Reinventing the European Model

Comments by Gilles Saint-Paul

For years European labor market institutions have been organized around a model consisting of three components: lifetime employment, a compressed distribution of wages, and a generous welfare state providing the unemployed and the elderly with a high level of insurance. In the sixties, this model was compatible with full employment because labor demand was boosted by the high growth rates generated by the needs for reconstruction and the catch-up with America. Thereafter, however, as growth slowed down, this set of institutions was increasingly perceived as a burden on job creation. On the other side of the Atlantic, free-market institutions were successful at maintaining unemployment at reasonable levels. In England, labor market reform made the economy more similar to the U.S., and there was a substantial benefit in terms of increased job creation. On the continent, attempts to reform the labor market were met with political opposition so that reform has only been partial and has led to a two-tier labor market were a core of protected workers coexist with a periphery of unprotected workers. The challenge of European societies at the dawn of monetary union is to reconcile the basic values of individual protection and insurance with economic incentives, so as to boost job creation. In the sixties there was no contradiction between the two objectives, as tight labor markets made labor rigidities less binding, and, despite existing restrictions on firing, allowed a high pace of job reallocation through voluntary quits. In the seventies and eighties, lower growth, increased openness, and changes in technology made the conflict apparent and created a growing class of workers excluded from the core of society. This was reinforced by the insider's initial reaction to the growth slowdown and the oil shock, which was to impose greater rigidities in order to protect their rents. Mobility and job creation fell, and the European model was increasingly perceived as a burden on employment and growth, and as a potential cause of social disruption. Up to now, however, reform attempts have been timid and only partially successful. Most importantly, and this may explain their failure, they focused on marginal amendments to the system, rather than trying to impose an alternative, consistent set of institutions. The key challenge faced by our economies today is therefore the following: how can we design an alternative socio-economic model which, while economically viable, maintains the basic philosophy of individual protection? One possible answer is shifting to the American model. In the U.S., competition provides a powerful force to eliminate disequilibria soon after they appear. The U.S. experience demonstrates that markets work well, in the sense that they quickly allocate resources to their best use. However, the U.S. experience has had undesirable developments, which may make the cost of overcoming the political opposition to scrapping rigidities greater its benefits. These are well known. Inequalities have soared, with the average wage stagnating and the bottom wage earners losing as much as 30 % of their income in fifteen years. While the unemployed find jobs quickly, many of them are confined to low-pay, low duration jobs and go back and forth between precarious jobs and unemployment, without an opportunity to settle in a durable job. While such features may be specific to America, rather than entirely due to free market institutions, such an increase in inequality has not been observed in Europe (either not at all or to a lower extent), with the notable exception of England, which is the only country to have shifted to competitive labor markets. Thus, while this is certainly a viable model, it seems difficult to convince European voters and unions that the best they can hope for is reproducing America. Another possibility is to combine an increase in flexibility with an increase in redistribution, so as to guarantee sufficient living standards to the low wage earners. This could be labelled the "fiscal model". Thus, more genrous transfers to the poorest would be coupled with a scrapping of most of existing regulation on employment protection, collective bargaining and minimum wages. The transfer system would take care of the poorest and the market would take care of the others. This runs into a certain number of problems. First, how can you redistribute more if you start from a situation where about a fourth of GDP is redistributed, which leads highly distortionary tax rates of 50% or more on average? How can we impose the fiscal model to economies were the burden of taxation is excessive to start with? The answer is that redistribution should be more targeted to those who need it, and that taxes and transfers should be made less distortionary. A substantial share of the tax burden is due to redistribution to people wo do not need it, and to distortions that could be eliminated. Pension policies have been irresponsible by not indexing the age of retirement on life expectancy. The public debate should have focused on years in retirement rather than the age of retirement. Years in retirement can be increased only if population growth or productivity growth allows it. Similarly, health insurance systems can be made more compatible with incentives, by putting a cap on the level of total reimbursement, including by private insurers, with full insurance taking effect only for costly cures. Unemployment benefits could be replaced, as has been proposed for Chile, with an interest bearing citizen's account, which could have a negative balance, which would be deducted (subject to a floor) from the individual's pension rights on the day of retirement. The tax base should be broadened by imposing social security taxes on the unemployed and the retirees. Spending can be reduced by removing subsidies to agriculture and industry, as well as many inefficient labor market programmes. Universities are a redistribution from the middle class and the lower class to the upper middle class. Moderate tuition fees at universities could be established, which would improve both equity and the budget. All these reforms (and many others could be thought of) would save on transfers and reduce tax rates, which would allow to redistribute more to the poorest. The bottomline is that because more redistribution will be needed in the future, savings are necessary. But because redistribution will take care of the poorest, savings are possible. Removing agricultural subsidies will harm rich farmers but poor farmers will be taken care of by the new fiscal system. At one extreme, one can think of all redistribution being removed and replaced by a single guaranteed income, non means tested, of about $1000 per month per adult individual.In a country like France, this would mean 50 % of current GDP, twice the amount currently redistributed. While this sounds out of reach, we should keep in mind that this computation ignores efficiency gains, which may be large, as well as potential gains from reducing public consumption, and that the amount currently redistributed understates the true burden of redistribution as defined by implicit commitments on future generations. Despite that, it seems more reasonable to assume a means-tested transfer scheme. This brings up the second question, that of the distortionary costs of transfers. If the transfer is income tested, then high marginal tax rates will create disincentives to work. If it is not, there will be a large deadweight loss which may create an excessive burden on the budget. Let us discuss the first hypothesis. Two points should be made. First, the welfare loss of disincentives to work at the bottom of the distribution of income should not be overemphasized. There is not much difference between the social value of idleness and that of packing purchases in a supermarket. Second, it is often argued that work is the only way to recover a social status, a sense of dignity and integration, etc, etc. If this is true (it is certainly true for some individuals), then the disutility of working is low and therefore people are willing to take jobs even if it yields them little extra income. This is indeed what is suggested by a recent experiment in the U.K. where unemployed workers could take a menial job that would top up their benefits by only £10 a month. The programme was a considerable success. The bottomline is that under current regulation in continental Europe, these jobs are not available. Under the coupling of transfers and a deregulated labor market, they would exist, and any idle worker who would like to recover his sense of dignity could pack purchases at the next supermarket. Third, the change is so drastic that it may well encounter strong political opposition. This is a likely outcome: why should the median voter accept a redistribution from the middle-class to the poorest? However, we should note that a lot of hardship has been imposed on the population with the contractionary macroeconomic policies of the eighties, and the ones associated with the fulfillment of the Maastricht criteria in the nineties. It would have been more worthwhile to impose these pains in exchange for structural reforms instead. And, to the extent that structural reforms lower the natural rate of unemployment, this could equally have achieved disinflation. Unfortunately, these efforts are lost, and the gains in terms of lower inflation might even go away as persistent unemployment creates pressure for fiscal and monetary expansion. It might not be too late, however, to trade an easing of the monetary stance in EMU against structural reforms that would guarantee the transition to a new social model as outlined above. This could be achieved through some sorts of social pact between unions and policymakers at the European level.