TCS Daily

Sick Man Is Europe

By Hans H.J. Labohm - April 24, 2003 12:00 AM

Despite a lot of rhetoric to the contrary Europe has not ceased to labour under persistent Eurosclerosis. Back in the seventies, it was the Swedish economist Assar Lindbeck, who coined the notion 'socioeconomic arteriosclerosis'. In the eighties, because of the fact that this phenomenon was more widespread in Europe than elsewhere in the developed world, the German economist Herbert Giersch gave it a European twist and came up with 'Eurosclerosis'.

This form of sclerosis refers to the growing ossification of national economic systems, which was first analysed by the American economist Mancur Olson. It is a form of old-age disease of long-term stable economies. It manifests itself in many forms of government intrusion into the economy, which have all in common that they encroach upon the proper functioning of markets. One example is the advent of special interest groups. The latter are acting as distributional coalitions, i.e. to receive special favours from the government in the form of protection, subsidies, monopolistic status, or other forms of barriers to exit and entry in a particular industry. If successful, their actions turn market participants into rent-seekers, thus stifling economic dynamism and growth.

The remedy is to improve the supply side of the economy, as opposed to the demand side, which was the main focus of Keynesianism. Supply side economics is aimed at unleashing market forces in order to foster structural adjustment, mobility, flexibility, dynamism and innovation. It includes, among other things, reduction of the power of vested interest groups, deregulation, reduction of the level of taxes, reduction of the 'wedge', and shifting the emphasis of economic policy from macro to micro. The overarching goal is getting the incentive structure right.

The European common market (subsequently the single European market) has fostered Europe-wide competition. In doing so it was applying the basic tenets of supply side economics and has indeed successfully reduced the power of many national interest groups. At the same time it has not been able to substantially constrain the power of the European-wide agricultural lobby. Additionally, the power of the national trade unions - perhaps the most important source of Eurosclerosis - has remained intact. As far as regulation is concerned deregulation effort of the eighties seems to have reversed gears and degenerated into something what looks like a new regulation frenzy. Tax reduction was inspired by the philosophy underlying the so-called Laffer Curve, named after the American economist Arthur Laffer. With his curve Laffer resuscitated the teachings of a great Arab sociologist and historian Ibn Khaldun (1332 - 1406), who was a kind of Adam Smith avant la lettre. He posed that, beyond a certain level, high tax rates would stifle economic activity, thus lowering total tax revenues for government, while lower tax rates would promote economic activity, with increased government revenues as a result. Although there has been some progress over the years in lowering the overall tax level in many European countries, this progress does not seem to be recession-proof these days.

As regards wedges, they are operating everywhere in the economy. Everybody understands that a 100% customs tariff is killing trade. Wedges have the same effect: they substantially reduce the number of transactions, thus damaging the Adam Smith's wealth-creating division of labour. Taxes and social security charges on wages offer a notorious example. They cause a big gap between total labour costs and take-home pay. In Europe the sum total of income tax and social security contributions typically ranges from 45% - 55% of total labour costs. Because of the combined effect of progressive taxes, social security contributions and means-tested subsidies (who are reduced or lost if someone moves from a lower to a higher income bracket) the marginal 'tax' rates (the 'tax' of an extra euro earned) of ordinary people may easily reach levels of 50% or far beyond - they may even exceed 100%! This is killing incentives.

What about the relationship between macro and micro? One of the basic thoughts of supply side economics is that rigidities at micro level will result in bad economic performance and instability at macro level, whereas flexibility and propensity to change on micro level, will increase economic performance and stability at macro level. Or to put it in other words: if you take care of the trees, the wood will take care of itself. But these insights are by and large ignored by current economic policy. The traditional beliefs in the effectiveness of some form of macroeconomic demand boosting die hard. The old Keynesian conditioned reflexes are popping up time and again. They manifest themselves in an attitude of overpermissiveness as regards budget deficits and the rise of public debt, thereby continuously shifting the day of reckoning to subsequent generations of tax payers, who are still in their childhood and who are, therefore, unable to protest on the grounds of 'no taxation without representation'.

