Social Responsibility versus Economic Efficiency?


Alexandre Lamfalussy

By way of introduction

The title of my presentation is a deliberately provocative question. It suggests that there is potential incompatibility between policies aiming at the improvement of economic efficiency and policies seeking to provide a social safety net. The thrust of my argument will be:

But before elaborating let me make a few points. I approach these issues from an explicitly European angle, and by Europe I have in mind essentially the greater part of Continental Europe (of which Euroland is the dominant component). I do not propose to deal explicitly with issues relating to the ten new member countries of the EU. I have also opted for focusing on our current problems, rather than presenting to you a solid, elegant and academically respectable theoretical framework. Both my comparative advantage and the time-limit for this sort of keynote speech invite me to follow this approach. Finally, I would like to apologise in advance for what might appear as somewhat simplistic generalisations in a field where there are substantial differences between the member countries of the EU: there is no such thing as "the" European social model, even though it is arguable that all European social models differ more profoundly from that of the United States than among themselves.

The need for effective safety nets

Those of you who are kind enough to remember my presentation to the first World Science Forum almost two years ago ("Knowledge, Science and Economic Growth: A European Perspective") will recall that among the challenges thrown up by a knowledge-based economy I assigned pride of place to the spectacular speed-up in the rate of structural change, or (what Schumpeter so aptly called) the process of "creative destruction". I concluded that this will put at severe test our European solidarity commitment, which in one way or other has since long been a common feature of the social models of all European countries - but I barely touched on the substance of this challenge. Let me do this to-day.

My starting point is the observation that our increasingly knowledge-based economy (which possesses a seemingly inexhaustible ability to produce innovations) is operating in a global environment which displays a couple of striking characteristics. One is the dismantling of cross-border barriers to the free flow of goods, services, capital, people and, most important, information. This dismantling has been, or will sooner or later be completed inside the European Union; but since a number of years it has also been progressing worldwide, almost without interruption. The fact that China and India are moving towards joining the global "village" represents a quantum jump in this process. Their remarkable economic performance since the early 1990s is good news both for themselves and for the example they show for other emerging countries; but it does throw up serious challenges for all member countries of the European Union, which cannot be swept under the carpet.

Another striking feature of the new environment is the sharply increased competitive pressure on businesses. This is the combined product of several developments. The flow of innovations itself erodes even apparently well entrenched monopolistic positions, which in any case are under active scrutiny by EU authorities. The opening of borders automatically enhances competition. Generalised de-regulation, coupled with privatisations, opens up to competitive pressure hitherto well protected sectors: telecommunications, postal services, water supply, energy, transport, and you name it. One significant, more recent development has been the erosion of pricing power in a number of manufacturing industries, as a result of persistent excess capacities which prevent the transfer of their input-price increases to their customers. Finally, the all-pervasive influence of financial markets imposes on managements the duty to care about short-term stock market developments and, therefore, their quarterly profit and loss accounts.

As a result, rigorous and "real time" cost control has become a condition not only of business success, but in many instances of simple survival. Labour cost control is part and parcel of global cost control. It is quite instructive to observe how the announcement of actual or prospective staff reduction is welcomed, for listed companies, by equity price increases.

The erosion of cross-border barriers opens up a range of opportunities to reduce labour costs for businesses operating in countries where wage costs are comparatively high - and such countries count among themselves not only the 15 "old" members of the EU, but increasingly also the 10 "new" ones. You cannot open a newspaper to-day in Europe, without learning about an "outsourcing" project, the transfer of data processing to a service centre, or an outright location displacement of a manufacturing production facility. For a number of these initiatives the direction is China, South-East Asia or India. Some still continue to flow to the new EU members; but I have observed in a number of instances movements out of these countries to Asia, especially in the case of highly labour intensive investments (which had come into their Central European locations barely 10 to 15 years ago).

