take off and catch up with the successful regions of the national economy.

In southern Italy, years of large-scale public intervention have done little to improve the region''s bleak prospects. In fact, since the beginning of the 1970s, when its income per capita stood at around 65% of northern Italy, things have only become worse. Since reunification, eastern Germany has been heading the same way, and is already being referred to as the Mezzogiorno on the Elbe.

Regional income differentials are large on both sides of the Atlantic: in 1998, per capita income in Massachusetts was 79% higher than in Mississippi; in Spain, Catalonia had an advantage of 80% over Extremadura; and in the UK, the South East was ahead by nearly 30% compared to Wales.

Worried about internal cohesion, national governments have been actively trying to reduce such income gaps in a variety of ways: creating public employment, subsidising investment and infrastructure, and providing unemployment benefits are just some examples. To see how seriously countries take their regional policies, the Canadian federal constitution explicitly mentions ''equalisation transfers'' between provinces. Unfortunately, governments often forget the virtue of having low wages: it may contain the key to future development. When northern Belgium overtook southern Belgium in the 1960s, this was because 10 years earlier new industries had found it profitable to locate to the low-cost rural North.

Similarly, when the US tyre industry migrated from Akron (Ohio) to the South, they had been attracted by lower wages. In fact, many other Midwestern suppliers of the automobile industry have since followed the same route to the South. The implication is that when regional policy is intent on improving the fate of lagging regions, it should make sure not to undermine their cost advantage. Unfortunately, this simple rule is often violated. For example, unemployment benefits, which go disproportionately to backward regions, reduce the number of people willing to work. This pushes up wages, making those regions less competitive.

Something similar occurs with public employment. By creating government jobs in backward regions, wages in the private sector tend to increase, undermining the attractiveness of those regions. The bottom line is straightforward: if wages grow faster than productivity, a region''s competitiveness goes down.

In the case of Italy, the Mezzogiorno enjoyed a period of rapid catch-up during the 1960s. This process came to a halt in the beginning of the 1970s, when the emphasis of public policy shifted from investment incentives to more direct income support. Alberto Alesina of Harvard University reckons that nowadays about half of the public wage bill in southern Italy should be viewed as a subsidy.

The case of eastern Germany is not much different. When trade unions set eastern wages equal to western wages, unsurprisingly, productivity failed to follow suit. Instead of attracting investment, the East created rampant unemployment, and not much came from the heralded convergence in living standards.

Of course, this does not imply that all government programmes should be scrapped. For example, the European Union''s structural funds, which are used to subsidise infrastructure and human capital in backward regions, do not suffer from the same flaws. Though their effectiveness is subject to debate, such funds improve productivity, and should therefore make regions more attractive as investment locations.

''A Simple Dynamic Model of Uneven Development and Overtaking'' by Klaus Desmet is published in the October 2002 issue of the Economic Journal. Desmet is at Universidad Carlos III de Madrid and a Research Affiliate of the Centre for Economic Policy Research (CEPR).