This graph shows that after the second world war, the income of the average Europeans has gotten closer and closer to that of the average American, in Dollar terms. However, after the crisis of 2008, that picture has changed, as European incomes stagnated, while that of Americans continued to rise. This has led to alarming reports by financial media that Europeans are getting poorer, and Americans richer. And, while some of that can be explained by Europeans working less, a new report by, arguably Europe’s most famous economist, Mario Draghi, claims that the main problem is that Europeans have become 20% less productive compared to Americans. This economic stagnation is a major threat to Europe’s prosperity because it will prevent European governments from making much needed investments to deal with a rapidly ageing population and increased outside threats.
However, as a European economist, who acknowledges that this chart is very real, I still had a nagging suspicion that a crucial piece of the puzzle was missing because whenever I make videos about western economies, it’s usually Americans complaining about the state of their economy, not Europeans. Of course, me just looking at my comments is hardly scientific.
But, when I inspected typical quality of life statistics, such as the human development index, life expectancy at birth, and self-reported happiness, which normally correlate consistently with GDP per person, this supposed massive impoverishment of Europeans does not show up at all.
This really got me wondering. What is going on? Did Europeans find the secret to having a good life without money?
No. The problem is that using this specific measure of GDP, that almost everyone uses, is very misleading, at least when it comes to comparing how rich Europeans are compared to Americans.
To understand why, let’s do a quick review of
How economists compare economies.
While economists have long been looking for an alternative, as of today, gross domestic product, or GDP for short, is still considered the best metric to compare how well off people in different countries are. In essence, GDP measures the monetary value of all final goods and services produced in a country in a year.
Now, while that misses a lot of economic activity, GDP actually tends to correlate really well with all sorts of different quality of life metrics.
But, while, for example life expectancy in terms of years lived can be easily compared between two countries, GDP cannot because countries often use a different unit of account for GDP. That is the value of British goods & services is measured in pounds, while the Europeans mostly use Euros and Americans Dollars.
Of course, the easiest way to compare economies that use different currencies is to just use today’s exchange rate to, for example convert Europe’s Euro GDP to Europe’s Dollar GDP. Indeed, this is exactly how this graph was produced by economists at the World Bank.
And, just to be clear, there is nothing wrong with that. In fact, when I compare economies on this channel, I most often use the GDP in Dollar terms metric simply because the US Dollar is the world currency. So, if your GDP drops in terms of US Dollars, your citizens have genuinely become poorer from a global perspective. That is, they can now buy less stuff on international markets. So, if, for example, we want to compare the international power of two small open economies that trade a lot with each other in different currencies, Dollar term GDP is in my opinion the best metric that we have.
However, GDP measured in US Dollars is less useful if we want to compare American incomes to those in Europe. You see, in such large economic blocks, only a small fraction of goods & services are actually traded across borders. For example, in the US, total imports were just 15% of GDP in 2022. On top of that, for many goods & services transportation costs are so high that it is extremely difficult to trade them across borders, even if such products or services would be much cheaper in a neighboring county. For example, if I go to the local hairdresser here in Belgium, I pay 15 euros to get, this haircut…
And it is worth every penny
Which is good because while I live fairly close to the Dutch border, travel cost to the nearest Dutch hair salon are way more than 15 euros, especially if I take into consideration travel time. This is why economist often use getting a haircut as an example of a non-trade-able good or service, where transportation costs are so high that international trade doesn’t make sense. As you can imagine, the bigger a country or region is, the fewer goods and services will be trade-able as it gets more and more expensive to travel to another country for an alternative. Specifically, economists have estimated that non-trade-able goods & services could be as low as 22% for a big country like the United States.
In other words, while it may be simplest to use today’s Dollar - Euro exchange rate to judge how rich Europeans are compared to Americans, the vast majority of the GDP of both regions is not directly impacted by this exchange rate because it is measuring mostly non-tradeable goods & services.
This is why, instead, economists often use so-called Purchasing Power Parity (or PPP for short) exchange rates to compare the economies of big currency blocs like Europe and the United States. In essence, the purchasing power parity comparison of GDP looks at the prices of a representative basket of goods & services, that includes both tradeable and non-tradeable goods and services. So, PPP GDP compares the purchasing power that people actually have to buy most goods & services in their own country, rather than on international markets using the US Dollar.
Interestingly, if we use PPP GDP to compare European incomes to those of Americans we will see that
Europe is NOT falling behind where it really matters
Indeed, as you can see here, while the average EU and UK citizen’s share of PPP GDP is lower than that of the average American, who works longer hours, we do not see the same stagnation as we saw in the US Dollar GDP graph.
But, why?
Well, since the difference between US Dollar GDP and purchasing power parity GDP comes from how they account for both prices and the exchange rate, we would expect that either Europe’s inflation and-or exchange rate compared to the US could explain why Europeans have gotten poorer in US Dollar terms since 2008.
And, as you can see here, after the 2008 crisis, prices in the US have gone up considerably faster than in key European countries. However, as we can see here for the case of the Turkish Lira, a high inflation currency should lose value compared to a low inflation currency. So, given that inflation was consistently higher in the US than in Europe, we’d expect the Dollar to have to lost value compared to the Euro. However, if we look at this graph, we can see that, instead, the low inflation Euro has lost value to the high inflation Dollar. While in 2008 you could roughly get 1 Dollar and 50 cents for 1 Euro, today you can only get roughly 1 dollar and 12 cents for your single Euro.
So, while, this graph is correct, Europeans are poorer in Dollar terms, most Europeans have not really felt this because most of what they buy are so-called non-traded goods and services, which come from the continent itself, where they do not use US Dollars. This can explain why quality of life metrics that usually correlate with GDP, like the human development index, life expectancy and reported happiness in Europe are doing just fine, despite Dollar value to GDP stagnating massively since 2008.
But, then
Why are financial newspapers and politicians making such a fuss about Europe’s decline?
Well, I think it is mostly a matter of perspective.
If you work for an international company, as financial journalists do, you will genuinely feel poorer on your trips to the United States, or when comparing yourself to your American colleagues.
And, if, like Draghi, you are worried about Europe’s place is a world that is rapidly becoming more hostile, Dollar GDP also matters a lot. For example, Europe’s new LNG energy imports will have to be paid for in US Dollars.
Finally, the fact that the Dollar has remained so strong despite higher inflation could be a reflection of fundamental U.S. strengths compared to Europe such as its cheaper energy, younger population, and better business environment for the companies of the future.
So, yes, people are right to worry about Europe’s diminished economic strength on the world stage. However, with this video, I’ve hoped to have convinced you that, despite a popular narrative, Europeans have NOT gotten poorer than Americans where it really matters, the purchasing power of its people.
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