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Europe's Economic Challenge
From: London School of Economics and Political Science
| By:
Peter Hall |
EDITOR'S INTRODUCTION |
 Between 1970 and 1990, the US created 50 million jobs while the EU created only 10 million. In France, the average cost of hiring a worker for a new company is US$14 per hour. At this rate, a fifth of the jobs in the US would not exist. In an era of globalisation, such discrepancies matter. But Peter Hall, professor of government at Harvard University, challenges the view that the economies of continental Europe will have to go the way of the US and Britain, sacrificing wage equality and job stability to secure prosperity. |
 olitical economy is ultimately about social civilisation. Thomas Friedman, a New York Times journalist, has a rather nice way of putting the overall problem. He says he likes to think about the political economies of the world as four different kinds of gas stations. |
So, at the Japanese gas station, gas costs $5 per gallon, and four uniformed men wait on you, wash your windshield and then you drive away with ease. At the European gas station, gas also costs $5 a gallon, but you're served by one person who works only 32 hours a week and has six weeks of statutory vacation a year, while four people living on generous social benefits play boccie across the street. At the Russian gas station, gas costs only 50 cents a gallon, but there is none--that is because the attendants have sold it all for $5 per gallon on the black market. |
Of course, at the American gas station, gas costs only $1 a gallon, but you pump it yourself, and as you try to leave the service station four homeless people from across the street steal your hubcaps. In short, differences in the character of capitalism also affect our ways of life. |
What is liberal orthodoxy?
Stylised as it is, I think that example captures a lot of contemporary economic debate and a good deal of the apprehension that accompanies it. To borrow a famous phrase, I think a spectre is haunting Europe and it is the spectre of what I call liberal orthodoxy. By this I mean the view that nations can secure high levels of employment and prosperity only if they deregulate, increase job insecurity, weaken their trade unions and intensify competition among firms. |
This is an Anglo-American orthodoxy developed in the late eighteenth century in Britain, and followed with considerable success by both the US and the UK. Whenever continental Europe has faced economic problems (it is worth remembering), liberal orthodoxy has been urged upon it as a solution by the Americans and the British. It was a prominent component of American advice after World War II and it figured again during the crisis of the 1970s but, as the story with which I began suggests, this prescription poses serious problems for continental Europe. It seems to threaten the very model of social civilisation constructed there since the war. |
Liberal orthodoxy implies rollbacks in precisely those achievements that many in Europe consider social progress--high levels of job security, long periods of free time, relatively egalitarian wages and an extensive public infrastructure. In 1968, the average German worker was entitled to 86 days a year off work. Today, he is entitled to 165 days and there is good reason to think of this as progress. Now, in the 1970s and 1980s comparative political economy provided an effective alternative to liberal orthodoxy. This alternative was associated with the concept of neo-cooperativism, suggesting that there was an alternative route to economic success, one built around strong trade unions, a large welfare state and a negotiated economy, and, indeed, there was good evidence that this could work. |
Why, then, has liberal orthodoxy become so powerful again? Why do we read about it every week in The Economist, the Financial Times and the like? And, to this question, I think there are two answers. The short one, of course, is unemployment. As you know, unemployment reached double digits in Europe during the 1990s and it is still hovering there in more than a few countries. Between 1970 and 1990, the US created 50 million jobs, the European Union in that period created only about 10 million. This is a chilling figure; perhaps equally chilling is the observation that the real income of the bottom 20 percent of the American labour force fell by 15 percent in this period, while that of the top quintile increased by 25 percent. Not a good omen for the social civilisation of Europe. The longer answer to the question is equally important. |
The European challenges
Three developments have called into question the capacity of the continental European economies to secure low levels of unemployment. The first is a technological revolution built around microprocessors, increasingly bio-engineering and telecommunications. Ten years ago, the best hard drives held eight megabytes a square inch. Today, hard drives can carry 3,000 megabytes a square inch, and such things have changed all our lives. The question here is whether economies built around collaboration rather than competition can innovate effectively enough to create jobs in the context of what is really a fourth industrial revolution. |
Secondly, as we know, the European economies are facing more intense foreign competition as a result of both Europeanisation and globalisation. Many have argued that the lowest common denominator effects of this competition will force all of the European nations to deregulate to create jobs. The final challenge: for years the industrial sector has been the motor for job expansion in Europe, and it is obvious today that if jobs are to be created there they are going to be created not in the industrial sector but in the service sector. In 1960, about a third of European workers were employed in services. Today, that number is closer to two-thirds, but rates of productivity increase in services have, historically, been lower than those in industries. So many argue that if new jobs are to be created, these are going to have to be low-paying jobs, jobs that threaten wage equality, job security and the labour market arrangements of many nations. |
In short, there are many who argue that because of these three developments, which are profoundly changing the structure of contemporary economies--the technological revolution, globalisation and the rise of the service sector--the traditional economic models of continental Europe are doomed. To create jobs, Europe must embrace the liberal orthodoxy that it has resisted for so many years. |
