European Affairs

Fall 2004

 

European Economic Reform
EU Governments Should Be the Agents of Change
By Martin Neil Baily and Jacob Funk Kirkegaard

 

The West European economy was one of the great postwar success stories, and today the enlarged European Union is the world's largest economic region with ever more countries knocking at its door. Yet as the affluent European economies have entered the 21st century, it has become clear that serious challenges lie ahead. EU leaders acknowledged this in adopting their combative Lisbon Agenda for reform in 2000, calling for a "radical transformation of the European economy" to make the region the "the most competitive and dynamic knowledge-based economy in the world by 2010." This vision entailed millions of Europeans finding more and better jobs, European industries leading the way in innovation and the diffusion of new technologies, and growth rates reaching a level that would double the size of the European economy in just 24 years.

Now, nearly at the halfway mark of Europe's planned economic transformation, it is time to take stock, to examine what needed to be done and why, what has been done, whether the right things have been done and what remains to be done. This task is complicated by at least two factors. The first is the comprehensive nature of the reforms needed and so far carried out, covering product markets, labor markets, welfare systems, healthcare, pensions, information technology and the macroeconomic framework. The second is the heterogeneous character of Europe. In some countries, reformed labor markets are yielding employment ratios and unemployment rates comparable to the United States, and well-regulated industries exhibit world-beating productivity. Other countries suffer chronic double-digit unemployment rates and constantly require government bailouts of failing industries. For a true picture of Europe's situation to emerge, all these different aspects must be brought together, not least so that decision-makers in need of inspiration may learn from the successes of other Europeans.

Against this background, it is worth asking where the best agents of European economic transformation are to be found. Our emphasis on European divergence leads us to stress the prime role of the EU member states, leaving the supranational institutions responsible only for particular elements of reforms. Many of the necessary reforms involve deep structural changes in social and labor institutions that are so important to the daily lives of the citizens that they can only be undertaken by elected leaders with strong direct popular mandates. Such mandates are not generally enjoyed by the Brussels institutions - nor even, unfortunately, by some member governments.

Comprehensive reforms of the European economies are needed for several compelling reasons: Productivity: European productivity growth soared until 1973 as it neared U.S. levels, and then declined with the rest of the world following the first oil crisis. Since 1995, however, productivity growth has slumped to between one percent and two percent a year in Europe's larger economies, while it has significantly accelerated in the United States and other countries. It is crucial that the main European economies undertake reforms to match the increases in productivity achieved in the United States. New global developments: Innovations today are increasingly spread throughout the world and European companies must be able to restructure in a flexible environment to take full advantage of new best practices if they are to remain competitive. With India, China and especially the new EU members in Central and Eastern Europe emerging as production platforms for both goods and services, the dynamics of global and intra-European competition have altered. New industries and companies must be allowed to emerge, even as old companies close and jobs are lost. Continued growth in Europe will require changes in the nature and number of jobs people have during their working lives, in the places where they live, and in their skills.

"In some countries, reformed labor markets are yielding employment ratios and unemployment rates comparable to the United States"

Labor Utilization: Far too few Europeans work, and far too many work very short hours. Countries like France and Italy have suffered very high unemployment rates for decades, even though as few as 60 percent or more of their people of working age are employed. The Lisbon Agenda has a target of 70 percent of the working population in employment by 2010, which will require the creation of more than 3 million jobs a year in the 15 countries that comprised the European Union before its enlargement in May 2004. Since 1992, however, Europe has experienced such rapid growth in employment only at the peak of the Internet boom in 2000. The only way to create a truly cohesive and inclusive Europe - with much lower unemployment and plentiful real jobs - is to overhaul the way most European labor markets function. Work Incentives: Most European workers pay very high taxes when they have jobs, and collect generous unemployment, disability, sickness or early retirement benefits when they do not. This system frequently undermines incentives to work more (or at all), especially for older workers aged 50 and above, to the detriment of society's productive capacity and the tax base. Similarly, employers who pay stiff social contributions to help finance this largesse are reluctant to create as many jobs as would otherwise be possible. There must be greater incentives for Europeans to work, or to work more, and for employers to create jobs.