May I ask you not to read into these remarks what quite emphatically I do not intend to say. First, I do not ignore that the quantitative impact of these initiatives on employment has so far been much more limited than would be suggested by anecdotal evidence (although the "so far" has to be stressed). Second, even if the numbers were to grow substantially (which may well happen), this would not become a zero sum game: the faster growth of the 10, and the much faster growth of the Asian countries provide an expanding export market for a number of activities located in the 15 in which the added value is higher than the one "lost" as a result of location displacements. This is the traditional argument in favour of trade liberalisation which I consider, with some reservations, basically valid.

"Releasing" labour from industries that lost their comparative advantage and offering to this "released" labour (potentially) better paid job opportunities elsewhere is, however, an abstraction which ignores the hardships associated with this transfer process, which requires the acquisition of new skills and often acceptance of geographical mobility. It would seem to me obvious that setting in motion and facilitating this transfer process should not be left to the sole initiative of the people directly concerned. A social solidarity effort is required. The need for this effort increases geometrically with the speed and the quantitative impact of these structural upheavals - people differ from each other, and they differ quite a lot in their ability to adjust. The radically novel challenge thrown up by the new world environment is precisely the sharply accelerating pace of structural change. In these circumstances I cannot avoid the conclusion that an effective safety net is more than ever needed in our European countries.

But what kind of safety net ? One, I submit, that would help, rather than hinder, to improve Europe's growth performance.

The European conundrum

There are good reasons to be worried about Euroland's recent dismal performance, and even more about prospective developments. The rate of growth of the area's real GDP slowed down from 2.4% in 1981-1990 to 1.7% in 2000-2004. During the same time-span, the rate of growth of labour productivity (as measured by GDP per employed person) fell from 1.4 to 0.7%. {A reminder: in the United States, the mediocre productivity increases of the more distant past - around only 1% - have been replaced since the mid-1990s by productivity increases of 2.5 to 3.0%}. This goes a long way towards explaining why all estimates of potential output growth for Euroland signal a trendwise decline over the past twenty to twenty-five years from close to 2.5 to 2.0%, and forecast a further decline below 2.0%. The basic assumption underlying these forecasts is that demographic trends - ageing and declining population - will further push down the rate of increase in potential output, unless there is a significant improvement in our productivity performance. {Note that the current rate of growth of potential output in the United States can be estimated to be around 3.5%.}

For such improvement to occur, our enterprise sector needs to accelerate its capital accumulation; but even more than that, it has to enhance the productivity of capital. This means achieving a higher incremental reverse capital-output ratio, which then would be likely to lead towards the increase of the most significant measure of the efficiency of an economy, that is to say, of total factor productivity. This is what seems to have happened in the United States for the past ten years. Why did it happen there and not in Euroland?

I share the view of those who, in the case of the United States, attribute crucial importance to the generalised de-regulation of the markets for goods and services which took place there during the 1980s and early 1990s. The result has been fierce competition, strong incentive to innovate and to reduce costs. It was in the IT sector that the largest productivity gains were registered, putting pressure on the prices of hard and softwear alike, thereby spreading the use of these products throughout the economy. It was just as important that de-regulation had a large impact in terms of productivity increases in the services sector: quite clearly in telecommunications, but also in the full chain of distribution, that is, in transport, wholesale and retail trade. The nature of the IT innovations allowed large-scale productivity increases to take place in the integrated purchase, production, distribution flows, which was a vast improvement over the pursuit of productivity gains via IT applications to narrowly defined specific processes without interconnection among them and therefore without being able to exploit the much larger productivity-raising capacity of integrated approaches. There has been progress in this direction in Europe, too, but at a much slower pace. The single market for goods is close to completion, but its benefits for the global economy are only very unequally visible. The most obvious culprit is the lack of generalised de-regulation in the services sectors, which to a large extent has offset the beneficial effects of de-regulation on production. The classic example is the persistence of scandalously large price differences between countries regarding the retail prices of motorcars. More generally, the sad story of the so-called Bolkenstein directive substantiates this proposition. Or take the example of the de facto protection enjoyed by the Italian banking industry which allows Italian banks to feed their PLAs at the expense of their customers - which is not the best way of stimulating the much needed re- structuring of the Italian financial scene. The Commission produced convincing estimates of the potential benefits of services de-regulation for the EU, but of no avail - so far.

