Winter 2005

Not the Supply Side, Stupid: What Europe Can Really Learn From America

David Blake

What’s wrong with Europe? Not just its economy, though that gets bad enough reviews from the international pundits. But the whole social model, which allows mass unemployment, bitter resentment in ethnic minorities in its slums and slow growth in its economy? Over the past few years a conventional wisdom has emerged to answer this question. It says that Europe needs massive structural reforms” to cope with rigidities.” –

These reforms” (and this particular set of reforms have managed to obtain monopoly rights over the word reform” itself) would bring in much more flexibility to labour markets, scrap many of the existing laws on employment protection, cut budget deficits and tackle the long term problem of a funding crisis” in the over-generous state pension system of these countries. Do this and, it is said, Europe could break through to a new prosperity and unemployment would vanish, removing the source of many of the other problems in society. –

Now all of these policies have something in common. They remove risk and other burdens from firms and governments and transfer them to individuals.

  • More flexible labour markets make it easier to pay wages lower than centralised collective bargaining;
  • removing employment protection makes it easier to sack people but at the cost of them having less job security; · cutting unemployment benefits for those without work to encourage them to take a job
  • cutting deficits means cutting spending on programmes people want or forcing them to pay more of their incomes in taxes;
  • reducing the cost of pension systems increases the burden on individuals of preparing for their old age. 

A decade ago these criticisms of Europe were mostly from outsiders looking in. Anglo-Saxon economists looked at and rejected the so called Rhenish” model of which Germany was the prime example or the French tradition of a much greater role for the state. But now they have become the routine patter of those inside the Eurozone. This view that Europe needs to adopt a far more free-market approach is the new consensus in the European policy-making elite.

It is espoused by the EU Commission, the ECB, leading business organisations and leading commentators. At G7 meetings, communiqués routinely include a paragraph saying Europe’s main contribution to solving the world’s economic problems would be reforms” to introduce more flexibility. Every month the ECB issues a statement which laments the lack of progress on structural reforms and cutting the Budget deficit. This mix of policies is now the only solution which respectable opinion allows. But what if they’re all wrong?

It is easy to see why most of those who support the policy are so attracted to the diagnosis. Take a G7 Finance Ministers meeting or the ECB Council. Everyone knows that European growth is too slow and unemployment is too high. The key thing is to come up with an explanation which proves that no one who has a say in drafting the communiqué is in any way to blame for the problem. (This principle is sometimes referred to as Blake’s Third Law of European Communiqués. The First Law states that any policy agreed must be guaranteed not to impose any costs on the individuals in the meeting, a point to which we shall return later; the Second Law says that the attractiveness of any policy is inversely proportional to the chance that it will be pursued firmly enough to be tested.)

So for example the ECB might consider the possibility that it kept interest rates too high for too long and stifled growth; or that its obsession with money supply has prevented the growth of consumer finance which has done so much to boost US demand. But why do that when it involves blaming a colleague or even yourself for things which have gone wrong. Much better to say that monetary policy has been right and it’s the fault of the governments for not cutting their deficits. What if the attempt to impose these policies is part of the problem not part of the solution? What if what really ails Europe is its refusal to enjoy being rich?

Let’s look at the theory which underlies the prescription. It really has two parts. The first is that the current framework in Europe imposes such onerous burdens on employers that they won’t take people on. In particular, it is so hard to sack people once they have been employed that it is better not to hire them in the first place. The intellectual birthplace of this theory is the OECD, which produced a highly influential Jobs Study in 1994. (Note that the OECD has almost legendary status with senior civil servants as being the only place harder to get sacked from for not working than the upper reaches of central government, thus confirming that this theory meets the conditions of the First Law, that it is no threat to those putting it forward. Since then a number of academic economists have produced studies which try to prove that countries which have too much employment protection have the worst unemployment records. Unfortunately for this thesis, the evidence is at best dubious.[i] Some countries, such as Spain, have seen improved employment in recent years as they reduce regulation of the labour market; other countries like Ireland have seen huge gains in employment without making significant changes. Nor does the theory become any more convincing if we look across countries. Scandinavian countries have high levels of protection and low levels of unemployment. So why should weaker levels of protection in Germany be the cause of that country’s unemployment?

