In the last decade, after several decades of strong economic convergence, economic performances throughout Europe started to diverge. The divergence in productivity growth between Europe’s Northern and Southern economies is at the heart of the imbalances that built up within the eurozone. (See Figure 1 below).

As a consequence, in order to truly exit from the current crisis, Europe needs to re-launch what we call the “Convergence Machine.”

What drives productivity differences in Europe? The productivity divergence between Europe’s North and South can be explained by underlying structural differences.

In the South, firms with less than ten employees account for around one-third of value added. In the rest of Europe, it is one-fifth. These are firms that struggle to access international markets, know-how and capital.

Figure 1: Labor productivity growth

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The next factor to be considered is EU enlargement. When it happened, investment shifted to Eastern Europe. Prior to the expansion, back in 1995, foreign direct investment in Europe’s East and South were about the same — about $14 billion each.

By 2008, the South was receiving considerably more — about $100 billion. But the East received $175 billion — or 75% more than the South. Banking flows within the eurozone covered up these growing imbalances, but led to a pattern of growth in the South that was increasingly reliant on domestic demand.

What lies behind diverging economic structures are significant differences in the cost of doing business. The Scandinavian countries and Germany all ranked in the top 20 in the World Bank’s Doing Business indicators in 2012.

Southern Europe’s strongest performer was Portugal, ranked 30th. Moreover, since the early 2000s, economies in Central and Eastern Europe have improved their ranking in the World Bank’s Doing Business indicators while improvements in Southern Europe have been more limited until very recently (Figure 2).

Figure 2: Quality of regulations

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This finding underscores that structural reforms to improve the business climate in the South are key to economic rebalancing in Europe. When the costs of doing business are prohibitive, new investment may take a long time to materialize.

In addition, when labor markets are rigid, rising unemployment as a result of macroeconomic rebalancing may not push wages down sufficiently fast to allow new jobs to be created.

Rates of youth unemployment in excess of 30% are indicative of labor market policies that protect jobs holders rather than facilitating the reallocation of workers from declining to growing sectors.

That is something that is entirely within the remit of individual countries. It is a policy choice which they have made — and which only they, not Brussels or any outsider — can correct.

Granted, none of the arguments presented above are new. But it is crucial to call them back to mind, for these basic economic facts of life seem to have been overshadowed by the debate over the appropriate dose of fiscal austerity.

Many skeptics argue that structural reforms may operate with such a lag that the patient may be dead before the medicine has had a chance to work. This skepticism is unfounded.

The Baltic States — Estonia, Latvia and Lithuania — are good examples from within Europe that demonstrate the benefits of a flexible economy for post-crisis recovery.

All three economies were buffeted in the global economic downturn in 2008-09 as capital flows suddenly stopped with pre-crisis current account deficits as a share of GDP in double-digit territory.

Their GDP fell by over 7% during 2009-10, but has since started to recover, with growth of 6.3% in 2011 and a projected 2.9% in 2012 (Figure 3). Similarly, Ireland, which saw its GDP decline by 3.9% in 2009-10, is projected to stop the fall in output this year.

Figure 3: Real GDP growth

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By contrast, Greece has seen GDP declines in every year since 2009, with cumulative losses of more than 20% since the onset of the crisis.

Ireland is now ranked 15th and all three Baltic States are ranked in the top 30 on the World Bank’s Doing Business index. Greece ranked 78th in 2012, after making significant strides forward this past year.

Clearly, other factors matter as well. The size of the tradable goods sector in the economy determines the extent to which a turnaround in net exports contributes to a recovery of GDP. In the Baltic countries, foreign trade averaged 153% of GDP in 2011. In Ireland, it was almost 190%, whereas in Greece it was just 56%.

Policymakers should not allow the debate over growth versus austerity to draw their attention away from the fundamental importance of improving the business climate and making labor markets more flexible to ignite growth in Europe’s South.

The good news is that progress is being made on this front as Greece’s and Italy’s advance in the Doing Business ranking this year attests. It needs to be sustained.

Europe’s Northern and Central economies could also contribute to relaunch Europe’s Convergence Machine. Significant growth impulses could come from deepening the Single Market for Services and removing administrative barriers on services that are prevalent in many of Europe’s core economies.

And the countries can help with financing for infrastructure investments that would support economic integration, such as in transport and energy.

In the past, Europe’s Convergence Machine worked quite magnificently. It has brought 100 million people in the South and another 100 million people in the East from low to high income. With the right structural reforms, this powerful machine can be restarted for the benefits of current and potential future EU members.

The first two graphs in this feature are adapted from Golden Growth: Restoring the Lustre of the European Economic Model by Indermit S. Gill and Martin Raiser (World Bank Press, 2012). The third is based on World Bank staff calculations on data from the ECA Regional Database