Europe\'s Economic Malaise: a Problem of Competitiveness?

Business Strategy Review, 1996, Volume 7 Number 2, pp 37-44

Europe’s Economic Malaise: a Problem of Competitiveness? Andrew Sentance

Unemployment in the EU is double that in the USA and over three times the level in Japan. This article discusses whether it makes sense to think of this as a problem of lack of European competitiveness. It outlines the policies that European countries should pursue, both collectively and individually, to combat Europe‘s economic malaise.

Recent news from Europe’s leading economies has provided little to smile about. In three out of four major European economies - France, Germany and Italy - national output fell in the final quarter of last year. Unemployment is rising again in Germany and France. Across the European Union (EU) as a whole, industrial production has stagnated. The UK economy - which appears to be faring better than most within the EU - has slowed to a growth rate of around 2% a year, after GDP rose by over 4% in 1994. These disappointing indicators have re-ignited the debate about the causes of Europe’s poor economic performance, which is most clearly evident in the pattern of unemployment. The European Union has become the unemployment blackspot of the developed world, home to over half of all the unemployed people in the high income OECD group of countries. The average EU unemployment rate of around 1 1% is double the jobless rate in the USA and over three times the rate in Japan. Such high unemployment is not simply a product of recession, though the sharp downturn in the European economy in 1992 and 1993 certainly aggravated the problem. In France and Germany, the declines in national output seen in 1993 were the sharpest experienced for over forty years. However, even in the boom years of the 1980sbefore the last recession, Europe’s tendency to high unemployment was apparent. Between 1986 and 1990, the EU unemployment rate averaged 9.4%

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of the labour force, compared to an average of less than 6% in the USA over the same period. (See figure 1.) At the European and national level, this state of affairs has raised concerns about a lack of “competitiveness” within the EU. In December 1993, the European Commission published a White Paper on “Growth, Competitiveness and Employment”. Europe-wide representative business organisations, such as UNICE and the European Round Table, have made their own contributions to the debate. The UK government has begun to publish its own annual review of competitiveness and other EU governments - such as Spain and Germany have undertaken similar initiatives. How can we account for Europe’s problems of slow growth and high unemployment? Does it make sense to think of this as a problem of competitiveness? Or is the concept profoundly misleading, as some economists have argued (Krugman, 1994). What policies should European nations pursue, both collectively and individually,to combat this economic malaise? This article aims to provide a framework for thinking about these issues and suggests some answers.

EU and US Growth and Unemployment A natural benchmark for comparing European economic performance is the United States. The EU and the USA are roughly equivalent in economic

0 London Business School

38 Andrew Sentance Figure 1

UNEMPLOYMENT IN EU, US AND JAPAN % of labour force

12

EU

-

10

us --.....-

8

Japan 6

UK

---

4 2

/

0 1974

1978

1982

size - measured in terms of gross domestic product. The EU has a higher population, with the current membership of 15 nations giving a total of 370 millions as against 260 millions in the USA. The table compares the growth and employment performance of the EU and the USA over five postwar cycles. (By measuring growth between peak years of economic activity, the distortion of the cycle is removed from the longer run comparisons.) It shows that the late-1970s were something of a watershed in terms of the relative economic performance of Europe and the United States. Throughout the 1950s, 1960s and 1970s, unemployment was lower in Europe than in the United States. Though unemployment rates were creeping up in the 1970s, the two preceding decades were a golden age for the European economy, particularly in contrast to the unemployment of the 1930swhich bred so much political and social unrest. Growth has also been lower in the EU since the mid-l970s, though this mainly reflects slower European population growth. Per capita living

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1986

1990

1994

standards have risen more strongly in Europe since 1960, partially closing the gap in absolute living standards. Average European living standards measured at comparable prices rose from just over half of US levels in 1960 to around 70% in the early 1990s. However, while there are modest differences in growth performance, the most striking contrast is in terms of unemployment, where the European unemployment rate has racheted up across every cycle since the early 1970s. In explaining Europe’s economic malaise, this puts the spotlight fairly and squarely on the labour market. Why has Unemployment Risen?