Similar problems exist in trying to tie generous unemployment benefits to high levels of unemployment, especially long-term unemployment. Indeed, in many countries the very high levels of unemployment came before the unemployment benefits became so generous; governments decided that if they could not create full employment they needed to act to mitigate the consequences. The relationship is weak in other ways. Italy has one of the highest levels of long term unemployment in Europe yet it has no long term unemployment benefits at all.

This argument obviously should not be pushed to extremes. If unemployment benefits are so high that they are equal to or greater than what can be obtained by working, they become a disincentive. In the same way it has to be admitted that some potential employers, especially small businesses, will be cautious about hiring people if they worry about the problems they face if business turns down. But businesses are not the only ones who face problems, which lead to the reason why the current stance of policy makers may be making things worse not better.

Take Germany, generally regarded as the biggest problem in Europe’s economy and very frequently cited as massively less successful than the UK. Over the past year, Germany has had a surplus on its current account of over $100bn dollars. If German employment laws make the country so uncompetitive, how is it able to achieve this while the US is running an enormous deficit?

The noticeable weakness in Europe’s economy is domestic consumption. Over recent years the savings ratio in Germany has climbed steadily. People lack the confidence to spend.

Here it is worth noticing a basic difference in the remit of policy makers. In the US, the Fed is charged with full employment and stable inflation. Everybody knows that if the economy slows down and unemployment rises, the central bank will cut interest rates to boost demand. Equally, it is accepted that the Federal government will spend more and tax less in order to keep the economy going. So individuals in US society know that there is a guarantee from the authorities to maintain demand which maintains employment. That is matched with a resolutely positive tone in describing the fundamentals of the US economy.

Contrast that with Europe, where there is no commitment to maintaining full employment, the Central Bank has stated repeatedly that it does not use interest rates to prop up demand and it, along with all the other main voices of economic policy making, maintains a steady drumbeat of pessimism about how little has been achieved, how much the governments have to tighten policy and how urgent it is to start hacking away at pension rights. We have just seen the ECB raise interest rates at the first sign of European recovery. The new German government has announced tax rises to get the deficit below the artificial 3% ceiling which is included in the Maastricht Treaty.

So when we see that employment is weak and output is weak, just give a thought to this possibility. If your government’s policy for curing unemployment is to make it easier to sack you, to ensure that if you lose your job you have less compensation and lower benefits, that you pay more taxes now and have to wait longer for a pension which is less than you were promised when you were paying in your contributions: consider, just for a moment, consider the possibility that you won’t rush out to the shops and start spending. And that maybe, just maybe, the people who think they have a policy for European recovery might be wrong.

There’s a newly fashionable tale by Benjamin Franklin swirling round the internet which explains a lot about how America is different from Europe. According to this, the Thanksgiving we know now came about as follows. In the early days of the English colonists in America, they were much prone to lamenting their troubles and praying to God and fasting in the hope of getting his attention. One day, as people were discussing a particularly big Fast and general recital of their woes, someone came up with a different idea.

Why don’t we stop complaining, say thank You for the fact that we’re here and we’re safe and have a really big feast not a fast to cheer ourselves up.” And that’s how what has now become the world’s biggest shopping festival came about. In the period between Thanksgiving and Christmas, the US retail sector does 20% of its business for the total year. Franklin Delano Roosevelt even changed the date of the Thanksgiving holiday to make sure people had more time to shop. Every year on the day after the holiday itself, the shops are flooded with people and the economy gets its regular annual boost of demand all the way to Christmas.

Obviously it’s the initiative of the private sector which makes this happen. But it is reinforced by the fact that in the US it is official policy to get people to spend money to keep the economy whirring round and to keep people in work. This isn’t only true at Thanksgiving time. The Federal Reserve Bank has as part of its twin mandate the requirement to secure the maximum sustainable rate of employment. It does this by using interest rate policy to boost demand when things get slack. And everybody knows this.

So when business is bad, rates are cut dramatically to encourage people to borrow thereby producing a pick up in activity. Nor is the Fed alone in doing this. Fiscal policy is used aggressively to boost demand in time of weakness. This is the feature of US policy which all too often gets overlooked in the Eurozone as it discusses its economic problems. All too often, the discussion turns into a gloomfest as the litany of Europe’s problems is discussed, making it sound as if Europe has ceased to be able to compete in the world. But on the most obvious measure of ability to compete, selling to the rest of the world, Europe is far more successful than the US or Japan. It is domestic demand in Europe which is the weakness. And that is made worse by the analysis which tries to make it better. 

David Blake is a financial analyst and commentator