European Affairs
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Fall 2004
By Martin Neil Baily and Jacob Funk Kirkegaard
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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 ø 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 ø 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
wedgeøthe 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 ø 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 ¬C 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 (above left), 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 (right), 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.
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