In explaining what has gone wrong, it is tempting to look for one major development - a single cause which transformed the benign employment environment of the first two-and-a-half post-war decades into the situation which we observe today. But history teaches us that major changes normally Summer 1996

Europe’s Economic Malaise: A Problem of Competitiveness? 39

occur not in response to a single isolated event but when many forces are working in the same direction. The same is true of major economic developments. Not one, but several influences have helped to shape the high level of European unemployment which we observe today. It is no coincidence that the sharp rise in unemployment occurred in the mid-1970s and early 1980s, following the two major oil price hikes of 1973/4 and 1978/9. These oil price rises pushed up inflation in all the industrialisedeconomies, but some were more successful at dealing with the shock than others, either because wage-earners took a more responsible view and did not chase up price increases, or because economic policy was tightened quickly to squeeze out inflation before it really took hold. There were considerable variations in the way that European countries responded to these oil price

“shocks”. Germany was one country which managed the inflationary consequences relatively successfully and was able to sustain both lower inflation and lower unemployment than other EU members in the 1980s as a result. But, on average, inflation rose higher in the countries of the EU and stayed high for longer than in either the USA or Japan. That meant economic policy had to be directed to reducing inflation throughout much of the 1980s, holding back economic growth and employment prospects. Some European countries and in particular France - used an exchange rate link with the low inflation Deutschemark within the European Monetary System (EMS) to sustain these disinflationarypolicies. A further round ofdisinflation has been a feature of the early 199Os, as Europe sought to squeeze out the inflationary impact of the late 1980s boom and German Unification.

Unemployment and growth: USA and EU compared GDP YOpa

GDPlhead YOpa

1960-68

4.8

1968-73 1973-79 1979-90 1990-95

3.5 2.9 2.6 1.9

3.5 2.4 1.9 1.6 0.8

4.7 4.9 2.5 2.2 1.5

3.9 4.2 2.1 1.9 1.1

Average Change in unemployment unemployment YOof labour Yoof labour force force

UNITED STATES

5.0 4.6 6.7 7.0 6.5

+I .3 +0.9 -0.3

2.2 2.7 4.7

+0.4 -0.1 +2.8

9.5 10.5

+3.0

-1.9

0.0

EUROPEAN UNION*

1960-68 1968-73 1973-79 1979-90 1990-95

+2.6

EU12 until 1990; EU15 from 1990 (inc. E Germany from 1991). Prior to 1994, the European Union was known as the European Community, as it technically remains for some purposes. To avoid confusion, we use the title “European Union” throughout this article. Source: European CommissiodOECD

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40 Andrew Sentance

Structural and Technological Change Overlaying this battle against inflation were a number of forces which undermined the employment prospects of low-skilled manual workers in manufacturing industry. Technological change has transformed the nature of many industrial processes, with robots replacing low-skilled workers on production lines. Labour-intensive processes and industries migrated away from relatively expensive manual workers in Europe to take advantage of much lower labour costs in ofthe Asia. Excluding Japan, Asia’s “ share of world exports rose European economies from 7.5% in 1913 to 17.5% is One Of inflexibiii4)”two decades later. This increase in trade share came at the expense of the mature industrialised countries of Europe and North America. In addition, the EU was undertaking its own process of restructuring, as companies rationalised their production facilities in anticipation of the establishment of the Single European Market at the end of 1992. These forces - the advent of new technology. the emergence of new low cost competitors in the Far East and the development of a Single European Market - are not bad for employment and growth over the longer-term. Indeed, as companies and individuals adapt to these changes, their impact should be positive - raising living standards and generating new employment opportunities. Higher exports from the Far East lead to higher imports into that region; indeed rising import demand from Asia helped to pull Europe out of the last recession. Technological changes create new products and new industries as well as displacing labour in mature sectors of the economy. And the objective of establishing the Single Market was precisely to provide a stronger “home” base so that European industry could become more competitive on world markets. But in order to realise these longer term benefits, structural shifts need to take place within the economies of the west. Service industries need to take the place of low value-added manufacturing as employers of unskilled labour. New industries need to be created based on high technology and innovative new products - requiring different and more advanced skills to those employed in declining industries. Business Strategy Review

In the case of both the oil price shocks and these structural shifts, we might expect to see some temporary effect on unemployment as the economy adjusts to the new situation. What has been surprising about Europe - and stands in stark contrast to the United States - is the fact that the rise in unemployment during the late 1970s and early 1980s was not reversed. This suggests that the mechanisms through which the economy absorbs and adjusts to major shocks are much less effective in Europe than the USA. In other words, the problem of the European economies is one of inflexibility. There are two aspects to this process of adjustment: employment flexibility - the ability of an economy to generate new jobs to take up slack in the labour market; and wage flexibility - the extent to which wages adjust in response to high unemployment and price workers into jobs. In both respects, the USA has fared much better than Europe. There appear to be three reasons for this. The first is the more entrepreneurial culture of the USA, which has led to the emergence of global competitors in new industries - such as Microsofi as well as the establishment of many smaller service companies which are so important to job creation. The second factor which has held back restructuring in Europe is the willingness of governments to support declining industries through state aids and hold back the process of rationalisation.

