Europe’s Economic Decline Debate
In the quote-unquote discourse, it’s generally taken for granted that Europe is in economic decline. It’s not hard to find unflattering charts comparing European and American economic performance, and American politicians occasionally chide their European counterparts for failing to keep up. The US ambassador to the EU, for instance, caused a bit of a furore last year when, in trying to defend Trump’s comments about European leaders being weak, he claimed that Germany had a lower GDP per capita than West Virginia, and that the EU had a lower GDP per capita than Mississippi, the poorest state in the US, but, this isn’t just some transatlantic prejudice.
European policymakers spend much of their time fretting about Europe’s alleged stagnation, and European Commission policy is very much inspired by the famous Draghi report at the moment, which painted a picture of a continent with lagging productivity and a structural over-reliance on legacy industries. However, a recent piece by Nobel Prize-winning economist Paul Krugman, in which he claimed that Europe has actually kept pace with the US, has provoked some debate among economists as to whether this widely held assumption is really true.
Measurement of GDP, Exchange Rate, and the PPP
So, to understand Krugman’s argument, we need to understand how we usually compare GDP. In short, we usually compare the GDP of different countries by converting everything into US dollars, which is sort of the world’s default currency. So, to compare the GDP of the European Union to that of the US, we take the EU’s GDP, which would originally be measured in euros, and then convert it into US dollars by multiplying it by the euro-to-dollar exchange rate. On this basis, the EU doesn’t look like it’s doing that great. According to World Bank data, for instance, the EU’s GDP per capita has always been a bit lower than the US’s, but since 2010, that gap has been widening dramatically.
However, some people, including Krugman, don’t like this way of measuring GDP for two main reasons. First, exchange rates can be affected by weird things like currency speculation, lower interest rates, and capital flows. The US dollar, for instance, is stronger than normal trade patterns would predict because it’s the world’s so-called reserve currency, i.e., the currency that central banks and other financial institutions like to hold in reserve. This creates additional demand for dollars, which pushes them up against other currencies, and can thus flatter the US in international comparisons. This is one of the big reasons for that widening gap after 2010. The euro fell against the dollar after the 2008 crisis, both because the crisis provoked a flight to supposedly safe assets like the US dollar and because the eurozone crisis raised questions about the structural sustainability of the euro. Second, and relatedly, this measure doesn’t necessarily tell you that much about the actual quality of life in that country.
When the euro fell against the dollar after 2008, for instance, this didn’t suddenly mean that Europeans’ quality of life deteriorated. This is why some economists, again including Krugman, prefer to use something called purchasing power parity, often abbreviated to PPP, which basically tries to figure out how much people can actually buy in a country. The way this works in practice is that the World Bank creates a so-called basket of goods that represents what your average household would buy.
Stuff like food, housing, transport, healthcare, clothing, education, and so on. The World Bank then effectively goes to each country, figures out how much the basket costs there, and then uses that to essentially create a new exchange rate. So, let’s say that the basket costs $1,000 in the US and €1,000 in the EU. This gives you an exchange rate of one to one because on a PPP basis, a euro goes as far in the EU as a dollar goes in the US.
On this basis, things look a lot better for the EU. According to World Bank data, on a PPP-adjusted basis, the gap between the EU and US GDP per capita has stayed relatively constant for the past 30 years. In fact, in percentage terms, the EU has actually closed the gap, going from about 60% of the PPP-adjusted GDP of the US in 2000 to more like 75% today.
Current Price vs Constant Price Metrics
However, there are actually two ways to do PPP. The first is to measure the cost of this basket each year and then create a new exchange rate each year. Importantly, the contents of this basket will change over time because what households consume obviously changes over time as well.
The average household, for instance, spends a lot more on software and a lot less on food than they did 20 years ago. This is what’s known as the current price metric, and this is the metric we just used to come up with that flattering chart showing the EU keeping pace with the US. However, some economists don’t like this metric.
because it basically punishes countries for making things cheaper. For instance, imagine that between 2021 and today, the US doubled its production of software, but because software production has become more efficient, the price of software drops by 50%. On a current price basis, this makes no difference to US GDP, even though the US is clearly producing twice as much stuff. To remedy this, some economists prefer to basically pick one specific basket from one particular year and then use that as an anchor or reference point. This is known as the constant price metric.
Going back to the software example, under this metric, a doubling in software output would indeed show up as an increase in GDP, because the price of software would be fixed to what it was in 2021. On this metric, Europe once again looks like it’s lagging. According to World Bank data, which does in fact use 2021 as the reference point, Europe has failed to meaningfully close the gap with the US. In fact, in percentage terms, the gap has actually widened, going from about 77% of the US in 2011 to 72% today. Nor can this decline be explained by differences in working hours. While it’s true that Americans work more hours than Europeans, and this might explain some of the gap in absolute terms, working hours have actually converged in recent years, while the percentage gap has apparently widened. So, that’s the broad outline of this dispute. We don’t really think there’s a right or wrong answer here as to which metric is best.
They all have their pros and cons, but the headline takeaway seems to be that, frustratingly, there is no single metric that can tell you how rich or poor a country or continent is. Ultimately, both the European and American economies have their own pros and cons, and both are incredibly rich by international or historical standards.
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The views and opinions expressed in this article/paper are the author’s own and do not necessarily reflect the editorial position of Paradigm Shift.
Muhammad Haseeb Sulehria is a student of Defense and Strategic Studies at Quaid-i-Azam University, and a former internee at Pakistan’s Ministry of Defense. With a keen interest in national and international affairs, he actively explores issues of security, strategy, and global politics, aspiring to contribute to policymaking and peacebuilding.
