Commentary Type

Europe's Route Back to Prosperity

Martin Neil Baily (Brookings Institution)

Op-ed in the Financial Times


The good news is that Europe does not need to scrap its generous welfare system to get its economy moving again. Some social programmes may need to be trimmed or cut but more important is changing the way these programmes operate. Europe must learn to take care of low-income families without creating massive disincentives to work. It must also learn to embrace economic change in a spirit of renewal.

Europe is in transition. After a prolonged period of confusion, several countries are starting to enact reforms that will make Europe prosperous again. In Germany, Chancellor Gerhard Schröder has proposed reforming the pension system and setting a 12-month limit on unemployment insurance benefits. In France, Jean Pierre Raffarin, the prime minister, has begun overhauling the pension system and introducing additional "stealth" reforms to keep public disquiet to a minimum.

Many of these proposals, however, continue to focus more on the short-term symptoms of the disease-chronic budgetary overruns and a looming crisis in public finance-than on the disease itself. Misunderstandings persist about the precise steps it will take to lead Europe out of its economic malaise. One problem is the view in much of the continent that anyone who holds a full-time job should be able to support his or her family on the resulting income. While this policy appeals to a sense of fairness, it creates serious problems. If all employers are required to pay high-skill wages for low-skill work, millions more jobs will disappear.

There are, however, changes that would allow countries to keep their strong social safety net while encouraging people to move into, or return to, the workforce.

Allowing employers to pay lower wages for some jobs, but asking governments to make up the difference with a "wage subsidy", would encourage or even require people to move off welfare and take a job, irrespective of the wage.

A wage subsidy would have the added advantage of getting people back into the workforce where their labour would contribute to society. It would also give all able-bodied family members an incentive to work, rather than an incentive to avoid work.

The idea of a wage subsidy is not new. A recent study suggests that 450,000 jobs in France were either created or maintained between 1994 and 1997 by reductions in employer taxes on low-wage jobs (a form of wage subsidy). And in the US, a strong economy, welfare reform and the expansion of the earned income tax credit cut the number of welfare recipients by half between August 1996 and June 2000.

Wage subsidies can also be used as a form of "wage insurance" for higher-skilled, higher-wage workers, thus encouraging greater flexibility in the workforce. In many countries, workers pay into an insurance scheme, so they may collect long-term unemployment benefits equal to 60 per cent or even 80 per cent of their prior wage if they ever lose their job. These are expensive and are a disincentive to re-entering the workforce once you have been sacked or made redundant.

One way to improve this might be to pay these generous benefits to unemployed people only for a short period. Knowing that their entitlement would eventually run out, the unemployed would be more likely to look for a new job. But more incentives and income protection should be built into the system. If, for example, a worker took a new job at a lower wage, the "unemployment payment" could be converted to a "wage subsidy" for a period, making up part of the difference in salary between the new job and the job that had been lost. This would encourage people to take jobs in rising sectors.

Indeed, increased job flexibility is crucial to restoring productivity growth in Europe. Since the mid-1990s, productivity growth in the US has risen by a percentage point or more; but much of Europe has missed out. If France and Germany increased productivity growth rates by as little as half a per cent a year, this would have a huge impact on their budget problems.

But Europe must facilitate and encourage industry restructuring. The French motor industry, for instance, has restructured and seen its productivity rocket.

The recipe for long-term growth is simple: increase the number of people in the workforce and create conditions that make them more productive. Europe is coming to terms with this but it must find the courage to attack the problem that the modern welfare state has created: the disincentives to create jobs, to take jobs or to change jobs. Europe can grow again-but governments must put into place a more flexible, incentive-laden system if they want to see faster, sustainable economic growth.

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