"An un-restructured, and thus less productive industry will eventually wither, destroying not just some, but all its jobs"

Demographics: Like all rich countries, and many poor ones, Europe faces the challenge of a rapidly graying population and a decline in the labor force. In Europe, however, low employment rates, and a very young effective retirement age, are accentuating the problem. Unless dramatic reforms are enacted to increase employment, raise the retirement age and/or substantially cut pension levels, the ratio of employees to retirees will very quickly reach a manifestly unsustainable level. In Italy the ratio is projected to reach 1:1 by 2030. Europeans face a Catch-22 situation, in which a rise in pension contributions would lower work incentives, meaning that simply sustaining current pension levels and retirement ages will certainly overwhelm government finances. Such a financial crisis, however, would deal another blow to the pension prospects of future generations and thus lower work incentives even farther today.

Comprehensive reform is needed, and the good news is that history shows that concerted government action in Europe can succeed—well designed and thoroughly implemented reforms have raised productivity and employment in numerous European countries and industries. Another important European lesson is that while industrial restructuring may cause short-term job losses, in the long term it raises both employment and productivity—the two are not mutually exclusive. Indeed the opposite is the case. An un-restructured, and thus less productive industry will eventually wither, destroying not just some, but all its jobs.

Many European industries that were privatized, allowed to restructure or regulated in ways that increased competition have achieved very high levels of productivity growth. In 2000, for instance, the French and German mobile telephone industries had productivity levels twice those of the United States. Privatized power utilities in Britain and Germany rapidly improved their productivity, although sustained falls in prices for consumers were achieved only after a second round of reforms to facilitate competition. A largely privatized French auto industry also increased productivity and profitability to German levels during the 1990s and is today surpassing it, while the European single market intensified competition in product markets throughout the European Union and caused prices to begin to converge. It remains crucial, however, that the member states build on these successes by resisting continued state protection of local champions and overcoming efforts to obstruct the implementation and broadening of the internal market. Contrary to widespread hopes when the Lisbon Agenda was adopted, information technology has not proved to be a silver bullet ensuring faster productivity growth. It is, rather, an important enabler of innovation. Information technology can certainly help to enhance productivity, but the mechanisms by which it does so vary from industry to industry, and even from company to company. Successful applications must be tailored to individual requirements and companies must be allowed to restructure to take full advantage of the new opportunities offered. The best way to encourage companies to use more information technology is to increase competitive pressures and to allow significant industry consolidation, as larger companies can more easily invest in information technology and reap benefits of scale from its use.

Not all European countries have high unemployment and low employment rates. The Netherlands, Sweden and Denmark all have levels comparable to the United States, after reforming their labor markets in the 1980s and 1990s. All three cut the level and/or duration of unemployment benefits and took other measures to improve labor market flexibility, for example by encouraging part-time jobs. They also increased the number of training programs and made participation in them compulsory under certain conditions. The three countries by no means dismantled their welfare states, but instead realigned work incentives to create truly inclusive societies, with employment for everybody who wanted to work. Significantly, in each of the three countries, all social partners engaged constructively in carrying out the measures, thus highlighting the fallacy that reform proposals in Europe must necessarily trigger a political clash between left and right. Instead, the cleavage in Europe is between countries that embrace reforms wholeheartedly, like the three mentioned, and those that do not.

"The cleavage in Europe is between countries that embrace reforms wholeheartedly and those that do not"

All the same, the Dutch, Swedish and Danish success stories must be subject to an instructive caveat. None of the three countries got their policies quite right, and their continuing problems show the need for comprehensive reforms of social systems, rather than piecemeal measures. In all three countries, very large numbers of people continue to draw permanent disability and sickness benefits, indicating the risk of "leakage" from social areas where more incentives to work have been created (unemployment benefits) to areas that remain geared to passive hand-outs (disability and sickness benefits). If the unemployed do not find work but are simply transferred to other social benefits, declining unemployment rates provide false comfort for policy makers. In addition, some types of reforms, such as Denmark's "tough love" focus on compulsory training for the unemployed, can quickly become very costly for a government. Although these European successes (or partial successes) are encouraging, further reform efforts are needed that aim at increasing flexibility, incentives and competition. In order to achieve those objectives, a number of more specific reforms will also be required:

"Generally speaking, economic reforms in Europe must aim at increasing flexibility, incentives and competition"

Land-Use Reform: This frequently overlooked reform is crucial, as new companies and establishments are key sources of productivity and employment growth. These will not be created if land is too expensive or not available at all. It is a major challenge for Europe to preserve its environmental quality while facilitating greater economic development. This will require changing the incentives faced by local planners, so that they see the economic gains of growth.