Labour Market Flexibility But the most crucial difference between the USA and Europe has been the structure of labour markets. European labour markets are characterised by much higher levels of employment protection and more generous social welfare systems than exist in the United States - though there are considerable variations between countries (with the UK being one of the most deregulated). These characteristics of European labour markets inhibit the ability of workers to price themselves into jobs and their incentive to do so. High overhead costs of employment - either in the form of large social security contributions or extensive employer obligations to their workers - create barriers that those with the poorest skills and employment records find it hardest to overcome. One consequence has been very high levels of long-term unemployment. Summer 1996

Europe’s Economic Malaise: A Problem of Competitiveness? 41

Figure 2

EU unemployment rates % of labour force, 1995*

Spain Finland Ireland Italy France Denmark Greece Belgium Sweden UK Germany Portugal Austria Netherlands Luxembourg 0

I

5

10

15

20

25

* OECD standardised definition, where available

As many economists have observed, this more “flexible” labour market structure in the USA has its own problems. The technological and competitive forces which have been reflected in higher unemploymentin Europe have resulted in a widening of the distributions of incomes for those in work in the United States. The difference in labour market structure does not change the basic fact - that the employmentprospects of low-skilled and some skilled manual workers have been eroded by changes in the world economy. If both unemployment and the problem of the working poor are to be avoided, the answer is to raise the skill base of the economy as a whole and reduce the supply of unskillcd workers or find ways in which those with skills can subsidise employment for those who do not have them, through redistributive taxhenetit systems. Business Strategy Review

A Problem of Competitiveness? Current high European unemployment is therefore the product of a complex set of causes. It has resulted from a prolonged period of disinflation, technological changes, the emergence of new competitors in the world economy: Single Market restructuring, a lack of entrepreneurialspirit, state aids and labour market structures which have inhibited employment growth. The importance of each of these influences has varied across the nations of Europe, reflecting their very different experiences, economic structures and policies. So though the recent recession has pushed unemployment up fbrther from the level generated by these longer term influences, we still see a very wide spread of current unemployment rates across

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42 Andrew Sentance

the European Union, as figure 2 shows. Does it make sense to describe this state of affairs as a problem of competitiveness‘? It is frequently, and correctly, observed that it is much easier to discuss the notion of competitiveness in relation to an individual business than in the context of a nation as a whole. For a firm, competitiveness is the ability to produce goods and services of an appropriate quality and price to meet customers‘ needs “we Should be careful about the use the at least as efficiently and effectively as other firms. It word competitiveness” can be measured by the performance of the business concerned in the marketplace. Though nations do not compete like firms, the economic performance of a nation is clearly heavily influenced by the competitive success of the companies that operate there The interest in national competitiveness stems from a desire to understand the factors that influence that success and policy changes that can be brought to bear upon them. Some economists - most notably Paul Krugman - have been very critical of the use of this notion of competitiveness in the recent policy debate. Krugman is particularly critical of the tendency to see improvements in competitiveness as associated with increases in a country’s share of world trade. He argues that the desire to improve market share at the expense of other trading nations can lead to protectionist policies, either through trade barriers or subsidies. In addition, he argues that a trade-based concept of competitiveness leads to an excessive focus on the performance of tradeable activities particularly manufacturing - whereas it is the performance of the economy as a whole which matters. “the contribution o f increased employment Krugman argues that improving the productivity has been lower in the and efficiency of service ElJ,’ activities is potentially more valuable for a nation’s standard of living since a much greater proportion of the workforce is employed in the service sector than in manufacturing. These arguments certainly suggest that we should be careful about the use of the word competitiveness. But used carefilly it can provide a valuable focus for discussion of the changes J

J

n - 7 . .

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needed to improve the performance of an economy over the longer term. According to the OECD, a nation’s competitiveness is: “the degree to which it can, under free and fair market conditions, produce goods and services which meet the test of international markets while simultaneously maintaining and expanding the real incomes of its people over the longer term.” Defined in this way, competitiveness is all about raising living standards under free and fair trading conditions. A nation can be considered more competitive than another if it is able to achieve and sustain for its citizens a higher standard of living. This will inevitably require successhl tradmg activities, as trade is an important mechanism through which countries can improve their living standards by exploiting their comparative advantage. However, trading success is purely a means to an end. The ultimate measure of economic success is the sustainable standard of living that can be achieved.