Rethinking the consensus
I would argue that this view is wrong. Economics may be a dismal science, but political economy need not be. Yes, there are bound to be changes. They are already going on in very clear measure, but I want to argue that the economies of Northern Europe, in particular, can survive these challenges substantially intact and, therefore, there remains an alternative path to economic success. I am going to make this argument in a particular way, namely by drawing on a "varieties of capitalism" approach to comparative capitalism. |
In broad terms, this is an approach that uses the new economics of organisation (which is normally applied to understand micro-behaviour in the economy) to understand the problems of the macro-economy. In contrast to approaches that place the state or trade unions at the centre of the analysis, this approach argues that firms are the key actors in the economy and that we should conceptualise firms in relational terms; that is to say, we assume that the core competencies of any firm derive from the quality of the relations that it is able to form with other actors, other firms and its own employees and the state. So we think of the firm as an entity embedded in networks of relationships that define the capacities of the firm in five key areas: finance, industrial relations, vocational training, technology transfer and employee relations. |
The character of the relationships that any particular firm is able to form in these areas is fundamentally conditioned by the institutional support present in the national political economy. That is, the capacities of institutions to provide support for the exchange of information, the formation of credible commitments, monitoring, sanctioning and, more controversially perhaps, for deliberation among the actors (other firms) about the distribution of risk within the relationship. |
This approach will be clearest if I outline it in terms of two ideal types of market economy. The first is that of a liberal market economy corresponding to the political economies of the US, Britain, Ireland and Canada, among others, and here the image will certainly be familiar to you. In liberal market economies, firms rely primarily on competitive market mechanisms, marked by arm's-length relationships, on the one hand, and formal contracts, on the other, to resolve the coordination of problems they face in their relationships with other firms and their employees. |
In America, large firms secure most of their finance, not only from internal funds but from highly dispersed equity markets which privilege quarterly profitability in judging a firm's worth. Labour is recruited from highly fluid labour markets where job tenures are low and layoffs are relatively easy and few sectors have the capacity to mount coordinated vocational training. As a result, training in liberal market economies tends to stress general skills and to turn relatively heavily on formal education. |
So that is what sits on one side of the spectrum. On the other side of the spectrum sits a group of nations that we call organised or coordinated market economies. These include the economies of Japan, Germany and many of the Northern European nations--Sweden, Austria, the Netherlands and the like. Here, markets certainly have some importance, but to construct their core competencies firms rely much more heavily on what we might think of as non-market relationships, that is to say, on strategic interactions with employees, other firms and other actors, relationships that do not turn on the kind of marginalist calculations on which neoclassical economic analysis puts so much emphasis. |
Now, what makes non-market relationships possible in these contexts is a range of institutions and systems rarely found in liberal market economies, including extensive patterns of cross-shareholding among firms, powerful business associations and interconnected trade unions. To take Germany as an example, firms have long had access to finance that does not turn heavily on short-term profitability but rather on the monitoring of firm strategy and firm capacity that is possible within the networks created by powerful business associations and systems of cross-shareholding. So the institutional capability of network monitoring is central to the capacities of firms in organised or coordinated market economies. This allows many firms in these economies to operate coordinated systems of vocational training; it facilitates coordinated wage bargaining; and it indeed allows German firms, for instance, to cultivate industry-specific skills. |
Now, one of the key features of my analysis is to argue that institutions in different spheres of the political economy can also be complementary to one another in the sense that the presence of a set of institutions in one sphere can enhance the feasibility or viability of another set of institutions in another sphere of the economy. So, financial arrangements that provide firms with access to long-term or patient capital make it more feasible for those firms to operate particular kinds of arrangements in labour markets and to offer long job tenures. |
How firms behave
One implication of this argument is that we will find differences in firm strategy or behaviour across nations, and there is some good evidence for this. |
German and British firms tend to behave quite differently. British firms faced with an appreciation of the exchange rate tend to accept the increase in foreign prices in order to maintain their short-term profitability, while German firms do just the reverse. They tend to accept such increases, to lower their prices in foreign markets and accept lower levels of profits, in order to preserve market share. |
So systematic differences in the behaviour of German and British firms correspond precisely to what we would expect. In other words, we think that British firms privilege short-term profitability and can sustain the loss of market share because they can lay off labour relatively easily. |
By contrast, German firms are able to sacrifice profitability, because in many cases their access to finance is not so dependent on it; but they try to retain market share, because it's very difficult for German firms and incongruent with their long-term corporate strategies to lay off labour. |
Who has the competitive advantage?