In this kind of environment, for European businesses to achieve productivity gains comparable to those realised in the United States becomes a daunting task, the successful realisation of which is not helped by a second major difference between the two areas. The labour market in the United States is highly flexible, while it is not in the greater part of Euroland. Firing is possible only within limits, and even then, at a cost. This is an obvious disincentive for hiring.

It is because of this that Euroland has been caught in a vicious circle. Unemployment has got stuck close to 9% of the labour force, with youth unemployment hovering between 18 and 19%. This is ethically unacceptable, socially disruptive and amounts, in dry economic terms, to an inexcusable waste of resources. It also plays a role by encouraging very high households saving rates and therefore putting a lid on demand-stimulating consumer spending. It is a "bad thing" from every conceivable angle.

Most important, the high level of unemployment makes it extremely difficult politically to grant business managements the freedom to hire and fire without which their ability to react swiftly to competitive challenges is severely impaired. Understandably, those still in employment consider that their main safety net should be the stability and security of their current job. Understandably, because when they look around them and observe the prevailing level of long-term unemployment their natural reaction is to stick to what they have. But by not accepting mobility they undermine the chances of the business sector to act as an engine of growth. This, in turn, implies that (a) those who have lost their jobs will find it increasingly difficult to find new ones, and (b) the financing of the safety net will become a growing, and therefore unsustainable burden for the economy as a whole. A special factor which is likely to aggravate the consequences of this process for the level of employment is that in a number of European countries a large proportion of the safety net is financed by adding to the labour cost incurred by business enterprises. This means that in the case of rising safety net costs, the labour cost increases, without there being any increase in the net income of wage or salary earners. Over time this has driven up in Europe the cost of labour to a multiple of 1.5 to 2.5 of wage or salary earners' net income, as a result of which labour costs are higher than in the United States, while net labour income is lower. Add to this the implied additional labour cost due to the impediments standing in the way of firing, and the disincentive to job creation becomes very strong indeed.

Trying to find a way out

Pulling Europe out of this vicious circle is going to be one of the greatest policy challenges of the coming years. As I see it, the major challenge is this. Sure, there are numerous possibilities of undertaking specific reform initiatives which are worth taking in any case. One is to enhance the job-creating capacity of SMEs - for which a commendable example has recently been set by France. Another is to foster a genuinely enterprise-friendly environment by reducing the administrative or regulatory barriers to setting up new enterprises. I fear, however, that initiatives of this kind (while unquestionably useful) will not add up to a global reform capable of giving a major impetus to European growth.

Any such global reform would have to meet several requirements simultaneously. First, it should give a breathing space to our enterprises which would allow them to adjust gradually to the kind of (otherwise welcome) external shocks as represented to-day by China. Second, it should reduce the perverse incentives produced by our current arrangements to avoid hiring labour even when it would be in the managements' interest to do so. Third, it should achieve these two objectives by market-friendly methods, rather than by having recourse to administrative measures. Fourth, the solidarity commitment should not be watered down - by which I mean that there should be an effectively functioning safety net for all those who are losing their job.

This would require a radical re-shaping of our current social model(s). At the heart of any such reform there should be two simple, interconnected propositions: the prime responsibility for operating, and financing, the safety net should be shifted from enterprises to the national community; and, simultaneously, the safety net would have to be re-defined as the right to receive effective assistance for finding a new job - rather than the right to keep one's job, come hell or high water. Let me try to briefly spell out what these propositions imply.

One clear implication is that the difference between labour cost and net labour income, which I have mentioned a few minutes ago, has to be significantly reduced. If this was done, the resulting reduction in labour cost would immediately improve the competitive position of our enterprises, weaken the incentive to re-locate production facilities, and provide at the same time an incentive to hire labour - on condition, of course, that the various impediments to firing would not be maintained. Any such initiative would have to meet two challenges.