In the mean time another spectre has emerged in the desolate landscape of an aborted supply side revolution, which may substantially reinforce existing Eurosclerosis. With almost masochistic delight Europe wants to inflict even more pain onto itself and impose a new layer of regulation on its citizens (some would even call it 'Stalinism via the backdoor') by endorsing 'Kyoto'. What is wrong with Kyoto? Well ... almost everything. Kyoto is a serious case of collective folly. Its underlying science is fatally flawed. It will cost hundreds of billions of euros per year and may cause massive lay-offs in energy-intensive industries. It will create a new and intrusive international bureaucracy. It will adversely affect Europe's worldwide competitiveness. It might lead to international trade conflicts between compliers and non-compliers. And what will be the benefits of all those sacrifices? According to a prominent spokesman of the Intergovernmental Panel on Climate Change (IPCC) Kyoto's (as amended in Marrakech) effect will be a cooling of 0.02 degrees Celsius in 2050, an amount too small to measure with standard thermometers. Why was the public not informed about the cost/benefit relationship of Kyoto? The conclusion is clear: Europe should reject Kyoto and should follow the American example, allowing more time for study.

But the immediate focus must be the reform of the sclerotic European labour markets. At the euphoric Lisbon ' summit', in March 2000, Europe expressed the ambition to become the most competitive and dynamic knowledge-based economy in the world in ten years time, capable of sustainable economic growth with more and better jobs and greater social cohesion ('capitalism with a human face'). The communique included many references to measures which were believed to be beneficial to job creation, such as completion of the internal market, infrastructure investment (including R&D), promotion of entrepreneurial activity, especially SMEs, macro-economic dialogue with social partners (the so-called Cologne process), investment in human capital (education and training to improve employability), public work programmes etc. What they had in common was that they had a high 'motherhood-and-apple-pie-content'. Nobody was against it - a sure sign that something was wrong with the approach.

Assar Lindbeck distinguishes between 'soft' and 'tough' labour market policies. The policies listed before belong to the soft options. Tough policy options include wage moderation, liberalisation of job-security legislation, less generous and more strictly administered unemployment and other welfare-state benefits, policy action that reduces the market power of insiders (those who already have a job as opposed to those who have not) and unions. Their application might reinstate the price of labour, or wage level, as a market clearing mechanism, thus reducing (structural) unemployment and social exclusion. Lindbeck concludes: 'A market economy cannot function well if one of the most important markets, that for labour, is not allowed to function simply as a market, rather than as a tightly regulated administrative system.'

More broadly, it is not only outside commentators who complain about the underperformance of the European economy, which contrasts starkly with the high-spirited ambitions of the Lisbon summit. Even the European Commission emphasis its shortcomings. In its recent spring assessment it recognises that there has been some progress, but it laments that its speed and breadth are insufficient to achieve the Lisbon goals for 2010. There has been no narrowing of the productivity gap between EU and US, neither in terms of labour productivity per hour worked, nor in terms of hours worked per worker. A significant portion of gap is due to the fewer number of hours worked per worker in the EU. The increase in industry financed R&D has been disappointing. Real unit labour costs are going up, while inflationary pressures have remained stubborn. Moreover, fiscal adjustment fatigue has become apparent, with the result that the steady decline of general government debt to GDP ratio since 1996 came to a halt.

The German economy offers perhaps the most notorious example of Eurosclerosis. However, even in Germany, which used to be Europe's economic powerhouse but is now generally considered to be the sick man of Europe, it is beginning to dawn upon policymakers that something is fundamentally wrong. Therefore, Chancellor Schröder has recently submitted a comprehensive package of labour market reforms, which even include some tough proposals à la Lindbeck. Is in uncertain whether his proposals may pass the Bundestag unscathed. But whatever the outcome will be, it is very likely to be too little and too late to turn Schröder's lost Chancellorship into something more worthwhile after all.

More generally, there is a political majority in Europe in favour of the welfare state. But people seem to be unaware of its high price tag, in terms of forgone economic prosperity, unemployment and social exclusion. It leads to a loss of economic incentives because of the narrowing of income differences, which are crucial in order to foster people's motivation to work, to save and to engage in risky entrepreneurial activity.

Europe's high structural unemployment is a man-made disaster and there is little sense of urgency to substantially reduce it. Measures which have been proposed so far are by and large politically uncontroversial. At the same time they are either ineffective or even counter-productive. Generous social safety nets are increasing the reservation wage of the unemployed (the minimum wage which a worker is prepared to accept), reducing incentives for active job search. High unemployment requires high social security contributions in order to finance unemployment benefits. These exercise upward pressure on labour costs, with job losses in their wake, sustaining a vicious circle.

Finally, it is often overlooked that economic dynamism implies a continual process of creation and (!) liquidation (Schumpeter's 'Neue Kombinationen', new combinations linked to creative destruction). High costs to lay off people are a disincentive to hire them, thus destroying employment, whereas high liquidation cost of enterprises act as a disincentive for high-risk start-ups, which may stifle innovation.

What should be the final conclusion of this all? It's the incentive structure, stupid!

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