Labor Market Flexibility: Contrary to what many believe, Europe has no shortage of entrepreneurs. As many new companies are started in Europe as in the United States. The difference is that in Europe they do not hire staff and grow. It is imperative that the legal and financial barriers to business expansion and restructuring that discourage hiring and prevent layoffs be sharply reduced.

Instead, companies must be required to make reasonable and predictable separation severance and redundancy payments to workers. Regulatory Reform, Competitive Pressure and Privatization: Many types of regulation hamper competition and business growth. Instead, all regulations should encourage competition as far as possible. Protected state-owned companies and local champions must face full market pressure under the aegis of powerful national competition authorities. EU institutions must play a crucial role in deepening the internal market, particularly with regard to services and financial markets.

Social Welfare: Social programs must be reformed, building on the lessons from countries such as Denmark and Sweden. Such programs must provide assistance to the poor and unemployed, but predominantly by helping them find jobs. Social programs must never become parking lots for healthy, but inactive citizens; instead they must ensure that it is always worthwhile to work.

Work Creation Incentives: Employers must be given improved economic incentives to hire more people, as well as to make their staffs perform better. A wage structure that is too compressed will prevent this, and in many European countries the pre-tax wage distribution must widen. Currently in Europe there is a huge tax wedge—the cost to the employer of hiring someone is much larger than the amount received by the worker in take-home pay. Social policy reforms can reduce that wedge and this would allow companies to pay less in wages and payroll taxes (lower pre-tax wage costs), even though employees would receive close to the same amount in their pay checks. Employers then have a greater incentive to hire, while social benefits like unemployment insurance are reduced (or made conditional on finding a job within a short time), giving workers a greater incentive to work.

The Macroeconomic Framework: Balancing budgets in the short-term must never interfere with establishing the right work incentives and creating jobs. The EU Stability and Growth Pact is a necessary evil, forced upon European governments today by their own past profligacy. Adherence to it, however, should take full account of long run sustainability of debt levels—meaning that governments must be able not only to service their debt now, but also to avoid trouble in the future, particularly as demographic changes occur. Effective automatic stabilizers must also be allowed to work in cyclical downturns. Similarly, now that the European Central Bank is well established, it should acknowledge that its inflation ceiling of "close to, but less than two percent" is too low to allow for differences in economic performance among the euro economies, while ensuring economic growth.

How have European states fared during the first half of the Lisbon Agenda, when set against this case for reform? Progress has been made in increasing work incentives, for instance as a result of the Agenda 2010 reform plan in Germany and payroll tax cuts in France. Incremental reforms of pension systems have begun in Germany, France and Italy, and most EU countries have had some success in reining in healthcare costs—particularly in comparison to the United States. The European Commission is gradually implementing the single internal market, often over the loud protests of national governments. So progress is being made and needs to be expanded. A major worry, on the other hand, is the lack of reforms to increase the flexibility of land use and labor markets. The need to remedy these sore spots has been made even more urgent by the onslaught of outsourcing production and jobs to other countries, which dramatically raises the costs of inaction on matters of flexibility. In other words,much progress has been achieved, but Europe must step up the pace, as the road remains long and will often be uphill.

Martin Baily is a senior fellow at the Institute for International Economics (IIE) in Washington. He was chairman of the Council of Economic Advisers under President Bill Clinton from 1999 to 2001.

Jacob Kirkegaard is a research associate at the IIE. They are the authors of Transforming the European Economy, a book published by the IIE in September 2004. It can be ordered from www.iie.com or, by telephone, from +1 800-522-9139.