One derives from the fact that the difference to be reduced is a mixed bag (not to mention that the size of the difference, and the composition of the "bag" varies substantially from country to country). Fiscal withholding on employees' income tax obligations should surely not been eliminated. By contrast, contribution to the financing of unemployment benefits, or of the costs implied in finding a new job obviously should. But what about contributions to healthcare insurance or pension rights? The criterion could possibly be that the employer's contribution should cover risks directly linked to the employee's work - for instance, accident - but not illness unrelated to work. But in practice such distinctions are not easy to implement.

The other challenge has to do with the additional tax-burden that would fall on the shoulders of taxpayers as a result of the transfer of the safety net costs. By raising what kind of taxes should these costs be financed? And should the answer be, say, income taxes, how can one make sure that any such increase would not offset the (hopefully) growth-stimulating effect of the whole exercise? Or should we accept a deterioration of the global fiscal balance - on the ground that such deterioration would only be transitory, since the acceleration of growth will correct the deterioration? My own inclination, resulting undoubtedly from my central banking background, would be to regard such course of action as a risky choice. I would rather recommend a hard look at what kind of other public expenditure could be cut. Surely not money spent on investment, and even less on education and research.

Let me now come to the second proposition: to the re-definition of the content of the safety net. This would raise far more demanding challenges than would the first proposition. To begin with, as already mentioned, the current level of unemployment provides in most of our countries for those actually employed a powerful incentive for trying to remain employed where they are - or at least to spread over time, by attrition, the "release" of "human resources". To quote one example, I noted in several recent wage negotiations that the trade unions were ready to accept wage freezes or very moderate wage increases in exchange of a commitment to maintain the level of employment.

How could we overcome such refusal of labour mobility? Admittedly, we should argue that all evidence, be it historical or cross country, points to the blatant failure of the "within the firm" safety net to preserve an acceptable level of employment - while, by contrast, those countries which have accepted labour mobility have been relatively successful in avoiding large-scale unemployment. But such argument, unless accompanied by a credible safety net arrangement, is unlikely to carry much weight. I simply do not believe that we could, or indeed should, follow the US example of labour mobility combined with very limited safety net arrangements. We should rather try to follow the example of the, unfortunately few, European countries where those who lose their job enjoy financial protection while they are unemployed and receive help for finding a new job.

The main features of such a safety net could be as follows: (1) A level of unemployment compensation which, during a limited period, would come close to the lost income; (2) At the end of this period, the amount of compensation would start declining, to reach a level which should not constitute a disincentive to the search of a new job; (3) The speed of this decline, and the time by which the floor is reached, as well as the period during which this floor is maintained should depend on the acceptance, or rejection, of "reasonable" job opportunities offered to the unemployed person. If no such opportunities are forthcoming, the speed should be slower and more time should be given to reach the floor and maintain the compensation at that floor. But if they are, rejection would entail accelerated decline to the floor, and a speedy end of the whole system of compensation.

To enhance professional mobility, the key feature of the scheme should be the provision of generous re-training opportunities. To facilitate geographical mobility, financial assistance should cover the greater part of the cost involved in moving to another location. Additional incentives could also be envisaged, of which the portability of pension arrangements is a good example. It is the efficient combination of such measures that would give a practical content to the meaning of a "reasonable" job opportunity. The likely success of such a system crucially hinges on (a) the ability of the unemployed to acquire new skills and (b) an increasing demand for labour by the business sector, which itself depends on the acceleration of growth. We have to face up to the fact that neither of this will happen overnight.

The success of re-training depends a lot on the adjustment capabilities of the concerned persons. There will always be differences in this regard between people, but there are ways and means of enhancing these capabilities. Efforts in this direction should start from the first steps in our social life - in the family and in the kindergarten, and during our school years - which puts a heavy burden on our educational and school systems. Such efforts should continue throughout our professional life: this is what we call in French "une éducation permanante". The heart of the matter is that in a knowledge-based economy, moreover one which functions in a globalised system, there are a lot of surprises. We cannot prepare ourselves gradually, both mentally and in terms of skills, to a well identified occupational challenge; we have to take up the challenge when it comes. And it is only when this challenge arises that specifically focused re-training can begin, which then falls on a fertile ground if and when it has been preceded by "une éducation permanente".

