The accession of 10 new member states to the European Union has cast a spotlight on the astonishing difference in relative wage levels between the countries east of the old Iron Curtain and those in the West. In the 1930s there was little difference in average wages between, say, the Czech Republic and its close neighbour Austria. Half a century of Communism, on top of a devastating war, has reduced average wages in the East to less than a fifth of those in the West.
The gap in real living standards is not as large as this because the other side of low wages is cheap services. Any task with a high labour content - cutting hair or cooking a meal - is much cheaper in the East than in the West. According to the OECD, price levels in Hungary, Poland and the Czech Republic are only half those in a prosperous western European country such as France. In Slovakia they are only a third. With earnings at around a quarter of Western levels, and prices at half Western levels, real living standards in the new accession countries are about half as high as in the West.
These very large differences between countries that are geographically close, and now in the same trading bloc, are bound to stimulate large movements of both labour and capital. Should we expect a flood of economic migrants? In theory yes, since many will want to leave the East to quadruple their earnings. But in the real world labour is never as mobile as in our economic models. It is hard to leave family and friends and go to a foreign country, especially if it does not speak your language and those whose jobs you threaten are less than welcoming.
Capital, on the other hand, is highly mobile. Capital doesn't have family or friends. Capital can buy interpreters to deal with the language problem. And capital, far from getting a hostile reception, will be welcomed with open arms in countries that have serious shortages of up-to-date plant and equipment. So rather than have cheap labour come from eastern Europe to the West, it makes a lot of sense for firms in western Europe to deploy their capital in the East.
There is no shortage of functions and processes in any manufacturing value chain that can be transported lock, stock and barrel to the East. A plant in eastern Europe need be no more than a day's drive away. The additional transport costs are small relative to the potential savings in wages.
Outsourcing is profitable today because the wage gap is large. But for how long will the wage gap persist? The answer is that it will take at least a generation. Consider the case of Ireland, whose living standards were also only half those in France when the country joined the European Economic Community in 1973. Ireland has been an astonishing success story since the mid-1980s, posting 7 per cent growth rates, yet its GDP per capita overtook that of France only in 1998. Greece, by contrast, joined the EU in 1986, but its living standards are no closer to the EU average now than then.
So any firm thinking of outsourcing to eastern Europe will almost certainly see the wage gap narrow as those countries catch up with us. But even if they match the Celtic Tiger, the catch-up process will take a quarter of a century. Outsourcing in eastern Europe is a durable profit opportunity.
Bill Robinson is director of economics at PricewaterhouseCoopersReuse content