Implications for Policy There are essentially two ways in which a nation can raise its sustainable standard of living. The first is by increasing the productivity of the existing workforce. The second is by harnessing more effectively the skills of the population - by drawing a higher proportion of people into the labour force. It is here that European performance has been so disappointing, as figure 3 shows. Productivitygrowth in the EU has been much more healthy than in the USA. But the contribution of increased employment to hgher living standards has been much lower, both because unemployment has risen and because participation in the workforce has grown more slowly. The recent performance of the UK is perhaps the most obvious exception to this pattern, reflecting changes in the labour market which have increased wage and employment flexibility. Just as high European unemployment does not have one simple cause, so there is not one simple remedy to apply. Moreover, the appropriate policies will need to vary between countries. The OECD Jobs study, which reviewed the unemployment experience and policies across the mature industrialised nations identified eight areas (in addition to stable macroeconomic policies) where western nations needed t o act t o reduce Summer 1996

Europe’s Economic Malaise: A Problem of Competitiveness?43 unemployment: encouraging the creation and diffusion of technological knowledge; allowing more flexibility of working time; creating a climate conducive to enterprise; making wage and labour costs more flexible, particularly for low-skilled and younger workers; reforming social security provisions whch mhlbitjob growth; providmg training and employment opportunities for the long-term unemployed; investing more heavily in education and vocational training; and removing disincentives to employment created by the tax and social security system. It is encouraging that the policy debate within individual European countries and within the institutions of the European Union is shifting. Governments are slowly embracing measures which will reduce barriers to employment and increase labour market flexibility. A combination of financial necessity and European competition policy is putting pressure on governments to reduce state aids and

expose protected state industries to competition through privatisation. There is a much wider recognition of the damaging impact on employment of labour market regulation and the need to strike a balance “Structural between protection for those already in work and opportunities unemployment of for those without jobs. Very few the sort that has proposals are coming forward become prevalent under the “Social Protocol” of in Europe will not the Maastricht Treaty - from besolved by a which the UK has famously “dashfor growth ” opted out. Meanwhile, lower interest rates should arrest the slowdown in the European economy which has emerged over the last year and support an increase in the growth of private sector consumption and investment demand, which has been weak throughout Europe over this recovery. Coupled with measures to increase employment and

Figure 3

SOURCES OF GDP GROWTH % per annum increase

-2

‘

I

I

I

I

I

60-68 68-73 73-79 79-90 90-95

European Union Business Strategy Review

I

I

I

I

I

I

1

60-68 68-73 73-79 79-90 90-95

United States Summer 1996

44 Andrew Sentance

wage flexibility, this should lead to the emergence of a more encouraging trend in European unemployment. But the world will not change overnight. The speed with which unemployment can be reduced will depend on policy-makers continuing to take steps to make labour markets more flexible and European economies as a whole more responsive to change. Structural unemployment ofthe sort that has become prevalent in Europe will not be solved by a “dash for growth”. Nor does it seem feasible to get back to the very low unemployment rates - of 2-3% of the labour force - which were the product of the post-war economic boom. Some countries are also likely to find their problems much more intractable than others - particularly those who find themselves continuing to run relatively high inflation rates in a low inflation world. Meanwhile, we should not allow the current prevailing mood of pessimism about the European economy to blind us to the fact that Europe has a lot of intrinsic strengths which should not be downplayed: a highly educated workforce, many

well-run worldbeating companies, a capacity for creativity and innovation and a strong tradition of democracy and social cohesion. The entirely wrong response to the current situation would be to acquiesce to populist pressures for a protectionist approach to Europe’s unemployment problem. That will certainly make the problem worse in the long term - and possibly in the short term too. Protectionism runs the risk of provoking retaliation, intensifying recessionary pressures worldwide. It imposes costs on consumers and, because barriers cannot be maintained indefinitely, stores up trouble for the future. This applies equally to state subsidies as it does to direct barriers to trade. There is no benefit to businesses or consumers from breaking down barriers within the internal market if new walls are going to be erected around a fortress Europe.

Andrew Sentance is Director of the Centre for Economic Forecasting at London Business School.

Reference

Krugman, P. ( 1 994), “Competitiveness: A dangerous obsession”, Foreign Affairs, Vol. 73, No.2,

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