The greater part of the costs implied in this life-long process should be borne by the national community, but not all of it. Enterprises should contribute to it: it is their obvious interest to promote intra-firm mobility; and there should also be a contribution by the concerned individuals.

Putting in place such a broad-based system takes time; and it will take years before it yields results in terms of effectively increased mobility. Similarly, the advantages that would be offered to business leaders are unlikely to be exploited with great speed. It took quite a long time in the United States before deregulation, combined with other "supply side" policies began to yield tangible results in terms of sustained faster growth, implying both an acceleration of productivity increases and job creation. Unfortunately I see no reason why, all other things remaining equal, it should happen more speedily in Europe. But this simply stresses the need for an urgent beginning.

Concluding remarks

By way of conclusion, I propose to very briefly address a legitimate concern: that the problem with the European economy has not been only the deceleration of the growth of its potential output, but also the inadequate expansion of domestic demand, which bears a non negligible responsibility for our high level of unemployment. I share this concern, but I disagree with those who argue that this could, or indeed should, be remedied by resorting to the two traditional macro-policy management tools, that is, to monetary and/or fiscal policy relaxation.

Forget about monetary policy. Anyone who cares to have a glance at the ECB's monthly bulletin (which should be made compulsory reading for politicians) knows that since mid-2001 broad money supply has been growing on average at the rate of around 7%, with the latest figure touching 8%. This has led to a sizeable "real money gap", which signals abundant liquidity. And if you are allergic to these "monetarist" reminders, consider that at 2% the ECB's key interest rate is in fact slightly negative in real terms. Moreover the 10 year government bond rate is 3.4% for the Euro area as a whole, which both in nominal and real terms is at a level that has not been seen since more than a century.

With such facts in mind, it would require a generous dose of imagination to believe that a further relaxation of monetary policy would significantly stimulate domestic investment and consumption. Since I do not possess such imagination, I do not believe that it would. But it could represent an inflationary danger in a medium-term perspective, and it would surely pile up trouble for the future by entertaining real-estate bubbles, which have the nasty habit of a sorrow ending.

But what about fiscal policy? It would seem to me difficult to argue that a relaxation of the current fiscal policy stance could provide no stimulus whatsoever to domestic demand in Euroland. Initially, and for a short period, it possibly could - but at a very high price. Public opinion is no longer ignorant to the point of not realising that any such relaxation would come on top of the rather cavalier way in which almost half of Euroland's member countries handled their commitment to the Stability and Growth Pact, which has seriously undermined the credibility of their future fiscal policy commitment. It is easy to lose credibility, much harder to regain it. And this happened at a time when the same public opinion has become acutely aware of the need to reform our health care and social security systems and to draw the appropriate conclusions, for our pension systems, of the aging (and declining) prospects of our populations. No wonder that the citizens of Euroland are disinclined to abandon their high propensity to save. To the prospective increase of the public debt burden they could even react by increasing their saving rates.

This does not mean that there is no hope of stimulating domestic demand. For reasons just mentioned, I would not recommend debt-creating fiscal policy relaxation. But there are ways of re-shaping public expenditure or the system of taxation which would give an incentive to raise capital expenditure, without increasing the fiscal deficit. I would favour in particular measures taken to encourage the development of small and medium-sized firms, which as a group are much more likely to create jobs than large firms - though I would certainly not recommend discriminating against large firms, without which the chances of turning small firms into medium ones would be severely limited. In the same spirit, the emphasis should be put on services, rather than on manufacturing industry: in all developed countries, employment in manufacturing is on a declining trend which cannot, and should not be reversed. It is for this reason that saving the core proposals of the Bolkenstein directive is of major importance.

More generally, the "supply side" or "structural" reforms which have to play a key role in accelerating the rate of growth of Europe's potential output are likely to have also a favourable impact on consumption. What holds back consumption expenditure in Europe is to a large extent lack of confidence in the future. I trust the common sense of our citizens who would gradually recover their confidence if they were to witness the determination of our political masters to conceive and implement the necessary reforms. There are signs that this is beginning to happen; so let us cross fingers!