The core contention is that the fluid labour and capital markets of liberal market economies give firms in those settings capabilities for radical innovation of the sort that involve movement into risky investments, hiring new kinds of workers, making radical shifts in the use of their resources and new technologies. You can see why this might be the case. American firms can hire in new scientific personnel relatively easily, knowing that they can lay them off again if a project doesn't work. They have ready access to venture capital. Powerful managerial prerogatives in these settings and highly hierarchical firm structures make it relatively easy for managers to impose new risky or unpopular strategies on the workforce. |
By contrast, if we think of German managers, we see they are hemmed in by a broader range of stakeholders, works councils, supervisory boards and the like, which require some measure of consensus in order to secure a shift in firm strategy; this makes it more difficult for German firms or firms in many organised market economies to move into radically new fields of endeavour or radically new technologies. However, firms in organised market economies do have real advantages for securing incremental innovation, namely, superior capacities for making continuous improvements to products and production processes. This is because we find here institutional structures that protect workers' jobs and make it more feasible for them to develop the psychological contract, the commitment that allows the firm to extract certain kinds of knowledge, the kind of shop-floor knowledge that is crucial in many cases to effective incremental innovation. |
If this argument is correct, we should expect to see some patterns of specialisation across nations corresponding to these kinds of advantages, and, indeed, this is precisely what we do find. We find that American firms tend to specialise in sectors that feature radical innovation. German firms tend to specialise in sectors that feature incremental innovation. |
Answering the challenges
Bearing this in mind, let me consider each of the three challenges that I outlined at the outset. Regarding the technological revolution, liberal market economies such as the US, Britain and Ireland seem to have greater capacities for radical innovation and therefore for job creation in precisely the new sectors being thrown up by the industrial revolution: biotechnology, semiconductors, software and telecommunications. Continental Europe is not without some resources here, notably in biotechnology and increasingly in software, but the organised market economies, based on this analysis, at least, should be slower to transfer resources from one kind of activity to another or from one sector to another and, therefore, they should be likely to lag in terms of job creation in the new sectors of the technological revolution. |
This argument suggests that organised market economies have other particular strengths, namely, they are particularly good at diffusing technology through the production process and using it to make the kinds of incremental product and process innovations I was just referring to. They have closer ties to their suppliers. In many cases, the managerial techniques that have accompanied this technological revolution (many of them pioneered in Japan, itself an organised market economy) are easier to implement in settings with long job tenures and close employer-employee relations. The kind of quality control that has become important in this context is something that we think the continental European economies are in many respects better placed to secure, and so they have a comparative advantage compared with the American or British economies. |
Let me turn to the second challenge of the contemporary era, namely, globalisation. Is it going to inspire competitive deregulation powerful enough to push all national economies to a liberal market model? |
There are systematic differences in corporate strategy across liberal market economies and coordinated market economies. So there is no need to assume that firms behave exactly as US firms do. Second, the competitiveness of firms does not depend as heavily on labour costs as many suggest. Indeed, one of the interesting implications of this approach is that firms in liberal market economies should be more tempted to move abroad than firms in organised market economies, because in liberal market economies firms tend to depend more heavily on cost competitiveness and, particularly, labour costs for their advantages. But firms in organised market economies will be reluctant to give up the facilities for non-market coordination that are found in their economies simply for cheaper labor. We expect some movement of activities, but according to a new dynamic. Instead of roaming the world for cheaper labour, many firms will exploit their opportunities to move to take advantage of precisely the comparative institutional advantages that can be found in one nation as compared with another. |
So Nissan will locate its design facilities in California to take advantage of the capacities for radical innovation there. Deutsche Bank will put some of its investment banking operations in Chicago, but, conversely, General Motors will locate its new engine plant in Düsseldorf rather than in Britain--again, to take advantage of the institutional possibilities present in a coordinated market economy. In short, we expect the dynamic of firm movement in the context of globalisation to represent something that might be called institutional arbitrage, which implies movement both to and from liberal and organised market economies. Finally, I think you can see that this analysis suggests that the political dynamic associated with globalisation should be rather different from the one that most expect. |
The final challenge: the rise of the service sector, something that many now consider more serious and more negative from the perspective of job creation than the challenge of globalisation. Indeed, there is no doubt that it is crucial to job creation. To take a slightly extreme example, France created 142,000 jobs in the last trimester of 2000, but only 16,000 of those jobs were in the industrial sector; the rest were in services. Some argue that high labour costs impede the creation of service sector jobs in many parts of Europe. I recently calculated that to hire a new worker in France at the minimum wage, if you wanted to start a firm or run a firm (given high social charges which, as in France and Germany, can come close to 35 or 40 percent of total wage costs), would cost about US$14 an hour and, of course, at $14 an hour about a fifth of the jobs in the American economy would not exist. So there do seem to be grounds for serious concern. |
But I remain optimistic for a number of reasons. First, the service sector is a very broad church. Most of the most pessimistic analyses focus on retailing and, particularly, on personal services, but there are many kinds of business services, financial services, professional services and the like where value added justifies much higher rates of pay, so it's not clear to me that, in order to create service sector jobs, the Continental economies have to accept significantly more inegalitarian wage structures. |
Secondly, as we well know, productivity in services is notoriously difficult to measure, and, given the new technological revolution, there are many reasons to think that productivity in services may be open to more substantial increases than we have seen in previous years. Finally, governments are not entirely impotent here. By subsidising the social charges of those at the low end of the wage scale, it may well be possible to reduce the cost of labour and create jobs without producing significantly greater inequalities in take-home pay. For all of these reasons I think that the distinctive economies of Northern Europe can create jobs and survive the challenges they now face. Optimistic though this analysis is, it is not blindly optimistic. |
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